Implications for retirement plans from COVID-19
Action steps for employers
TAX ALERT |
Many aspects of business are changing due to the COVID-19 pandemic, and many employees and employers will face financial hardships in 2020. This article focuses on the provisions in qualified retirement plans that employers may want to consider in light of employee and business financial hardships.
Rather than simply paying more compensation directly, many employee benefit plans may provide methods for making cash available to employees that are more tax beneficial or less cash-intensive for employers. Likewise, plan obligations may be reviewed based on some of the employer plan changes below to determine whether plan obligations can be delayed to save employers cash during difficult economic times.
Employers should review their qualified retirement plans and consult with their advisors to understand the methods available, and the proper reporting or communication for any methods they choose to use.
Some of these methods are permitted under the Coronavirus Aid, Relief, and Economic Security Act (CARES Act), enacted on March 27, 2020, and some methods were available under pre-Cares Act law.
The following actions are available to employers with qualified employee benefit plans (401(k) plans, defined benefit pension plans and other qualified retirement plans):
Elimination or reduction of employer contributions. Employers may decide to forego discretionary employer contributions in any tax year, without any plan amendment requirement. Employers can amend their plans to eliminate matching or employer contributions required by the plan document.
For employers sponsoring 401(k) safe harbor plans, eliminating safe harbor employer contributions or matching contributions may result in the loss of safe harbor status, requiring non-discrimination testing. Safe harbor status may be preserved if the employer can show that it is ‘operating at an economic loss’, as referenced in section 412(c)(2)(a) (see below). However, unless the IRS grants relief from the notice requirements, the employer must provide employees with a 30-day notice of the suspension of employer contributions.
Temporary waiver of funding deficiency for defined benefit plans under section 412(c)(2). The IRS may grant a temporary waiver of funding deficiency for an employer that fails to make a timely required minimum contribution to a defined benefit plan for a tax year due to a ‘business hardship’ under section 412(c). A business hardship for this purpose means:
- the employer is operating at an economic loss,
- there is substantial unemployment or underemployment in the trade or business and in the industry concerned,
- the sales and profits of the industry concerned are depressed or declining, and
- it is reasonable to expect that the plan will be continued only if the waiver is granted.
Anticipated reductions in force. A plan sponsor of a defined contribution plan or a defined benefit plan may avoid the costs of obtaining an audited financial statement for years that an employer plan has fewer than 100 participants (or is in a specified range). Such plans may dip below the 100-employee limit due to job eliminations and layoffs. In that case, an employer is not required to attach an audited financial statement to their Forms 5500. It is important to note that a plan determines whether it has less than 100 participants on the first day of the plan year (Jan. 1, 2020) for most plans. Therefore, the COVID-19 crisis will only affect the number of plan participants for plan years that begin later in 2020 or in 2021.
It is also important to note that a percentage drop in the number of participants could result in a partial plan termination, requiring all affected certain participants to become 100% vested in their account balances. Generally, a 20% reduction in an employer’s workforce can trigger a partial termination. However, the 20% reduction is not a bright line test, and there are exceptions based on the facts and circumstances. Therefore, employers should discuss these issues with their advisors before concluding that a partial termination has occurred.
For defined benefit plans, employers should consult their third party administrators and legal advisors to determine whether a ‘reportable event’ under the Employee Retirement Income Security Act (ERISA) has occurred due to a percentage drop in the number of participants.
Definition of eligible plan compensation. Employers with fewer than 500 employees should examine their plans to determine whether the Families First Coronavirus Response Act paid leave provisions for paid sick leave or enhanced Family Medical Leave Act (FMLA) should be included or excluded in the plan’s definition of eligible compensation.
Extension of grace period for deductions. For employers with a tax return due date of April 15, 2020, the end of the grace period for deductions under section 404(a)(6) with respect to 2019 plan contributions is extended to July 15, 2020. For example, if an employer is a corporation with an April 15, 2020, due date for filing the Form 1120, then the grace period under section 404(a)(6) for the employer to make contributions to its employer plan for 2019, ends on July 15, 2020. The employer will also be able to rely on any further extensions.
