IRS Rules on Key Point on 401(k) Vesting

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The IRS recently considered this key issue regarding a 401(k) plan participant’s vesting when there are breaks in service.

Here is the case: A 401(k) plan uses a six-year graded vesting schedule for matching contributions, and forfeits the nonvested portion in a terminated participant’s matching contribution account after a cash-out or five consecutive one-year breaks in service. 

Recently the company rehired, on a full-time basis, a former employee who had two years of vesting service when he was cashed out in 2008. When he quit, he was 20 percent vested in his matching contribution account, and during his absence, he accrued three consecutive one-year breaks in service. Must the company give him credit for those two years of vesting service?

The IRS reasoned that because the employee was rehired prior to having five consecutive one-year breaks in service, his two pre-break years of service must be counted for vesting of his matching contribution account. If he repays the entire amount of the distribution, the amount forfeited when he was cashed out will be restored. 

Break in Service Rule

Under the plan, participants had a one-year break in service for any year in which they did not complete the minimum hours of service required by the plan’s terms (for example, 501 hours).

The plan also used the special break-in-service rule where an employee’s post-break service is counted for vesting in pre-break accounts only if the employee is rehired prior to having five consecutive one-year breaks in service.

Vesting of Pre-break Account

Although the plan distributed the employee’s entire vested account balance in 2008, it must give him the opportunity to repay his entire distribution to the plan within five years of being rehired, because he didn’t have five consecutive one-year breaks in service. If the rehired employee repays the entire distribution to the plan, the employer must reinstate the amount he forfeited and vest him in the reinstated amount based on both his pre and post-break years of service. 

Vesting of Post-break Account and Waiting Period

The employee was 20% vested when he left the company in 2008. He was rehired after having only three consecutive one-year breaks in service (2009–2011). Therefore, the IRS ruled, the plan must credit his two pre-break years of service for vesting.

However, a plan may require an employee to complete up to one year of vesting service after being rehired to receive vesting credit for his or her pre-break years of service. If a plan has a post-break waiting period, the rehired employee must complete another year of service before he would be credited with three years of service (the two pre-break years plus the one-year waiting period). 

Types of Contributions

While participants are always 100% vested in their salary deferrals, the agency said the plan’s six-year graded vesting schedule applied only to employer matching contributions.

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