401(K) PLANS By Pamela D. Perdue Summers, Compton, Wells & Hamburg

Transcription

1 401(K) PLANS By Pamela D. Perdue Summers, Compton, Wells & Hamburg I. Introduction Section 401(k) of the Internal Revenue Code (the Code) permits certain eligible plans to include a feature allowing eligible employees to contribute to a qualified cash or deferred arrangement (CODA) on a before-tax basis. Such a feature allows employees to elect, individually, whether to contribute on a before-tax basis. In addition, as a result of legislative changes, a Section 401(k) plan may also, starting for years after December 31, 2005, include a feature allowing employees to contribute to a Section 401(k) plan on an after-tax basis as well. The features and requirements of both the basic before-tax Section 401(k) feature as well as the newly allowed after-tax feature will be discussed in this outline. II What is a Qualified CODA? A qualified CODA (what we essentially refer to as a Section 401(k) plan or feature) is any arrangement which is a part of a profit-sharing plan, stock bonus plan, a pre-erisa money purchase pension plan, or a rural cooperative plan that meets the specific requirements set forth in the Internal Revenue Code (the Code) applicable to such plans. [IRC 401(k)(2)] This means that although such plans are generally referred to merely as Section 401(k) plans (because of the section of the Code that primarily governs them), a Section 401(k) plan must technically be a feature of an underlying profit-sharing, stock bonus, pre-erisa money purchase, or a rural cooperative plan. Generally, a CODA includes any arrangement under which an eligible employee may make a cash or deferred election with respect to contributions to, or accruals or other benefits under, a plan that is intended to satisfy the qualification requirements of Section 401(a), including, for this purpose, a contract that is intended to satisfy the requirements of Section 403(a).[Treas. Reg (k)-1(a)(2)(i)] However, a cash or deferred arrangement does not include an arrangement under which amounts contributed under a plan at an employee's election are designated or treated at the time of contribution as after-tax employee contributions, i.e., by treating the contributions as taxable income subject to withholding. [Treas. Reg (k)-1(a)(2)(ii)] However, under the new final regulations that will be effective generally for plan years beginning on or after January 1, 2006, a designated Roth contribution is not to be treated as an after-tax contribution for 1

2 purposes of these rules. [Treas. Reg (k)-1(a)(2)(ii)] Also excluded from the definition of a cash or deferred arrangement is an arrangement under an ESOP (employee stock ownership plan) under which dividends are either distributed or invested pursuant to an election made by participants or their beneficiaries in accordance with Section 404(k)(2)(A)(iii). [Treas. Reg (k)-1(a)(2)(iii)] However, to be a qualified cash or deferred election, cash must be available. This means, for example, if an eligible employee is provided the option to receive a taxable benefit (other than cash) or to have the employer contribute on the employee s behalf to a profit sharing plan an amount equal to the value of the taxable benefit, the arrangement is not a qualified cash or deferred election. Similarly, if an employee has the option to receive a specified amount in cash or to have the employer contribute an amount in excess of the specified cash amount to a profit sharing plan on the employee s behalf, any contribution made by the employer on the employee s behalf in excess of the specified cash amount is not treated as made pursuant to a qualified cash or deferred arrangement, but would be treated as a matching contribution. [Treas. Reg (k)-1(e)(2)(i)] Finally, to be a qualified cash or deferred election, the arrangement must provide an employee with an effective opportunity to make (or change) a cash or deferred election at least once during each plan year. Whether an employee has an effective opportunity is determined based on all of the relevant facts and circumstances, including the adequacy of notice of the availability of the election, the period of time during which an election may be made, and the other conditions on elections. [Treas. Reg (k)-1(e)(2)(ii)] III. General Timing Rules Applicable to CODA Elections A cash or deferred election is any direct or indirect election (or modification of an earlier election) by an employee to have the employer either: 1. provide an amount to the employee in the form of cash that is not currently available; or 2. contribute an amount to the trust, or provide an accrual or other benefit, under a plan deferring the receipt of compensation. In determining whether an election is a cash or deferred election, it is irrelevant whether the default that applies in the absence of an affirmative election is that the employee receives an amount in cash or some other taxable benefit or is that the employer contributes an amount to a trust or provides an accrual or other benefit under a plan deferring the receipt of compensation. [Treas. Reg (k)-1(a)(3)] This means that automatic enrollments (sometimes referred to as negative elections) whereby, the failure to make an affirmative election will result in the employee being deemed to have elected to participate will not prohibit the arrangement from being treated as a bona fide cash or 2

