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Sham termination of employment and distributions

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“What are the rules regarding firing an employee, allowing the individual to take a distribution from his 401(k) account and then rehiring the same individual? Is it a valid distribution? If not, is the plan in jeopardy of processing an impermissible withdrawal?”

ERISA consultants at the Retirement Learning Center Resource Desk 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, Social Security and Medicare. We bring Case of the Week to you to highlight the most relevant topics affecting your business. A recent call with a financial advisor from West Virginia is representative of a common inquiry related to severance of employment and distributions.

Highlights of the Discussion

The IRS could view the firing and re-hiring of an employee who has taken a distribution of plan assets due to separation of service or severance of employment[1] as either a “sham” or a “bona fide” termination depending on the facts and circumstances. Qualified retirement plan assets, typically, are not distributable until the participant incurs a distribution triggering event as outlined in the governing plan document, for example, separation of service or severance of employment (see pages 196-197 from the pdf for Revenue Ruling 56-214). In the case of a sham termination, the processing of an impermissible distribution without a legitimate distribution triggering event is an operational failure that, potentially, could put the plan at risk of disqualification, resulting in possible adverse tax consequences to the participant and the employer (see Private Letter Ruling 2000-0245).

There is no definitive rule prohibiting the rehiring of an employee who has received a plan distribution as a result of leaving employment. For example, at least one court ruled that a participant had a true termination, even though he returned to employment with his former employer five months after he retired, because at the time of his retirement he had no intention of returning to work and was only able to return to employment following an unforeseen change in circumstances (see Barrus v. United States, 23 AFTR 2d 990 (DC NC 1969)).  And in Revenue Ruling 69-647 (see pages 100-101 of Internal Revenue Cumulative Bulletin 69[2] , the IRS ruled that a senior executive who retired from full-time employment and continued to render services to the same company, but on a part-time basis as an independent contractor, was considered to have terminated employment.

However, if the IRS determines the termination is a ruse merely to facilitate a distribution not otherwise available, and both the plan sponsor and participant know in advance that the fired individual will be rehired, the IRS may view such action as a sham termination. The IRS specifically “does not endorse a prearranged termination and rehire as constituting a full retirement” (see the preamble to REG-114726-04 ).

The basic rule is that, to receive a distribution from a 401(k) plan on account of a severance of employment, the participant must have experienced a bona fide termination of employment in which the employer/employee relationship is completely severed.

Facts and circumstances the IRS will consider include the following:

  1. Did the plan sponsor follow the terms of the plan document? (Allowing a distribution as a result of a sham termination would constitute a failure to follow the terms of the plan document because plan assets were distributable in a situation not provided for under the terms of the plan).
  2. Did the termination of employment and processing of the distribution follow all the established administrative procedures?
  3. How long was the time interval between termination and rehire?
  4. What documentation exists to substantiate the termination and distribution?
  5. Did the alleged sham termination involve a highly compensated employee?

Conclusion

A plan sponsor and participant(s) who collude to stage a firing/re-hiring scenario to facilitate a qualified plan distribution are potentially putting the qualified status of the plan at risk. Under investigation, the IRS could determine the termination is a sham and impose sanctions.

Any information provided is for informational purposes only. It cannot be used for the purposes of avoiding penalties and taxes. Consumers should consult with their tax advisor or attorney regarding their specific situation.

[1] Prior to January 1, 2002, most plans used the term “separation from service” rather than “severance of employment.” Separation of service carried the “same desk rule,” which prevented many 401(k) plans from making distributions to former employees who continued working at the same job but for a different employer as the result of a merger, acquisition or similar transaction. The Economic Growth and Tax Relief Reconciliation Act of 2001 allowed plan sponsors to replace the separation from service/same desk requirement to allow for distribution upon a participant’s severance from employment with the employer sponsoring the plan.

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Changes to hardship distributions for 2019

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“Are the rules for hardship distributions from 401(k) plans changing?”

ERISA consultants at the Retirement Learning Center Resource Desk 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, Social Security and Medicare. We bring Case of the Week to you to highlight the most relevant topics affecting your business. A recent call with a financial advisor from Illinois is representative of a common inquiry related to hardship distributions.

