Code Section 401(k)(12) Safe Harbor Plans

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1 Code Section 401(k)(12) Safe Harbor Plans Chuck Rolph, J.D. Director, Advanced Consulting Group Nationwide Financial I. Overview Qualified retirement plans that contain a cash or deferred arrangement ( CODA ), as authorized by Internal Revenue Code ( Code ) section 401(k), are subject to two specific nondiscrimination tests relative to the CODA feature. The first is the actual deferral percentage ( ADP ) test which tests the elective deferral contributions (i.e., salary deferral contributions made by the employees) for nondiscrimination. The intent of the test is to prevent the group of highly compensated employees ( HCEs ) from deferring more than a specified percentage or amount deferred by the group of nonhighly compensated employees ( NHCEs ). The second test is the actual contribution percentage ( ACP ) test, which tests the matching contributions made by the employer for nondiscrimination. The intent of this test is similar to that of the ADP test. For an employer that doesn t want to deal with the nondiscrimination testing on an annual basis, there is a safe harbor alternative found in Code section 401(k)(12) [Safe Harbor Matching and Nonelective Contributions] that is the subject of this paper. The purpose of this paper is to summarize the safe harbor matching and nonelective contribution alternatives to the ADP and ACP testing rules, so as to give the reader a basic understanding of the concepts involved. It is not intended as a comprehensive discussion of all aspects of the rules pertaining to the safe harbor alternatives and is presented as general information and not legal or tax advice. The reader is encouraged to perform his or her own research or consult tax or legal professionals for any questions that may arise. II. The Code Section 401(k)(12) [Matching and Nonelective Contributions] Safe Harbor A. Basic Requirements A Code section 401(k) plan that satisfies the requirements of Code section 401(k)(12) is: (i) treated as satisfying the ADP test; and (ii) treated as satisfying the ACP test if certain limitations on matching contributions in excess of the required contributions are satisfied and employee FOR BROKER/DEALER USE ONLY NOT FOR USE WITH THE PUBLIC 1

2 after-tax contributions are not permitted. 1 A Code section 401(k)(12) safe harbor plan is also exempt from the top-heavy requirements of Code section 416 for the year if the plan allows only contributions required to satisfy the safe harbor requirements. 2 In order to meet the requirements of the design-based safe harbor in Code section 401(k)(12), the CODA must satisfy: (i) the safe harbor contribution requirement; 3 (ii) the withdrawal and vesting requirements; 4 (iii) the notice requirement; 5 and (iv) the plan year requirement. 6 In addition to these basic requirements, a safe harbor plan must also comply with certain additional rules, discussed below. Finally, the plan document must contain the applicable provisions of the Code section 401(k)(12) safe harbor. B. Safe Harbor Contribution Requirement ADP Test General Rule for Safe Harbor Contributions. There are two alternative contribution requirements under Code section 401(k)(12)(B) - a matching contribution requirement or a nonelective contribution requirement. There are no restrictions in the statute or the regulations on the employer s switching back and forth between the matching and nonelective methods of satisfying the safe harbor contribution requirements, so long as: (i) the plan permits switching from year to year; (ii) the employer determines which test it will satisfy before the beginning of the year; and (iii) the notice requirement is met before the beginning of the year. Safe Harbor Matching Contributions. The safe harbor matching contribution requirement is satisfied if, under the plan, qualified matching contributions are made on behalf of each eligible nonhighly compensated employee in an amount determined under a basic matching formula or an enhanced matching formula, and certain other conditions are met. 7 The basic matching formula provides for matching contributions to be made on behalf of each nonhighly compensated employee equal to one hundred percent (100%) of the employee's elective contributions up to three percent (3%) of compensation, and fifty percent (50%) of the employee's elective contributions between three percent (3%) and five percent (5%) of compensation. 8 Thus, the maximum matching contribution required for an employee to meet the safe harbor is equal to four percent (4%) of compensation. The enhanced matching formula must provide that each eligible nonhighly compensated employee receives a matching contribution that, at any rate of elective contributions, provides an aggregate amount of qualified matching contributions at least equal to the amount that would 1 Code sec. 401(k)(12) 2 Code sec. 416(g)(4) 3 Code sec. 401(k)(12)(B) or (C) 4 Code sec. 401(k)(12)(E)(i)(1) 5 Code sec. 401(k)(12)(D) 6 Treas. Regs. sec (k)-3 7 Code sec. 401(k)(12)(B) 8 Treas. Regs. sec (k)-3(b)(2) FOR BROKER/DEALER USE ONLY NOT FOR USE WITH THE PUBLIC 2

