Is Your Retirement Plan Ready for the New 401 (k) Regulations?
The Internal Revenue Service (IRS) recently issued final regulations governing retirement plans that allow salary deferrals and/or matching contributions. These regulations are the first set of comprehensive regulations issued on 401(k) plans in more than a decade. All 401(k) plans must be amended to comply with these new regulations during the 2006 plan year. This article will highlight significant provisions of the final regulations.
First, some 401(k) plans allow “hardship” distributions to participants while they are employed. 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 post-secondary education expenses, and prevention of foreclosure or eviction. The final regulations expand this list of hardship events to include: Burial or funeral expenses for the participant’s deceased parent, spouse, or dependents, and expenses for repair of damage to the participant’s principal residence that would qualify as deductible casualty expenses.
Second, the final regulations contain detailed guidance on “safe harbor” 401(k) plans. Safe harbor 401(k) plans are exempt from certain nondiscrimination testing associated with deferrals and/or matching contributions if they satisfy certain requirements. This testing exemption typically allows highly compensated employees to contribute larger amounts to a 401(k) plan. The primary requirement for safe harbor 401(k) plans is a mandatory contribution of either a 3% contribution to all 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 by all eligible employees who make salary deferrals. In addition, participants must receive an annual notification that the plan is electing the Safe Harbor. If a plan chooses to avoid nondiscrimination testing by making safe harbor contributions, the final regulations provide that the plan document must specify this election. The plan cannot state that it will have the option to perform the nondiscrimination tests if the contribution or notice requirements of the safe harbor are not met.
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, provided that 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 that (1) the employer funds the required contributions to the date of termination, (2) gives employees notice of the termination, (3) and the plan satisfies the applicable nondiscrimination tests.
Third, several technical changes were made to the nondiscrimination testing rules and correction methods applicable to salary deferrals and matching contributions. The nondiscrimination tests, called the “ADP” (Actual Deferral Percentage) and “ACP” (Average Contribution Percentage) tests, can be performed using NHCE (Non-Highly Compensated Employee) testing data from the current year or from the prior year. The final regulations require that the use of current or prior year testing data must be specified in the plan document. The chosen testing method 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.
When an employer fails the ADP or ACP nondiscrimination test, the failure may be corrected by making a “qualified nonelective contribution” (QNEC) or “qualified matching contribution” (QMAC) to the plan. There are a number of methods that an employer could 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 could greatly reduce the cost of nondiscrimination compliance. The final regulations have added restrictions that severely limit the use of these methods of compliance.
Plans may also correct a failed ADP or ACP nondiscrimination test by making corrective distributions of excess contributions to “HCEs” (Highly Compensated Employees). 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.
Finally, the 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. Occasional early contributions that are made for bona fide administrative consideration (e.g., the temporary absence of the bookkeeper responsible for transmitting contributions) are allowed.
Please contact Randy Cook in our office for more information on the final regulations and how they may impact your retirement plan.