Highlights of the Discussion

Yes, changes to the hardship distribution rules for 401(k) plans as a result of the Bipartisan Budget Act of 2018 will take effect for the 2019 plan year (e.g., as of January 1, 2019, for calendar year plans). There are three primary changes to the current hardship distribution rules.

Participants will

  1. Not be required to take plan loans before a hardship distribution is granted;
  2. Not need to suspend their employee salary deferrals for six months following a hardship withdrawal; and
  3. Will be able to distribute other types of contributions beyond employee salary deferrals and grandfathered, pre-1989 earnings thereon as part of a hardship distribution, including qualified nonelective contributions (QNECs), qualified matching contributions (QMACs), safe harbor contributions, and earnings from all eligible sources (including post 1988 earnings on elective deferrals).

Items 1. and 2. are currently part of the IRS’s requirements for a hardship distribution to meet the safe harbor definition of “necessary to satisfy an immediate and heavy financial need.” [See Treasury Regulation Section 1.401(k)-1(d)(3)].

In order to implement the new provisions, plan sponsors will need to

  • Update their hardship distribution procedures,
  • Ensure plan record keepers are making necessary administrative changes, and
  • Review plan document language for necessary amendments.

We believe it was Congress’s intent to have the same changes apply to hardship distributions from 403(b) plans, but clarifying guidance from the IRS is needed. Treasury regulations under Section 403(b) of the Internal Revenue Code state that a hardship withdrawal from a 403(b) plan has the same meaning, and is subject to the same rules and restrictions, as a hardship withdrawal under the 401(k) regulations [see Treasury Regulation Section 1.403(b)-6(d)(2)]. The Treasury Secretary has until early 2019 to modify the current 401(k) regulations to reflect the new hardship distribution rules.

Conclusion

Come 2019, plan sponsors may incorporate softer hardship distribution rules into their plans, policies and procedures as a result of changes under the Bipartisan Budget Act of 2018.

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Defined Benefit Plan Annual Funding Notice

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What information does the Annual Funding Notice for a defined benefit (DB) plan reveal and why is it important?

ERISA consultants at the Retirement Learning Center Resource Desk 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, Social Security and Medicare. We bring Case of the Week to you to highlight the most relevant topics affecting your business. A recent call with an advisor in Missouri is representative of a common question related to DB plan Annual Funding Notices.

Highlights of Discussion

The Annual Funding Notice is one of several important retirement plan notifications that should be considered as part of a comprehensive financial planning process. It is one of the best tools for a participant and his or her advisor to measure the solvency or health of a DB plan.

The law requires sponsors of all DB plans that are subject to Title IV of the Employee Retirement Income Security Act of 1974 (ERISA) to provide an Annual Funding Notice to each DB plan participant and beneficiary, as well as other entities. Businesses that fail to provide an Annual Funding Notice each year face a Department of Labor (DOL) penalty of $110 per day of delay, up to a maximum of $1,100 per request. (See related final DOL Regulations, which include a model notice, at Annual Funding Notice for Defined Benefit Plans.)

The notice provides participants with information about

  • How well the pension plan is funded, measured by the funding target attainment percentage (FTAP);
  • The value of pension plan’s assets and liabilities;
  • How a pension plan’s assets are invested; and
  • Employer events taking place during the current year that are expected to have a material effect on the plan’s liabilities or assets
  • The legal limits on how much the Pension Benefit Guaranty Corporation (PBGC) can pay participants if the PBGC (the federal agency that insures private-sector DB plans) determines it is in the participants’ best interest to step in and take control of the plan.

The first thing to focus on when looking at an Annual Funding Notice is the FTAP, which is a measure of how well the plan is funded to meet liabilities on a particular date. This figure is the best single indicator of the current health of a DB plan. The FTAP must be reported for the current year and two preceding years. In general, the higher the percentage, the better funded the plan and the better able the plan is to pay promised benefits. The FTAP is a determinant as to whether the plan is considered “at risk.”

If a plan’s FTAP for the prior plan year is below 80 percent that is the first indication the plan may be entering at-risk status. The plan’s actuary calculates whether a plan is at risk using the FTAP and a multi-step process. At-risk plans require more funding by the employer because they are required to use actuarial assumptions that result in a higher value of plan liabilities. The annual funding notice must state whether the plan has been determined to be in at-risk status, and must reflect the increased at-risk liabilities due.