3 have been provided under the basic matching formula. 9 The rules pertaining to the enhanced matching formula also provide that the ratio of matching contributions to elective contributions may not increase as the elective contributions increase. 10 One example of an enhanced matching formula that would meet the requirements is a match equal to one hundred percent (100%) of elective contributions up to four percent (4%) of compensation. If the plan involved allows for employee after-tax contributions, additional rules apply in order to satisfy the safe harbor matching formula. 11 Safe Harbor Nonelective Contributions. In lieu of satisfying the matching contribution safe harbor, an employer may make qualifying nonelective contributions on behalf of each nonhighly compensated eligible employee equal to at least three percent (3%) of the employee's safe harbor compensation, without regard to whether the employee makes elective contributions. 12 A plan may limit the period used to determine safe harbor compensation to the eligible employee's period of participation. 13 Definition of Compensation for the Safe Harbor Matching and Nonelective Contribution Rules. One of the first practical considerations an employer encounters in making the safe harbor contributions is the definition of compensation used. Safe harbor employer contributions must be based on a definition of compensation within the meaning of Treas. Regs. section 1.401(k)-6, which refers, in turn, to the definition of compensation under Code section 414(s), but without the ability to exclude all compensation in excess of a specified dollar amount. 14 The reader is advised to check the regulations for additional rules and examples concerning the definition of compensation and the alternative choices surrounding the periods available for determining the compensation. C. Safe Harbor Contribution Requirement - ACP Test The general rule for a safe harbor plan that uses the matching contribution alternative to satisfy the ADP safe harbor contribution requirement, and does not provide for any other matching contributions, is that the plan is treated as satisfying the ACP test. It is, however, possible for an employer to provide additional matching contributions, i.e., a more generous matching contribution formula, and to continue to be treated as satisfying the ACP test if certain requirements are satisfied Treas. Regs. sec (k)-3(c)(3) 10 Id. 11 Treas. Regs. sec (k)-3(c)(5)(i) 12 Code sec. 401(k)(12)(C); Treas. Regs. sec (k)-3(b) 13 Id. 14 Treas. Regs. sec (k)-3(b)(2) 15 Code sec. 401(m)(11); Treas. Regs. sec (m)-3 FOR BROKER/DEALER USE ONLY NOT FOR USE WITH THE PUBLIC 3

4 First, matching contributions may not be made with respect to an employee's contributions or elective deferrals in excess of six percent (6%) of the employee's compensation. 16 Second, matching contributions that are discretionary may not exceed four percent (4%) of the employee's compensation. 17 Third, the rate of matching contribution may not increase as the rate of employee contributions or elective deferrals increases. 18 Fourth, at any rate of employee contribution or elective deferral, the matching contribution with respect to a highly compensated employee may not be greater than the matching contribution with respect to a nonhighly compensated employee. 19 A plan does not fail to satisfy this last requirement merely because it provides that matching contributions will be made separately with respect to each payroll period, or with respect to all payroll periods ending with or within each month or quarter of a plan year, so long as the matching contributions for any quarter are contributed to the plan by the last day of the following quarter. In applying the fourth limitation, matching contributions for a highly compensated employee under all plans of the employer will be taken into account. However, non-simultaneous participation in more than one plan during a year, or the period used to determine compensation under each plan is limited to periods of actual participation in the plan, will not result in failure to satisfy the safe harbor matching contribution requirements. 20 D. Effect of Additional Matching, Nonelective, or After-Tax Employee Contributions The basic purpose of a Code section 401(k)(12) safe harbor plan is to enable the employer sponsoring the plan and its plan administrator to avoid the nondiscrimination testing associated with the employees salary deferral contributions and the employer s matching contributions. As discussed above, a Code section 401(k)(12) safe harbor plan must satisfy the safe harbor contribution requirements for purposes of the ADP and ACP tests. What is the effect on the contribution safe harbor for the ADP and ACP tests if the employer makes matching or nonelective contributions in excess of the safe harbor amounts or if the employer allows employees to make after-tax contributions? General Rule. Additional contributions above and beyond the safe harbor contributions are treated in the same manner as contributions to a non-safe harbor plan. In practical terms, that means the additional contributions allocated to employees must be tested for coverage under Code section 410(b) and for nondiscrimination under Code section 401(a)(4). It also means that the additional contributions are not subject to the vesting and withdrawal requirements that apply to safe harbor contributions. Additional Matching Contributions. The effect of matching contributions in excess of the safe harbor limit is discussed above in section C. 16 Treas. Regs. sec (m)-3(d)(3)(i) 17 Treas. Regs. sec (m)-3(d)(3)(ii) 18 Treas. Regs. sec (m)-3(d)(2) 19 Treas. Regs. sec (m)-3(d)(4) 20 Treas. Regs. sec (m)-3(d)(5) FOR BROKER/DEALER USE ONLY NOT FOR USE WITH THE PUBLIC 4

