Terminating a 401(k) plan is a significant decision with legal and financial consequences. This article explains when termination is appropriate, what alternatives to consider, and how the process works from start to finish.
Terminating a 401(k) plan is a complex process with several important considerations. Depending on your circumstances, there may be alternatives worth considering before moving forward.
The Internal Revenue Service (IRS) requires a 401(k) plan to be established with the intent of being permanent. However, a company is not required to provide a retirement benefit and can elect to terminate its 401(k) offering for valid reasons.
According to the IRS, acceptable reasons for terminating a qualified retirement plan may include a change in ownership by merger, reorganization, or a change in the law. Certain circumstances require plan termination, like the dissolution of the sponsoring employer or the death or retirement of a sole proprietor. If an entity no longer exists, it can no longer sponsor a plan.
Important: If you terminate your plan, the IRS will not permit you to establish a new 401(k) plan within 12 months of the final liquidation date.
Before terminating, you may want to consider other options:
Changing or reducing employer contributions.
Increasing eligibility requirements.
Transferring to a new 401(k) provider.
Merging with another plan.
Freezing the plan.
If your company is undergoing a merger or acquisition, you may have the option to merge, transfer, or spin off all or part of your plan. We recommend consulting an experienced Employee Retirement Income Security Act (ERISA) attorney to advise on your options and considering the effect on the 401(k) plan before the transaction is completed.
Once Gusto Retirement receives your termination request, the trustee will need to sign and date a plan termination amendment through a task on their dashboard. Currently, only the trustee can complete the plan termination task. If you need to change the individual for this role, here's how to submit the request.
The plan will remain active until all required documents are completed and approved.
Once we have received all signed documentation, our team will begin the termination process. It generally takes at least 90 days from the plan termination date to wind down the plan and distribute all assets, but complications like uncashed checks can extend the timeline.
Once the plan is terminated, the following steps apply:
Per IRS requirements, the account balances of all active and former participants affected by a plan termination will become fully vested, regardless of whether they have satisfied vesting service conditions.
It is also somewhat common for terminating plans to have experienced a partial plan termination in the recent past that would vest participants who may have already terminated. It is your responsibility to let us know if your plan has experienced a partial plan termination.
Gusto Retirement will provide all participants with a notice that includes instructions on how to request a distribution of their assets. Although participants can request distributions, the request will be held and not processed until the account review is done.
Any IRS-required nondiscrimination testing will be completed. A final account review will also be conducted to make sure all outstanding issues have been addressed and any required plan contributions have been made.
We review your plan's documentation, operations, and recordkeeping before distributions begin, so we can find and address issues upfront rather than after an employee has already requested a distribution. If we find something that needs to be corrected, we will work with you to resolve it so the plan can be wound down in a compliant way.
Important: A plan termination or transfer can pause while required corrections are addressed.
If the plan's termination is mid-year (before December 31), be aware of the following:
Safe harbor plans will need to undergo ADP and, if applicable, ACP testing for the year of termination — unless the plan sponsor is (1) operating at an economic loss as described in IRS Code Section 412(c)(2)(A) for the plan year, or (2) involved in a transaction that results in becoming part of or ceasing to be part of a legally related group.
Employer contribution limits, including the annual additions limit and the annual compensation limit, will be prorated and may result in forfeitures and other corrections. Self-employed owners will not be able to contribute to the plan for the year of termination. This is because self-employed owners are deemed to earn income on Dec. 31 of the applicable plan year (see IRS Reg. 1.401(k)-2(a)(6)(iii)), and if no income is earned for a plan year, no contributions can be made to the plan.
Once the account review is done, our team will process participant distribution requests. Per your direction, we will transfer any remaining funds from participants who did not respond to distribution requests — or who fail to cash the check within 90 days — to an IRA at a third-party provider (or a taxable savings account, if applicable).
Gusto Retirement will prepare and file the final Form 5500. This must be filed no later than seven months after the trust account has been fully liquidated and cannot be filed before full liquidation.
Complete all pending tasks and notifications as they are received. There may be tasks related to missing company or compensation information needed for compliance testing.
Any outstanding required contributions can hold up the plan termination process and prevent Gusto Retirement from closing the trust account. Make sure a valid and active bank account remains connected to the plan. If you need to make updates, you can update your banking information in the Settings section of your retirement dashboard.
Billing for monthly service fees will continue for up to three months from either the termination date or date of submission, whichever is later. Billing will not continue past the service end date. Learn more about how billing works for terminating plans.
Visit IRS.gov for more information on regulatory requirements and constraints regarding termination of a 401(k) plan.