IRS Guidance Clarifies Pandemic Rehiring Need Not Always Affect Retirement Benefits

Morgan Lewis - ML Benefits
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Morgan Lewis - ML Benefits

The IRS recently issued FAQs to address workforce issues and labor shortages resulting from the COVID-19 pandemic. The guidance seems to be in response to well-publicized labor shortages affecting schools and the education industry, although it is not limited to that industry. The FAQs reaffirm prior IRS guidance, but may give comfort to employers who are contemplating rehiring retirees as they try to manage workforce issues “related to” the pandemic.

Specifically, the guidance clarifies that rehiring a retiree due to circumstances that were unforeseen when they retired would not prevent the retirement from being a bona fide retirement. It also clarifies that, should a plan’s terms allow distributions to continue (for example, because the plan does not include suspension of benefits provisions), distributions need not be halted. Finally, it clarifies that plans may allow in-service distributions.

Note: The guidance does not describe what circumstances would be considered “related to” the pandemic, but it does give the example of the current labor shortage affecting the education industry as satisfying the requirement.

As background, the Internal Revenue Code (Code) requires someone to retire before being eligible to receive defined benefit pension benefits prior to normal retirement age—otherwise, the plan is making an in-service distribution, which is a qualification failure in the absence of an enumerated withdrawal event. A similar rule applies to defined contribution (such as 401(k)) plans, which generally requires a “termination of employment” before a participant can be paid their benefits (unless they qualify for an in-service distribution, e.g., by virtue of having attained age 59½). However, neither ERISA nor the Code define “retirement” or “termination of employment.”

Note: This guidance and the underlying rules do not apply to welfare plans or, for example, benefits under retiree medical plans.

Prior IRS guidance requires employers to evaluate the facts and understanding of the parties at the time of the retirement to determine whether it is, in fact, a bona fide termination of employment. See, e.g., PLR 201147038. The latest FAQs confirm this interpretation and clarify that in the IRS’s view, rehire due to unanticipated circumstances such as the current labor shortages would not prevent a retirement from being bona fide. Specifically, a rehire due to “unforeseen circumstances that do not reflect any prearrangement to rehire the individual” is permissible.

Note: While the guidance does not specifically address the standard that applies to a “separation from service” under nonqualified plans, it may be relevant in interpreting requirements under those plans as well. A “separation from service” is deemed to occur when the employer and employee both reasonably anticipate that the employee will either cease entirely providing services, or that services will drop to a level less than 20% of the average amount of service provided during the preceding 36 months. Because the standard similarly looks to the understanding at the time of the separation, the concepts in the FAQs may also be helpful when determining when to make a distribution under nonqualified plans.

Because of the uncertainty that accompanies the facts and circumstances analysis, many employers have adopted practices to limit when and how they will consider rehiring retirees. The latest FAQs should give employers reassurance that deviating from any such policy due to unforeseen circumstances during the pandemic would not inherently present qualification issues. Nevertheless, employers should still be mindful to avoid a situation where there’s an explicit understanding at the time of retirement that the retiree would be rehired, as such a retirement would not be bona fide.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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