5 Additional Nonelective Employer Contributions. As mentioned above, employer contributions in excess of the nonelective safe harbor contribution limits are subject to the general nondiscrimination requirements of Code section 401(a)(4). In meeting these requirements, the safe harbor nonelective contributions made to the plan may be taken into account. Nonelective contributions used to satisfy the design-based safe harbor can be used to satisfy other qualified retirement plan nondiscrimination rules as well. 21 However, these contributions cannot be taken into account in determining whether a plan meets the permitted disparity rules of Code section 401(l). 22 After-Tax Employee Contributions. The designed-based safe harbors provide relief from ACP testing only for matching contributions, and not after-tax employee contributions. After-tax employee contributions continue to be subject to ACP testing. 23 Moreover, employer matching and nonelective contributions used to satisfy the safe harbor requirements cannot be considered in applying that ACP test, except to the extent they exceed the amounts required to satisfy the safe harbor requirements. It is for this reason that a plan intended as a Code section 401(k)(12) safe harbor plan will not likely include a provision for after-tax employee contributions. Effect of Additional Contributions on the Code Section 416 Top-Heavy Requirement. The topheavy rules do not apply to a Code section 401(k)(12) safe harbor plan that only provides for safe harbor contributions. 24 The mere inclusion in a plan of a provision that provides for additional contributions at the employer's discretion will also not cause the plan to be subject to the top-heavy rules. 25 However, any additional contribution that is actually made will cause the plan to be subject to the top-heavy rules. 26 If a Code section 401(k)(12) safe harbor plan falls outside of the top-heavy exemption, safe harbor nonelective contributions may be counted under Code section 416 toward the minimum contribution requirement for top-heavy plans. 27 Please consult the top-heavy regulations [Treas. Regs. sec ] for additional details. E. Withdrawal, Vesting, and Other Restrictions A Code section 401(k)(12) safe harbor plan must provide that all safe harbor employer contributions, including safe harbor matching contributions, are fully vested and nonforfeitable. 28 In addition to vesting limitations, safe harbor plans may not condition contributions on certain requirements. A plan may not require that an employee be employed on the last day of the plan year in order to receive a safe harbor matching or nonelective contribution and may not condition 21 Treas. Regs. sec (k)-3(h)(2) 22 Code sec. 401(k)(12)(E)(ii); Treas. Regs. sec (k)-3(h)(2) 23 IRS Notice Code sec. 416(g)(4)(H) 25 Rev. Rul Id. 27 IRS Notice Code sec. 401(k)(12)(E)(i) FOR BROKER/DEALER USE ONLY NOT FOR USE WITH THE PUBLIC 5

6 the match or nonelective contribution upon completion of a certain number of hours of service, e.g., 1,000 hours of service in the plan year. 29 In addition, a safe harbor plan must impose the same withdrawal restrictions that apply to elective deferrals under a Code section 401(k) plan to employer safe harbor contributions. 30 F. Notice Requirement To satisfy the Code section 401(k)(12) safe harbor, each employee eligible to participate in the CODA must, within a reasonable period before any year, be given written notice of the employee's rights and obligations under the CODA in a manner that is sufficiently accurate and comprehensive to apprise the employee of his or her rights and obligations under the plan, and written in a manner calculated to be understood by the average eligible employee. 31 To be considered sufficiently accurate and comprehensive, the notice must include the following elements: (i) the safe harbor matching or nonelective contribution formula used under the plan (including a description of the levels of matching contributions, if any, available under the plan); (ii) any other contributions under the plan (including the potential for discretionary matching contributions) and the conditions under which such contributions are made; (iii) the plan to which safe harbor contributions will be made (if different from the plan containing the CODA); (iv) the type and amount of compensation that may be deferred under the plan; (v) how to make cash or deferred elections, including any administrative requirements that apply to such elections; (vi) the periods available under the plan for making cash or deferred elections; (vii) withdrawal and vesting provisions applicable to contributions under the plan; and (viii) information that makes it easy to obtain initial information about the plan (including an additional copy of the summary plan description) such as telephone numbers, addresses, or electronic addresses. 32 A notice is treated as satisfying the reasonable time requirement if it is provided to each eligible employee within a period of at least thirty (30) days, and no more than ninety (90) days, before the beginning of each plan year. In the case of newly-hired employees, the notice must be provided within the ninety (90)-day period ending with the day the employee becomes eligible. 33 However, the general rule is that the notice must be provided within a reasonable period before 29 Treas. Regs. sec (k)-3(c)(7), Ex Code sec. 401(k)(12)(E)(i) 31 Code sec. 401(k)(12)(D); Treas. Regs. sec (k)-3(d)(2)(i) 32 Treas. Regs. sec (k)-3(d)(2)(ii) 33 Treas. Regs. sec (k)-3(d)(3)(ii) FOR BROKER/DEALER USE ONLY NOT FOR USE WITH THE PUBLIC 6

