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Final 401(k) Plan Regulations and IRS Form 5500
Retirement plans; Cash or deferred arrangements under section 401(k) and matching
contributions or employee contributions under section 401(m) Regulations
SUMMARY: This document contains final regulations that provide guidance for certain
retirement plans containing cash or deferred arrangements under section 401(k) and
providing for matching contributions or employee contributions under section 401(m).
These regulations affect sponsors of plans that contain cash or deferred arrangements or
provide for employee or matching contributions, and participants in these plans.
401k Tip
Although there are many different types of retirement plan options available to corporations, they fall into two general categories: defined benefit plans and defined contribution plans. The following pages provide a brief overview of these plans and their benefits. Figure 1 offers a quick means of identifying the plan that best suits your current needs. Target Laboratories in California
(www.targetlab.com) has selected a defined contribution plan because it is easier to setup and less expensive to operate.
Background
This document contains final regulations setting forth the requirements (including the
nondiscrimination requirements) for cash or deferred arrangements under section 401(k)
and for matching contributions and employee contributions under section 401(m) of the
Internal Revenue Code (Code).
The most substantial changes to the statutory provisions of section 401(k) and
section 401(m) were made to the methodology for testing the amount of elective
contributions, matching contributions, and employee contributions for nondiscrimination.
Section 401(a)(4) prohibits discrimination in contributions or benefits in favor of highly
compensated employees, within the meaning of section 414(q) (HCEs). Section 401(k)
provides a special nondiscrimination test for elective contributions under a cash or
deferred arrangement that is part of a profit-sharing plan, stock bonus plan, pre-ERISA
money purchase plan, or rural cooperative plan, called the actual deferral percentage
(ADP) test. Section 401(m) provides a parallel test for matching contributions and
employee contributions under a defined contribution plan, called the actual contribution
percentage (ACP) test. These special nondiscrimination standards are provided in
recognition of the fact that the amount of elective contributions and employee contributions
(and corresponding matching contributions) is determined by the employee's utilization of
the contribution opportunity offered under the plan. This is in contrast to the situation in
other defined contribution plans where the amount of contributions is determined by the
amount the employer decides to contribute.
Sections 401(k) and 401(m) provide alternative methods for satisfying the
applicable nondiscrimination rules: a mathematical comparison and a number of designbased
methods. The inherent variation in the amount of contributions among employees,
and the fact that the economic situation of HCEs may make them more likely to make
elective or employee contributions, means that the usual nondiscrimination test under
section 401(a)(4) -- under which, for each HCE with a contribution level, there must be a
specified number of nonhighly compensated employees (NHCEs) with equal or greater
contributions -- is not appropriate. Instead, average rates of contributions are used in the
ADP and ACP tests (with a built-in differential permitted for HCEs) and minimum
standards for nonelective or matching contributions are provided in the design-based
alternatives.
Prior to the enactment of SBJPA, sections 401(k) and 401(m) provided only for
mathematical comparison. Specifically, the ADP and ACP tests compare the average of
the rates of contributions of the HCEs to the average of the rates of contributions of the
NHCEs. For this purpose, the rate of contributions for an employee is the amount of
contributions for an employee divided by the employee’s compensation for the plan year.
These tests are satisfied if the average rate of HCE contributions does not exceed 1.25
times the average rate of contributions of the NHCEs. Alternatively, these tests are
satisfied if the average rate of HCE contributions does not exceed the average rate of
contributions of the NHCEs by more than 2 percentage points and is no more than 2 times
the average rate of contributions of the NHCEs. To the extent that these tests are not
satisfied, the statute provides for correction through distribution to HCEs (or forfeiture of
nonvested matching contributions) or, to the extent provided in regulations,
recharacterization of elective contributions as after-tax contributions. In addition, to the
extent provided in regulations, nonelective contributions can be made to NHCEs and
elective contributions and certain matching contributions can be moved between the ADP
and ACP tests, in order the reduce the discrepancy between the average rates of
contribution for the HCEs and the NHCEs.
SBJPA added design-based alternative methods of satisfying the ADP and ACP
tests. Under these methods, if a plan meets certain contribution and notice requirements,
the plan is deemed to satisfy the nondiscrimination rules without regard to actual utilization
of the contribution opportunity offered under the plan. These regulations reflect this change
and the other changes that were made to sections 401(k) and 401(m) under SBJPA, TRA
’97 and EGTRRA since the issuance of the pre-SBJPA regulations.
SBJPA made the following significant changes affecting section 401(k) and section
401(m) plans:
• The ADP test and ACP test were amended to allow the use of prior year data for
NHCEs.
• The method of distributing to correct failures of the ADP test or ACP test was
changed to require distribution to the HCEs with the highest contributions.
• Tax-exempt organizations and Indian tribal governments are permitted to maintain
section 401(k) plans.
Safe harbor alternatives to the ADP test and ACP test were introduced in order to
provide design-based methods to satisfy the nondiscrimination tests.
• The SIMPLE 401(k) plan (an alternative design-based method to satisfy the
nondiscrimination tests for small employers that corresponds to the provisions of
section 408(p) for SIMPLE IRA plans by providing for smaller contributions) was
added.
• A special testing option was provided for plans that permit participation before
employees meet the minimum age and service requirements, in order to encourage
employers to permit employees to start participating sooner.
TRA ’97 made the following significant changes affecting section 401(k) and
section 401(m) plans:
• Grandfathered state and local governmental plans are treated as automatically
satisfying the ADP and ACP tests.
• Matching contributions for self-employed individuals are no longer treated as
elective contributions.
