Considerations When Facing a Short Plan Year

Retirement plans, like other financial entities, and most of life, operate on the cycle of a year.

Rules pertaining to participant accounts, company matches and taxes on savings are written to cover an established 12-month period. Occasionally, an employer must step outside that time frame—the result is a short plan year.

According to Jeff Bograd, director, managing ERISA [Employee Retirement Income Security Act] consultant for John Hancock Retirement, short plan years can happen when a company establishes a plan in the middle of a year, terminates a plan or changes its plan year—e.g., from its fiscal year to the calendar year—but usually it’s because of a corporate action. Bograd says annually he saw 20 to 30 mergers or acquisitions, while working at New York Life Retirement Plan Services, compared with maybe three instances of a plan year change.

Whatever the reason for the short plan year, companies should think the step through before taking it. In some cases, the requirements might even seem simple—complete the legal documents and notify participants of the change, in the case of terminating a 401(k), says Diane Morgenthaler, a partner with McDermott Will & Emery LLP. But the decisions leading up to a small plan year are highly complex and will vary with each transaction.

“You don’t want to do it rashly, as it can definitely have an effect on participants and their contributions,” Bograd says. “Have a plan of action.”

Morgenthaler says all of the major players—plan sponsor, recordkeeper, payroll vendor, attorney and human resources (HR)—need to assemble all pertinent information, play out all the scenarios, then decide which makes the most sense from their combined perspectives. The overarching goal, she says, is to have the least impact on participants and their savings.

Because each situation is “fact-specific,” a good starting point is to consider the particular reason for the short plan year and for the initial business decision that called for it, she says. Maybe the company was sold, so the plan will be terminated and wound down. Or a brand new company wants to adopt a new 401(k) to attract talent. Such givens can help guide other decisions such as how soon payroll can integrate new employees or what education to provide.

For example, if, through an acquisition, Plan B, not a safe harbor plan, is merged into Plan A, which is a safe harbor plan, on June 30, the new participants would need the difference explained. “Though you’re not used to issuing mass notices at that time, that would have to happen,” Morgenthaler says. “But if you’re terminating a plan, you’re not going to give a safe harbor notice. Whatever steps you’re going to take depend on the particular facts and circumstances,” she stresses.

Strategies to structure a short plan year run the gamut. In the case of a merger, for example, Bograd says, “Some companies will say these are our new employees—we want them in our regular plan right away, so we’ll do the plan merger right away.”

However, in some situations “a company will put their employees into the new plan right away but not merge the plans until the end of the year to keep it cleaner and avoid that short plan year situation,” he adds. This may cause complications, though, such as how to repay loans in the frozen plan. “So it can get a little messy there,” he says. “In each situation, you have to weigh the pluses and minuses of what’s the easiest thing to do.”

One critical factor may be how quickly the recordkeeper or payroll vendor anticipates being able to meet the new demands. Occasionally, with a swift transaction, the seller will lag behind the closing in removing ex-employees from its payroll. To avoid what would amount to a multiple employer plan situation if those employees also remained in their old 401(k), “the buyer and seller may agree that the target employees have no 401(k) plan available for a few months until a separate payroll and 401(k) plan for target employees can be established,” Morgenthaler says.

Once the short year has been established, the plan sponsor will turn its attention to compliance and administration, part of which is informing participants about the change and how it will affect them.

Bograd recommends compiling a calendar of the upcoming events and providing it to the participants. “It can get confusing for them, especially if it affects the amount they can put into the plan or their vesting,” he says.

Particularly in a short plan year, the sponsor needs to monitor compliance, to ensure all limits are adhered to. “It’s easier to exceed limits in a short plan year,” Morgenthaler observes. For example, participants moved into their new company’s 401(k) may think they get a second opportunity to save $18,000 that plan year. “It doesn’t work that way,” she says. “Plan A is going to have to accept the contribution history of Plan B, so the 401(k) contributions of both may not exceed $18,000. It has to be explained to people.”

Likewise, highly compensated employees (HCEs) could fail nondiscrimination tests for over-saving—say if they front-load contributions with bonuses they’d received in March, Bograd says. “You have to prorate the compensation limit of $265,000, for example, by taking half of that—$132,500 if you have a six-month plan year. If you know you’ll be changing your plan year, communicate that so they can spread their contributions over the full calendar year,” he says.

Vesting also could create compliance challenges. In instances of a plan year change from a fiscal to a calendar plan year, a company needs to consider how many hours employees have worked toward that goal, Bograd says. You need to track that 1,000 hours twice: for example, from July 1 through June 30—the old plan-year end—and January 1 through December 31—the new plan-year end, he says. “You’re counting the 1,000 hours in both places, so they count in both years.” This procedure—mandated by ERISA—ensures that participants are not punished by the change of plan year.

Conversely, a plan year change will not affect vesting for a plan that uses the elapsed-time method, as vesting is measured from date of hire to anniversary of date of hire and is unrelated to the number of hours worked.

Vesting could be important to consider when a company first debates the shortened plan year. It could affect the amount of forfeitures the plan sponsor may have been planning to use for plan-related expenses, Bograd says.

Short plan years for start-up and terminating plans face similar issues, he adds. “Specifically, sponsors should be aware that prorated compensation limits can lead to failing compliance tests.”

The most serious compliance issue, though, may involve Form 5500. People forget to file it, both experts say. “Form 5500 is always due seven months after the last day of the plan year,” Morgenthaler says. For a company that terminated or merged its plan on June 30, the form will be due seven months after that date—“far earlier than you’re used to filing that return for the calendar year. That’s what trips up people sometimes. It’s a moving target.”                          

Further, the person who traditionally submitted the form may have been a casualty of the acquisition. So someone else has to remember to do it—and to do it off-cycle, she says. “You’re going to forget a few times; it’s not how you’re used to doing it.” Her recommendation: Have a good transition plan in place, and a good calendar.

Any transition plan should cover the service providers as well, including those of the acquired company, Bograd says. If that firm’s plan will be merged with the parent firm’s in a short plan year, you may be dealing with two different recordkeepers, he says. If so, “make sure the recordkeeper of the plan that’s going away understands what it’s processing and what the requirements are—meaning it’s still doing the 1099s for that short period, that it’s going to do the 5500 on a timely basis. I’ve seen situations where prior recordkeepers will forget that—they’ll think because the plan isn’t there at the end of the year, they’re not responsible for it anymore.”

Plan sponsors that discover they have missed the date may apply to the Department of Labor (DOL)’s Delinquent Filer program. “And bring in your auditor as fast as you can,” Morgenthaler advises.