Clients often ask if they are required to vest employees when they terminate employment. The answer is usually no. Although employers may vest an employee’s 401(k) account balance on termination, they are generally not required to do so.
You said “generally” – so, when is it required?
Good catch. Employers must vest 401(k) account balances if it is required by contract or if they determine that the plan has experienced a “partial plan termination.”
Contracts may require that an employer vest the balance of employees on certain events. This comes up most often when a purchase agreement requires the buyer in a corporate transaction to accelerate vesting for employees who are involuntarily terminated during a certain period following closing or if an existing employment agreement requires vesting if an executive is involuntarily terminated during the term of the employment agreement. So, plan sponsors should check plan documents before conducting an employer-initiated termination.
The Internal Revenue Code (“Code”) also requires plans to vest the balances of employees who are affected by a partial plan termination. Under Internal Revenue Code (“Code”) Section 411(d), a plan is considered partially terminated if there is a significant change to the plan or a significant corporate event that affects the rights of employees to vest in their plan benefits. The IRS generally deems a partial plan termination to have occurred if 20% of total plan participants (excluding former employees) are terminated outside of normal annual turnover during a plan year or in connection with the same corporate event (e.g., a long-term reduction in force that crosses plan years). While a 20% turnover rate is rare in normal circumstances, more plan sponsors have approached or passed this mark as a result of employee terminations in connection with COVID and the related economic downturn.
Note, however, that the 20% presumption of a partial plan termination may be rebutted if the facts and circumstances demonstrate that the plan did not suffer a partial termination. For example, if a plan sponsor terminated 25% of employees in March 2020, but later rehired half of the employees, then a partial plan termination may not have occurred. Therefore, we advise that plan sponsors (i) keep good records related to employee terminations (and rehires) during the year and (ii) wait until the end of a plan year to determine whether a partial plan termination has occurred.
But we may vest employees if we would like to, right?
Yes, it is absolutely fine to vest employees in a non-discriminatory manner who experience a termination of employment and, in fact, this is not unusual in circumstances like those we find ourselves in today. Discrimination concerns arise under Code Section 401(a)(4) if, for example, a plan sponsor decides to accelerate vesting only for highly compensated employees. Not only will this help participants retain their retirement savings and provide additional capital if they decide to take advantage of a plan loan or in-service withdrawal in an emergency, it will also insulate the employer from a partial plan termination and avoid a significant forfeiture balance.
Anything we should keep in mind if we do not vest people (and are not required to do so)?
Yes. As alluded to above, the plan’s forfeiture balance may increase significantly if a large number of employees are terminated with unvested balances. This forfeiture balance must be exhausted during the plan year in which they are incurred or, in appropriate circumstances, no later than the following plan year either to (i) fund employer contributions or (ii) pay plan expenses. This may create a challenge for plan sponsors, especially those that suspended employer contributions this year but have growing forfeiture balances.
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