Did COVID-19 Layoffs Trigger a Partial 401(k) Plan Termination? by Melissa Fleitas, CPA

Posted on November 12, 2020 by Melissa Fleitas

Businesses that sponsor 401(k) plans and have had to make significant workforce reductions due to the COVID-19 pandemic may have unintentionally triggered a partial plan termination that can result in significant costs and administrative headaches.

According to the IRS, partial plan terminations can occur when employers lay off 20 percent or more of employees covered by a defined-contribution plan in a particular plan year, either due to downsizing or adverse economic conditions. Workers who leave voluntarily to retire or pursue jobs with other employers are generally not included in the calculation of a business’s turnover rate. Similarly, businesses generally should not consider workers they may have terminated or furloughed temporarily only to rehire them before the end of the plan year or other applicable period.

When an employer’s turnover rate reaches 20 percent, a partial plan termination is initiated, and it is required to fully vest all 401(k) plan participants whose employment was severed during the applicable period. In other words, the plan sponsor must pay 100 percent of the employer-match and profit-sharing contributions promised to plan participants terminated during the applicable period, regardless of the plan’s vesting schedule or the employees’ actual years of service. Failure to meet this requirement may endanger the 401(k) plan’s tax-exempt status and put the plan sponsor at risk of tax penalties and legal claims.

To determine a plan’s turnover rate, the IRS requires employers to first identify the applicable period for which a partial plan termination may have occurred. While this generally covers a plan’s calendar year, it may extend over multiple plan years, especially when it involves a strategic downsizing.

Next, plan sponsors must calculate the turnover rate by dividing the total number of employees involuntarily terminated during the applicable period by the sum of 1) all employees who were eligible to contribute to the 401(k) plan since the start of the plan year, plus 2) employees who became eligible to participate in the plan during the applicable period. All employees include every worker who qualifies to contribute to the employer-sponsored plan during an applicable year regardless of the plan’s vesting status or the employees’ history of making prior salary-deferred contributions to that plan. Generally, employees who should not be counted for purposes of calculating the turnover rate are those who voluntarily severed from the plan sponsor’s employment and those who the employer terminated and later rehired before the end of the applicable period.

As 2020 draws to close, plan sponsors should take the time to assess their current staffing levels and determine if layoffs that occurred earlier in the year caused a partial plan termination and a potential requirement to fully vest those former employees. Employers will need to decide 1) if they can bring back those workers before the end of the applicable period and avoid a partial plan termination or 2) if they have a duty to fully vest those former employees and immediately pay them any remaining unvested funds plus earnings that may have accumulated since the employees’ termination dates. Consequently, employers may owe considerable amounts of unplanned matches and profit-sharing contributions to plan participants they severed from employment back in March. However, if an employer rehires enough workers within the applicable period it may avoid these expenses.

About the Author: Melissa Fleitas, CPA, is an associate director of Audit and Attest Services with Berkowitz Pollack Brant Advisors + CPAs, where she provides accounting, auditing and consulting services to a wide range of companies in the healthcare, manufacturing and distribution sectors. She can be reached at the firm’s Miami office at (305) 379-7000 or