News and Commentary

401(k) Plan Sponsors Must Be Careful of Unintended Partial Plan Terminations By Olga Ismail

Employee terminations and extended furloughs spurred by the COVID-19 health crisis are setting off a tsunami of partial 401(k) plan terminations that employers must be prepared to address, both administratively and financially. Failure to do so may jeopardize a plan’s tax- exempt status and expose the plan sponsors to substantial tax penalties and legal claims.

A partial termination of a qualified 401(k) plan occurs when an employer permanently lays off “a significant percentage” of plan participants in a particular year, whether due to deliberate downsizing or adverse economic conditions outside the employer’s control. IRS guidance generally defines this turnover rate as employer-initiated terminations of 20 percent or more of all plan participants during an applicable period.

At the point that a partial plan termination occurs, the employer has a requirement to fully vest plan participants whose employment was severed during the applicable period, including those employees who left the company voluntarily during the year and may continue to maintain an account balance with the plans. This is similar to what happens when a company closes its doors and fully terminates its defined-contribution plan. The plan sponsor must immediately pay affected plan participants 100 percent of the employer-match and profit-sharing contributions promised, regardless of the vesting schedule or the employees’ actual years of service.

It is critical for employers to recognize that employee terminations do not automatically result is a forfeiture of employees’ accrued benefits. Rather, employers must wait until the end of the plan year, or other applicable period, to determine if they must pay unvested funds, plus accumulated earnings, to laid off workers or if they may use forfeited funds for the benefit of their remaining plan participants.

Calculating the Turnover Rate

 According to the IRS, employers may determine their turnover rate by dividing the total number of employees involuntarily terminated at the end of the plan year (or other applicable period) by the sum of all plan participants at the start of the plan year plus any additional employees who joined the plan or were automatically enrolled in the plan during the applicable period. All plan participants include every employee eligible to contribute to an employer-sponsored 401(k) plan during an applicable year, regardless of their vesting status and whether or not they previously made any salary-deferred contributions to that plan.

Specifically excluded from this calculation of turnover rate are employees who voluntarily resigned or retired from employment as well as those who were temporarily furloughed and then rehired later in the plan year. In addition, plan sponsors with a 20 percent or more reduction of plan participants can avoid a partial plan termination when they can demonstrate that such a turnover rate is routine for their businesses.

With less than two months before the end of the year, it is critical for employers to review the status of their furloughed and terminated employees and determine if they are close to the 20 percent turnover rate. While they may avoid a partial plan termination by rehiring workers and bringing them back into their 401(k) plans before the year closes, it may not be a viable option. Instead, plan sponsors should ensure they maintain meticulous employee files and financial records while practicing patience and waiting until the end of the plan year before allocating what they assume to be forfeited employee funds. Acting too fast can be an a significantly expensive and time-consuming risk that business cannot afford during these uncertain economic times.

About the Author: Olga Ismail is a retirement plan consultant with Provenance Wealth Advisors (PWA), an Independent Registered Investment Advisor affiliated with Berkowitz Pollack Brant Advisors + CPAs, and a registered representative with Raymond James Financial Services. For more information, call (954) 712-8888 or email

Provenance Wealth Advisors (PWA), 515 E. Las Olas Blvd., Ft. Lauderdale, FL 33301 (954) 712-8888.

Olga Ismail is a registered representative of and offers securities through Raymond James Financial Services, Inc., Member FINRA/SIPC. Raymond James is not affiliated with and does not endorse the opinions or services of Berkowitz Pollack Brant Advisors + CPAs. PWA is not a registered broker/dealer and is independent of Raymond James Financial Services. Investment Advisory Services offered through Raymond James Financial Services Advisors, Inc., and Provenance Wealth Advisors.

This material is being provided for information purposes only and is not a complete description, nor is it a recommendation. Any opinions are those of PWA and not necessarily those of Raymond James. You should discuss any tax or legal matters with the appropriate professional. The information contained in this report has been obtained from sources considered to be reliable, but Raymond James does not guarantee that the foregoing material is accurate or complete.

401(k) plans are long-term retirement savings vehicles. Withdrawal of pre-tax contributions and/or earnings will be subject to ordinary income tax and, if taken prior to age 59½, may be subject to a 10% federal tax penalty. Investing involves risk, investors may incur a profit or loss regardless of the strategy or strategies employed. Future investment performance cannot be guaranteed. Matching contributions from your employer may be subject to a vesting schedule, please review your retirement plan documents or consult with a financial professional for more information.