Beyond the FTAP, Annual Funding Notices must include important information regarding a DB plan’s assets and liabilities. For example, notices must include a statement of the value of the plan’s assets and liabilities on the same date used to determine the plan’s FTAP. Notices also must include a description of how the plan’s assets are invested as of the last day of the plan year.

Annual Funding Notices must disclose “material effect events,” which are plan amendments, scheduled benefit increases (or reductions) or other known events having a material effect on the plan’s assets and liabilities if the event is taken into account for funding purposes for the first time in the year following the notice year. If an event first becomes known to a plan administrator 120 days or less before the due date of a notice, the plan administrator is not required to explain, or project the effect of, the event in that notice.

Finally, Annual Funding Notices must include a general description of the benefits under the plan that are guaranteed by the PBGC, along with an explanation of the limitations on the guaranteed benefits and the circumstances under which such limitations apply.

Some DB plan sponsors must provide supplements to their plans’ standard Annual Funding Notices if all three of the following circumstances are true:

  1. The funding target is less than 95% of the funding target determined without regard to the adjusted interest rates of MAP-21 and HAFTA, and
  2. There is a funding shortfall greater than $500,000, and
  3. There are 50 or more participants on any day during the preceding plan year. (See supplemental Notice Guidance FAB 2013-01and FAB 2015-01. )

With the information on this supplement, participants will be able to compare the FTAP, funding shortfall in dollars, and minimum required contributions in dollars calculated with the adjusted interest rates of MAP-21/HAFTA and without MAP-21/HAFTA adjusted interest rates for the applicable plan year and the two preceding years. The most conservative approach to evaluating this information from a retirement planning standpoint is to focus on the numbers “without adjustment,” which in recent years have resulted in lower funding levels than calculations made using the MAP-21/HAFTA adjusted interest rates.

Conclusion

The Annual Funding Notice is one of several important retirement plan notifications that should be considered as part of a comprehensive financial planning process. It reveals important information about the overall health of a DB plan, such as how well the plan is funded, assets and liabilities, the plan’s investment policy, business events that may affect the plan and whether the plan is considered at risk.

 

 

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Qualifying for Medicare on Spouse’s Record

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“I have a 68-year-old client whose spouse will be 65 this year. My client signed up for Medicare at age 65. His spouse will not have 40 quarters of covered employment when she attains age 65. Is there any way she can qualify for Medicare on her spouse’s record when she turns 65?”

ERISA consultants at the Retirement Learning Center Resource Desk 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, Social Security and Medicare. We bring Case of the Week to you to highlight the most relevant topics affecting your business. A recent call with a financial advisor from Minnesota is representative of a common inquiry related to Medicare.

Highlights of Discussion

Good news. She will likely be eligible for premium-free Part A Medicare coverage at 65 based on her spouse’s record. Let’s review how the Medicare eligibility rules work.

Medicare consists of four basic parts: Parts A (hospital insurance), B (medical insurance), C (Advantage Plans) and D (drug coverage).  While Parts B, C and D have a premium amount attached to them—Part A may not.  Medicare Part A coverage is premium-free if the individual has forty 40 quarters of covered employment for Social Security retirement benefits at age 65. That means the individual paid Medicare taxes while working for roughly 10 years.

If, at age 65, the individual does not have 40 quarters of coverage, he or she may be able to buy Part A coverage. The premium for Part A coverage in this case is up to $422 a month. However, if the individual’s spouse had 40 quarters of coverage and is eligible for Social Security retirement benefits (and the couple has been married at least a year), then the spouse without the 40 quarters is considered eligible at 65 and would not be subject to a

Part A premium.[1] The result in the prior example would be the same if the married couple was now divorced, provided they had been married for at least 10 years.

The Medicare Website has an online eligibility and premium calculator for consumers, which may be of help in making a determination based on their individual circumstances.

Conclusion

Medicare Part A coverage is premium-free for individuals who have forty quarters of covered employment for Social Security retirement benefits at age 65. If they don’t personally have the covered employment and are married, they may be able to qualify on their spouses’ record.

[1] Note: if the older spouse has less than forty quarters they are eligible for Medicare at age 65 if the younger spouse is at least 62 and has forty quarters of coverage.

 

 

 

© Copyright 2024 Retirement Learning Center, all rights reserved