Client Memorandum. What You Need to Know About the Final 401(k) and 401(m) Regulations By: Ann M. Kim, Carol Hines Wacaser and David Wolfe

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1 Client Memorandum HR Law/Employee Benefits March 2005 What You Need to Know About the Final 401(k) and 401(m) Regulations By: Ann M. Kim, Carol Hines Wacaser and David Wolfe In August 2003, we distributed a client memorandum that discussed proposed 401(k) and 401(m) regulations issued by the United States Treasury Department on July 17, On December 29, 2004, these regulations became final with some modifications. The final regulations impact cash or deferred arrangements (commonly referred to as CODAs ), but do not make sweeping changes to existing law. Instead, they centralize many Internal Revenue Service ( IRS ) notices, procedures, and opinions regarding changes in the law made by the Small Business Job Protection Act of 1996, the Tax Reform Act of 1997, and the Economic Growth and Tax Relief Reconciliation Act of The final regulations include the following changes and clarifications that are worth particular note. Contributions As discussed in more detail below, the regulations address the timing of deferrals, safe harbor 401(k) plan rules, Roth contributions, and automatic enrollment (or negative elections). The regulations retain the rule that employers generally may not prefund participant deferrals or employer matching contributions. Also, under a safe harbor 401(k) plan that makes safe harbor matching contributions, employers will need to include catch-up contributions as deferrals eligible for the safe harbor match. The regulations also state that a safe harbor 401(k) plan cannot claim to be a safe harbor plan and then stop making or not make the safe harbor contributions and revert to testing during or with respect to a particular plan year. Finally, the regulations address Roth contributions and negative elections. Prefunding The regulations retain the rule that a CODA cannot accept prefunded salary deferrals or prefunded matching contributions. The primary purpose of this rule is to preclude a plan sponsor from accelerating tax deductions by making plan contributions in an earlier taxable year. Under the regulations, all contributions under a CODA must be made after the employee has made the relevant deferral election, after the services have been performed, and, for purposes of salary deferrals, only if the amounts deferred would otherwise be paid in cash to the employee. On occasion, plan sponsors may make contributions to a CODA before services by employees are performed if the contributions need to be made for bona fide administrative reasons. However, this exception does not apply if the principal purpose for prefunding the contributions is to allow the plan sponsor to accelerate a deduction. Safe Harbor 401(k) Plans Safe harbor 401(k) plans can avoid performing the Actual Deferral Percentage ( ADP ) test and the Actual Contribution Percentage ( ACP ) test if they contain a safe harbor qualified nonelective employer contribution ( QNEC ) or a safe harbor qualified matching contribution ( QMAC ) formula. A safe harbor 401(k) plan must specifically state the amount of the contribution and whether it is a QNEC or QMAC. In the case of the QMAC, the IRS had not previously issued guidance on whether the age 50 catch-up contributions were required to be matched. Under the new regulations, if a plan permits employees to make age 50 catch-up contributions under a safe harbor 401(k) plan that uses the QMAC, to meet the safe harbor matching contribution requirements, the plan must match the catch-up contributions. GCD Note: This clarification will affect few employees. A typical safe harbor matching contribution plan that contains a true-up provision will reach the maximum matching contribution under the safe harbor formula before any participant makes catch-up contributions. However, this clarification could affect employees who transfer employment midyear and make catch-up contributions without making substantial salary deferral contributions to a new employer s plan. Also, participants in plans that do not true-up or that have a 1

