When times are tough, many employers make the difficult decision to furlough or lay off employees to reduce costs. Then, when circumstances improve, they eagerly bring those affected back into the company and its 401(k) plan. Adding these valued employees back into a 401(k) plan must be done thoughtfully and in accordance with the plan document. Make sure you pay attention to these key considerations when you have furloughed or rehired employees.
Employment status: furloughed or rehired
Before we dive into how employment status can affect your 401(k) plan, let’s define who’s considered a furloughed or rehired employee.
- A furloughed employee is an individual who’s on an involuntary, unpaid leave of absence and expects to resume their job at some point in the future.
- A rehired employee is someone who terminated employment (either voluntary or involuntary) and is later rehired.
If you have furloughed or rehired employees (or both), you’ll want to work closely with your 401(k) third-party administrator (TPA) or plan consultant to make sure you’re handling these employees in accordance with your plan document provisions for eligibility, vesting, loans, and withdrawals.
Are furloughed and rehired employees eligible to participate?
The eligibility question is pretty straightforward for furloughed employees. These individuals haven’t separated from service, so they’re generally eligible to participate in your plan, assuming they’re already enrolled or have met the plan’s age and service requirements.
That said, since furloughed employees aren’t being paid, they can’t make 401(k) contributions while they’re on leave. They have to wait until their furlough ends to make or resume contributions; however, plan sponsors can choose to make nonelective (profit sharing) contributions for their furloughed employees based on plan provisions, including any allocation conditions, provided they had eligible compensation during the plan year.
The answer is more complex with rehired employees, as it depends on whether the employee had a break in service and whether they were participating in the plan when they terminated employment. The definition of a break in service is based on how a plan calculates its service requirement, as outlined below. An explanation of the break in service rules is beyond the scope of this article, and we recommend that you consult with your TPA or plan consultant with any specific questions.
Eligibility calculation method
Break in service definition
A break in service occurs when an employee doesn’t perform any service for 12 consecutive months.
Example: Mary terminates employment on September 16, 2021. She’ll incur a break in service if she doesn’t perform any services for her previous employer between September 17, 2021, and September 16, 2022.
A break in service occurs when an employee works less than 501 hours during the plan year or employment year, as defined by the plan document.
Example: Steve worked 400 hours before resigning on May 5, 2021, and the plan determines breaks in service based on the plan year. He’ll incur a break in service on December 31, 2021 (calendar year plans), assuming he’s not rehired before then.
Let’s break down rehired employees into three categories to determine when they’re eligible to enter (or re-enter) a 401(k) plan.
1 Rehired employees who were participating in the plan prior to termination of employment
Generally, rehired employees who were participating in the 401(k) plan prior to their termination of employment will re-enter the plan at their date of rehire (or as soon as administratively practicable thereafter), unless a break in service rule applies.
A plan may contain optional provisions that permit an employer to disregard a rehired employee’s past service if a break in service has occurred under the rule of parity or the one-year holdout rule.
Rule of parity
The rehired employee’s prior service isn’t recognized, and the employee is treated as a new employee if they were:
- A participant when the break in service period started
- Rehired after five consecutive one-year breaks in service (for credited hour plans) or five consecutive one-year periods of severance (for elapsed time plans)
- 0% vested in their account when they terminated employment and didn’t make any elective deferrals to the plan
Comment: The rule of parity is often irrelevant in 401(k) plans since it’s inapplicable once an employee makes elective deferrals (through an affirmative election or automatic enrollment).
One-year holdout rule
Following a single break in service, a rehired employee’s prior service isn’t recognized for eligibility purposes until they complete a year of service after their rehire date. Once the employee satisfies this requirement, they can retroactively join the plan as of their rehire date.
Comment: This rule is seldom (if ever) used in 401(k) plans due to administrative issues and the lack of IRS guidance as to how it would apply to a 401(k) arrangement.
