Terminating a Defined Benefit Plan: Our 10 Step Process


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Life happens and sometimes even the best laid plans must end. If you’re self-employed and have offered a defined benefit plan but due to unforeseen circumstances, you need to end it, you need to know what steps to take. 

Terminating a Defined Benefit Plan

You can terminate a defined benefit plan but only for valid reasons. Just what’s a valid reason? It must show necessity, not a voluntary reason, such as wanting to hand over responsibility to the participants. Valid reasons include:

  • Lower company profits
  • Business closing
  • Change in ownership
  • Inability to afford to fund the plan 

In addition, the IRS often puts a time test to the plan termination. If the plan has been in existence between 5 – 10 years, there are typically no questions asked. However, if the plan is newer than 5 years old, there may be questioning from the IRS.

self employed

For example, you can’t decide that you want to give plan participants responsibility for the investments and terminate the account. There must be a true business reason for the termination, most notably that you can’t afford the plan any longer whether you are going out of business or your business isn’t doing well. There must be a financial component to the reason. 

Looking for more information on cash balance plans? Take a look at our ultimate guide to cash balance plans. Discover our favorite strategies!

Terminating a defined benefit plan requires careful planning and the following steps. Make sure to follow them carefully as the IRS has very strict rules regarding how you can terminate the plan and what participants should expect.

How to Terminate a Defined Benefit Plan

Just follow the 10 steps below:

  1. Amend the Plan

    The existing plan requires you to inform plan participants of every detail including how they’ll get their funds, when, and that contributions will stop. Make sure all vested funds are returned in a timely manner, or as most feasibly possible following termination of the plan. Plan amendments must include a date to terminate all contributions and a plan to enforce full vesting to give participants access to their funds. 

  2. Let Plan Participants Know About the Termination

    Participants must receive all important details regarding plan termination, including the date and method of fund disbursement. You should alert participants as soon as possible. 

  3. Alert Plan Participants of Rollover Information

    15 days or less from the date of the plan amendment, you must provide the required rollover notice to plan participants if a rollover will be offered.

  4. Update all Employer Contributions

    you have any unpaid employer contributions, get caught up on them before plan termination. If you don’t, you could face several liabilities long after plan termination.

  5. Vest all Participants

    Participants affected by the plan termination must be 100% vested. This applies to all employees or past employees that have a positive balance.

  6. Asset Distribution

    Establish a plan to properly distribute the assets. The IRS prefers you set this up within 12 months. But if that’s not possible, make the date as soon as you can and alert the IRS.

  7. Complete IRS Form 5500

    Form handles all annual reporting for defined benefit plans and meets all ERISA and IRS guidelines. This will be the final time you have to complete this form. 

  8. Finalize Termination and do a Review

    sure that you’ve completed all the paperwork and that you’ve satisfied all IRS requirements before finalizing the termination.

  9. Finalize with the IRS

    If your plan was not preapproved, you can ask the IRS to help determine your plan’s qualification status by completing IRS Form 5300 – Application for Determination for Employee Benefit Plan.

  10. Communicate with your CPA

    Make sure your accountant is in the loop for an tax compliance issues or for assistance with final funding issues.

Can you terminate the plan and start another?

You can start another plan, but only under certain circumstances. If the IRS believes that the new plan is identical to the old plan, the IRS may rule that the original plan never truly terminated. This would make any distributions made from the old plan unqualified, which may result in tax consequences and penalties.

Financial planning puzzle piece

What if you don’t distribute the funds within 12 months? IRS may consider the plan ongoing, which leaves you with other obligations, including minimum funding requirements. It’s in your best interest to distribute the funds as quickly as possible.

What options do you have for asset disbursement? You have two options to disburse the assets:

  • Pay the plan participants one lump sum in the amount owed
  • Buy an annuity for the plan participants in the amount owed (any participants already receiving benefits may only receive their payout as an annuity)

Plan Termination

Terminating a defined benefit plan requires many careful steps. The IRS is involved in the process from the start, including approving your reason for terminating the plan.

Make sure you follow all of the steps and rules in order to avoid any litigation and/or liability down the road. Once you terminate the plan, the hope is that it’s behind you, but if you don’t close it properly, you may face more consequences. 

The key is to run your plan past your third-party administrator who can help you ensure that you’re meeting all requirements and avoid any issues down the road. 

Paul Sundin

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2 thoughts on “Terminating a Defined Benefit Plan: Our 10 Step Process”

  1. My DBP was administered by someone who sold their business to another group. I signed a document that states that I cannot make contributions to the plan, therefore I want to terminate it. The new group (TRA) says that I owe penalties for not making RMDs. Is there a way out of this for me?

    Reply
    • Hi Waddell – it sounds like your plan may be overfunded? You have a few issues going on so you should probably reach out to us for a free consultation to discuss.

      Reply

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