EGTRRA made the following significant changes affecting section 401(k) and
section 401(m) plans:
• Catch-up contributions were added to provide for additional elective contributions
for participants age 50 or older.
• The Secretary is directed to change the section 401(k) regulations to shorten the
period of time that an employee is stopped from making elective contributions
under the safe harbor rules for hardship distributions.
Beginning in 2006, section 401(k) plans will be permitted to allow employees to
designate their elective contributions as "Roth contributions" that will generally be
subject to taxation under the rules applicable to Roth IRAs under section 408A.
• Section 401(k) plans using the design-based safe harbor and providing no
additional contributions in a year are exempted from the top-heavy rules of section
416.
• Distributions from section 401(k) plans are permitted upon ”severance from
employment” rather than ”separation from service.”
• The multiple use test formerly specified in section 401(m)(9) is repealed.
• Faster vesting is required for matching contributions.
• Matching contributions are taken into account in satisfying the top-heavy
requirements of section 416.
In addition, since publication of the pre-SBJPA regulations, a number of items of
guidance affecting section 401(k) and section 401(m) plans addressing these statutory
changes and other issues have been released by the IRS, including:
• Notice 97-2 (1997-1 C.B. 348) provides initial guidance on prior year ADP and
ACP testing and guidance on correction of excess contributions and excess
aggregate contributions, including distribution to the HCEs with the highest
contributions.
Explanation of Provisions
1. Rules Applicable to All Cash or Deferred Arrangements
Section 401(k)(1) provides that a profit-sharing, stock bonus, pre-ERISA money
purchase or rural cooperative plan will not fail to qualify under section 401(a) merely
because it contains a qualified cash or deferred arrangement. As under the proposed
regulations, §1.401(k)-1 sets forth the general definition of a cash or deferred arrangement
(CODA), the additional requirements that a CODA must satisfy in order to be a qualified
CODA, and the treatment of contributions made under a qualified or nonqualified CODA.
As under the proposed regulations, the final regulations define a CODA as an
arrangement under which employees can make a cash or deferred election with respect to
contributions to, or accruals or benefits under, a plan intended to satisfy the requirements
of section 401(a). A cash or deferred election is any direct or indirect election by an
employee (or modification of an earlier election) to have the employer either: 1) provide an
amount to the employee in the form of cash or some other taxable benefit that is not
currently available; or 2) contribute an amount to a trust, or provide an accrual or other
benefit, under a plan deferring the receipt of compensation.
These final regulations retain the definition of a CODA from the proposed regulations, with
some minor modifications. First, the exclusion of an arrangement under which employees
make after-tax contributions from the definition of a CODA does not encompass an
arrangement under which employees make designated Roth contributions1. Second, the
final regulations clarify that the regulatory provision specifying that compliance with section
401(k) and section 402(e)(3) is the only means of providing a cash or deferred election to
an employee without violating the constructive receipt rules is limited to cash or deferred
elections under which the contribution or accrual is made under a qualified plan or trust.
As under the proposed regulations, these final regulations incorporate prior
guidance on automatic enrollment and thus reflect the fact that a CODA can specify that the
default that applies in the absence of an affirmative election by an employee can be a
1 A designated Roth contribution is an elective contribution that is included in income. The Treasury
and the IRS expect to issue guidance on designated Roth contributions in the near future.
contribution to a trust, as described in Rev. Rul. 2000-8. Although the facts of Rev. Rul.
2000-8 specified a certain percentage of compensation that would apply as a default, the
percentage chosen was merely illustrative. Thus, the final regulations do not constrain the
choice of default provisions.2 However, in order to be a qualified CODA, as indicated in
Rev. Rul. 2000-8, it is essential that the employee have an effective opportunity to elect to
receive cash in lieu of the default employer contribution.
These final regulations also clarify the rules relating to one-time irrevocable
elections that are not treated as cash or deferred elections. First, the final regulations
replace the requirement that the election be made upon commencement of employment or
first becoming eligible under the plan or any plan of the employer with the requirement that
the election be made no later than first becoming eligible under the plan or any other plan
of the employer. Second, the final regulations define any other plan of the employer for this
purpose to mean any plan or arrangement that is described in section 219(g)(5)(D), which
includes a section 457(b) governmental plan and a section 403(b) plan, as well as a
qualified plan.
The final regulations retain the rule that a contribution is made pursuant to a cash or
deferred election only if the contribution is made after the relevant election. Thus,
The Department of Labor has advised Treasury and the IRS that, under Title I of the Employee
Retirement Income Security Act of 1974 (“ERISA”) (88 Stat. 829), Public Law 93-406, fiduciaries of a plan
must ensure that the plan is administered prudently and solely in the interest of plan participants and
beneficiaries. While ERISA section 404(c) may serve to relieve certain fiduciaries from liability when
participants or beneficiaries exercise control over the assets in their individual accounts, the Department of
Labor has taken the position that a participant or beneficiary will not be considered to have exercised control
when the participant or beneficiary is merely apprised of investments that will be made on his or her behalf in
the absence of instructions to the contrary. See 29 CFR 2550.404c-1 and 57 FR 46924.
contribution made in anticipation of an employee’s election is not treated as an elective
contribution. A number of commentators indicated that the rule in the proposed regulation
requiring that elective contributions not precede the services to which they relate (or the
date when the compensation would otherwise be paid, if earlier than the date when the
services are performed) was too broad. Some of these commentators suggested the
addition of an exception to cover instances where the employer has administrative reasons
for depositing the contributions before the employee’s services or pay day (for example,
the temporary absence of the bookkeeper responsible for transmitting funds to the plan),
while others suggested loosening the rule where the early contribution does not result in an
accelerated deduction.