7 the beginning of the plan year (or, in the year the employee becomes eligible, within a reasonable period before the employee becomes eligible), determined based on all the facts and circumstances. A special notice must be provided if the employer decides to suspend its contributions mid-year. That special notice will be discussed in section H of this paper. The required notice may be provided in writing or in electronic form, provided that the general IRS requirements for paperless delivery of notices in Treas. Regs. sec (a)-21 is satisfied. 34 G. Plan Year Requirement General Rule. As a general rule, a plan will not satisfy the Code section 401(k)(12) designbased safe harbor unless plan provisions that satisfy the applicable rules are adopted before the first day of the plan year and remain in effect for the entire twelve (12)-month plan year. 35 The regulations go on to provide that, except as provided with respect to a permissible reduction or suspension of safe harbor contributions in accordance with Treas. Regs. sec (k)-3(g), a plan which includes provisions that satisfy the rules of the Code section 401(k)(12) safe harbor will not satisfy the requirements of Treas. Regs. sec (k)-1(b) [the coverage and nondiscrimination requirements applicable to the CODA] if it is amended to change such provisions for that plan year. 36 Initial Plan Year. The regulations provide that a newly-established plan (other than a successor plan) may have a plan year that is less than twelve (12) months long, but at least three (3) months long. A newly-established employer may establish its plan as soon as administratively feasible after the employer comes into existence. A CODA may be added to an existing profit sharing, stock bonus, or pre-erisa money purchase pension plan for the first time during that year provided that: (i) the plan is not a successor plan; and (ii) the CODA is made effective no later than three (3) months prior to the end of the plan year. 37 Change of Plan Year. A plan that has a short plan year as a result of changing its plan year does not violate the general rule that a plan must have a twelve (12)-month plan year, provided that: (i) the plan satisfied the plan year requirements for the immediately preceding plan year; and (ii) the plan satisfies the plan year requirements for the immediately following plan year. 38 Final Plan Year. A plan that terminates during a plan year, with the result that the final plan year is less than twelve (12) months in length does not fail to satisfy the general rule if the plan 34 Treas. Regs. sec (k)-3(d)(1) 35 Treas. Regs. sec (k)-3(e)(1) 36 Id. 37 Treas. Regs. sec (k)-3(e)(2) 38 Treas. Regs. sec (k)-3(e)(3) FOR BROKER/DEALER USE ONLY NOT FOR USE WITH THE PUBLIC 7

8 satisfied all the plan year rules through the date of termination and either: (i) the plan would satisfy the requirements discussed in section H (relating to the permitted reduction or suspension of safe harbor contributions); or (ii) the plan termination is in connection with a transaction described in Code section 410(b)(6)(C) [employer either becomes or ceases to be a member of a controlled group or affiliated service group] or the employer incurs a substantial business hardship comparable to a substantial business hardship described in Code section 412(c). H. Permitted Suspension or Reduction of Safe Harbor Contributions Matching Contributions. If a plan utilizes matching contributions to satisfy the safe harbor contribution requirement, the plan may be amended during the plan year to reduce or suspend those safe harbor matching contributions on participants future elective contributions provided certain conditions are met: (i) in the case of plan years beginning on or after January 1, 2015, the employer either - (A) is operating at an economic loss as described in Code section 412(c)(2)(A) for the plan year; or (B) includes in the annual notice to participants a statement that the plan may be amended during the plan year to reduce or suspend safe harbor nonelective contributions and that the reduction or suspension will not apply until at least thirty (30) days after all eligible employees are provided notice of the reduction or suspension; (ii) all eligible employees are provided a supplemental notice that explains (A) the consequences of the amendment that reduces or suspends future safe harbor contributions; (B) the procedures for changing cash or deferred elections and (if applicable) employee after-tax contribution elections; and (C) the effective date of the amendment; (iii) the reduction or suspension of safe harbor matching contributions is effective no earlier than the later of the date the amendment is adopted or thirty (30) days after eligible employees are provided the supplemental notice; (iv) eligible employees are given a reasonable opportunity (including a reasonable period after receipt of the supplemental notice) prior to the reduction or suspension of safe harbor matching contributions to change their cash or deferred elections and, if applicable, their employee contribution elections; (v) the plan is amended to provide that the ADP test will be satisfied for the entire plan year in which the reduction or suspension occurs using the current year testing method described in Treas. Regs. sec (k)-2(a)(2)(ii); and (vi) the plan satisfies all the requirements of Treas. Regs. sec (k)-3 [the safe harbor regulations] with respect to amounts deferred through the effective date of the amendment Treas. Regs. sec (k)-3(g)(1)(i) FOR BROKER/DEALER USE ONLY NOT FOR USE WITH THE PUBLIC 8