2 discretionary true- up of matching contributions may be affected by this provision. Some safe harbor 401(k) plans provide a reversion clause under which the plan will test if, for a particular plan year, such plans do not meet the safe harbor requirements. According to the Treasury Department, the purpose of the safe harbor is to provide participants with a minimum amount of benefits in exchange for easier compliance, and a reversion provision is inconsistent with the intent of the safe harbor provisions. Therefore, the regulations state that a plan cannot provide that an ADP test will be performed if the plan does not satisfy the safe harbor provisions. In addition, the regulations specify that a plan may not be amended to revert to a testing plan if, at the beginning of the plan year, it contains a safe harbor contribution formula. Action Item: Safe harbor contribution plans should be reviewed and amended to reflect these rules. A plan that provides that the ADP and/or ACP tests will apply in years when a safe harbor contribution is not made should be fine. However, not making the safe harbor contributions would require a plan amendment. Roth 401(k) Plans For tax years beginning after December 31, 2005, a CODA may incorporate a qualified Roth contribution program. Under this program, participants may designate elective deferrals as Roth contributions. Unlike other after-tax contributions, the regulations provide that Roth contributions are permitted to be treated as a CODA. Roth contributions are included in the participant s taxable income and are included for purposes of the ADP test. If necessary, such contributions may be reclassified as after-tax contributions in the event of an ADP failure. Any plan that includes a qualified Roth contribution program must test the program to ensure that it does not discriminate in favor of highly compensated employees ( HCEs ). A GCD client memo on the additional regulations issued on Roth contributions will be posted soon. Automatic Enrollment More and more plan sponsors are considering adding automatic enrollment (or negative election) provisions to their CODAs. Under these provisions, an employee who does not submit an election form will be deemed to have elected to contribute a certain percentage of his or her compensation to the plan. An employee may elect to contribute a different amount of his or her compensation to the plan, up to plan limitations, or he or she may elect not to participate. Only inaction by the employee will trigger the automatic deferrals. Revenue Ruling , which was issued in January 2000, specified the criteria a CODA must satisfy to automatically reduce an employee s compensation. In its examples of plans with permissible automatic enrollment provisions, the IRS referred to an automatic deferral rate of 3%. Since the release of that Revenue Ruling, plan sponsors have been hesitant to use an automatic deferral rate in excess of 3%. The regulations clarify that the deferral percentage referred to in the Revenue Ruling was for illustrative purposes only. The regulations do not specify an amount for automatic deferrals. GCD Note: Although a plan sponsor is not limited by the regulations in the amount of an automatic deferral, plan sponsors should take care in determining the amount, as state wage withholding rules may restrict the amount by which an employer may reduce an employee s wages. GCD Note: One approach used by plan sponsors in choosing the rate of automatic deferral is to set the rate for a new employee very low and have the deferral rate increase each year if the employee does not otherwise make an election. In this case, the automatic deferral rate would stop increasing when it reaches the amount necessary for the participant to obtain the full matching contribution under the plan. Testing The regulations also discuss in detail the ADP and ACP tests, amendment to other nondiscrimination testing procedures, and a couple of anti-abuse provisions, including limitations on corrective QNECs (to be distinguished from safe harbor QNECs) to certain nonhighly compensated employees ( NHCEs ). Legal Changes in Testing Each portion of a plan must either meet a safe harbor or be tested to ensure that the plan does not discriminate in favor of HCEs. Certain portions of the plan must be required to be aggregated or disaggregated for testing purposes. Before these regulations, if a plan contained both an employee stock ownership plan ( ESOP ) and a CODA, the ESOP and CODA portions had to be disaggregated and tested separately. The new 2