After considering these comments, the IRS and Treasury have concluded that the
prefunding of elective contributions and matching contributions is inconsistent with sections
401(k) and 401(m) and that the restrictions on the timing of contributions are consistent
with the fundamental premise of elective contributions (i.e., these are contributions that are
paid to the plan as a result of an employee election not to receive those amounts in cash).
Accordingly, the final regulations generally provide that contributions are made pursuant to
a cash or deferred election only if the contributions are made after the employee’s
performance of services which relate to the compensation that, but for the election, would
have been paid to the employee. Amounts contributed in anticipation of future
performance of services generally are not treated as elective contributions under these
final regulations. Thus, an employer is not able to prefund elective contributions in order to
accelerate the deductions for elective contributions; and employer contributions made
under the facts in Notice 2002-48 (2002-2 C.B.139) are no longer permitted to be taken
into account under the ADP test or the ACP test and would not satisfy any plan requirement
to provide elective contributions or matching contributions.
The proposed regulations contained an exception to the rule precluding the funding
of elective contributions before the performance of services in the situation where the
compensation would also have been paid, but for the election, before the performance of
services and that exception has been retained in the final regulations. After consideration
of the administrative concerns raised by the comments, these final regulations also include
an exception for occasional bona fide administrative considerations. Under this exception,
employer contributions will not fail to satisfy the regulatory requirements relating to the
timing of elective contributions merely because contributions for an occasional pay period
are made before the services with respect to that pay period are performed, provided that
the early contributions are made for bona fide administrative considerations and are not
made early with a principal purpose of accelerating deductions. In addition, the final
regulations include changes to the rules precluding the prefunding of matching
contributions discussed below.
One commentator asked for clarification of the interaction between these timing
rules and the rule under the regulations that treats a self-employed individual’s earned
income as being currently available on the last day of the individual’s taxable year and
whether this last day rule precludes a partner from making elective contributions during the
year through a reduction in the partner’s draw. The restriction on the timing of contributions
is not intended to prevent a partner from deferring amounts that are paid to the partner
throughout the year on account of services performed by the partner during the year, and
the final regulations have been modified to clarify this point. However, self-employed
individuals who take advantage of this opportunity to defer amounts during the year must
make sure that the amount contributed during the year will not exceed the limits (such as
the limits of section 415) that will apply to the individual, based on the individual’s actual
earned income for the relevant period.
2. Qualified CODAs
A. General rules relating to qualified CODAs
Elective contributions under a qualified CODA are treated as employer
contributions for purposes of the Internal Revenue Code.3 Elective contributions under a
qualified CODA generally are not included in the employee’s gross income at the time the
cash would have been received (but for the cash or deferred election) or at the time
contributed to the plan. Elective contributions under a qualified CODA are included in the
employee’s gross income, however, if the contributions are in excess of the section 402(g)
limit for a year, are designated Roth contributions (under section 402 A, effective for tax
years beginning after December 31, 2005), or are recharacterized as after-tax
contributions as part of a correction of an ADP test failure.
A CODA is not qualified unless it is part of a profit sharing plan, stock bonus plan,
pre-ERISA money purchase plan, or rural cooperative plan and provides for an election
3 The Department of Labor has advised Treasury and the IRS that its view is that amounts a
participant pays to or has withheld by an employer, whether pursuant to a cash or deferred election or
otherwise, for contribution to an employee benefit plan constitute participant contributions for purposes of
Subtitle A and Part 4 of Subtitle B of Title I of ERISA.
Between contributions to the plan or payments directly in cash. In addition, a CODA is not
qualified unless it meets the following requirements: 1) the elective contributions under the
CODA satisfy either the ADP test set forth in section 401(k)(3) or one of the design-based
alternatives in section 401(k)(11) or (12); 2) elective contributions under the CODA are
nonforfeitable at all times; 3) elective contributions are distributable only on the occurrence
of certain events, including attainment of age 591/2, hardship, death, disability, severance
from employment, or termination of the plan; 4) the group of employees eligible to
participate in the CODA satisfies the coverage requirements of section 410(b)(1); 5) no
other benefit (other than matching contributions and certain other specified benefits) is
conditioned, directly or indirectly, upon the employee’s making or not making elective
contributions under the CODA; and 6) no more than 1 year of service is required for
eligibility to elect to make a cash or deferred election.
Subject to certain exceptions, State and local governmental plans are not allowed to
include a qualified CODA. Plans sponsored by Indian tribal governments and rural
cooperatives are allowed to include a qualified CODA.
B. Nondiscrimination rules applicable to qualified CODAs
As under the proposed regulations, these final regulations provide that the special
nondiscrimination standards set forth in section 401(k) (the ADP test, the ADP safe harbor
and the SIMPLE 401(k) plan) are the exclusive means by which a qualified CODA can
satisfy the nondiscriminatory amount of contribution requirement of section 401(a)(4).
Pursuant to section 401(k)(3)(G), a State or local governmental plan is deemed to satisfy
the ADP test.
These final regulations retain the rule that the plan must satisfy the requirements of
§1.401(a)(4)-4 with respect to benefits, rights and features in addition to the requirements
that contributions satisfy the nondiscrimination requirements of section 401(k). In addition
to stating that the availability of each level of elective contribution is a right or feature
subject to the requirements of section 401(a)(4), the final regulations point out that the right
to make a designated Roth contribution is a right or feature.
The proposed regulations included an anti-abuse rule which provided that a plan will
not be treated as satisfying the requirements of section 401(k) if there are repeated
changes to plan testing procedures or plan provisions that have the effect of distorting the
ADP so as to increase significantly the permitted deferrals for HCEs, or otherwise
manipulate the nondiscrimination rules of section 401(k), if a principal purpose of the
changes was to achieve such a result.
