Benefits Basics – When An Employee Is Dismissed: A Resource Guide For HR & Benefits Professionals

When an employee's employment ends – whether due to a routine layoff, a negotiated separation, or an unexpected termination for-cause – human resources and legal teams must coordinate quickly and carefully. The departure of an employee, regardless of the reason, sets off a chain of events affecting wages, bonuses, equity awards, retirement benefits, health coverage, and other company-sponsored programs. The manner in which each of these benefits is handled will depend on the termination circumstances, the precise language of the governing documents, and the applicable legal requirements. Mistakes can be costly, both financially and reputationally, so it is essential to approach each dismissal situation with care and consistency.

The information given in this guide is general in nature and is not intended to address every wage payment, benefit, or tax issue that may come up when dealing with the dismissal of an employee or other nuances that may arise when considering the dismissed employee or the specifics of your company's benefit plans. In addition, any tax or other rules described in this guide are current as of the date of this guide, and do not infer that the rules described are the only rules (tax or otherwise) that may apply and are subject to change. As a result, we always recommend that you engage your in-house or external legal counsel or other tax or employee benefits advisors when working through compensation and benefits issues related to terminating an employee.

This guide is part of Foley's Employee Benefits & Executive Compensation Practice "Benefits Basics" resource series — please see our prior resource guides for important benefits considerations when an employee dies or becomes disabled.

AN OVERVIEW OF RELEVANT LAW

Before we dive into discussing issues for administering your company's compensation and benefit plans, it is important to have a high-level understanding of the termination process and related legal and administrative basics.

Gather Your Documents

Before you take any action, gather all relevant documents. This may include some or all of the following:

• The employee's offer letter or employment agreement.
• Any severance agreements or company-sponsored severance policies.
• Any change-in-control, signing, retention or similar bonus agreements.
• Any employee loan documents.
• The employee handbook.
• All equity award agreements and related plan documents and, if applicable, shareholders agreement, operating agreement, or other governance documents.
• All bonus and commission plans.
• Qualified and nonqualified retirement plan documents and summary plan descriptions.
• Insurance policies and third-party administrator agreements.
• Benefits booklets and summary plan descriptions.
• COBRA notices.
• Any restrictive covenant agreements (like non-competes or confidentiality agreements).

The manner and extent to which each of these documents will be relevant largely depends on the termination circumstances.

Understand the Basis for Dismissal

Once you have located all relevant documents, the first practical step is to clearly understand the basis for the employee's termination. A termination "for-cause" is rare and typically involves misconduct, such as theft, fraud, gross negligence, or a serious breach of company policy. This type of termination often results in the forfeiture of certain benefits and the loss of post-employment rights. A "not-for-cause" termination generally occurs for business reasons unrelated to misconduct – such as position elimination, restructuring, or changes in business direction – and may entitle the employee to severance and continued participation in certain incentive arrangements.

Review the Law

Next, make sure you are complying with all applicable federal, state, and local requirements. This includes providing proper notice under laws like the WARN Act, issuing final paychecks on time, and following any restrictions on payroll deductions. The requirements of these laws are beyond the scope of this article, but compliance is very important because missing a statutory deadline or failing to provide required notices or other documentation can create unnecessary legal exposure.

As discussed in some detail below, it is important to be mindful of Internal Revenue Code Section 409A (Section 409A), which governs the timing and form of certain deferred compensation payments. Improperly timed payments or changes in the form of benefit delivery can lead to immediate income inclusion for the former employee, plus a 20% additional tax and other penalties imposed by the Internal Revenue Service. So, before altering any payment terms, HR and legal should confirm that revisions will not create unintended negative tax consequences.

