What happens to the unvested portion of an employee’s 401(k) account when a company goes out of business? That’s a question employees of Physicians Pain Specialists of Alabama (PPSA), one of the largest pain clinics in the upper Gulf Coast region, had to figure out after the Drug Enforcement Administration (DEA) and the Federal Bureau of Investigation (FBI) raided the clinic’s Mobile, Ala., offices in May 2014 and its two physician owners and several other individuals affiliated with the clinic eventually went to prison.

PPSA’s 401(k) had two components. The first was a profit-sharing component that vested immediately upon contribution. The second part of the plan had a matching component and a five-year graduated vesting period. Due to both the growth of the company and high employee turnover, a number of employees hadn’t yet reached their five-year vest.

With the company shutting down, employees were faced not only with finding new jobs but also figuring out what to do with the 401(k) plan they had through the company. While some options were straightforward, office administrators and representatives of the plan couldn’t readily answer the question about the unvested portions of employees’ 401(k) accounts.


Representatives of the 401(k) plan and office administrators knew the employees’ contributions were vested, and several options existed to transfer funds. One option for employees was to “cash out” their 401(k) by paying all taxes due and a 10% early withdrawal penalty if they were younger than 59-and-a-half years old. While this option wasn’t advised, it became necessary for some employees who had difficulty finding a new job.

Another option was for employees to transfer their 401(k) funds into a traditional IRA. This allowed employees to avoid paying any immediate taxes and allowed the money to continue to grow tax deferred. Employees also had the option of placing their funds into a Roth IRA by paying all taxes due. The Roth option allows all future earnings to grow tax-free.

Some employees had to make a partial rollover of funds. In a partial rollover, some funds are transferred to an IRA while the remaining funds are cashed out. The employee must pay taxes and penalties on the cashed-out portion.

Employees who secured new employment before the plan’s termination had the option of transferring their funds to their new employer’s 401(k) if the new employer’s plan allowed it.

For employees who were either unsure what they wanted to do with their 401(k) or who had to wait to transfer funds to their new employer’s 401(k), a “conduit IRA” was possible. This kind of IRA is set up to hold an employee’s 401(k) distribution until he or she is able to roll it into a new employer’s 401(k) plan or another retirement plan.


While employees had several different options to choose from, the question remained as to what happens to the unvested portion of an employee’s 401(k). After some investigation by plan representatives, it was determined that the unvested portion of the 401(k) plan vested immediately upon the plan’s termination. IRC §411(d)(3) protects an employee’s right to vest in his or her benefits in the event the plan terminates or a partial termination occurs. A partial termination is generally triggered if an employer lays off 20% or more of its employees within a year. Similarly, employer contributions under a profit-sharing plan or stock bonus plan also vest when an employer completely discontinues contributing to such plans.

Revenue Ruling 2007-43 provides potential guidance. The Internal Revenue Service (IRS) ruled that a partial termination had occurred and that separated employees were fully vested in their 401(k) plan when an employer ceased operations in one of its four business locations and 23% of the plan participants were severed from employment.

And in Weil v. Terson Co. Retirement Plan Administrative Committee, 933 F.2d 106 (2d Cir. 1991), the court ruled that both vested and nonvested participants were taken into account in determining whether there has been a reduction in the workforce that constituted a partial termination.

In the case of PPSA, bankruptcy wasn’t filed so employees were able to transfer their funds fairly quickly. If PPSA had filed bankruptcy and terminated the plan, it could have taken six months or more to get IRS approval for the plan’s termination. During this period, employees couldn’t have made withdrawals from the plan. Once the plan’s termination is approved, all employees become fully vested.

One thing to remember under a bankruptcy filing is that any 401(k) contributions deducted from an employee’s paycheck but not yet deposited in the 401(k) account on the date of the bankruptcy filing don’t have the same priority claims as unpaid wages and salaries. Thus, employees must get in line with other creditors for the return of any undeposited contributions.


Another element to consider is what happens with loans from the 401(k) when the plan terminates. Employees in plans that permit loans can currently borrow up to either (1) the greater of $10,000 or 50% of their vested account balance or (2) $50,000, whichever is less. For example, if a participant has a vested account balance of $40,000, the maximum amount that he or she can borrow from the account is $20,000. If a participant has a vested balance of $120,000, the maximum 401(k) loan is $50,000.

If an employee is unable to repay the loan to the plan prior to transferring funds out of the 401(k), it will be considered a taxable distribution and reported to the IRS on Form 1099-R. A taxpayer younger than 59-and-a-half years old will also owe the 10% early withdrawal penalty.

Following the Tax Cuts and Jobs Act of 2017, a taxpayer can now avoid paying taxes and penalty by repaying the loan to another IRA or qualified plan by the due date of the tax return for the year when the taxpayer left his or her job.

While most employees won’t work for an employer shut down due to criminal activity, it’s certainly possible that a company could terminate operations due to mismanagement or difficult economic conditions. Regardless of the reason an employer ceases operation, it’s important to know what options employees have with their 401(k) plan.

© 2019 A.P. Curatola

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