Several commentators suggested eliminating the anti-abuse rule in the proposed
regulations. One of these commentators suggested that the proposed regulation’s
restrictions on ADP testing (including the restriction on the use of targeted QNECs and
changes in testing method discussed below) made the anti-abuse rule unnecessary and
noted that there may be legitimate reasons (for example, change in participant
demographics or merger of plans for administrative reasons) for changes to a section
401(k) plan’s testing procedures. Another commentator suggested that the anti-abuse rule
be replaced with guidance addressing various specific abusive transactions.
After considering these comments, IRS and Treasury have determined that the need
for rules to prevent abuse associated with changes in plan testing procedures or other plan
provisions to inflate inappropriately the ADP for NHCEs or to otherwise manipulate the
nondiscrimination provisions of section 401(k) outweighs the concerns raised by these
commentators. In addition, IRS and Treasury do not believe that the anti-abuse provisions
of the proposed regulations constrain legitimate testing procedure changes. Therefore,
these final regulations retain the anti-abuse provisions of the proposed regulations.
C. Aggregation and disaggregation of plans
As under the proposed regulations, these final regulations consolidate the rules
regarding identification of CODAs and plans for purposes of demonstrating compliance
with the requirements of section 401(k) and retain the rule that all CODAs included in a
plan are treated as a single CODA for purposes of applying the nondiscrimination tests.
For this purpose, a plan is generally defined by reference to §1.410(b)-7(a) and (b) after
application of the mandatory disaggregation rules of §1.410(b)-7(c) (other than the
mandatory disaggregation of section 401(k) and section 401(m) plans) and permissive
aggregation rules of §1.410(b)-7(d), as modified under these regulations. For example, if
a plan covers collectively bargained employees and noncollectively bargained employees,
the elective contributions for the separate groups of employees must be treated separately
for nondiscrimination under section 401(k). As under the proposed regulations, the final
regulations retain the special rules in the pre-SBJPA regulations that permit the
aggregation of certain employees in different collective bargaining units and the prohibition
on restructuring under §1.401(a)(4)-9(c).
The proposed regulations included a change to the treatment of a CODA under a
plan that includes an ESOP. Under the pre-SBJPA regulations, such a plan must be
disaggregated into the ESOP and non-ESOP portions and apply two separate ADP and
ACP tests: one for elective contributions going into the ESOP portion (and invested in
employer stock) and one for elective contributions going in the non-ESOP portion of the
plan. The proposed regulations eliminated the disaggregation of the ESOP and non-
ESOP portions of a single section 414(l) plan for purposes of ADP and ACP testing and
allowed an employer to permissively aggregate two section 414(l) plans, one that is an
ESOP and one that is not.
Commentators responded favorably to this change. Therefore, the final regulations
retain the rule of the proposed regulations that eliminates the disaggregation of the ESOP
and non-ESOP portions for the ADP and ACP tests. Several of these commentators
suggested that plans be permitted to implement this change before the effective date of the
regulations. After considering these comments, the IRS and Treasury have determined
that it would not be in the best interest of plan administration to allow this change to be
made before the effective date of the entire regulations. However, as discussed below, a
plan is permitted to implement this change for plan years that end after December 29,
2004, provided the plan applies all the rules of these final regulations, to the extent
applicable, for that plan year and all subsequent plan years
These final regulations retain the proposed regulations’ requirement that a single
testing method must apply to all CODAs under a plan (after application of the aggregation
and disaggregation rules as modified). This has the effect of restricting an employer’s
ability to aggregate section 414(l) plans for purposes of section 410(b) if those plans apply
inconsistent testing methods. For example, a plan that applies the ADP test of section
401(k)(3) may not be aggregated with a plan that uses the ADP safe harbor of section
401(k)(12) for purposes of section 410(b). However, the final regulations make clear that if
a plan is disaggregated into separate plans under the rules of section 410(b), each
separate plan can apply a different testing method. Thus, for example, if an employer
maintaining a plan that covers otherwise excludible employees is using the optional rule of
section 410(b)(4)(B) to determine whether the plan satisfies the requirements of section
410(b), then the plan is treated as comprising two separate plans for purposes of section
410(b) and the plan covering the employees who have satisfied the minimum age and
service requirements of section 410(a)(1)(A) can use the ADP safe harbor of section
401(k)(12), while the plan covering the remaining employees uses the ADP test of section
401(k)(3).
D. Requirement that the elective contributions be immediately nonforfeitable.
The final regulations reflect the statutory requirement that elective contributions to a
qualified CODA be immediately nonforfeitable. However, the final regulations clarify that
the reference to these contributions being “disregarded for purposes of applying section
411(a) to other contributions” is limited to being disregarded for purposes of section
411(a)(2). Thus, for example, elective contributions under a qualified CODA are taken into
account for purposes of determining whether a participant is a nonvested participant for
purposes of section 411(a)(6)(D)(iii).
E. Restrictions on withdrawals
As discussed above, a qualified CODA must provide that elective contributions may
only be distributed after certain events, including hardship and severance from
employment. EGTRRA amended section 401(k)(2)(B)(i)(I) by replacing ”separation from
service” with ”severance from employment.” This change eliminated the “same desk rule”
as a standard for distributions under section 401(k) plans.