Prepare the Documentation

If you're offering severance, accelerated bonuses, or equity vesting, as part of a terminating employee's separation package (or if any of these items are required under applicable contracts, plans or award agreements), these benefits are often conditioned on the employee signing a separation agreement that includes a general release of claims. When preparing the separation agreement, make sure the release complies with all applicable laws, including the Older Workers Benefit Protection Act (OWBPA) for employees over 40, and that the consideration for the release is clearly described. Employees over 40 years old typically must get 21 days to consider the agreement, and an additional seven days after signature to revoke their agreement to age claim releases. Generally, the release should not be provided for execution until on or after the employee's last day of employment, though there are circumstances where it might be provided sooner than the last day to start the OWBPA consideration period running. Payments should not begin until the release is executed and any revocation period has expired or, if later, the date required under the terms of any agreements that are subject to Section 409A. State laws may also require certain additional waiting periods, admonitions, or express waiver language or notices for an effective release, so be sure to understand local obligations based on the employee's physical work location.

If the employee is being terminated "for-cause," then be sure to document the circumstances giving rise to the "for-cause" termination very carefully and consider how to include them effectively in any recitals to the separation agreement. Also, if the employee remains subject to any restrictive covenants, be sure that there is valid consideration for the covenants, as recent case law suggests that equity awards that are forfeited at termination may not be valid consideration for these types of post-termination restrictions.

CASH AND EQUITY ARRANGEMENTS

Overview

When an employee is dismissed, you will need to consider the impact on a variety of cash compensation amounts or equity benefits. First, you should survey all the cash and equity compensation that is or may be due with respect to the employee. Almost certainly, a final paycheck will be due. You should also determine whether the employee has accrued vacation or other PTO that may need to be paid based on applicable state law and the company's PTO policies and/or business expenses that were incurred or submitted to the company but have not yet been reimbursed. These requirements, and the related timing for payment, are governed by state law and company policy.

Cash-Based Payments

For cash-based bonus plans and commission arrangements, plan documents should be reviewed to confirm whether the employee must be actively employed on the ordinary course payment date to receive a payment, or – if termination is not for-cause – whether a pro-rated award is due based on service during the performance period. In many for-cause terminations, unpaid bonuses are forfeited entirely, regardless of performance results, but this is dependent on the terms of the plan and, sometimes, state law.

On the flip side, you should determine whether the employee owes any money to the company at the time of termination. If the repayment obligation is due to a loan, be sure to determine whether the loan becomes due at termination and if the terms of the loan permit the company to offset the loan amount from other compensation. Be sure to review documents to determine whether the employee may be subject to a claw-back/repayment obligation if any service requirement related to a previously paid bonus was not satisfied (e.g., for a signing or retention bonus).

Equity Arrangements

Equity awards present other issues. Award agreements and the related plan documents will specify whether unvested options, restricted stock, restricted stock units, or performance awards are forfeited immediately upon termination, or whether some form of accelerated or pro-rata vesting applies to not-for-cause terminations. If the employee is being terminated "for-cause," then review any equity arrangements (and shareholder agreements) to determine if awards (including vested awards) are forfeited or subject to specific company repurchase rights. In the case of stock options, pay special attention to the post-termination exercise period. The standard window is 90 days following termination, but some companies offer longer periods for individuals who are terminated without cause. Extending the exercise period requires care because modifications may affect the award's tax treatment — for example, turning an incentive stock option into a nonqualified option — and may also create Section 409A implications if extended beyond the original expiration date or if the extension amendment is executed after the post-termination exercise period expires. In addition, some agreements or shareholder arrangements allow the company to repurchase shares (including any shares acquired when a terminated employee exercises vested stock options) upon termination at fair market value or another formula price. These rights should be reviewed early so that any associated timelines can be met. Finally, if the company maintains an employee stock purchase plan, you should determine whether there is an amount held in an employee stock purchase plan account for the employee that was waiting to be used to buy employer stock and determine how that is supposed to be administered post-termination.

Severance

As noted above, employees may be entitled to severance pursuant to the terms of the company's general policy or individual agreement. Review the relevant documents to determine severance eligibility and conditions. A company may also choose to offer severance payments to an employee who is terminated without cause in particular circumstances, particularly if the company wants to obtain a release of claims from the employee and the employee is not otherwise receiving benefits at termination that are already conditioned on executing a release of claims.