3 deferred election. Example: The ABC company maintains a profit sharing plan containing a feature pursuant to which an employee may elect whether to have part, up to 10%, of each payroll check paid, rather than to the employee, to the trust. An employee who elects to have a part of his/her paycheck instead contributed to the trust will only be taxed, for federal and state income tax purposes, on the gross amount of the check reduced by the amount elected to be contributed to the trust. An employee who fails to make an affirmative election is deemed to have elected not to participate and will receive his/her full paycheck each period. The plan contains a valid cash or deferred arrangement allowing employees to make a cash or deferred election. Example: Assume the same facts as in the above Example except that an employee who fails to make an affirmative election, is deemed to have elected, by default, to participate and to have 3% of each payroll check contributed to the trust rather than paid directly to the employee. The employee receives information advising of this default election and the employee s ability to make an affirmative election or to otherwise change the deemed election. Again, the plan has a valid cash or deferred arrangement pursuant to which employees can make a cash or deferred election under a so called negative election. The election is subject to a host of special timing rules. First, a cash or deferred election can only be made with respect to an amount that is not currently available to the employee on the date of the election. Further, a cash or deferred election can only be made with respect to amounts that would (but for the cash or deferred election) become currently available after the later of the date on which the employer adopts the cash or deferred arrangement or the date on which the arrangement first becomes effective. Further, a contribution is deemed to be made pursuant to a cash or deferred election only if the contribution is made after the election is made. [Treas. Reg (k)- 1(a)(3)(iii)(B)] This means then, that a contribution made in anticipation of an employee's election is not treated as an elective contribution. Moreover, the contribution may not precede the service. Specifically, the regulations provide that a contribution is deemed to be made pursuant to a cash or deferred election only if the contribution is made after the employee's performance of services with respect to which the contributions are made (or when the cash or other taxable benefit would be currently available, if earlier). [Treas. Reg (k)-1(a)(3)(iii)(C)] 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 of Notice , C.B.139 are no longer permitted to be taken into account under the special nondiscrimination tests that apply to Section 401(k) plans and would not be deemed to satisfy any plan requirement to provide elective contributions or matching contributions. 3

4 [Preamble, 1. Rules Applicable to All Cash or Deferred Arrangements] However, the final regulations retain the exception contained in the proposed regulations allowing prefunding where the compensation would have been paid, but for the election, before the performance of services. [Preamble, 1. Rules Applicable to All Cash or Deferred Arrangements] Notwithstanding the general prohibition on prefunding, the new final regulations contain an exception for occasional bona fide administrative considerations. Specifically, employer contributions will not fail to be treated as made pursuant to a cash or deferred election 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. An example would be where the early contribution is made due to the temporary absence of the bookkeeper with responsibility to transmit contributions to the plan.[treas. Reg (k)- 1(a)(3)(iii)(C)(2)] The general timing requirements are not intended to preclude a partner from deferring amounts that are paid to the partner throughout the year. However, self-employed individuals who make such contributions throughout the year must nevertheless ensure that the amount contributed during the year does not exceed the maximum applicable limit under Section 415 based upon the individual s actual earned income. [Treas. Reg (k)-1(a)(6)(iv)] This definition of CODA election is broad enough, however, to include arrangements that were not intended by the plan or by the plan sponsor, to constitute a Section 401(k) feature. Such situations can arise, for example, where an employee's compensation will be increased by virtue of the employee's decision not to participate in a qualified plan sponsored by the employer or to participate at only a specified restricted level. The Service will sometimes view such arrangements as coming within the definition of a CODA. However, because the plan had not intended to be structured as a CODA and therefore does not satisfy the requirements to constitute a CODA, the arrangement can be viewed by the Service as a nonqualifying CODA. Example: The AB Company maintains a profit-sharing plan under which all employees elect into or out of participation. No one elected out in However, over the course of the next three years, employees C, D, and E elect into and out of participation in the plan. C elects out for 1991 and in for 1992 and D and E elect in for 1991 and 1992 and out for C 125, , , ,000 D 120, , , ,000 E 100, , , ,000 4

5 As C, D, and E elect into and out of the plan, their salaries increase and decrease in a way that is roughly analogous to the contribution that would otherwise have been made to the plan. This is probably a CODA, because employees appear to choose between increased income and a deferral into the plan on their behalf. However, if there are facts and circumstances that suggest that the changes in salary have nothing to do with the elections, it may not be a CODA. [Former Internal Revenue Manual 7(10)54, the Employee Plans Examination Guidelines Handbook, , Ex. 15]. In order to prevent the CODA rules from ensnaring arrangements and opt outs that the Service viewed as legitimate, the regulations have always contained a specific exception from the CODA election definitions for certain one-time irrevocable elections. Under the exception under the new regulations generally effective for plan years beginning in 2006, the exception provides that a cash or deferred election does not include a one-time irrevocable election made not later than the employee s first becoming eligible under the plan or any other plan or arrangement of the employer, whether or not such other plan or arrangement has terminated, to have contributions equal to a specified percentage or amount, including zero, made by the employer on the employee s behalf and/or divided among all other plans or arrangements, including plans or arrangements not yet established. The phrase plan or arrangement means as described in Section 219(g)(5)(A), including, according to the Preamble, Section 457(b) governmental plans, Section 403(b) plans as well as Section 401(a) qualified plans. [Treas. Reg (k)- 1(a)(3)(v); Preamble to Final Reg (k)-0, et. seq., 1. Rules Applicable to All Cash or Deferred Arrangements. Under a grandfather rule, with respect to irrevocable elections made on or before December 23, 1994, an election does not fail to be treated as a one-time irrevocable election merely because an employee was previously eligible under another plan of the employer (whether or not such other plan has terminated). Similarly, an election will not fail to be treated as such in the case of a partner, merely because the election was made after commencement of employment or after the employee s first becoming eligible under any plan of the employer, provided that the election was made before the first day of the first plan year beginning after December 31, 1988 or, if later, March 31, [Treas. Reg (k)-1(a)(3)(v)(A) & (B)] IV Consequences of Qualification as a CODA If the plan qualifies as a CODA, the following consequences flow. First, the plan will not be deemed to be disqualified merely because it contains a CODA.[IRC 401(k)(1)] This is important because without this specific exception, a feature that allowed highly compensated employees to contribute, on average, more than non-highly compensated employees might fail to qualify due to problems of 5