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Welcome to the Retirement Learning Center’s (RLC’s) Case of the Week. Our ERISA consultants regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans, and other types of retirement savings and income plans, including nonqualified plans, stock options, Social Security, and Medicare. This is where we highlight the most relevant topics affecting your business. A recent call with a financial advisor in Arizona is representative of a common question on the successor plan rule.
“My client has a 401(k) plan with very low participation. He is thinking of terminating the plan and starting a new one. Is there anything that prevents my client from terminating the plan and starting a new 401(k) plan?”
In most cases, with limited exceptions, the “successor plan rule” would prevent terminating a 401(k) plan and immediately replacing it with a new 401(k) plan. Your client may want to consider amending the existing plan to improve it rather than terminating it.
Specifically, the successor plan rule of IRC §401(k)(10)(A) and Treasury Regulation Section (Treas. Reg. § 1.401(k)-1(d)(4)(i)] provides that a 401(k) plan that is terminated cannot distribute participants’ elective deferrals if the employer maintains or establishes another 401(k) plan at any time during the period beginning on the date of plan termination and ending 12 months after all the assets from the terminated plan are distributed. A similar rule exists for 403(b) plans in Treas. Reg. § 1.403(b)-10(a)(1).
Consequently, a sponsor could not terminate a 401(k) plan and replace it with another 401(k) plan within the 12-month waiting period. Similarly, a 403(b) sponsor could not terminate a 403(b) plan and replace it with another 403(b) plan within the 12-month waiting period. (However, if a sponsor terminates its 403(b) plan, it may set up a 401(k) plan with no waiting period if it is otherwise eligible to do so, and vice versa.)
The successor plan rule was created to prevent employers from circumventing the age 59½ early distribution restriction that applies to salary deferrals by simply terminating a 401(k) [or 403(b)] plan, allowing withdrawals, and immediately establishing a new successor plan. Plans that violate the successor plan rule risk disqualification, taxation of assets, and penalties.
For a 401(k) plan, Treasury Regulation 1.401(k)-1(d)(4)(i) states that the following defined contribution plans are not considered successor plans:
Employee stock ownership plans (ESOPs),
Simplified employee pension (SEP) plans,
Savings incentive match plan for employees (SIMPLE) IRA plans,
403(b) plans, or
457(b) or (f) plans.
There is one more exception. Plans that otherwise would be considered a successor plan are notified at all times during the 24 months beginning 12 months before the date of plan termination. Fewer than two percent of the employees eligible to participate in the 401(k) plan at the time of its termination are eligible to participate in the new defined contribution plan.
The successor plan rule prevents 401(k) plans and 403(b) plans that are terminated from distributing employee salary deferrals from the terminated plan if the employer maintains or establishes a like plan too soon.