3 regulations revise this rule to provide that the ESOP and CODA portions of the plan may be permissively aggregated for the ADP and ACP tests, but not for the 410(b) minimum coverage test. Other clarifications to the nondiscrimination tests include the following: if a plan is disaggregated under the minimum coverage rules of 410(b), each separate portions of the plan can apply different ADP and ACP testing methods; and in addition to catch-up contributions, makeup deferrals made under 414(u) after a participant returns from a qualified military leave are not taken into account for the ADP test. Anti-Abuse Provisions The final regulations make two attempts to limit what the IRS views as testing abuses. First, to correct an ADP failure, certain plan sponsors use a bottom-up leveling method. Under this method, corrective QNECs are targeted to certain NHCEs to limit the total corrective contribution necessary to correct the failure. Under the bottom-up leveling method, a plan sponsor makes a QNEC up to the maximum amount permitted under Internal Revenue Code Section 415 to the NHCEs with the lowest compensation one at a time, until the plan passes the ADP test. This method causes the lowest paid employees to have the highest ADP ratio (up to 100 percent), which, when averaged with the ratios of the remaining NHCEs, is high enough for the plan to pass the ADP test. The regulations substantially limit the use of the bottomup leveling method. Generally, QNECs of over 5% of an employee s compensation may be considered for purposes of the ADP or ACP test only if the QNEC contribution passes a test that compares the QNECs of all NHCEs. If the QNEC for certain NHCEs is unusually high when compared to the QNECs of other NHCEs, only a portion of the QNEC contribution will count for purposes of the ADP or ACP test. Second, the regulations include a general anti-abuse rule. If a plan s testing provisions or policies are amended or revised with the primary purpose being to distort the ADP or ACP test results or permit HCEs to receive higher plan contributions, the plan will fail to satisfy Code Section 401(k). The IRS is particularly concerned with plans that change back and forth from prior-year to current-year testing for ADP or ACP or change from a safe harbor to nonsafe harbor 401(k) plan from year to year. This rule does not prevent legitimate changes in testing procedures. If the testing provisions of a plan are amended as a result of a change in employee demographics or a plan merger, this anti-abuse rule will not apply. For example, if an employer sponsors a nonsafe harbor 401(k) plan 2003, amends the plan to become a safe harbor plan in 2004, acquires a company in late 2004, and further amends the 401(k) plan to no longer be a safe harbor plan in 2005 because of the change in participants as a result of the acquisition, then this change will not be viewed as abusive. Gap Period Income If a plan fails the ADP or ACP test, it can distribute excess contributions made by HCEs as an alternative to providing corrective QNECs to NHCEs. The excess contributions need to be adjusted for earnings that accrue after the plan year in which the deferrals were made and before contribution. Because testing typically takes place after the end of the plan year in which deferrals are made, distributions of the excess contributions are normally made in the plan year following the year of deferral. The period between the last day of the deferral year and the date the distributions are made is called the gap period. Prior to the effective date of the regulations, plan sponsors could choose whether the excess contributions were adjusted for investment returns during the gap period. The regulations now specify that distributions of excess contributions must be adjusted for gap period income if the employee would have been credited with allocable gain or loss for that period if his or her total account were to be distributed. Further, the regulations clarify that the value of distributed excess contributions is included in the taxpayer s taxable income on the date the elective deferrals would have been received by the employee had he or she not elected to defer such amounts (i.e., in the year of deferral). Note that the regulations provide two exceptions to the required gap period earnings adjustments. First, the plan sponsor can determine the attributable earnings up to seven days before the date of the distribution. This exception is to provide plan sponsors with a cutoff date for the purpose of determining the amount of the distribution. Second, if a plan sponsor uses the safe harbor method of calculating earnings, a corrective distribution that is made on or before the 15th day of a month is treated as made on the last day of the previous month for purposes of calculating the number of months that have elapsed. 3