In addition, EGTRRA amended section 401(k)(10) by deleting disposition by a
corporation of substantially all of the assets of a trade or business and disposition of a
corporation’s interest in a subsidiary, leaving termination of the plan as the only
distributable event described in section 401(k)(10). Further, EGTRRA directs the
Secretary of the Treasury to revise the regulations relating to distributions under section
401(k)(2)(B)(i)(IV) to provide that the period during which an employee is prohibited from
making elective and employee contributions following a hardship distribution is 6 months
(instead of 12 months as required under §1.401(k)-1(d)(2)(iv)(B)(4) of the pre-SBJPA
regulations).
4 Finally, section 662 of EGTRRA amended section 404(k)(2) to allow a
deduction for dividends paid on employer securities held by an ESOP if those dividends
are reinvested in employer securities pursuant to an election by the participant or
beneficiary to reinvest the dividends or have them paid in cash. Section 662 of EGTRRA
is effective for taxable years of a corporation beginning on or after January 1, 2002.
Notice 2001-56, Notice 2002-2 (2002-1 C.B. 285), and Notice 2002-4 provided
guidance on these EGTRRA changes to the distribution rules for elective contributions.
That guidance was generally incorporated in the proposed regulations. These final
4 Under section 402(c), as amended by the IRS Restructuring and Reform Act of 1998, Public Law
105-206 (112 Stat. 685), and EGTRRA, a hardship distribution is not an eligible rollover distribution. While
the change affects distributions from a section 401(k) plan, there is no specific reference to the change in
these regulations because these regulations are under sections 401(k) and (m).
regulations adopt the rules in the proposed regulations but clarify that the requirement that
a participant must have obtained all distributions currently available under all qualified
plans of the employer in order to qualify for a hardship distribution applies equally to a
distribution of an ESOP dividend. This implements the rule set forth in Notice 2002-2.
Comments were requested on whether a change in status from a common law
employee to a leased employee described in section 414(n) should be treated as a
severance from employment that would permit a distribution to be made. After reviewing
the comments, these final regulations do not add the change to leased employee to the list
of distributable events and retain the use of the section 410(b) definition of employee for
purposes of section 401(k). Because an individual who is a leased employee (as defined
in section 414(n)) is treated as an employee of the recipient of the individual’s services for
purposes of section 410(b) (unless the safe harbor plan requirements described in section
414(n)(5) are met), the individual does not incur a severance from employment as a result
of becoming a leased employee.
In addition to the statutory changes, the rules relating to hardship distributions were
reorganized in the proposed regulations in order to clarify certain ambiguities, including the
relationship between the generally applicable rules, employee representations, and the
safe harbors provided under the pre-SBJPA regulations. The final regulations adopt the
rules in the proposed regulations with some minor modifications. In response to
comments, the final regulations add funeral expenses and certain expenses relating to the
repair of damage to the employee’s principal residence to the list of events that are
deemed to be immediate and heavy financial needs.
The pre-SBJPA regulations and the proposed regulations treated medical
expenses for an employee’s spouse or dependent described in section 152 as a deemed
heavy and financial need. The Working Families Tax Relief Act of 2004 (118 Stat. 1166),
Public Law 108-311, modified section 152’s definition of dependent, effective for tax years
beginning in 2005. These final regulations revise the proposed regulations to disregard
certain provisions in section 152’s definition of dependent in the case of post-secondary
educational expenses. These final regulations also revise the proposed regulations to
treat expenses for (or necessary to obtain) medical care that would be deductible under
section 213(d) (determined without regard to whether the expenses exceed 7.5% of
adjusted gross income) as a deemed heavy and financial need. These changes have the
effect of allowing medical expenses and post-secondary educational expenses for an
employee, spouse, or dependent (without regard to the change in the definition of
dependent under the Working Families Tax Relief Act of 2004) to be treated as a deemed
heavy and financial need. The modifications in these final regulations also effectively
expand the definition of dependent for medical expenses to include a non-custodial child
who is subject to the special rule of section 152(e), but would exclude nonprescription
drugs or medicine (other than insulin). Prior to the effective date of these regulations with
respect to a plan, a sponsor can continue to interpret the plan terms and the pre-SBJPA
regulations without regard to the statutory change in the definition of dependent.
Some commentators asked for specific guidance on the documentation and
verification requirements for a hardship distribution. The final regulations do not address
this issue. However, taxpayers are reminded that section 6001 requires that they keep the
records necessary to demonstrate compliance with the qualification requirements of
section 401 and the rules of section 401(k) and 401(m).
F. Other rules for qualified CODAs
The final regulations retain the additional requirements set forth in the pre-SBJPA
regulations that a CODA must satisfy in order to be qualified, with some minor
modifications. First, in order to be a qualified CODA, the arrangement must provide an
employee with an effective opportunity to elect to receive the amount in cash no less than
once during the plan year. Whether an employee has an effective opportunity is
determined based on all the relevant facts and circumstances, including adequacy of
notice of the availability of the election, the period of time before the cash is currently
available during which an election may be made, and any other conditions on elections.
The final regulations also require a plan to provide for satisfaction of one of the
specific nondiscrimination alternatives described in section 401(k). As with the pre-
SBJPA regulations, the plan may accomplish this by incorporating by reference the ADP
test of section 401(k)(3) and the regulations under proposed §1.401(k)-2(a) and (b), if that
is the nondiscrimination alternative being used. If, with respect to the nondiscrimination
alternative being used, there are optional choices available, the plan must provide which of
the optional choices will apply. For example, a plan that uses the ADP test of section
401(k)(3) must specify whether it is using the current year testing method or prior year
testing method. Additionally, a plan that uses the prior year testing method must specify
whether the ADP for eligible NHCEs for the first plan year is 3% or the actual ADP for the
eligible NHCEs for the first plan year. The final regulations also provide that the
Commissioner may, in guidance of general applicability, specify the default options that will
apply under the plan if the nondiscrimination test is incorporated by reference in
accordance with the final regulations.