Lump-sum or installment severance paid entirely within two-and one-half months after the end of the year in which an employee terminates employment is generally exempt from the Section 409A rules. There is also a Section 409A separation-pay safe harbor that exempts from Section 409A rules severance amounts not exceeding the lesser of (i) two times the employee's annualized compensation for the year before termination, or (ii) two times the Code Section 401(a)(17) limit (which is $345,000 in 2025), as long as all of the separation payments are made by the end of the second year following separation. If severance exceeds these limits or is paid in installments beyond the safe harbor period, then the arrangement must satisfy certain Section 409A requirements, including specifying fixed payment dates or objectively determinable schedules and must not allow for acceleration or discretion with respect to the timing of payments. If the payments are subject to the employee executing a release of claims, certain payment timing considerations need to be addressed for compliance with Section 409A rules.

For additional information on how Section 409A applies to severance arrangements, see our article here.

EMPLOYEE BENEFIT PLANS

Qualified Retirement Plans

401(k) and Other Types of Defined Contribution Retirement Plans. 401(k) plans are the most common employer-provided retirement benefit offered to employees, but small employers may offer other retirement plans, like a SIMPLE-IRA or SEP-IRA plan. When an employee terminates employment, their vested balance in a 401(k) or other qualified defined contribution retirement plan is typically available for distribution, rollover to another tax-qualified plan, or may be retained in the plan, depending on the account size and plan rules. Unlike other types of benefits described in this guide, whether an employee is terminated for-cause or not-for-cause should not have any impact on the employee's rights to their vested 401(k) plan balance. The most critical action item for HR professionals when an employee is terminated is to promptly notify the 401(k) plan's third-party administrator of the termination so that the third-party administrator can start the standard process to properly and timely notify the individual about distribution rights and rollover options (which include certain legally required notifications). This is also a good time to encourage the employee to check beneficiary designations and ensure that, going forward, correct contact information is available to the plan.

If the departing employee has an outstanding 401(k) loan, you must also communicate any repayment options and default consequences as required by the plan and your current plan loan policy – many plans require outstanding loans to be repaid or will offset the employee's 401(k) balance shortly after termination. If the loan policy allows a terminated employee to continue to make 401(k) loan repayments (which, would need to be made through separate direct payments from the individual since the employee will no longer be on the company's payroll), then you should communicate that process to the individual (or the third-party administrator will do so). If repayment on an outstanding 401(k) loan is not continued after termination, then those unpaid amounts will be considered a taxable distribution to the departing employee at the time set out in the 401(k) plan loan policy.

Other issues to consider:

• If the terminations are part of a larger reduction in force (or series of planned reductions), employers can consider accelerating vesting for unvested 401(k) balances of the affected employees. This is usually permissible under 401(k) plan rules but may require a plan amendment or other proper authorization to do so. In addition, if company layoffs or other terminations without cause during a plan year are significant enough, 401(k) plan rules may require the plan to treat the reductions as a "partial plan termination," which would require the plan to fully vest account balances for affected individuals. These partial plan rules are complex and nuanced, so we suggest you consult with counsel when there have been any ongoing layoffs or reductions in force to confirm whether accelerated vesting is required.
• One "gotcha" to be aware of is to make sure that any employee deferral contributions are only withheld from eligible post-termination payments. The key is to remember that severance payments are never eligible for 401(k) plan contributions (or related employer matching contributions), but depending on the terms of your 401(k) plan certain "post-termination payments" could be eligible. Severance payments are any type of payment or benefit that does not relate to the services provided by the employee through the date of termination (meaning, if the employee had not been terminated those types of payments wouldn't have been paid, like cash severance payments). Contrast that with post-termination payments, which include pay or benefits that are paid following termination, but would have been paid if employment had continued, like a departing employee's final paycheck or accrued vacation payout. These latter types of payments may need to have 401(k) plan deferrals withheld (and be eligible for employer matching contributions) if the payments are made within certain statutory periods after employment and your plan document requires it. This is a common area for inadvertent 401(k) operational errors (which can require costly corrective action to fix and maintain the tax-qualified status of the plan), so it is important to make sure that you understand the plan's rules on payments made after termination and coordinate with payroll and 401(k) plan administrators to ensure plan terms are followed.

