401(k) and 401(m): IRS Issues Final Regulations

On December 29, 2004, the Internal Revenue Service (IRS) issued long awaited final regulations governing cash or deferred arrangements (CODAs) under Code section 401(k) and matching contributions under Code section 401(m) that consolidate and simplify previous guidance, as well as reflect substantial legislative changes. This article will highlight significant provisions of the final regulations.

On July 17, 2003, the IRS proposed regulations that addressed numerous CODA plan issues, including nondiscrimination requirements, matching and employee contribution requirements and SIMPLE 401(k) plans. The proposed regulations were the first set of comprehensive regulations on CODAs since the last set of final regulations were published in 1991 and amended in 1994. The new final regulations follow the proposed regulations, with a few exceptions.

The final regulations incorporate statutory changes and other IRS guidance issued since 1991. Included are statutory changes made by the Small Business Job Protection Act of 1996, the Taxpayer Relief Act of 1997 and the Economic Growth and Tax Relief Reconciliation Act of 2001.

Effective Date
The final regulations are generally effective for plan years beginning on or after January 1, 2006. However, plan sponsors are permitted to adopt the regulations for plan years beginning on or after December 30, 2004, provided that the plan sponsor applies all the rules of the final regulations.

Nondiscrimination Testing Method
Under existing regulations, plans either test on a current year basis or use a prior year method when performing their annual ADP and ACP nondiscrimination tests. The final regulations provide that a plan does not have to use the same testing method both for deferrals (the ADP test) and 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 use current year testing for the ACP test, but might prefer prior year testing for the ADP test. The final regulations require that whatever testing method is chosen, it must 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 final regulations also provide that changes in testing elections or procedures used primarily to manipulate testing results will cause a plan to fail nondiscrimination testing. Because such abusive techniques are not defined by the final regulations, plan sponsors may have difficulty determining whether a change will be viewed as abusive. Accordingly, plan sponsors should carefully consider this anti-abuse provision when deciding to make changes to their testing procedures. An example of an abusive technique is provided in the Department of Treasury Memorandum issued October 22, 2004, (prior to the issuance of the final regulations) on the use of short-service employees to impact nondiscrimination testing.

Restrictions on Targeted QNECs and QMACs
An employer may correct a failed ADP or ACP nondiscrimination test by making a “qualified nonelective contribution” (QNEC) or “qualified matching contribution” (QMAC). There are a number of methods that an employer may use in allocating QNECs and QMACs to participants. Under the “targeted” QNEC or QMAC method, additional contributions are made to one or more of the NHCEs with the lowest compensation. An employer’s use of this “targeted” method can greatly reduce the cost of nondiscrimination compliance. The final regulations have added restrictions that severely limit the use of these methods of compliance.

Under the new rules, a plan can count a QNEC greater than 5% of compensation only if the QNEC does not exceed two times the plan’s “representative contribution rate.” The representative contribution rate measures the rate of QNECs received by all members of a testing group (which consists of either half of all eligible NHCEs or all eligible NHCEs employed on the last day of the plan year). A similar 5% limitation applies to QNECs taken into account in the ACP test. The final regulations increase the 5% limit to 10% for QNECs made in connection with a prevailing wage obligation under a plan subject to the Davis-Bacon Act. Similar rules apply to QMACs, with a few variations.

Calculation of Gap Period Earnings
To correct a failed ADP or ACP nondiscrimination test, plans may make corrective distributions of excess contributions to HCEs. The excess contributions are required to be adjusted for related investment gains or losses. Under prior rules, excess contributions did not have to be adjusted for gains and losses from the end of the plan year until the distribution date (referred to as the “gap period”). The final regulations provide that gap period gains and losses must be included if a plan would credit a participant’s account with income between the last day of the plan year and the distribution date if the plan were to distribute the entire account (e.g., a daily valuation plan). Accordingly, a plan that is valued annually (or in some cases quarterly) will not have a valuation date during this period and, thus, an adjustment will not be necessary. For plans subject to the new rule, the final regulations provide that the plan must use a reasonable method in calculating such gain or loss and provide for a 7 day window period. Since it may be extremely difficult to estimate when the distribution will actually be processed, the final regulations also provide a safe harbor earnings calculation method. Under this safe harbor 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. Some practitioners have noted that most daily valued plans will need to use the safe harbor method, since 7 days probably is not sufficient to allow a distribution of calculated amounts. Plan sponsors should note that failure to return such excess contributions and all applicable earnings to HCEs is an operational failure that could jeopardize the plan’s qualified status.

Safe Harbor 401(k) Plans
The final regulations contain detailed guidance on safe harbor 401(k) plans. Safe harbor 401(k) plans are exempt from ADP and ACP nondiscrimination testing if they satisfy certain requirements. Key requirements for safe harbor 401(k) plans include the following:

  • The plan must provide either a 3% nonelective contribution to eligible employees, or a matching contribution of at least 100% of the first 3% of compensation deferred and 50% of the next 2% of compensation deferred;
  • The rate of the match for any non-highly compensated employee must not be less than the rate of match for any highly compensated employee; and
  • A plan may not provide a last day of plan year or 1,000 hour requirement for any matching contribution.

Important changes and clarifications to the requirements for safe harbor plans contained in the final regulations are:

The final regulations:

  • clarify that the rules regarding safe harbor matching contributions apply to catch-up contributions as well as other elective deferrals.
  • permit an employer to suspend or reduce the safe harbor contribution during the year if certain conditions are met.

