New 401(k) and 401(m) Proposed Regulations Issued
July 31, 2003
 

INTRODUCTION

On July 16^th the IRS issued new regulations for 401(k) plans incorporating a variety of IRS pronouncements and law changes that occurred after 1994 — the last time the 401(k) regulations were amended. The new regulations (over 200 pages) were issued in proposed format, allowing for the public to make comments before they are finalized. Public hearings are scheduled for November 12, 2003. Written and electronic comments on the proposed regulations must be received by the IRS by October 22, 2003.

Many issues were clarified, such as what constitutes a cash or deferred arrangement and what qualifies as an elective deferral.  Among the major changes are a requirement to calculate interest during the gap period on an excess deferral and some safe harbor 401(k) changes including, some exceptions to the 12-month plan year requirement. As expected, the “bottom-up” or targeted QNEC as we know it today will be severely restricted in their application. The proposed restrictions would require QNECs greater than 5% of compensation to be rigorously tested. Keep in mind that the proposal does not require immediate discontinuance and therefore this practice may continue until the effective date of the final regulations. There are also some significant issues that were not addressed.

Effective Date Is After Issuance of Final Regulations

The general effective date of the regulations is for plan years beginning 12 months after the date the final regulations are published in the Federal Register. However, the IRS proposed regulations state that IRS intends to write in the preamble to the final regulations the option for plan sponsors to implement the final regulations for the first plan year beginning after the final regulations are published in the Federal Register.
 

McKay Hochman Commentary: Changes and clarifications from the proposed regulations are in blue italics.
Quotes indicate the statement is directly from the proposed regulations.
The information is presented by subject.
You may scroll down through the subjects or click on the subject in the list below to go directly to the subject:
 

Contributions made in anticipation of the election are not elective deferrals.

CODA contributions must be made after the employee’s performance of services for which the compensation would have been paid if it had not been deferred.

If the compensation payment precedes the performance of services, a contribution may be made no earlier than the date the compensation would have been paid.

No prefunding of matching contribution(s)

The definition of matching and employee contribution under §1.401(m)-1 follows the existing regulations. However, matching contributions may not be made before the employee’s performance of services for which the elective deferral is being made. Thus, the match may not be prefunded. Any contributions made before the elective deferral for which the match would apply may not be a matching contribution. 
 

"Effective opportunity" to receive cash versus deferral defined

A CODA arrangement must provide an employee with an effective opportunity to receive the amount in cash at least once each plan year. Whether an effective opportunity has been provided  is determined based on all relevant facts and circumstances, including the notice of availability of the election, the period of time before the cash is currently available during which an election may be made and any other conditions on elections.
 

Elective contributions may be limited by amounts withheld for payroll withholding for benefits and taxes
In the case of a benefit that requires an amount to be withheld from an employee’s pay, an employer is not violating 401(k)(4)(A) (the rule stating that benefits must not be contingent on the election to defer except for matching) if the CODA restricts elective contributions to amounts available after such benefit’s being withheld from pay and after the deduction of applicable income and employment taxes. 
 

Anti-abusive practices provisions clarified
“A plan will not satisfy the requirements of section 401(k) if there are repeated changes to the plan testing procedures or plan provisions that have the effect of distorting the ADP so as to increase significantly the permitted ADP for HCEs, or otherwise manipulate the nondiscrimination rules of section 401(k), if a principal purpose of the changes was to achieve such a result.” 

McKay Hochman Commentary: The result is that abusive practices will be targeted by the IRS.

ESOP and Non-ESOP portion of  plan may be aggregated for ADP/ACP testing but not for coverage
Aggregation and disaggregation of plans
The proposed regulations would eliminate the mandatory disaggregation of the ESOP and non-ESOP portions of a 401(k) plan for purposes of ADP and ACP testing. In addition, the proposed regulations would allow an employer to permissively aggregate two section 414(l) plans, i.e., one that is an ESOP and one that is not. However, plan coverage testing under section 410(b) would still be subject to mandatory disaggregation for ESOPs and non-ESOPs.

