Closing a cash balance plan

When closing is reasonable

A qualified plan is meant to be permanent. Treas. Reg. 1.401-1(b)(2) says a plan implies a permanent program, not a temporary one, and that abandoning it for any reason other than business necessity within a few years of setting it up is evidence it was never a genuine plan. If the IRS reached that view, the deductions already taken could be at risk.

The law sets no fixed number of years. What matters is the reason. Reasons that are generally accepted include:

• a sustained fall in the business's income that makes the contributions unaffordable
• selling, merging or winding down the business
• retiring, or reaching the point where the plan has paid in about as much as the law allows
• hiring employees, where the plan would have to change fundamentally (see hiring your first employee)

Closing after a year or two with none of these reasons, only because the deduction has been taken, is the case the rule is aimed at. If money is tight but the business continues, freezing the plan or lowering future pay credits may be a better fit than closing it; see minimum contributions and lean years.

The steps

1. Talk to the actuary about the date. The termination date decides which year's pay credit you earn and what the final contribution is. Choosing it before the next pay credit is earned usually keeps the final year simpler.
2. Adopt a written resolution. A corporation's board, or the owner of a sole proprietorship or LLC, signs a resolution to terminate the plan as of the chosen date, along with a plan amendment that ends benefit accruals. The plan document should be brought up to date for any changes in the law at the same time.
3. Vest fully. On termination every participant becomes 100% vested in the benefit earned to that date (IRC 411(d)(3)). In a solo plan you are usually fully vested already, but the rule applies either way.
4. Final valuation. The actuary calculates the final benefit, checks it against the IRC 415 limits, and works out any contribution still due for the final year, including any minimum required contribution.
5. Pay out the account. The usual route is a direct rollover of the lump sum into an IRA or another retirement plan, which is not taxed when it is done as a direct rollover. Money you take in cash is taxed as ordinary income and may face an additional tax if you are under 59½. If you are married, the plan document may require your spouse's written consent to a lump sum.
6. File the final Form 5500-EZ. A return is required for the year the last assets are paid out, whatever the balance, even if the plan never needed one before. See Form 5500-EZ.
7. Close the plan's brokerage account and keep the plan's records, including the final valuation and the resolution.

Pay the money out promptly once the plan is terminated. A plan that is closed on paper but keeps its assets for a long time may be treated as still running, with its valuations, minimums and filings.

A plan that covers only the owner and spouse is not insured by the Pension Benefit Guaranty Corporation, so there is no PBGC termination filing.

If the account is short of the benefit

Most solo plans now credit the actual return on the plan's investments, so your account and the plan's assets usually stay close together. There are still two ways the plan can come up short when it closes:

• The floor at payout. Under the preservation of capital rule, the payout cannot be less than the total of the pay credits made to your account. If investment losses have left the account below that total, the business must contribute the difference.
• Unpaid contributions. If the business has paid only the minimum, or less, the assets may be short of the benefits owed. The shortfall generally has to be funded before the benefit can be paid in full, and the rules on lump sums in IRC 436 can limit what is paid out of an underfunded plan.

What can be done in that situation depends on the plan document and the numbers. Talk to the actuary before you set a termination date, not after.

If the account is above the benefit

The opposite problem is a surplus: more money in the plan than it can pay you. The plan can never pay a benefit above the IRC 415(b) limit, so if strong returns or large contributions have taken the assets past the most you may receive, the excess cannot simply be rolled into your IRA.

Surplus assets that go back to the business are taxable income to the business and also face an excise tax on the reversion under IRC 4980, of 50%, reduced to 20% where the business sets up a qualified replacement plan or increases benefits in line with the statute's conditions. Some of the surplus can often be moved into a replacement plan instead of reverting.

The better approach is to avoid the surplus in the first place. Your actuary can see it coming in the annual valuation, and the usual response is to contribute less in the years before closing. This is one reason investment returns matter to your future contributions; see investing cash balance plan assets.

What it costs

Plan providers usually charge a separate fee for a termination, for the final valuation, amendment and paperwork. Ask what it is before you sign up; see what a cash balance plan costs.