10 Steps to Terminating a Defined Benefit Plan [Example]

You are probably aware of why defined benefit plans are such great retirement options. But we know that things happen in life and retirement plans get terminated.

The termination process can be a little complex. There are a few hurdles to navigate. As such, I have completed this how to guide for terminating a defined benefit plan.

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Can a defined benefit plan be terminated?

Of course it can. But make sure you have done your diligence.

With the permanency rule in place, it should only be terminated for reasonable cause. This would generally include:

  • a company that is being sold or acquired;
  • a significant change in financial condition that limits the company’s funding ability; or
  • a major business event that negatively impacts the defined benefit plan going forward.

Plan permanency

Business owners enjoy the high tax deductions and large retirement contributions associated with defined benefit plans. But they are not elective plans like defined contribution plans. They also have more extensive compliance requirements compared to your average 401k plan.

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As a CPA, Paul has extensive experience with overfunded pension issues. Schedule a FREE call to discuss your overfunding issue and to review your options.

When a plan is established, the IRS assumes the plan is permanent in nature. This does not mean that the plan has to stay open forever. The IRS assumes a plan will continue for at least a “few years.” However, the IRS does not clearly establish what a “few years” truly means. It has been left to interpretation.

But as a general rule, the IRS will not challenge a plan termination that occurred more than 5-10 years since plan inception. Companies that are terminating a defined benefit plan that has been established for at least 5 years don’t typically have an issue.

Valid business reason for termination

The IRS wants there to be a “business necessity” when it comes to terminating a defined benefit plan. This decisions should not be taken likely and should be discussed with your CPA and administrator. 

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There are certainly valid reasons for plan termination. You just have to make sure to coordinate with your administrator and your CPA. Make sure you do plenty of due diligence so that you don’t come under the scrutiny of the IRS.

The following are many of the reasons that companies looks to close or terminate plans:

  • the business does not have the ability to make such large contributions on an ongoing basis;
  • the company is be sold or dissolved; or
  • when owners have many employees and are concerned about growing exposure or plan liabilities.

How to terminate a defined benefit plan

Below you will find the 10 steps to terminating and closing a defined benefit plan:

  1. Formal review process

    Before you make the final decision to terminate, complete a formal review of plan assets and compliance to ensure that there are no issues.

  2. Plan amendment

    The plan must be amended to establish a termination date. Also, the plan must be updated to reflect required amendments and be brought current.

  3. Determine overfunding or underfunding

    Plans are often overfunded or underfunded. There can be significant consequences in both situations. This step will require careful communication with your administrator.

  4. Participant vesting

    Upon termination, all participants with account balances will be fully vested. This is one downside for small companies with large owner contributions. There will be no employee forfeiture.

  5. Freeze plan contributions

    The business should have stopped any contributions. However, there may be an additional contribution that is required especially if the plan is underfunded.

  6. Participant notification

    All participants must be formally notified of termination. This includes all vested balances and termination disclosures as applicable.

  7. Rollover notification

    Participants must receive a required rollover notice within 15 days of the plan termination. This will allow them time to roll the balances to an IRA or another qualified plan.

  8. Coordinate distribution

    Work with the administrator and custodian so that all benefits are distributed consistent with plan terms.

  9. Distribute assets

    Make sure that plan assets are distributed as soon as feasible possible. This should occur within 12 months of the termination date. This is usually not very challenging, but you should make sure that it does not cross over calendar years.

  10. File final 5500

    A final 5500 must be filed with the IRS for the last year of the plan. The box for final plan year must be checked to ensure no future 5500s are required.

Can You Terminate then Restart a Defined Benefit Plan?

Yes you can. But be careful. The IRS could consider this a “step transaction” and deem it invalid. What this means is that if the termination and restart had the effect of discriminating against other employees or the plan is identical, the IRS could state that no termination occurred and the new plan is a continuation of the prior plan.

Paul Sundin, CPA

As a CPA, Paul has extensive experience with overfunded pension issues. Schedule a FREE call to discuss your overfunding issue and to review your options.

In this occurred, the distributions from the prior plan may be deemed prohibited. This could possibly result in plan disqualification. Although this is unlikely, the IRS could raise concerns. 

Overfunded defined benefit plans

One of the biggest issues we see if overfunded defined benefit plans. There are many concerns when this happens because the taxes and penalties can be as high as 90%. So careful strategies should be considered to mitigate any issues. If structured correctly, no excise tax should occur.

Some of the ways to mitigate an overfunded pension include:

  • Increasing compensation or employing family members or other employees.
  • Merging the overfunded plan with a company who has an underfunded plan.
  • Amending the plan to allow for increase benefit accruals.
  • Rolling the plan assets into a qualified retirement plan. This strategy will not actually eliminate any excise tax, but it will lower it from 50% down to 10%.
  • Keep the plan open for additional years to build up years of service.

And overlooked problem associated with an overfunded pension is the fact that they’re unable to receive large investment returns. Any stock gains dividends or interest income will typically make the funding issue worse. So many will just leave it dormant in cash. There is significant opportunity cost with respect to the pension assets. 

Defined benefit plan termination

A business necessity is typically justified when the company has lower cash flow and/or business net income. There might also be a change in ownership structure that inhibits the companies ability to continue to fund. The IRS has even accepted when a company adopted a different retirement structure as a valid reason for termination. 

If you are terminating your defined benefit plan and you need assistance with an overfunded plan, we can help. Just reach out to us using the calendar link below and we would be glad to schedule a 30 minute call to discuss your options.

Paul Sundin

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