Most plan documents will specify that a rehired former employee who had been a participant in the plan will reenter the plan upon rehire. This generally doesn’t pose a problem for profit sharing and pension plans where the employer’s allocation is made at the end of the plan year. It can cause a problem for 401(k) plans.
When a participant is eligible to participate in the plan, either on initial eligibility or in a rehire, the participant must be notified of that right. Fail to provide that notice, and you have an operational failure that could lead to a loss of plan qualification. The IRS permits an employer to correct such a failure by making the participant “whole.” That is, the employer makes a contribution equivalent to the rate of salary deferrals for the other employees plus lost earnings and match, if any. This correction is outlined in Revenue Procedure 2000-17, Section 2, examples 5 and 7.

It’s easy to miss this notification requirement when 401(k) participants reenter the plan on the date of hire. Some 401(k) plans are drafted to help avoid this problem. A plan can be drafted to limit the dates when a rehired participant reenters the plan, say on the next plan entry date following the date of rehire.

Many non-401(k) plans impose a “break in service (BIS) rule that temporarily delays reentry into the plan for a former participant when the participant has been credited with a one-year break in service. For most plans, a BIS occurs when a plan year passes in which the participant is credited with 500 or fewer hours of service. [DOL Regs. 2530.200b-4] Plans with a BIS rule delay the rehired employee’s reentry until he or she again meets the plan’s eligibility requirements (e.g., one year of service and employment on the next entry date). When that condition is met, the rehired employee is brought into the plan on a retroactive basis. Thus, if a full-time employee was rehired but was terminated prior to the first applicable entry date, no contribution is provided to this participant’s account. If the retroactive entry applies after a rehire, the employer will be required to treat the individual as eligible as of the date of rehire.

This break-in-service rule doesn’t work well for 401(k) plans; and, unfortunately, the IRS has provided no special guidance on its application to 401(k) plans. As a result, a plan using the break-in-service rule generally limits the eligibility condition to the profit sharing contribution. The plan document will always control. If it’s silent on the rehired participant’s status, the individual should be treated as in the plan on the date of rehire.

The regulation also permits a plan to ignore a rehired employee’s participation and establish a new eligibility requirement under the “rule of parity.” Note that this rule has very limited application for a former participant who is rehired. Under the rule of parity, a participant’s status at an earlier date is ignored; and the rehired employee is treated as a new employer who must meet the plan’s eligibility requirements. The rule of parity is available when three conditions are met:

  1. The employee must have been a participant when the break-in-service period commenced,
  2. The individual must be credited with a number of five consecutive one-year breaks in service, and
  3. The employee must be zero percent vested in the plan (i.e., not sufficient credited vesting service to have any vested percentage).

Gregory E. Matthews, CPA, Matthews Benefit Group, Inc. St. Petersburg, Florida, , June 2001