Terminated 401(k) Plans and the ‘12-Month Rule’ (2024)

If you’re older than a certain age, you’re familiar with the tagline, “Roaches check in, but they don’t check out.” It’s kind of like that in a 401(k) plan. You can easily check your money in (contribute to the plan), but it can be hard to check it out (withdraw it).

The Successor Plan Rule

Here is what Treas. Reg. 1.401(k)-1(d)(4) has to say:

• Plan termination is not a distributable event for salary deferrals if the employer establishes or maintains a successor plan, referred to as an alternative defined contribution (DC) plan in the regulation.
• An alternative DC plan means a DC plan that exists at any time between the date of a 401(k) plan termination and 12 months after distribution of all assets from the terminated plan. Hence, the rule under 1.401(k)-1(d)(4) is referred to sometimes as the “12-month rule.”
• In addition to 401(k) plans, profit sharing and money purchase plans can be alternative DC plans. So can SIMPLE 401(k) plans. ESOPs, SEPs, SIMPLE IRAs, 403(b) plans, and 457(b) and 457(f) plans cannot be alternative DC plans.
• The “employer,” by the way, means the controlled group. That distinction will be very important in our discussion further on.
• A DC plan is not an alternative DC plan if at all times 12 months before and 12 months after the plan termination date, fewer than two percent of those eligible under the terminated 401(k) are eligible under the other DC plan.

Let’s try to translate this a little bit. Assume ABC Company has a 401(k) plan that terminates. It establishes, or already had, a profit sharing plan.

Here are the rules regarding distributing the salary deferrals from the 401(k):

1. Anyone who had a distributable event besides plan termination (severance from employment, death, disability, hardship, attainment of age 59½) is free to withdraw his deferrals, as well as the other money types such as match.
2. Those who have no distributable event besides the plan termination may withdraw all their account balance except their salary deferrals:

a. The salary deferrals may be left in the terminated plan until a different distributable event applies, or
b. The deferrals may be transferred directly into the profit sharing plan. (Note that this is different from a “rollover” in that the employee chooses to do a rollover, but a transfer is something chosen by the employer with no input from the employee.)

3. If they are not already participating in it, the profit sharing plan could be written to exclude the 401(k) plan participants for 12 months. (Or it could be written so that it includes no more than two percent of them.) In this case, distributions from the 401(k) could include salary deferrals for all the participants.

Distributions that were permissible at a given time could retroactively become violations of the law. This could happen if a 401(k) plan terminates and distributes all the salary deferrals, and a new DC plan covering at least two percent of the 401(k) participants is established afterward but within 12 months of the 401(k) distributions.

Uncooperative Service Providers

Usually, we don’t see employers terminating their 401(k) plans and then starting new plans just for the fun of it. Occasionally, the successor plan rule will come up when there are uncooperative service providers. For instance,

We are a third party administration (TPA) firm that coordinates with various recordkeepers on behalf of our clients. When an employer wants us to take over services for its 401(k) plan from its current TPA and recordkeeper, let’s just say that some service providers are a little easier to work with than others. With some we’ve dealt with, getting historical records or having funds transferred was harder than pulling teeth. We would like to have said to our new client, maybe you should terminate this old plan, we’ll start fresh with a new one, and you can deal with your old service provider on your own time. While making such a clean break would have been great for our sanity, it would not have been in the best interests of the client’s employees, who would be precluded from participating in a successor plan for 12 months.

Mergers and Acquisitions

Most often, the successor plan rule comes into play when there are mergers or acquisitions. Occasionally, one of our clients merges with or acquires another company or is acquired itself. Often, our client and the company it acquired will both have 401(k)s. They will want to terminate one of the 401(k)s and have the employees start participating in the other 401(k). As you may have guessed, this is a problem under 1.401(k)-1(d)(4). Even if the entities remain separate companies, they are part of the same controlled group and are therefore considered one employer.

Does this mean the employer is stuck maintaining two separate 401(k) plans in perpetuity? Will distributions of deferrals have to be restricted? Will employees have to go 12 months without being in a DC plan? Maybe not.

The best thing would be to have thought of all the issues beforehand and taken appropriate steps before the transaction occurred. The successor plan rules come into play when you have an alternative DC plan sponsored by the same employer. Before two companies merge or one buys another, they are not part of the same controlled group, and therefore they are not the same employer. Once the merger or acquisition occurs, they are treated as the same employer. For instance,

If ABC Company buys XYZ Company, and it is intended for the XYZ 401(k) plan to be terminated, it would be best if this termination occurs before the acquisition date. The XYZ plan will then be free to distribute all the plan assets, including salary deferrals, and the XYZ plan participants may join the ABC 401(k) plan. The ABC plan is not a successor plan to the XYZ plan because the XYZ plan was never sponsored by the combined ABC-XYZ employer.

What often happens is the sale or merger occurs, and no one thinks about the 401(k) plans until after the fact. Assume ABC buys XYZ, both have their 401(k)s, and it is desired that the XYZ plan be terminated. Now ABC and XYZ are part of the same controlled group. Plan termination isn’t such a good option in this case because of the potential restrictions described earlier: XYZ plan deferrals can’t be distributed, XYZ participants will have to be excluded from the ABC plan for 12 months, etc.

Once in this situation, the easiest solution is just to merge the two plans together rather than terminating one of them. If the XYZ plan is merged into the ABC plan, all the XYZ account balances will be transferred directly into the ABC plan, with no opportunity for the XYZ participants to elect a cash withdrawal or rollover to an IRA. This does not violate the successor plan rule.

If the XYZ plan has a lot of terminated employees, then the active employees for XYZ could be spun into the ABC plan, leaving only terminated employees in the XYZ plan. The XYZ plan could then be terminated with deferrals immediately paid out to the participants. This would be permissible since those terminees have had a distributable event besides the plan termination.

Stock Sale vs. Asset Sale

This might be a good time to say a few words about stock sales vs. asset sales. A detailed summary is best left to a legal textbook, but generally a stock sale means you’re buying the whole company while an asset sale means you’re buying the assets and the company stays behind, often as a shell of its former self.

The example above with ABC and XYZ was a stock sale because ABC was acquiring the entire company. Let’s say ABC simply acquired the assets of XYZ. In that case, all the employees of XYZ would be considered terminated from XYZ on the closing date and hired by ABC the following day. XYZ’s 401(k) would remain with XYZ and would never be maintained by ABC or its controlled group, since XYZ remained unaffiliated with ABC. Therefore, XYZ could terminate its 401(k) and pay out salary deferrals. All the XYZ employees would have had a distributable event. This is true even if the ABC plan gave credit for past service with XYZ.

In any merger or acquisition cases, legal counsel should be consulted prior to the transaction to ensure proper language is in the sales documents and that any outcomes with respect to qualified plans are the ones that are intended.