Plan Document
The final regulations provide that the plan document must contain the relevant provisions if a plan chooses to avoid ADP and ACP nondiscrimination testing by making safe harbor contributions. The plan cannot state that it will have the option to perform the ADP or ACP test if the contribution or notice requirements of the safe harbor are not met.

Full 12-Month Plan Year
A safe harbor 401(k) plan must generally be adopted before the beginning of the plan year and be maintained throughout a full 12-month plan year. However, the final regulations do permit a safe harbor 401(k) plan to terminate during the plan year and to maintain its safe harbor status (not violate the 12-month rule), provided the termination is on account of a substantial business hardship (as defined in the final regulations) or a merger or acquisition. The plan may terminate for other reasons, provided the employer funds the required contributions to the date of termination and gives an employee notice of the termination, and the plan satisfies the ADP test. The final regulations also contain an exception to the twelve-month plan year requirement for a short plan year caused by a change in plan year (for which the plan will remain a safe harbor plan) that is preceded and followed by a twelve-month plan year (or followed by a short plan year if the plan satisfies the safe harbor requirements for the immediately following twelve months).

Safe Harbor Notice
The use of different mediums to provide the requisite safe harbor notice is also addressed in the final regulations. The required written notice of the employee’s rights and obligations under a safe harbor plan can be provided through another medium that the IRS permits as satisfying a written notice requirement for qualified retirement plans. Plan sponsors may rely on IRS Notice 2000–3 regarding the use of electronic media to satisfy the safe harbor written notice requirement.

Hardship Distributions
Under the hardship safe harbor events, a hardship distribution is deemed to be on account of an immediate and heavy financial need if the distribution is for certain medical expenses, purchase of a home, payment of tuition and related educational fees and prevention of foreclosure or eviction. The final regulations expand this list of safe harbor hardship events to include:

  • Burial or funeral expenses for the employee’s deceased parent, spouse, children or dependents; and
  • Expenses for repair of damage to the employee’s principal residence that would qualify as deductible casualty expenses (without regard to the 10% “floor” on deductibility).

As a result, there are now six “deemed hardship” events. In addition, for hardships pertaining to medical expenses, the definition of dependent has been expanded to include a non-custodial child.

The final regulations clarify the rule that a hardship distribution can be taken only after all available distributions under the qualified plan of the employer, including the distribution of dividends under an ESOP.

Automatic Enrollments
A CODA may provide for a default deferral election if no affirmative election is made by a participant. The final regulations clarify that there is no limit on the amount of the default election, and that the 3% figure set forth in Revenue Ruling 2000–8 was only for illustrative purposes. However, the final regulations provide that, in order for a plan to retain qualified status, the employee must have an effective opportunity to elect cash instead of deferral. This means that plan sponsors that adopt automatic enrollments must ensure that plan participants are aware of their right to opt out of the CODA. This would entail informing employees of the automatic enrollment provisions prior to the date they are eligible to participate in the plan, and allowing participants to cease the automatic deferrals at any time.

Prefunding of Contributions
The final regulations provide that elective deferral and matching contributions generally cannot be funded prior to the performance of services for which compensation is being deferred or matched. Accordingly, an employer may not prefund contributions to accelerate the deductions as permitted under Notice 2002–48. Plan sponsors also should note that the acceleration of 401(k) plan deductions is on the IRS’s list of abusive tax transactions. However, the final regulations allow for the following three limited exceptions if the principal purpose is not the acceleration of tax deductions:

  • Occasional early contributions that are made for bona fide administrative consideration (e.g., the temporary absence of the bookkeeper responsible for transmitting contributions);
  • Forfeitures that are allocated as matching contributions; and
  • Matching allocations of shares from an ESOP loan suspense account when the contribution is for a required payment that is due under the loan terms.

Other Clarifications
The final regulations also clarify the following:

  • A self-employed individual (sole proprietor or partner) may fund elective deferrals during the plan year based on advance salary or draw.
  • Deferrals are counted in determining whether a participant is “nonvested” under the break in service parity rule.
  • If excess contributions are distributed, they are includible in income on the dates the elective contributions would have been received by the employee had the employee originally elected to receive the amounts in cash, treating the excess contributions that are being distributed as the first elective contributions for the plan year.
  • The change in status of a participant from a common law employee to a leased employee does not qualify as a distributable event.
  • ESOP and non-ESOP portions of the same plan no longer are required to be disaggregated for purposes of nondiscrimination testing.
  • A plan may allow employees to make a one-time irrevocable election to defer, if the election is made no later than the date on which the employee first becomes eligible under any plan of the employer (rather than upon employment). 403(b) plans and governmental 457(b) plans are included in the definition of a “plan of the employer” for these purposes.

Issues Not Addressed
The final regulations do not address the timing of plan amendments if a plan is changing from current year testing method to prior year testing method (or vice versa). Also not addressed are rules relating to Roth 401(k) deferrals or to post-severance contribution for plan participants. The IRS is expected to issue guidance on these issues at a later date.

Plan sponsors should review the final regulations now to determine which of the many changes affect their plans. Plan sponsors also should decide whether to apply the final regulations as of the first plan year beginning on or after January 1, 2006 or earlier. If applied earlier, plan sponsors must remember to apply all the provisions of the final regulations. In addition, if the provisions are applied in the middle of a plan year, plan sponsors must ensure that all provisions are observed in operation from the beginning of the plan year.

The IRS has not issued guidance on when plans are to be amended to reflect the changes of the final regulations. We will update you on the timing for plan amendments once guidance is issued.

Please contact our office for more information on the final regulations and how they may impact your plans.