When a plan sponsor establishes a defined contribution plan, its intention is to continue that plan indefinitely. But things can change—a sale or dissolution of the company, a lack of employee interest, or a long-term financial distress of the sponsor—which make it desirable, or even necessary, to terminate the plan. Terminating a defined contribution plan is not difficult, but it does require certain specific steps and considerations.
Step 1: Officially Terminating the Plan
In order to officially terminate the plan, the plan sponsor must adopt resolutions which provide, at a minimum, for the effective date of the termination and the authorization and direction for designees to carry out the remaining steps of the termination process. The resolutions also may explain the reason for the plan termination, provide for specific steps to be taken, and adopt any needed plan amendments. Note that the form of a plan document must be fully up-to-date before it can be terminated, as further discussed below.
Step 2: Plan Operation Following Termination of the Plan
Once the termination effective date happens, certain plan functions must cease, while others must continue as usual. What this means is, now that the plan is terminated:
- No new participants may enter the plan
- No new contributions will be accrued or deferred into the plan
- All participants become fully vested
- All participants must be notified of the termination
But there are plan assets remaining in the plan, so:
- Participants may continue to make changes to their investments (assuming it is a participant directed plan)
- Qualified domestic relations orders must continue to be reviewed and processed
- Distribution requests must be processed (see discussion below regarding distribution considerations)
- Form 5500 (Annual Return) must be filed for every plan year until all assets have been distributed, after which a final Form 5500 must be filed. For example, if a calendar year plan is officially terminated in November 2022 and the assets are fully distributed by June 2023, then a Form 5500 will be filed for the 2022 plan year and then a final Form 5500 will be filed for 2023.
Step 3: Distributing the Plan Assets
Defined contributions plans may only provide for distributions to participants when certain events happen, including termination of employment or retirement; while still employed, distributions are often triggered by such events as reaching a certain age, suffering a disability, or at death. The plan document must describe these “distributable events.”
Plan termination is also a distributable event, provided there is no continuation of another qualified plan within the sponsor’s controlled group or any successor qualified plan. In fact, once a plan has been terminated, all of the assets of the plan must be distributed within a reasonable time, generally 12 months, or be deemed to be an ongoing plan and subject to ongoing qualification requirements.
Participants must be provided the opportunity to elect how their distributions will be made, including the opportunity to roll amounts into an IRA or other qualified plan. The good news is that the plan can set a deadline by which participants must make an election; and, if they fail to make any election, the accounts can be distributed without the participants’ consent, even if they hold amounts in excess of $5,000. Where a participant fails to make an election directing the distribution, their account must be automatically rolled into an IRA on behalf of the former participant, which has been set up with a custodian with whom the plan sponsor has contracted to take such assets
Other Considerations When Terminating a Plan
Various other compliance issues are involved in a plan termination, but the specific tasks required will vary depending on the circumstances. Keep in mind the following:
- Participant Communications. It will be very important, when terminating a plan, to communicate with participants about what is happening. Not just that the plan is terminating, but how that affects them, what they need to do, the deadline for making distribution elections, and so forth. In addition, information about why the plan is terminating may also be important to communicate, especially if there is a sale or dissolution of the company, As with all participant communications, the information should be conveyed in a clear, and comprehensive manner, understandable to the average participant.
- Forfeiture Accounts. If a terminating plan has a balance in the forfeiture account, then that account must be fully exhausted along with other plan assets. This might mean using the forfeitures to pay remaining plan expenses or allocating them to participants, depending upon the plan provisions and the circumstances. If an allocation is needed, this should be completed before distributions commence.
- Amendments to the Plan. For a termination to be effective, the plan document must be up to date with changes in law as of the date of the termination. The IRS has indicated that stand alone amendments are sufficient, and complete plan restatements are not necessary when a plan is terminated. Therefore, a preliminary step in a plan termination is to assess whether the plan document is up-to-date with all required interim amendments through the termination date, and then to adopt any outstanding amendments. Note that if the plan assets are not distributed within a reasonable period (see above), the plan is deemed to be ongoing (not terminated), which may require additional amendments even after the termination effective date to reflect subsequent changes in law.
- File for a Determination Letter. In years past, it was common for a terminating plan to apply for a favorable IRS determination of the plan document’s tax-qualified form, but this is no longer expected for a plan that is stated in a pre-approved document. However, the IRS will accept determination letter applications for a terminating plan. Filing the necessary application form, Form 5310, takes time, however, and involves a user fee and preparation expenses. A plan sponsor should therefore consider applying for a determination letter only in circumstances that justify the costs.
- No Successor Plan. As mentioned above, a plan termination is a distributable event unless there is another qualified plan in the plan sponsor’s controlled group, or a successor plan. The plan sponsor who terminates its plan may not establish a new qualified plan for at least twelve (12) months following the date the plan assets are fully distributed. Otherwise, the new plan is considered a successor to the prior plan, and therefore there was no distributable event. This will then taint the new plan with an immediate qualification failure. If the intention if for the plan sponsor to establish another plan, then timing should be taken into consideration before terminating the plan.
- Corrections and Audit Risk. Once the plan is terminated and all assets distributed, it can still be audited in subsequent years. For this reason, it is important to make sure that:
- any operational or document failures are corrected prior to the distribution of all plan assets;
- the termination process is done in a thorough and compliant manner; and
- all documentation for the plan is retained for at least 7 years after the termination.
Gather a Team and Plan Ahead
All of this taken together may seem overwhelming to a plan sponsor. But the plan sponsor should not attempt to take on a plan termination alone. The plan sponsor will work closely with the plan’s third-party administrator to go through the termination process and distribution of plan assets. Consultation with benefits counsel is also important to help navigate the requirements, considerations, and best practices of terminating a defined contribution plan.