Impact of employee reduction on employee benefit plans

Valuable Information on 401ks, Pensions, ESOPs, Form 5500 Preparation + More

In the wake of the COVID-19 pandemic and the resulting economic uncertainty, employers are faced with decisions that could have significant impacts on their 401k retirement plans. A serious decision that employers face is a potential employee reduction. It is important to consider the impact this decision can have on the retirement plan. A reduction in workforce can cause two main issues, triggering of 100% vesting and a bump in 401k loan defaults.

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Triggering 100% Vesting in a 401k Plan

If a 401k plan is “partially terminated” all participants who have been affected by the partial termination and who are not yet fully vested in their plan benefits must become fully vested. A partial termination has generally been determined to be a termination of 20% or more of the total number of plan participants. So, if an employer terminates 20% or more of their participating employees all the terminated employees will receive the full amount of employer contributions made to their plan accounts when they take their distributions from the plan. Another factor that can affect whether 100% vesting is triggered is how the workforce is reduced.

A layoff is considered termination and therefore will result in a plan being partially terminated if 20% or more participants are laid off. However, if employees are furloughed it will depend on the specific facts and circumstances such as the length of the furlough, method of vesting measurement, and other factors to determine if a plan has been partially terminated. Employee benefits attorneys should be consulted to verify if 100% vesting has been triggered.

401k Loan Defaults

Significant reductions in employees could result in an increased number of employees defaulting on their 401k loans. It is common for plan provisions to require the payment of the entire remaining principal and interest of the loan upon the employee’s termination and may not allow manual repayments following termination which makes it even more likely laid-off employees will default on their loans. Furloughed employees may also end up defaulting on loans if they are only able to make payments through payroll deductions.

A defaulted plan loan results in the unpaid portion being deemed a distribution, which is subject to ordinary income tax and could be subject to a 10% penalty. While the Cares Act provides some relief by delaying certain loan payments for furloughed and laid off employees this will likely add additional burdens to the employees as well as create additional administrative work for employers, especially where furloughed employees are involved.

Due to the Coronavirus Aid, Relief and Economic Security Act (the CARES Act) plan amendment deadlines have been changed. Plan sponsors have until at least the last day of the first plan year beginning on or after January 1, 2022 (i.e., December 31, 2022 for calendar year plans) to amend their plans to implement the relief provided by the CARES Act. As such 401k plan’s loan procedures can be changed to prevent employees from automatically defaulting on their loans if they are laid off or furloughed.

For more information and resources on COVID-19, see our coronavirus page. Feel free to contact your Henry+Horne tax adviser with any questions.

Davis Smith, CPA