Proceed with Caution

Over the last few months, I have received many calls from employers (and their advisers) regarding the mechanics of terminating their 401(k) plans. The impetus behind the calls is varied and many employers are surprised to learn that, under certain rather frequently encountered circumstances, they cannot distribute the elective contributions from their terminated 401(k) plans. Why would this be the case, especially where the 401(k) plan, by its very terms, provides that the employer may, in its sole discretion, terminate the 401(k) plan and that, following such termination, the plan’s assets will be distributed?

There is an often overlooked provision within the Internal Revenue Code (in Section 401(k)(10)(A)) that provides that a distribution of elective contributions under a 401(k) plan is only permitted following termination of such plan if the employer does not establish or maintain another defined contribution plan or successor plan. To understand how this rule applies to the real world, it is helpful to focus on the relevant parts of the rule.

First, the term “employer” is determined as of the date the 401(k) plan is terminated. Second, the plan is considered “terminated” as of the execution date of the Board resolution or other similar legal action. Third, the term “successor plan” means any other defined contribution plan maintained by the same employer (the employer terminating its 401(k) plan) if it exists at any time during the period beginning on the date of the plan termination and ending 12 months after distribution of all assets from the terminated plan. Significantly, “successor plan” is a broad term and not limited to the establishment of another 401(k) plan. Rather, the term “successor plan” includes other defined contribution plans such as money purchase pension plans, profit-sharing plans, and target benefit plans. By contrast, the establishment of the following types of plans are not considered successor plans and, therefore, will not prohibit distribution under the Section 401(k)(10)(A) rules: 403(b) plans, 457 plans, employee stock ownership plans, simplified employee pensions (SEPs), and SIMPLE IRA plans.

So, how does this rule work? Consider the following example: Employer A terminated Plan A (a 401(k) plan) on October 1, 2007, and completed distribution of Plan A’s assets by March 30, 2008. Employer A then established Profit Sharing Plan A on January 1, 2009. Is this permissible? No. Employer A’s actions violate Section 401(k)(10)(A) because it established a successor plan within 12 months after distribution of all assets from Plan A.

An Exception

Notwithstanding the rule described above, there is an exception that frequently is overlooked and that, in certain circumstances, may permit the employer to distribute elective contributions under its terminated 401(k) plan, even where another defined contribution plan is maintained. Under this exception, if fewer than 2% of the eligible employees under the employer’s terminated 401(k) plan would be eligible under the other defined contribution plan during the 24-month period beginning 12 months before the 401(k) plan termination, then the other defined contribution plan will not be considered a “successor plan.”

So, how does this exception work? Consider the following example: Employer A maintains two divisions, Division I and Division II. Division I maintains 401(k) Plan I and Division II maintains 401(k) Plan II. Employer A terminated and distributed the assets of 401(k) Plan I. Are Employer A’s actions permissible since Employer A maintains another defined contribution plan, 401(k) Plan II? If the employees of Division I were not eligible to participate in 401(k) Plan II during the 12 months prior to the termination of 401(k) Plan I, as well as the 12 months following the termination of 401(k) Plan I, then Employer A’s actions are permissible. If, however, the employees of Division I were permitted to participate in Division II’s plan immediately following termination of 401(k) Plan I, then Employer A’s actions would violate the rules under Section 401(k)(10)(A).

The moral to the story is that it is important to consider the Section 401(k)(10)(A) rules prior to terminating a 401(k) plan. It is not sufficient simply to work with an employer to terminate its plan without also exploring with the employer its intentions with respect to retirement benefits during the 12 months following plan termination and distribution of assets. Failure to engage in such discussion and to provide appropriate guidance may lead to some unwelcome surprises.

Quana C. Jew is a partner at the law firm of Arent Fox LLP, focusing on ERISA, employee benefits, and executive compensation. Quana frequently serves as a guest lecturer in these areas for various law schools, bar seminars, and employee benefits-related organizations. Washingtonian magazine has repeatedly named Quana as one of Washington’s best tax lawyers.