New IRS regulations address post-termination 401(k) deferrals

As a general principle, only an active employee may make deferrals into a 401(k) plan, because an individual who is not an active employee does not satisfy the plan's eligibility provisions and the IRS deferral rules.  Given this rule, plan administrators have struggled to determine whether they may take deferrals out of a commission check earned before termination but paid afterwords, or a severance payment made to induce early retirement.

Last week the IRS updated its 1981 limitations on benefits and contributions under qualified retirement plans.  One area of particular interest to employers was handling post-severance salary or other payments.  The IRS general rule is that amounts received after severance from employment are not considered "compensation" from which contributions to a plan may be made, since the recipient is no longer an active employee.  But in last week's new regulations, the IRS created several exceptions to the general rule. 

Payments made under bona fide sick, vacation or other leave plans that would have been available if termination had not occurred are "compensation" (eligible for contributions) if made within 2½ months of termination or the end of the plan's current limitation year, if later.  So, employers that make lump sum payments of unused sick or vacation leave to departing employees at or shortly after employment termination may now include those amounts as eligible for plan contributions (but may require a plan amendment to do so). 

Post-severance distributions from non-qualified deferred compensation plans that would have occurred at the same time if the individual had remained employed are also now included as "compensation" if they occur within that same 2½ month/limitation year time period, as are amounts included in income under Code section 409A.  And post-termination payments to permanently disabled participants are also excepted, if certain conditions are met. 

The lengthy new regulations make many other adjustments and clarifications, some of which have already been well-established in practice over the last 25 years based on IRS Announcements, Notices or other non-regulatory guidance.  As with any other changes to the rules governing a qualified plan, consider how these changes might affect your plan, which ones provide potential benefits to your employees, and discuss with your plan counsel how your plan should respond.