Defined Benefit Pension Plans. For defined benefit or cash balance pension plans, the crucial question is whether the participant is vested at the time of termination or, if not, whether the plan provides for full vesting in the particular circumstance. If so, participants may be entitled to commence benefits at normal retirement age or, if the plan allows, at an earlier date. Similar to 401(k) plans, for-cause terminations generally do not affect vested benefits, but could impact certain early-retirement subsidies depending on plan design.

The partial plan termination rules addressed in the 401(k) discussion above also apply to qualified pension plans, so be sure to consult with counsel when there have been any ongoing layoffs or reductions in force to confirm whether accelerated vesting is required.

When terminating an employee who is also a pension plan participant, you should work closely with your plan administrators to ensure that required notices and other communications are timely distributed to the individual. In addition, this is a good time to ensure that the plan's recordkeeping has all of the necessary historical benefits data (including service, compensation, hire and termination dates, and participant-specific data) for properly calculating and paying pension benefits and encourage the employee to check beneficiary designations and ongoing contact information for future communications and notices.

Group Health Plans

The loss of group health coverage due to termination is generally a qualifying event for COBRA continuation coverage. COBRA generally applies to plans providing health benefits, including medical, dental, and vision plans. Most health FSAs qualify for a limited COBRA obligation, which lets an employer only offer COBRA coverage when the employee's account is underspent (meaning that more money has been contributed to the FSA as of the date of termination from employment than has been reimbursed), and typically only for the rest of the plan year. There is a narrow and rarely-used COBRA exception for terminations due to "gross misconduct," but this is a high legal standard that many for-cause terminations do not meet, and employers should consult counsel before applying it.

If the company is subject to federal COBRA rules (generally, employers with at least 20 employees are subject to COBRA), you must notify the COBRA administrator of the employee's termination within 30 days from the termination date, and then the COBRA administrator has 14 days to send out the COBRA election packet. If you administer COBRA internally, then you have a total of 44 days to send out the COBRA election packet. In addition, you will need to review any employment agreements to confirm if the company has agreed to pay for all or any part of the COBRA premiums in the event of the employee's termination.

If you are a small employer not subject to the federal COBRA rules, there still may be similar requirements under a state "mini COBRA" law of which you should be aware. You should not assume that the insurance carrier will administer your insurance policy's mini COBRA provisions; often, insurance policies impose certain administrative obligations on the employer, such as notice obligations related to mini COBRA requirements.

Life and Disability Insurance

For life and disability insurance that have portability or conversion provisions, be sure to provide the required notices that allow the employee (and, if applicable, dependents) to convert group coverage to an individual policy, usually within 31 days of termination. If your company owns a key-man policy on an executive, remember that terminating employment does not affect the company's ownership of the policy unless otherwise specified in the contract. Finally, review any collateral assignments or split-dollar arrangements to ensure proper handling.

Other Benefits

Dependent care account plans only reimburse expenses that enable the employee or their spouse to work, so claims generally stop at termination. Any unused balances are typically forfeited unless the plan allows for a limited grace period. For other fringe benefits—such as commuter, tuition reimbursement, car leases, cell phone benefits, or wellness programs—be sure to terminate deductions and communicate any deadlines for submitting claims or suspending benefits.

Be sure not to overlook business expense reimbursements. As noted above, many state wage-payment laws require that all outstanding business expenses be reimbursed with the final paycheck. Also, be sure to audit corporate card accounts to ensure that no new charges are made after termination.

Nonqualified Deferred Compensation Plans

Executives and certain key employees may participate in nonqualified deferred compensation plans. Like pension plans and 401(k) plans, the first issue to consider is whether the employee was vested in their entire benefit or plan account at the time of termination. Some plans also impose additional forfeiture if the termination is for-cause or if the participant violates post-employment covenants, such as non-compete or non-solicitation agreements. The plan document will define whether unvested amounts are forfeited upon termination and whether termination triggers a payment.