Freezing benefits accruals. Normally, for some discretionary amendments (e.g. redefining hardship withdrawal provisions), the employer has until the last day of the plan year to formally amend the plan. However, other amendments, such as freezing benefit accruals in a defined benefit plan require the employer to adopt the amendment in advance of the freeze date, with prior notice to participants.
Employee financial assistance. Employers should remind employees to assess their own personal situations, such as age and the likelihood of having enough time to rebuild their account balances, and should consult their financial advisors in taking advantage of any of the following.
- Changes in salary deferral elections. As under pre-CARES Act rules, employees may elect at any time to reduce or cancel their salary deferral elections and to receive the amounts in their paychecks as taxable compensation.
- Participant loans. Normally, employees are not permitted to borrow more than the lesser of $50,000, or one-half of their vested account balances from their 401(k) or 403(b) plans. For a limited period ending Sept. 28, 2020, the CARES Act allows for increased loan availability equal to the lesser of $100,000, and eliminates the limit of 50% of the borrower’s account balance. However, in order to qualify for the higher limit, the loan must be coronavirus-related.
The CARES Act also provides that loan repayments due between now and Dec. 31, 2020, are suspended, and gives employees an additional year to make those repayments.
Employers could remind employees that plan loans made from their account balances are repaid to their accounts, with interest over five years, which can be more beneficial than taking a loan from a third-party lender.
- Three-year repayment right on distributions. Normally, taxpayers who repay employer plan distributions within 60 days are not subject to tax on the repaid amounts. The CARES Act extends the 60-day period so that taxpayers who receive coronavirus-related distributions will have three years (instead of the normal 60 days) to repay the distribution without incurring taxes. In this respect, the distribution is treated as if it were a 60-day tax-free rollover. Importantly, a taxpayer who chooses not to repay a coronavirus-related distribution can elect to include the distribution in income ratably over three years starting with the year of the distribution.
- Hardship distributions. In general, plans that allow hardship withdrawals have adopted the IRS safe harbor rules for deemed and immediate financial need. Some of the safe harbor events helpful for employees during the COVID-19 crisis include distributions to make rent or mortgage payments, medical expenses and some tuition costs. Working reduced hours because of COVID-19 or other financial hardships, such as the costs related to additional day care expenses associated with school closings would not qualify for safe harbor hardships. In this regard, employers may want to amend their plan to adopt a facts-and-circumstances standard to determine an employee’s hardship. The IRS regulations permit such an amendment.
- Relief from 20% mandatory withholding on distributions. Employer plans are normally required to withhold 20% of any distribution not rolled over directly to an IRA or other qualified retirement plan. The CARES Act provides that the 20% mandatory withholding requirement will not apply to a coronavirus-related distribution, as defined below.
- Age 59½ premature distribution penalty relief. Normally, an individual that has not attained age 59-1/2 incurs a 10% penalty on distributions from an employer plan. The CARES Act provides relief from the penalty on up to $100,000 of distributions for coronavirus-related distributions received in a tax year.
Under the CARES Act, a ‘coronavirus-related distribution’ is a distribution to a taxpayer who is officially diagnosed with the SARS-CoV-2 virus, has coronavirus disease (COVID-19), whose spouse or dependent is diagnosed with such virus or disease, who experiences adverse financial consequences, such as being quarantined, furloughed, laid off or having work hours reduced, being unable to work (or telework) due to lack of child care, and the closing of a business or reduction of hours of an individual who owned or operated the business, in each case due to the virus or disease. The CARES Act provides that employers may accept an employee’s certification that a coronavirus-related distribution is necessary.
- Extended relief from required minimum distribution rules. The CARES Act provides for a one-year waiver of the payment of required minimum distributions (RMDs) from employer plans. The waiver applies to both 2019 RMDs required by April 1, 2020, and RMDs made in 2020. The CARES Act also allows taxpayers to rollover RMDs made in 2020 to an IRA or other qualified employer plan. However, the 60-day rollover rule still applies unless the IRS waives that requirement.
The CARES Act extends the deadlines for most employers to adopt any necessary CARES Act amendments to the end of the first year beginning on or after Jan. 1, 2022, provided the plan in the interim operates in compliance with the rules. Nonetheless, employers should start reviewing their plans and consider any changes or necessary employee communication as soon as possible.