A partial plan termination is when 20% or more of your employees are laid off in a given year. If all 20% or more are participants in the company retirement plan, then this layoff causes them to automatically become 100%-vested. Employers must then pay out the benefits sooner rather than later.
Many businesses may have experienced partial plan termination due to layoffs letting employees go permanently during the global health and economic crisis. If your business has a tax-qualified employee retirement plan, these layoffs may trigger this specific event called a partial plan termination that can have serious consequences for the plan and your business.
What Is Partial Plan Termination?
If your business has a retirement plan for employees (like a 401(k) plan) and you lay off more than 20% of your total plan participants in a year, you may have created a partial plan termination. This is a significant plan event that affects the status of your plan with the IRS and the Pension Benefit Guaranty Corporation (PBGC), which insures certain defined benefit plans.
Having a partial plan termination occur may mean that all the employees whose jobs you terminated become 100%-vested in your company’s retirement plan and that you must pay out their benefits sooner rather than later. Normally, employees reach 100% vesting if they stay employed and in the plan for a specific number of years. Once this is true, they own all of their retirement account.
Vesting means ownership. An employee’s contributions to a plan are always 100% vested, so the employer cannot forfeit, or take them back, for any reason. An employee also vests (owns) a certain percentage of the employer contributions to their retirement plan account each year, depending on the plan documents.
Types of Partial Plan Terminations
The IRS looks at the types of terminations in a year at companies to determine if a partial plan termination has occurred. Employee terminations initiated by the employer are counted in the 20%, including those driven by events outside the employer’s control, such as depressed economic conditions. Death, disability, or retirement of employees aren’t included because these events weren’t started by the employer.
Routine turnover, even if it’s 20% or more, does not figure into a partial plan termination. Keep good records to be able to show your turnover rates in the past.
The IRS looks at the facts and circumstances of each situation to determine whether a partial plan termination has occurred.
How Partial Plan Termination Works
A partial plan termination for your company’s retirement plan, whether it’s a defined contribution or defined benefit type, triggers a sequence of events:
- If you’ve laid off a qualifying 20% or more of your workforce in a particular year due to events beyond your control, this may cause a partial plan termination.
- Next, all participating employees who were laid off or terminated during the year must be 100% vested in their employer matching contributions and other employer contributions, regardless of years of service.
- You must pay out retirement or pension benefits to these terminated employees within a specific number of days, depending on the plan type.
- The vesting calculation for employees affects the funding of your defined benefit retirement plan because the plan is funded each year by counting all the percentages of participants’ vesting.
- The resulting underfunding of a defined benefit plan could result in an underpayment from the plan to participants, which triggers a requirement to report this change to the plan participants and the PBGC.
How Vesting Works
How much you give employees as a benefit distribution in this situation depends on the type of vesting provided for in your company’s retirement plan.
All contributions by an employer and employees in Simplified Employee Pension Plans (SEP), SIMPLE IRAs, and other IRA-based plans are 100%-vested immediately. Vesting can be granted to employees in different ways.
In cliff vesting, the employee has 0% vesting until a specific number of years of service. Then they are 100% vested. In graded vesting, the employee has an increasing percentage of vesting each year until they reach 100%. An employee who voluntarily leaves the company before being vested forfeits their right to any amounts not vested.
A retirement plan distributes vested benefits as described in the plan documents, usually within a specific number of days after your plan year ends. Unless your plan states otherwise, if you fire or lay off 20% or more of your employees, and a partial plan termination is triggered, you must give them their vested retirement benefit (both their own contributions and your company’s contributions) within 60 days after the end of the plan year. For example, if you laid off employees in April 2020, and your plan year ends Dec. 31, 2020, you must give employees their benefits by March 2, 2021.
Here’s an example of how vesting might work for an employee with two years of service. For the purpose of this example, let’s say that if the company offered cliff vesting, the employee would be vested after three years, and if it offered graded vesting, the employee would receive 10% vesting for each year of service.
|Cliff Vesting||Graded Vesting|
|Employee leaves voluntarily or is laid off (no partial plan termination)||0%||20%|
|Employee is fired or laid off (partial plan termination)||100%||100%|
What Happens When the Plan Is Underfunded?
The IRS sets minimum funding requirements for retirement plans. An enrolled actuary computes the funding required for defined benefit plans (with a pension). For money purchase plans (with contributions by employers and employees) the funding requirements are set in the plan documents.
If your plan becomes underfunded, you must report this status to plan participants. The PBGC may impose penalties for not informing employees about this situation, if that’s not done.
There are two possibilities to avoid penalties:
- You may be able to get a determination from the IRS on whether your plan does or does not have a partial plan termination. Your plan administrator can file Form 5300 Application for Determination for Employee Benefit Plan for this purpose.
- The IRS has a Voluntary Correction Program (VCP) to encourage plan administrators to correct compliance failures.
Before Laying Off Employees
Most retirement plans have a retirement plan administrator that is familiar with plan rules. Before you lay off employees, consider the effects of the job terminations on your retirement plan:
- Review your plan documents to see when employees are vested and when the plan documents say they can take their distributions.
- Calculate the plan liability for each laid-off employee based on the difference between their current vesting in the plan and the 100% vesting level.
- If underfunding is a possibility with a defined benefit plan, prepare for the reports you must send to the PBGC, and consider next steps.
Employee retirement and pension plans are regulated by the IRS, the Department of Labor (under ERISA), and the PBGC. These regulations are complicated, and each business situation is different. Get help from your plan administrator before you make any decisions—including layoffs—that could affect your company’s retirement plan.