Additionally, a plan that uses the safe harbor method must specify whether the safe
harbor contribution will be the nonelective safe harbor contribution or the matching safe
harbor contribution and is not permitted to provide that ADP testing will be used if the
requirements for the safe harbor are not satisfied. The safe harbors are intended to
provide employees with a minimum threshold in benefits in exchange for easier
compliance for the plan sponsor. It would be inconsistent with this approach to providing
benefits to allow an employer to deliver smaller benefits to NHCEs and revert to testing.
Accordingly, if, at the beginning of the plan year, a plan contains an allocation formula that
includes safe harbor matching or nonelective contributions, these regulations clarify that,
except to the extent permitted under §1.401(k)-3 and §1.401(m)-3, the plan may not be
amended to revert to testing for the plan year.
Additional non-profit websites
that include relevant unbiased information about 401k plans
include: www.web-403b.com and www.401k-classroom.com
The final regulations retain the existing rules relating to the section 401(k)(4)(A)
prohibition on having benefits (other than a match) contingent on making or not making an
elective contribution. These final regulations also reflect the amendment to section
416(c)(2)(A) (under which matching contributions can be taken into account for purposes of
satisfying the top-heavy minimum contribution requirement without violating the prohibition
on making benefits contingent on making or not making elective contributions), the
amendment of section 401(k)(4)(B) by SBJPA (allowing tax exempt organizations to
maintain section 401(k) plans), and the enactment of section 402(g)(8) (providing that
matching contributions with respect to partners and sole proprietors are no longer treated
as elective contributions).
3. The Actual Deferral Percentage (ADP) Test
A. General rules relating to the ADP test
Section 1.401(k)-2 sets forth the rules for a CODA that is applying the ADP test
contained in section 401(k)(3). Under the ADP test, the percentage of compensation
deferred for the eligible HCEs is compared annually to the percentage of compensation
deferred for eligible NHCEs, and if certain limits are exceeded by the HCEs, corrective
action must be taken by the plan. Correction can be made through the distribution of
excess contributions, the recharacterization of excess contributions, or additional employer
contributions.
Section 401(k)(3)(A), as amended by SBJPA, generally provides for the use of prior
year data in determining the ADP of NHCEs, while current year data is used for HCEs.
This testing option is referred to as the prior year testing method. Alternatively, a plan may
provide for the use of current year data for determining the ADPs for both NHCEs and
HCEs, which is known as the current year testing method. The regulations use the term
applicable year to describe the year for which the ADP is determined for the NHCEs.
Section 401(k)(3)(F), as added by SBJPA, provides that a plan benefiting
otherwise excludable employees and that, pursuant to section 410(b)(4)(B), is being
treated as two separate plans for purposes of section 410(b), is permitted to disregard
NHCEs who have not met the minimum age and service requirements of section
410(a)(1)(A). Thus, the regulations permit such a plan to perform the ADP test by
comparing the ADP for all eligible HCEs for the plan year and the ADP of eligible NHCEs
for the applicable year, disregarding all NHCEs who have not met the minimum age and
service requirements of section 410(a)(1)(A). Because section 401(k)(3)(F) is permissive,
the final regulations follow the proposed regulations and do not eliminate the existing
testing option under which a plan benefiting otherwise excludable employees is
disaggregated into separate plans where the ADP test is performed separately for all
eligible employees who have completed the minimum age and service requirements of
section 410(a)(1)(A) and for all eligible employees who have not completed the minimum
age and service requirements.
B. Elective contributions used in the ADP test
The regulations generally follow the proposed regulations in defining which elective
contributions are reflected in the ADP test and which ones are not. Thus, these regulations
reflect the rule contained in the regulations under section 414(v), under which catch-up
contributions that are in excess of a statutory limit or an employer-provided limit are not
taken into account under the ADP test. See §1.414(v)-1. The final regulations add a
comparable rule for additional elective contributions that are made by reason of an eligible
employee’s qualified military service pursuant to section 414(u). The final regulations
retain the rule that elective contributions must be paid to the trust within 12 months after the
end of the plan year. However, for plans subject to Title I of ERISA, contributions must be
paid to the trust much sooner in order to satisfy the Department of Labor’s regulations
relating to when elective contributions become plan assets.
Section 401(k)(3) provides that the actual deferral ratio (ADR) of an HCE who is
eligible to participate in 2 or more CODAs of the same employer is calculated by treating
all CODAs in which the employee is eligible to participate as one CODA. These final
regulations adopt the provision in the proposed regulations that provides that the ADR for
each HCE participating in more than one CODA is determined by aggregating the HCE’s
elective contributions that are within the plan year of the CODA being tested.
C. Additional employer contributions used in the ADP test
The final regulations generally retain the rules in the proposed regulations permitting
a plan to take qualified nonelective contributions or qualified matching contributions (i.e.,
nonelective or matching contributions that satisfy the vesting and distribution limitations of
section 401(k)(2)(B) and (C)) into account under the ADP test, except as described below.
Thus, an employer whose CODA has failed the ADP test can correct this failure by making
additional qualified nonelective contributions (QNECs) or qualified matching contributions
(QMACs) for its NHCEs.