2 Rehired employees who were eligible to participate in a plan but didn’t join prior to termination of employment
Generally, rehired employees who met the age and service requirement under the plan but terminated employment prior to their entry date will enter the plan at the later of their date of rehire (or as soon as administratively practicable thereafter) or the entry date that would’ve applied if they hadn’t left the company.
3 Rehired employees who were ineligible to participate in a plan prior to termination of employment
Rehired employees will be eligible to join the plan once they satisfy the plan’s eligibility requirements.
How is vesting calculated?
For plans that use the credited hours method to determine a year of vesting, furloughed employees won’t see any change in their vesting percentage since they’re not working (i.e., not performing any hours of service during the furlough). For example, an employee who was 40% vested at the time of the furlough will remain at this level until the furlough ends, they return to work, and they’re credited with additional vesting service. Of course, employees always remain 100% vested in any contributions they’ve made to the company’s 401(k) plan.
For plans that use the elapsed time method to determine a year of vesting, the furloughed employees’ accounts continue to vest since vesting is tied to when an employee starts and stops employment. Remember, furloughed employees are still considered employed, although they’re not currently working.
The vesting rules for rehired employees are similar to the normal eligibility rules, but vesting is based on a vesting computation period (i.e., any 12-month period, but the plan year is most commonly used). The break in service rules also apply to the determination of vesting service. Lastly, plans may include the rule of parity or the one-year holdout rule.
What about forfeitures? Plan sponsors also have to consider how to handle forfeitures for rehired employees. When an employee terminates employment, they forfeit the unvested portion of their 401(k) account in accordance with the terms of the plan. Rehired employees who haven’t incurred five consecutive breaks in service must be provided with an opportunity to repay the amount that was distributed to them and “buy back” the forfeited amount (i.e., the forfeited amount will be restored to the employee’s account).
For example, Mary was 60% vested when she terminated employment in September 2021. She received a distribution of the vested portion of her account in the amount of $15,000, and the non-vested portion of $10,000 was forfeited. Mary will be rehired in June 2022. If she repays the $15,000 distribution to her account, the $10,000 forfeiture will be restored, putting her account back to where it was prior to her termination of employment.
How are loans, loan repayments, and withdrawals handled?
Furloughed employees may be allowed to request loans and withdrawals while on leave, if they qualify under the terms of the plan document. The challenge is with loan repayments for new and outstanding loans since loan repayments are usually deducted from a participant’s paycheck, something furloughed employees don’t receive. Your ERISA attorney and plan consultant can help you evaluate options to prevent loan defaults during the furlough, which might involve finding another way for these employees to make loan repayments or temporarily suspending the repayments.
Rehired employees are subject to the terms of the plan, including the availability of loans and withdrawals, if any. In addition, any outstanding loans that may have been issued prior to the employee’s termination of employment that weren’t repaid and aren’t yet in default will need to be addressed. For example, if a plan permitted the terminated participant to continue loan repayments through ACH or check, the loan policy may require payroll deductions at rehire for future repayments. Alternatively, the loan policy may permit the employee to continue to make repayments through ACH or check.
Keeping your plan compliant during all business cycles
The possibility of furloughs, layoffs, and rehires is part of running a business, and the time to prepare is before they happen. Work with your TPA or plan consultant to make sure your plan document contains the necessary language to address these events, and train everyone involved with the plan on those provisions.
Additionally, you should review your employee census data regularly to make sure employment status and employee contact information are correct. Accurate contact information is essential for notifying furloughed and terminated employees about any developments with your 401(k) plan and information about their accounts.
These best practices, along with help from a knowledgeable TPA or plan consultant, can help keep your plan running smoothly through economic ups and downs.
The content of this document is for general information only and is believed to be accurate and reliable as of the posting date, but may be subject to change. It is not intended to provide investment, tax, plan design, or legal advice (unless otherwise indicated). Please consult your own independent advisor as to any investment, tax, or legal statements made herein.
All samples provided are for illustrative purposes only. Figures are based on assumptions as set out, and individual circumstances may vary.
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