The Internal Revenue
Service has at long last issued final regulations under sections
401(k) and 401(m) of the Internal Revenue Code. The regulations,
issued on December 29, 2004, make some significant changes to the
proposed regulations issued in 2003, and update the final
regulations issued back in 1994. Since that time, numerous statutory
changes have taken place, as well as revenue rulings and procedures
which are all reflected in the new regulations.
The final regulations are quite extensive. This article will
review some of the most significant provisions and their impact on
the administration of 401(k) plans.
Nondiscrimination Testing
Most 401(k) plans must pass annual nondiscrimination tests
regarding employee deferrals and employer matching contributions.
The tests compare contributions made on behalf of "highly
compensated employees" (HCEs) with contributions made on behalf of
"non-highly compensated employees" (NHCEs). HCEs are defined as more
than 5% owners of the employer in the current or the previous plan
year and those who received compensation in the previous plan year
in excess of a specified level ($90,000 for 2004 and $95,000 for
2005).
The nondiscrimination tests require average contributions for the
HCE group to be within a certain range of the average contributions
for the NHCE group. The maximum average HCE contribution, as a
percentage of compensation, is based on the average NHCE percentage
as follows:
NHCE
Percentage |
|
Maximum HCE
Percentage |
|
2% or less |
|
NHCE % x 2 |
|
2% - 8% |
|
NHCE % + 2 |
|
8% or more |
|
NHCE % x 1.25 |
Plans that do not pass the test must take some action, such as
making corrective distributions or additional employer
contributions.
Testing Method
Plans may choose current year testing, where current year
contributions are used to compare the percentages of both HCEs and
NHCEs, or prior year testing, where the contributions for NHCEs in
the prior year are compared with HCE contributions in the current
year. The prior year testing method gives employers the average
contribution limitations for the HCEs in advance and reduces the
chances of a failed test.
Another option exists for the first year of a plan utilizing the
prior year method. It can choose to use 3% for the average
contributions for NHCEs, or it can use actual NHCE contributions in
the first year.
The regulations provide that a plan does not have to use the same
testing method for deferrals (the ADP test) as it does for matching
and voluntary after-tax contributions (the ACP test). This may be
relevant where a plan allows for discretionary matching
contributions but chooses not to make any in certain years. Such a
plan would have to use current year testing for the ACP test but
might prefer prior year testing for deferrals.
Whatever testing methods are chosen, the regulations require them
to be specified in the plan document. The testing methods may only
be changed by amendment, subject to certain restrictions on changing
from current year to prior year testing. The regulations also
provide that changes in testing methods or procedures cannot be done
in such a manner as to be abusive in benefiting HCEs.
QNECs and QMACs
One method of correcting a failed nondiscrimination test is
having the employer make a "qualified nonelective contribution" (QNEC)
or "qualified matching contribution" (QMAC). QNECs and QMACs are
required to be immediately 100% vested and subject to withdrawal
restrictions. These contributions must be deposited by the last day
of the following plan year. For that reason, these contributions are
not very practical with the prior year testing method, because the
deposit would have to be made by the last day of the testing year,
which is usually before the tests can even be performed.
There are a number of ways that QNECs and QMACs can be allocated
to participants. One of the more controversial ways is referred to
as a "bottom-up" or "targeted" QNEC. Additional contributions are
made to one or more of the NHCEs with the lowest compensation. The
contribution can be a very large percentage of the compensation for
these individuals and still not cost the employer a lot of money.
These large percentages can have a big impact in helping the plan
pass the nondiscrimination tests.
However, the final regulations have added restrictions which
severely limit the impact of these types of allocations. Under the
new rules, QNECs in excess of 5% of compensation for any individual
may only be used for testing purposes if additional requirements are
met. Here is a comparison of the old and new rules:
The ADP for Hobbit Company is 3% for its 50 NHCEs and 6% for its
5 HCEs. The test is failed since the maximum ADP permitted for HCEs
is 5% (3% NHCE + 2). Under the prior rules, Hobbit Company could
make a QNEC of 25% of compensation for 2 employees earning $1,000
which would increase the NHCE ADP to 4% and only cost the employer
$500 to pass the test.