As under the pre-SBJPA regulations, these final regulations provide that QNECs
must satisfy four requirements in addition to the vesting and distribution rules described
above before they can be taken into account under the ADP test: 1) The amount of
nonelective contributions, including the QNECs that are used under the ADP test or the
ACP test, must satisfy section 401(a)(4); 2) the amount of nonelective contributions,
excluding the QNECs that are used under the ADP test or the ACP test, must satisfy
section 401(a)(4); 3) the plan to which the QNEC or QMAC is made must be a plan that
can be aggregated with the plan maintaining the CODA; and 4) the QNECs or QMACs
must not be contingent on the performance of services after the allocation date and must
be contributed within 12 months after the end of the plan year within which the contribution
is to be allocated.5 Thus, in the case of a plan using prior year ADP testing, any QNECs
that are to be allocated to the NHCEs for the prior plan year must be contributed before the
last day of the current plan year in order to be taken into account.
Some plans provide a correction mechanism for a failed ADP test that targets
QNECs to certain NHCEs in order to reduce the total contributions to NHCEs under the
correction. Under the method that minimizes the total QNECs allocated to NHCEs under
the correction, the employer makes a QNEC to the extent permitted by the section 415
limits to the NHCE with the lowest compensation during the year in order to raise that
NHCE’s ADR. If the plan still fails to pass the ADP test, the employer continues expanding
the group of NHCEs who receive QNECs to the next lowest-paid NHCE until the ADP test
is satisfied. By using this bottom-up leveling technique, the employer can pass the ADP
test by contributing small amounts of money to NHCEs who have very low compensation
for the plan year (for example, an employee who terminated employment in early January
with $300 of compensation). This is because of the fact that the ADP test is based on an
unweighted average of ADRs and a small dollar (but high percentage of compensation)
contribution to a terminated or other partial-year employee has a larger impact on the ADP
test than the same contribution to a full-year employee.
5 With respect to this timing requirement, it should be noted that in order to be taken into account
for purposes of section 415(c) for a limitation year, the contributions will need to be made within the time
frame set forth in the regulations under section 415 (generally, no later than 30 days after the end of the
section 404(a)(6) period applicable to the taxable year with or within which the limitation year ends).
employers may pass the ADP test by making high percentage QNECs to a small number
of employees with low compensation rather than providing contributions to a broader group
of NHCEs. In addition, the legislative history to EGTRRA expresses Congressional intent
that the Secretary of the Treasury will use his existing authority to address situations where
qualified nonelective contributions are targeted to certain participants with lower
compensation in order to increase the ADP of the NHCEs. (See EGTRRA Conference
Report, H.R. Conf. Rep. 107-84, 240).
Accordingly, the proposed regulations added a new requirement that a QNEC must
satisfy in order to be taken into account under the ADP test. This requirement, designed to
limit the use of targeted QNECs, generally prohibited a plan from counting QNECs for
purposes of the ADP test to the extent that QNECs are more than double the QNECs at
least half of the other NHCEs are receiving, when expressed as a percentage of
compensation.
The restriction on targeting QNECs is implemented by providing that a QNEC for an
NHCE that exceeds 5% of compensation could be taken into account for the ADP test only
to the extent the contribution, when expressed as a percentage of compensation, does not
exceed two times the plan's representative contribution rate. The plan’s representative
contribution rate is defined as the lowest contribution rate (i.e., the sum of QNECs made
and QMACs taken into account for an employee divided by the employee’s compensation)
among a group of NHCEs that is half of all the eligible NHCEs under the arrangement (or
the lowest contribution rate among all eligible NHCEs under the arrangement who are
employed on the last day of the year, if greater).
While some commentators applauded the restriction on targeted QNECs, a number
of commentators suggested that certain types of contributions be exempted from the
definition of targeted QNECs. In particular, commentators suggested that QNECs equal to
a flat dollar amount that are made to all NHCEs and QNECs that are made in connection
with an employer’s obligation to pay a prevailing wage under the Davis-Bacon Act (46 Stat.
1494), Public Law 71-798, Service Contract Act of 1965 (79 Stat. 1965), Public Law 89-
386, or similar legislation should be able to be taken into account under the ADP test (even
though such contributions create widely different contribution percentages among the
NHCE population) because they are not “targeted”.
After reviewing the comments, the IRS and Treasury believe that the restrictions on
targeting QNECs should apply essentially as they were proposed. While flat dollar QNEC
contributions may not have the appearance of targeting, allowing those contributions to
skew the results of the ADP test undermines the integrity of the ADP test. However, the
final regulations provide more flexibility for QNECs that are made in connection with an
employer’s obligation to pay a prevailing wage under the Davis-Bacon Act (46 Stat. 1494),
Public Law 71-798, Service Contract Act of 1965 (79 Stat. 1965), Public Law 89-286, or
similar legislation by allowing a QNEC of up to 10% of compensation to be taken into
account under the ADP test in such a case.
The final regulations under section 401(m) provide parallel restrictions on QNECs
taken into account in ACP testing, and a QNEC cannot be taken into account under both
the ADP and ACP test (including for purposes of determining the representative
contribution rate). As discussed more fully below, the final regulations generally retain the
proposed regulations limitation on targeting matching contributions, which limits the extent
to which QMACs can be targeted as a means of avoiding the restrictions on targeted
QNECs.
D. Correction
Section 401(k)(8)(C), as amended by SBJPA, provides that, for purposes of
correcting a plan’s failure to meet the nondiscrimination requirements of section 401(k)(3),
the distribution of excess contributions is made on the basis of the amount of the
contributions by, or on behalf of, each HCE. The final regulations implement this correction
procedure in the same manner as set forth in Notice 97-2. Thus, the total amount of excess
contributions is determined using the rules under the pre-SBJPA regulations (i.e., based
on high percentages). Then, that total amount is apportioned among the HCEs by
assigning the excess to be distributed first to those HCEs who have the greatest dollar
amount of contributions taken into account under the ADP test (as opposed to the highest
deferral percentage). If these amounts are distributed or recharacterized in accordance
with these regulations, the plan complies with the ADP test for the plan year with no
obligation to recalculate the ADP test.