If any part of the account balance or benefit is unvested (or becomes unvested as a result of a for-cause termination), it should be forfeited in accordance with the terms of the plan.

If any portion of the account is vested, the document and, if applicable, employee deferral elections will dictate whether a payment is due following the employee's termination (which, in this context, is referred to as a separation from service under Section 409A). In public companies, be sure to note that "specified employees" are subject to a six-month delay for most post-termination payments. Accelerations and re-deferrals of nonqualified plan payments are generally prohibited under Section 409A, except in narrow circumstances, so be sure to consult counsel before making any changes to payment timing.

If you have a third-party administrator for the plan, then reach out to them as soon as possible to notify them of the employee's termination and direct any actions they need to take regarding the employee's account or benefit under the plan (such as forfeiting balances or starting payments).

OTHER ISSUES TO CONSIDER

Public Company Considerations

Form 8-K Requirement. Generally, when a publicly traded company terminates a Chief Executive Officer (CEO), president, Chief Financial Officer (CFO), Chief Operating Officer, Chief Accounting Officer, or any named executive officer, this triggers the need to file a current report on Form 8-K with the Securities and Exchange Commission (SEC). In addition, if the company enters into a "material compensatory agreement" (or materially amends an existing agreement) in connection with the departure of a CEO, CFO or named executive officer (e.g., entering into a separation agreement or amending existing separation benefit terms), a Form 8-K is needed. This disclosure requirement is required within four business days of the relevant event, so it is important to understand when this obligation will be triggered as soon as possible so the company is prepared to timely make these filings. In addition, a separation agreement or other agreement entered into with an executive officer may need to be filed as an exhibit to the company's quarterly or annual reports, as a material contract, so close coordination with the company's securities and disclosure teams is critical when the terminated employee is an officer.

Proxy Reporting. If the terminated employee is a "named executive officer" whose compensation must be disclosed in the company's next proxy statement, any compensation actions taken in connection with the officer's separation may need to be discussed in the Compensation Discussion and Analysis section of the next proxy statement. Any amounts paid in connection with the separation (or the incremental value of modified equity awards) may also need to be disclosed in the proxy statement and may need to be quantified as part of the disclosure of potential payments upon termination.

Section 16 Reporting. If the terminated employee is an officer who is subject to Section 16 reporting obligations (including the requirement to report transactions in the company's stock on Forms 4), any actions the company takes with respect to the officer's stock awards or holdings in connection with the termination – particularly if such actions take place prior to the officer's loss of Section 16 "insider" status – may trigger Form 4 reporting obligations.

Six-Month Payment Delay for Specified Employees. As noted above, payments made to certain key employees (called "specified employees") of publicly traded companies upon termination of employment may be subject to a six-month delay under Code Section 409A deferred compensation rules. A detailed discussion about who is a "specified employee" is beyond the scope of this guide, but "specified employees" may include (among other individuals) up to 50 of the most highly compensated officers of the company, if their compensation is greater than an indexed threshold amount ($230,000 for 2025). Determining if someone is a "specified employee" and what payments may need to be delayed under these rules is governed by complex and nuanced rules and the company should consult with counsel as needed to make these determinations and time payments in accordance with these rules.

KEY TAKEAWAYS

Benefit and compensation decisions when a company terminates an employee must be made with careful attention to plan documents, legal requirements, and timing rules. It is vital to:

• Accurately classify the termination as for-cause or not for-cause consistent with applicable plan definitions.
• Gather and review all relevant agreements and benefit plan documents as early as possible.
• Be mindful of statutory notice deadlines, COBRA election timelines, and payroll processing requirements.
• Avoid 409A pitfalls when altering payment timing or equity exercise periods.
• Document all determinations, communications, and payments in the employee's file.

By approaching the process methodically, HR leadership and in-house counsel can ensure that the organization meets its legal obligations, treats the employee consistently with plan terms, and avoids the all-too-common traps that lead to disputes or penalties.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.