Single testing method for all CODAs under a plan
The proposed regulations would provide that a single testing method must apply to all CODAs under a plan.
For example, a plan that applies the ADP test may not be aggregated with a plan that uses the ADP safe harbor for coverage purposes.

Nonqualified CODAs - Rules retained for handling a loss of qualified CODA status
The proposed regulations would retain the rules in the regulations for nonqualified CODAs. These regulations address the handling of elective deferrals made to a CODA that has failed to meet the requirements of a qualified CODA.

In such a case, elective deferrals are not treated as pre-tax deferrals but instead are currently taxable to the employee. The intended elective deferrals are treated as after-tax employee contributions.  In addition 401(a)(4) nondiscrimination testing must be passed.

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RESTRICTIONS ON WITHDRAWALS
 

"Severance from employment" replaces the "same desk rule" and the word "retirement"
Restrictions on distribution of elective contributions remain generally the same. The EGTRRA triggering event changes are incorporated. Thus, “severance from employment” formally replaces “separation from service” as an event that may trigger a distribution. This change was made in accordance with EGTRRA’s repeal of the “same desk” rule. Further, the proposed regulations clarify that “retirement” is replaced by separation from service as an event permitting distribution.
 

Other EGTRRA changes incorporated
The EGTRRA modification of the contribution suspension rule that applies after receiving a hardship withdrawal from 12 to 6 months has been incorporated into the proposed regulations.

IRS requests comment on employee to leased employee change
The IRS has requested public comments as to whether a change in an employee’s status from employee to leased employee should be treated as a severance from employment, thus, creating a distributable event.

Hardship rules clarified
“The hardship rules have been reorganized to clarify ambiguities, including the relationship between the generally applicable rules, employee representations, and the safe harbor provisions under the existing regulations.” 

The proposed regulations state that an employee representation used to satisfy the 2 basic requirements (i.e. that an immediate and heavy financial need exists and that a distribution necessary to satisfy that need) must provide that need cannot reasonably be relieved by any available distribution or a nontaxable loan (even if the distribution or loan would not be sufficient to satisfy the financial need). The representation does not have to provide that a commercial loan will be taken if such a loan is not sufficient to satisfy the need on reasonable commercial terms.

Plans that may be maintained after a CODA plan termination
The proposed regulations modify the list of plans an employer may maintain after termination of a CODA while permitting elective deferral distributions due to plan termination. In addition to ESOPs and SEPs, the proposed regulations would add SIMPLE IRAs, 403(b) contracts and section 457 plans.

McKay Hochman Commentary: Note that a Defined Benefit cash balance plan is also acceptable. 

Plan-to-plan transfer requires withdrawal restrictions to be maintained, transferor plan responsible
The proposed regulations state that the transferor plan will fail to comply with the withdrawal restriction rules if it transfers elective deferrals, QNECs or QMACs to a plan without withdrawal restrictions for those funds.  However, the transferor plan will not fail to comply if it reasonably concludes, using rules related to the acceptance of a rollover distribution, that the transferee plan provides restrictions on withdrawals.

McKay Hochman Commentary: The result is that the elective deferrals and other qualified contributions must maintain their attributes after a plan-to-plan transfer occurs.

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ADP AND ACP TESTING

Otherwise excludable testing rules retained

McKay Hochman Commentary: Otherwise excludable testing on our website www.mhco.com under our “Hot Topics," listed as Hot Topic number 8. 

HCE in multiple plans with different plan years, aggregate HCE's ADR by plan year being tested
The existing regulations require that the CODAs of an HCE who participates in multiple plans maintained by the same employer be combined. This requirement has lead to inappropriate results that occur when combined plans have different plan years. The results are inappropriate due to the inclusion of over 12 months of elective deferrals in the testing. The proposed regulations continue to require the aggregation of the elective deferrals, but modify the rule to provide that the aggregated ADR of the HCE be based only on elective deferrals made during the plan year being tested.  

Existing rules state that plans that cannot be aggregated do not need to have the HCEs elective deferrals combined. The proposed regulations clarify that the prohibition on aggregating plans with inconsistent testing methods and the coverage prohibition on aggregating plans with different plans years would no longer apply.  

