Rules of the Road for Rehiring Ex-Employees

Proceed with caution if the former employee previously participated in your firm’s 401(k) or retirement plan, say these tax experts.

The current labor shortage is creating challenges for employers across the board. With vaccination rates on the rise, many have finally been authorized to fully reopen only to find that they’re unable to hire the employees they need to operate at full capacity.

Some employees opted to take an early retirement or simply resign in the wake of the pandemic — but may now be reevaluating those decisions as life returns to normal. Employers who are thinking about rehiring those employees should proceed with caution if the employee previously participated in the business’ 401(k) or retirement plan.

While the IRS provided relief for business owners who sponsor defined benefit plans, most are grappling with the 401(k) qualification rules — and small business clients should carefully review their plan documents and take steps to avoid qualification problems with rehired employees.

401(k) Eligibility Rules When Rehiring Employees

New employees aren’t always automatically eligible to participate in an employer-sponsored 401(k) plan. Under the SECURE Act, employees who perform at least 500 hours of service for at least three consecutive years (and are at least 21 years old) must be allowed to participate in the employer-sponsored 401(k) (pre-SECURE Act rules required eligibility only for workers with at least 1,000 hours of service per year). 

In evaluating an employee’s eligibility to participate in the 401(k), complications can arise when an employee is rehired after a break in service. In most cases, an employee who was previously participating in the employer’s 401(k) plan prior to leaving the company must be eligible to participate in the 401(k) immediately upon rehiring that employee. Similarly, employees who satisfied eligibility requirements prior to leaving, but did not yet enter the plan, may be eligible immediately upon rehire.

However, the employer may be entitled to disregard the employee’s former service if the employee had five or more “breaks in service”. A “break in service”, for this purpose, is a 12-month plan year where the employee had 500 or fewer hours of service. So, if the employee left employment for at least five years, the employer may be entitled to disregard prior service—unless the employee was vested in the plan.

If the employee was vested in the plan, the employer must credit the employee for previous years of service when evaluating plan eligibility. Employees are always 100 percent vested in their own plan contributions. However, it’s possible that the employee may not have been vested in employer contributions.

Some plan documents contain provisions that could impact the application of these rules. For example, it’s possible that the plan documents could include a provision allowing the employer to disregard prior service until the rehired employee completes one year of service.

Distributions and Forfeitures

401(k) participants often take plan distributions based on a severance from employment. If the rehired employee took any plan distributions prior to rehire, it’s important to determine whether the distribution was “bona fide”. 

Whether a distribution was bona fide is based on a facts and circumstances analysis. Typically, if the employee has left the employer’s service and there’s no prearranged plan to return to employment, the distribution will be considered bona fide. If there was some plan for the employee to be rehired at a later date, the distribution will not be bona fide.

If the employee did take a bona fide distribution and that distribution caused a forfeiture from their account, the employer may be required to restore the amounts to the employee’s account. The employee must repay the distribution within five years of the employee’s severance from service to qualify to have the forfeited amounts restored.

Conclusion

Rehiring an employee who already knows the ropes can be helpful to many business owners.

However, any small business client who is considering rehiring an employee who left employment for a period of time should review their 401(k) plan documents before taking any concrete action. The terms of the specific plan may provide rules that must be complied with to prevent qualification issues down the road.

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