- Nondiscrimination Testing
- QNECs and QMACs
- Gap Period Earnings
- Safe Harbor 401(k) Plans
- Hardship Distributions
- Other Provisions
- Effective Date
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
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
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:
|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.
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
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
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
Similar rules apply for QMACs with some variations concerning the
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 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.
The final regulations expand the list of safe harbor hardship events to
- Burial or funeral expenses for the employee’s parent, spouse, child or
- 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.
Guidance was also provided for the following issues:
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.
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
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.
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.
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.