QNECs/QMACs permitted in ADP
The proposed regulations would no longer describe QNECs or QMACs as elective contributions but would permit them to be taken into account under the ADP test.

NOTE: In the case of prior plan year testing, any QNECs must be contributed before the end of the current plan year in order to be taken into account.  

Double counting elective contributions or matching contributions
In conformance with Notice 98-1, the proposed regulations would prohibit the double counting of QNECs. Generally, a QNEC previously used to satisfy a 401(k) safe harbor contribution, an ADP or ACP test, or a SIMPLE 401(k) contribution may not be used again to demonstrate compliance under subsequent ADP or ACP testing. For example, if an employer used QNECs in current year testing method in year 1 and then in year 2 the employer switched to prior year testing, the employer may not use the same QNEC in year 2 as part of the NHCEs portion of the ADP test. 

However, unlike Notice 98-1, in the proposed regulations there would be no additional limitations on the double counting of elective contributions or matching contributions that are moved between ADP and ACP tests.

Correcting ADP failure for HCE participating in multiple plans with CODAs
The proposed regulations retain the excess contribution leveling method that requires returning the excess to the HCE with the largest elective deferral contribution first.  An HCE participating in more than one CODA will have the elective deferrals from all CODAs aggregated and then the HCE with the largest aggregate elective deferral will be the first to have excess returned. The excess returned will not exceed the HCE’s amount in the plan failing ADP. If that amount is not sufficient to satisfy the excess, then the HCE with next largest aggregate deferral will be leveled and so on. If correction is needed in more than one plan, the ADRs of HCEs who already received corrective distributions is not to be recalculated. 
 

Taxable year of recharacterization of elective contribution to after-tax contribution
The recharacterization change proposed would make the year that the employee must include the recharacterization, from pre-tax to after-tax funds, as current income coincide with the year in which the employee would have had to include the excess contribution in income if it had been distributed.  However, a recharacterization of less than $100 will be included in income in the year in which it is recharacterized.

Elective deferrals not allowed in ACP test if a plan is not subject to ADP testing
The proposed rules would provide that under a plan not subject to the ADP test such as a safe harbor 401(k) plan or a 403(b) plan, elective deferrals may not be taken into account for the ACP test.
 

Prior year testing
The rules of Notice 98-1 are generally retained. In addition, the proposed regulations allow the ADP test to be made by one method and the ACP test to be made under another method. For example, ADP could be tested using the prior year method while ACP may be tested using the current year method. However, if inconsistent methods are used, any movement of elective contributions or QMACs between ADP and ACP tests would be prohibited.  

McKay Hochman Commentary: Revenue Procedure 2000-20 does not permit prototype plans to use the above inconsistent testing method.

The proposed regulations would retain the current rule that a plan coverage change affecting 10% or less of the NHCEs is disregarded when calculating the ADP for the HCEs.

The proposed regulations would add to the following clarification, “the term plan coverage change means a change in the group(s) of eligible employees under a plan,” a fourth point:
“(4) A reclassification of a substantial group of employees that has the same affect as amending the plan (e.g., a transfer of a substantial group of employees from one division to another division).”

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BOTTOM-UP QNECS: PROPOSED RULES WILL REQUIRE BROADER GROUP TO RECEIVE QNEC

Background
In the legislative history to EGTRRA, Congress requested the Secretary of the Treasury to exercise his regulatory authority to eliminate situations where a high percentage of compensation QNEC is targeted to a small number of participants who have a low income in the affected year. A bottom-up or targeted QNEC allows an employer to make a relatively small contribution that inflates the targeted participants’ ADR to an extremely high level which dramatically improves the average of the entire NHCE group’s ADP and allows the plan to cure an ADP failure. It was Congress’ opinion that this tactic circumvented the spirit of the law.  

Note that because the IRS did not impose its new rules as a “temporary rule,” plans with documents that permit their use may continue to use a bottom-up QNEC until the effective date in the final regulations. 