9 Nonelective Contributions. If a plan utilizes nonelective contributions to satisfy the safe harbor contribution requirement, then for amendments adopted after May 18, 2009, the plan may be amended during the plan year to reduce or suspend those safe harbor nonelective contributions provided certain conditions are met: (i) the employer either - (A) Is operating at an economic loss, as described in Code section 412(c)(2)(A) for the plan year; or (B) includes in the annual notice to participants a statement that the plan may be amended during the plan year to reduce or suspend safe harbor nonelective contributions and that the reduction or suspension will not apply until at least thirty (30) days after all eligible employees are provided notice of the reduction or suspension; (ii) all eligible employees are provided a supplemental notice that explains (A) the consequences of the amendment that reduces or suspends future safe harbor contributions; (B) the procedures for changing cash or deferred elections and (if applicable) employee after-tax contribution elections; and (C) the effective date of the amendment; (iii) the reduction or suspension of safe harbor matching contributions is effective no earlier than the later of the date the amendment is adopted or thirty (30) days after eligible employees are provided the supplemental notice; (iv) eligible employees are given a reasonable opportunity (including a reasonable period after receipt of the supplemental notice) prior to the reduction or suspension of safe harbor matching contributions to change their cash or deferred elections and, if applicable, their employee contribution elections; (v) the plan is amended to provide that the ADP test will be satisfied for the entire plan year in which the reduction or suspension occurs using the current year testing method described in Treas. Regs. sec (k)-2(a)(2)(ii); and (vi) the plan satisfies all the requirements of Treas. Regs. sec (k)-3 [the safe harbor regulations] with respect to amounts deferred through the effective date of the amendment. 40 III. Effect of Automatic Contribution Arrangement in a Code Section 401(k)(12) Safe Harbor Plan There are certain automatic contribution arrangements that have permeated Code section 401(k) plan design in recent years and include: (i) Automatic Contribution Arrangements (ACA); (ii) Eligible Automatic Contribution Arrangements (EACA); and (iii) Qualified Automatic Contribution Arrangements (QACA). Those arrangements are discussed separately in another white paper. However, it is significant to note that a QACA, found in Code section 401(k)(13), 40 Treas. Regs. sec (k)-3(g)(1)(ii) FOR BROKER/DEALER USE ONLY NOT FOR USE WITH THE PUBLIC 9

10 can be utilized as an alternative safe harbor arrangement to the Code section 401(k)(12) safe harbor discussed in this paper. The Code section 401(k)(12) safe harbor does not require that the CODA include an automatic contribution arrangement. That is, in contrast to the QACA safe harbor found in Code section 401(k)(13), a Code section 401(k)(12) safe harbor may require affirmative elections to defer. However, nothing found in Code section 401(k)(12) precludes a plan from including an automatic contribution arrangement. CIRCULAR 230 DISCLOSURE: To comply with US Treasury Department regulations, we inform you that, unless otherwise expressly indicated, any tax advice as contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, by any person other than Nationwide and its affiliates, for the purpose of (i) avoiding penalties that may be imposed under the Internal Revenue Code or any other applicable tax law, or (ii) promoting, marketing or recommending to another party any transaction, arrangement or other matter. The Employee Retirement Income Security Act of 1974 ( ERISA ) and the federal income tax laws are complex and subject to change. Notwithstanding the foregoing, the information in this is not intended to be, nor is it to be construed as, tax or legal advice. Neither Nationwide nor its representatives give legal or tax advice. Please consult your attorney or tax advisor for answers to specific questions. Nationwide and the Nationwide framemark are registered service marks of Nationwide Mutual Insurance Company. Nationwide Financial Services, Inc. All rights reserved. Nationwide Investment Services Corporation, Columbus, Ohio, member FINRA PNM-2757AO (12/13) FOR BROKER/DEALER USE ONLY NOT FOR USE WITH THE PUBLIC 10