4 Action Item: Most CODAs provide for daily valuation of accounts. These plans and all others that would adjust for earnings if a participant s account were to be distributed should be amended to reflect the regulations, and, if the plan is silent on this point, the administration must be amended to comply with the regulations. Hardship Withdrawals Generally, distributions from a CODA may be made only after a participant has incurred a distributable event, such as termination from employment. Under an exception to this rule, a plan may allow a participant who experiences a severe financial hardship to request a hardship withdrawal during active employment. An expense qualifies as a severe financial hardship if the participant experiences an immediate and heavy financial need that the participant cannot pay except through a withdrawal from his or her CODA. There are two components to determining whether a participant is entitled to a hardship withdrawal. The first is the determination of whether the participant has an immediate and heavy financial need, and the second is the determination of whether the amount of the withdrawal requested is necessary to satisfy the need. Each component can be satisfied under a general rule or a safe harbor rule (or use of both). In the case of the first component, the determination of the existence of an immediate and heavy financial need, the safe harbor is a list of reasons that are deemed to constitute immediate and heavy financial needs. The final regulations have formally added two additional reasons to the list: funeral expenses and certain expenses to repair a principal residence. The final regulations also address the implication to hardship withdrawal determinations of recent changes in the definition of dependent under Code Section 152, as modified by the Working Families Tax Relief Act of This was necessary because a number of reasons on the safe harbor list apply to expenses incurred on behalf of a participant s dependents as well as the participant. The regulations modify the new definition of dependent for hardship withdrawal purposes to override certain of the changes to this definition to avoid unintended effects on the availability of hardship withdrawals. The result is that a plan can rely on its existing definition of dependent, or it can incorporate the new definition (qualified children and qualified relatives) but ignore certain new limitations. A detailed discussion of the changes to the dependent definition is beyond the scope of this client alert. Please refer instead to our December 2004 Client Memorandum entitled It Wasn t Broken, But Congress Fixes Dependent Definition. Finally, with respect to the second component, determining whether the amount of the withdrawal request is necessary to satisfy the need, the regulations clarify that a CODA participant will not be deemed to have received all allowable distributions unless cash dividends from an ESOP are taken into account. Action Item: Plan sponsors may want to amend their plan documents to include funeral expenses and the cost to repair a participant s principal residence to the types of expenses that will permit a hardship withdrawal. Also, plan sponsors should review how the plan defines dependent in its hardship withdrawal provisions to determine whether modifications should be made. Effective Date The regulations are effective for plan years beginning on or after January 1, A plan sponsor can apply the regulations to plan years beginning after December 29, However, with one exception noted below, if a plan sponsor wants to apply a portion of the rules early, it must apply all of the final regulations to the plan, not just selected portions. The one exception to this all-ornone rule is that plan sponsors can currently apply the regulation s amendment to the recent changes to the definition of dependent as applied for hardship withdrawal purposes for plan years beginning after December 29,

5 EMPLOYEE BENEFITS Carol Abing (414) Kathleen O Connor Adams (312) koconnor_adams@gcd.com Marla B. Anderson (312) manderson@gcd.com Vicki Beckenbaugh (312) vbeckenbaugh@gcd.com Elizabeth Binder (202) ebinder@gcd.com Kimberly J. Boggs (414) kboggs@gcd.com Gregory K. Brown (312) gkbrown@gcd.com Barbara A. Cronin (312) bcronin@gcd.com Gary W. Howell (312) ghowell@gcd.com Jonathan E. Hyun (312) jhyun@gcd.com Ann M. Kim (312) akim@gcd.com Tina Kuska (312) tkuska@gcd.com David Levin (202) dlevin@gcd.com Howard J. Levine (312) hlevine@gcd.com Joyce L. Meyer (312) jmeyer@gcd.com Sarah Bassler Millar (312) smillar@gcd.com John E. Murray (414) jmurray@gcd.com Kirk A. Pelikan (414) kpelikan@gcd.com Carrie Roberts Rivera (312) crivera@gcd.com Michael D. Rosenbaum (312) mrosenbaum@gcd.com Heather Heath Ryan (312) hryan@gcd.com Mary K. Samsa (312) msamsa@gcd.com Kathleen Sheil Scheidt (312) kscheidt@gcd.com Lori L. Shannon (312) lshannon@gcd.com Robert J. Simandl (414) rsimandl@gcd.com Timothy J. Stanton (312) tstanton@gcd.com Carol Hines Wacaser (312) cwacaser@gcd.com David L. Wolfe (312) dwolfe@gcd.com