The IRS has proposed administratively complex additional requirements to prevent the targeting of a high percentage of compensation QNEC to a small number of individuals. The IRS would treat the plan as providing impermissible targeted QNECs if targeted QNECs are provided in excess of the following IRS rules:

The new targeted QNEC rules for ADP Testing
 

401(k) Safe Harbor from ADP Testing

Rate of match not higher for HCEs limited to the match made to the safe harbor plan.
Rate of match for HCEs participating in more than one CODA would no longer be aggregated for the safe harbor 401(k) match rule that requires HCEs not to receive a match at a higher rate than NHCEs. The requirement that the rate of match for an HCE not be at a higher percentage will only be applied to the matching contributions based on elective deferrals made to the safe harbor plan. 

Safe harbor 401(k) short plan year exceptions
The proposed regulations adopt exceptions to the 12-month plan year requirement.  In addition to the initial plan year exception contained in Notice 98-52, the following events would be exceptions to the 12-month requirement:

Safe harbor 401(k) plan contribution to other plan
The rule allowing the safe harbor 401(k) contribution to another plan is retained. In addition, the other plan does not have to be one that is aggregated with the safe harbor plan.
 

Accounting for contribution timing for safe harbor plan
“Whether a contribution is taken into account for purposes of the safe harbor is determined under the rules regarding inclusion in ADP testing under the proposed §1.401(k)-2(a). Thus, for example, a plan that provides for safe harbor matching contributions in 2006 need not provide for a matching contribution with respect to an elective contribution made during the first 2½ months of 2007 and attributable to service during 2006, unless the elective contribution is taken into account for 2006.”

401(k) Safe Harbor from ACP Testing
 

Safe harbor ACP plans may not have last day or 1,000 hour requirement
“The proposed regulations would clarify that, for purposes of determining if an HCE has a higher rate of matching contributions than any NHCE, any NHCE who is an eligible employee under the safe harbor CODA must be taken into account, even if the NHCE is not eligible for a matching contribution due to not completing the last day or hours of service requirement.”   

McKay Hochman Commentary: Thus, plans with a last day rule or up to a 1,000 hour requirement for any matching contribution will not satisfy the ACP safe harbor.

The proposed rules state that discretionary matching contributions may not exceed 4% of the employee’s compensation. In addition the proposed regulations clarify that a safe harbor plan must permit all eligible NHCEs to make sufficient elective contributions to receive the maximum matching contributions provided under the plan. 

HCE in a plan safe harbor from ACP and another matching plan(s)
The proposed regulations would provide if an HCE participates in more than one plan that provides matching contributions, the safe harbor rules will not be violated provided the HCE is not receiving matching contributions under the two plans for simultaneous time periods during the same plan. This also requires that the matching compensation under each plan is limited to the time the HCE participated in each plan. This provides a facility for an HCE to move within a controlled group.

If these rules are followed, an HCE could switch from a plan with a more generous matching schedule to a safe harbor plan without violating the safe harbor plan rules. The matching in the non-safe harbor plan would be subject to the aggregate matching contributions for the HCE as provided in 401(m)(2)(B).

MCKAY HOCHMAN COMMENTARY

ITEMS NOT ADDRESSED IN THE PROPOSED REGULATIONS

There are some issues for which the expected guidance was not provided.  

Timeframes for amending plans to change ADP/ACP testing related provisions.
There are some practitioners who believe that it is permissible to change the testing method by amending a plan during the 2 ½ months after the plan year has ended (when testing is being done). This retroactive plan amendment may or may not be acceptable. There are two testing rules being amended. One is changing from current to prior or vice versa, the other is changing the definition of HCE to include the top 20% rule.  

Permitted disparity issue
Another issue not addressed is the unequal treatment of permitted disparity when comparing the safe harbor 401(k) plan rules with the cross-tested gateway rules. The safe harbor 401(k) plan rules do not allow the 3% safe harbor contribution to be used as the first step in the excess allocation permitted disparity formula. Surprisingly, the cross-tested gateway works the opposite way and does allow the 3% provided as the first step in the excess integrated allocation formula to also be used as 3% towards satisfying the cross tested gateway.

 Click here for the 401(k) Proposed Regulations
 

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