The final regulations generally follow the rules in the proposed regulations on the
determination of net income attributable to excess contributions. However, the regulatory
language regarding the calculation of gap period income (i.e., income for the period after
the plan year) has been clarified to specify that gap period income needs to be included
only to the extent the employee is or would be credited with allocable gain or loss on those
excess contributions for that period, if the total account were to be distributed. In addition,
in response to administrative concerns raised by comments, the final regulations provide
that a distribution of excess contributions is not required to include the income allocable to
the excess contributions for a period that is no more than 7 days before the distribution. As
under the pre-SBJPA regulations, the determination of the income for the gap period could
be based on the income determined using the alternative method for the aggregate of the
plan year and the gap period or using 10% of the income for the plan year (determined
under the alternative method) for each month in the gap period.
The final regulations retain the rules in the proposed regulations regarding the
timing and tax treatment of distributions of excess contributions, coordination with the
distribution of excess deferrals and the treatment of matches attributable to excess
contributions. However, the final regulations clarify that 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.
4. Safe Harbor Section 401(k) Plans
Section 401(k)(12) provides a design-based safe harbor method under which a
CODA is treated as satisfying the ADP test if the arrangement meets certain contribution
and notice requirements. Section 1.401(k)-3 of these final regulations, which sets forth the
requirements for these arrangements, generally follows the rules set forth in Notice 98-52
and Notice 2000-3. Thus, a plan satisfies the section 401(k) safe harbor if it makes
specified QMACs for all eligible NHCEs. The matching contributions can be under a basic
matching formula that provides for QMACs equal to 100% of the first 3% of elective
contributions and 50% of the next 2% or an enhanced matching formula that is at least as
generous in the aggregate, provided the rate of matching contributions under the enhanced
matching formula does not increase as the employee's rate of elective contributions
increases. In lieu of QMACs, the plan is permitted to provide QNECs equal to 3% of
compensation for all eligible NHCEs. In addition, notice must be provided to each eligible
employee, within a reasonable time before the beginning of the year, of the employee’s
right to defer under the plan.
The proposed regulations did not include any exception to the requirements for safe
harbor matching contributions with respect to catch-up contributions. As part of the
proposed regulations the IRS and Treasury solicited comments on the specific
circumstances under which elective contributions by an NHCE to a safe harbor plan would
be less than the amount required to be matched, e.g., less than 5% of safe harbor
compensation, but would be treated by the plan as catch-up contributions, and on the
extent to which a safe harbor plan should be required to match catch-up contributions under
such circumstances. After reviewing the comments and the applicable statutory provisions
(including the amendments to section 414(v)(3)(B) made by the Job Creation and Worker
Assistance Act of 2002, (JCWAA) (Public Law 107-147)), the IRS and Treasury have
determined that no such exception is appropriate.
Section 401(k)(12)(D) contains a requirement that each eligible employee be
provided with a written notice of the employee’s rights and obligations under the plan.
These final regulations provide that the notice can be provided in writing or through another
medium that is prescribed by the Commissioner as satisfying the requirement for a written
notice. As reflected in the priority guidance plan, the IRS and Treasury are currently
developing guidance setting forth the extent to which the notice described in section
401(k)(12)(D), as well as other notices under the various requirements relating to qualified
retirement plans, can be provided electronically, taking into account the effect of the
Electronic Signatures in Global and National Commerce Act (E-SIGN) (114 Stat. 464),
Public Law 106-229. Until that guidance is issued, plan administrators and employers may
continue to rely on the interim guidance in Q&A-7 of Notice 2000-3 on the use of electronic
media to satisfy the notice requirement in section 401(k)(12)(D).
These final regulations specify that a section 401(k) safe harbor plan must generally
be adopted before the beginning of the plan year and be maintained throughout a full 12-
month plan year. This requirement is consistent with the notion that the statute specifies a
certain contribution level for NHCEs in order to be deemed to pass the nondiscrimination
requirements. If the contribution level is not maintained for a full 12-month year, the
employer contributions made on behalf of NHCEs should not support what could be a full
year’s contribution by the HCEs.
The final regulations adopt the exceptions to this 12-month rule that were set forth in
the proposed regulations. Thus, a section 401(k) safe harbor plan could have a short plan
year in the year the plan terminates, provided the plan termination is in connection with a
merger or acquisition involving the employer, or the employer incurs a substantial business
hardship comparable to a substantial business hardship described in section 412(d). A
section 401(k) safe harbor plan could also have a short plan year in the year the plan
terminates (without regard to the reason for the termination or the financial condition of the
employer) if the employer makes the safe harbor contributions for the short year,
employees are provided notice of the change, and the plan passes the ADP test. In either
case, the employer must make the safe harbor contributions through the date of plan
termination.
In addition, a safe harbor plan could have a short plan year if it is preceded and
followed by plan years as a section 401(k) safe harbor plan. Under these final regulations,
the following plan year is permitted to be shorter than 12 months if the short plan year is as
a result of a plan termination (whether or not the plan termination is in connection with a
merger or acquisition involving the employer). These final regulations clarify that this
treatment is unavailable if in the following plan year safe harbor matching contributions are
reduced or suspended. In the event that the short plan year is followed by another short
plan year, this treatment is available if the plan satisfies the 401(k) safe harbor
requirements for the 12 month period immediately following the first short plan year.
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