However, the final regulations will limit the QNEC in the above
example to 5% of compensation. Therefore, 10 NHCEs will need to
receive 5% of compensation to pass the test which may considerably
increase the cost of passing the test compared to the prior rules.
An exception was made for prevailing wage plans (under the
Davis-Bacon Act) that allows QNECs of up to 10% to be used for
testing purposes.
The new provisions could also impact QNECs and QMACs allocated on
a flat dollar basis since a specific dollar amount will represent a
higher percentage of a lower-paid employee’s compensation than a
higher-paid employee’s compensation.
Similar rules apply for QMACs with some variations concerning the
matching contribution.
Gap Period Earnings
The most common method used to correct a failed nondiscrimination
test is to make corrective distributions of excess contributions to
HCEs. The excess contributions are required to be adjusted for
related investment earnings or losses. These contributions are
presumed to be the first deposits made during the plan year, and
under prior rules, did not have to be adjusted for earnings from the
end of the plan year until the distribution date (referred to as the
"gap period").
Under the final regulations, earnings during the gap period can
no longer be ignored for certain plans. Earnings for the gap period
must be included if there was a valuation date during the period,
e.g., daily valued plans. If there is no valuation date within the
gap period, no gap period earnings are required. For example, a
calendar year plan that has quarterly valuation dates will not need
to include gap period earnings for a distribution made in February
since there was no valuation since the end of the plan year.
Plans with daily valuations must calculate income within seven
days of the distribution date. But since it is extremely difficult
to estimate exactly when the distribution will actually be
processed, some plans may want to use the safe harbor calculation
provided in the regulations. Under this method, 10% of the income
for the preceding plan year is multiplied by the number of months in
the gap period, including the month of payment if the corrective
distribution is made after the 15th of the month. For example,
corrective distributions made on March 15th would have a gap period
adjustment of 20% of the preceding plan year earnings.
Safe Harbor 401(k) Plans
Safe harbor 401(k) plans are exempt from nondiscrimination
testing if they satisfy certain contribution and notice
requirements. These plans must provide either a 3% nonelective
contribution to eligible employees or a minimum matching
contribution of 100% of the first 3% of compensation deferred and
50% of the next 2% of compensation deferred.
The final regulations provide that the plan document must contain
the relevant provisions if a plan chooses to avoid nondiscrimination
testing by making safe harbor contributions. The plan cannot state
that it will revert to testing if the contribution or notice
requirements are not met.
The regulations also allow safe harbor plans to have short plan
years under certain circumstances involving plan terminations for
business hardship, mergers or acquisitions. In addition, the rules
regarding safe harbor matching contributions apply to catch-up
contributions as well as other elective deferrals.
Hardship Distributions
The final regulations expand the list of safe harbor hardship
events to include:
- Burial or funeral expenses for the employee’s parent, spouse,
child or dependent; and
- Repair of damage to the employee’s principal residence that
would qualify as deductible casualty expenses.
For hardships pertaining to medical expenses, the definition of
dependent has been expanded to include a non-custodial child.
Other Provisions
Guidance was also provided for the following issues:
Automatic Enrollments
Plans may provide for a default deferral election if no
affirmative election is made by a participant (e.g., an election
form is not returned). There is no limit on the amount of the
default election.
One-Time Irrevocable Election
Under the final regulations, an employee can make a one-time
irrevocable election not to participate in a retirement plan up
until the date of participation. The election applies for the
duration of employment with the employer.
Timing of Deferral Contributions
In general, elective deferral and matching contributions cannot
be funded prior to the performance of services for which
compensation is being deferred or matched. However, an exception was
established for occasional administrative necessities, such as when
a bookkeeper will be out of the office when the contributions must
be deposited.
Effective Date
The final regulations are effective for plan years beginning on
or after January 1, 2006. However, plan sponsors can apply the new
rules for any plan year ending after December 29, 2004, provided the
plan applies all of the rules of the final regulations, to the
extent applicable, for that plan year and all subsequent plan years.
Conclusion
The final 401(k) and 401(m) regulations address an extensive
number of issues involving plan administration. For the 2005 plan
year, plan sponsors may continue to operate their plans under the
prior regulatory guidance. However, plan sponsors should consult
with their advisors to determine how the final regulations will
affect their plans beginning in 2006.
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