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Final Regs - An Overview
February 17, 2005


On December 29, 2004 the IRS issued the long awaited final regulations for 401(k) plans. These regulations, which are available on our website, www.mhco.com , incorporate a variety of IRS pronouncements and law changes that occurred since 1994, when the 401(k) regulations were last updated. In the final version of the regulations, the IRS retained most of the provisions of the proposed regulations. The IRS is expected to release guidance on the subject of Roth 401(k) shortly.

The Effective Date
These final regulations are effective for plan years that begin on or after January 1, 2006. However, a plan sponsor may elect to apply the regulations to any plan year that ends after December 29, 2004, as long as all of the applicable final regulations are applied to the affected plan year and all subsequent plan years. Sponsors who elect earlier application are not permitted to apply them selectively, however. The IRS cautions that mid-year adoption of the final regulations is possible only if the plan has complied operationally with the final regulations for the entire plan year.

The following are some of the highlights of the final regulations that will have a significant effect on plan operations starting in the 2006 plan year (or earlier if so elected by the sponsor):
CODAs: Elective Contributions and Matching Contributions
  ○ No prefunding
Prefunding of elective deferrals or matching contributions prior to the time the services are rendered or the amounts are made available to the participant is not permitted. An exception was granted for the situation where a bona fide administrative consideration exists, such as the occasional pay period where the deposit of the contribution may be affected by absence of the employer’s bookkeeper. (This was the fact set that Rich Hochman testified about during the hearings on the Regulations.)
  ○ One-time irrevocable elections
The deadline for making such elections has been changed from the date of commencement of employment to the date the individual first becomes eligible to participate in any plan of the employer.
  ○ Sole Proprietor and Partner’s Elective deferral timing clarified.
(See our FAQ on this subject)
RESTRICTIONS ON WITHDRAWALS

Change to leased employee status
A change in status of an employee to a leased employee who still performs services for the same recipient employer is not a severance from employment and thus is not a distributable event.

Hardship Rule Changes
Hardship rule safe harbor deemed acceptable distribution reasons have been expanded to include:
● Funeral expenses have been added to the safe harbor list.
● Certain expenses relating to the repair of damage to the employee's principal residence that would qualify for the casulaty deduction under section 165 (determined without regard to whether the loss exceeds 10% of adjusted gross income).
Plans that may be maintained after a CODA plan termination
SIMPLE IRAs, 403(b) and 457(b) plans are added to the list of permissible plans that may be maintained after the termination of a 401(k) plan and distribution of the elective deferrals. Currently, defined benefit plans (including cash balance plans), ESOPs and SEPs are plans that do not constitute prohibited alternative defined contribution plans.

Plan-to-plan-Transfers require withdrawal restriction maintenance
In the event of a plan-to-plan transfer of assets, withdrawal restrictions on elective deferrals and qualified contributions must be maintained post-transfer by the receiving plan.

ADP AND ACP TESTING

New Rules for contributions used in ADP testing
  ○ The regulations confirm that both the age 50 and older and the military service catch-up elective deferrals are excluded from the ADP test.
  ○ Where a HCE participates in multiple plans of the same employer or control group with different plan year ends, the new testing rules require the HCE's ADR be aggregated based upon the plan year being tested and be no longer than a 12-month period.
Corrective QNECs and QMACs: allocation and timing of contribution:
● The actual contribution must be made within 12 months after the end of the plan year
  ○ The final regulations retain the requirement of Notice 98-1 that a plan using the prior year testing method must have the QNEC contributed by the last day of the current plan year for the QNEC to be an acceptable correction.
Bottom-up or Targeted QNECS and QMACs; the proposed rules requiring a broader group to receive QNEC and/or QMAC are retained
The final regulations generally retained the onerous targeted QNEC rules for ADP and ACP testing. A limited exception for prevailing wage (Davis Bacon) plans was provided, however. We will more fully describe the restrictions rules and potential their effect on plan operations in a future article.

Gap income on refunded excess contributions or excess aggregate contributions

The gap period is the time between year end and date of actual correction. The regulations now mandate that gap income must be calculated, to the extent it is accrued to the participant’s account. Thus, if earnings are posted quarterly in a balance forward plan, and the distribution is made before the end of the quarter, then no earnings would be included in the correction amount.

IF it is too burdensome to calculate the actual earnings accrued to a participant’s account, a safe harbor method of allocating gap period income was provided which permits the allocable income to be calculated for each month of the gap period at 10% of the income that was calculated for the preceding plan year using the regulations’ alternative method. For example, if the prior plan year’s earnings were 25%, then 2.5% per month of the gap period (if distribution is in the first 15 days of the month, ignore that month.) This could have the interesting impact of posting earnings even though the participant really incurred a loss in the year of distribution.

An administrative burden, on daily valued plans, was alleviated in the final regulations in that the gap period income calculation does not have to include earnings within 7 days of the distribution.

Corrections are distributed on FIFO basis
The correction of excess contributions is done on a First-in, First-out (FIFO) basis, with the taxability based on the year in which the earned income would have been taxed if it had not been deferred. Off-calendar year plans beware the tax implications.

401(k) SAFE HARBOR FROM ADP TESTING

The final regulations permit the provision of the safe harbor notice in writing or by electronic means electronically provided Notice 2000-3 is followed via E-SIGN until further guidance is issued.
Safe Harbor 401(k) Short Plan Year Exceptions
The final regulations fill the gaps in safe harbor administration caused by the omission of short plan year guidance in the earlier IRS releases. Short plan years are permitted under the following circumstances:
● In the year the plan terminates:
  ○ provided the termination is in connection with a merger or acquisition involving the employer, or the employer incurs a substantial business hardship as described in IRC section 412(d), or
  ○ provided the employer makes the safe harbor matching contribution for the short plan year and provides a notice of the change to employees and passes the ADP test.
● A short plan year is permitted if the short plan year is preceded and followed by a full 12-month safe harbor plan year. This is helpful if the plan year is amended.

Safe Harbor Discretionary Matching Allocation requirements
The final regulations contain a provision that states that any employer allocations protected by the ACP safe harbor may not be discriminatory. Thus, if in addition to a safe harbor contribution, the employer makes a non-safe harbor matching contribution which contains a last-day-rule or a 1,000 hours-of-service rule allocation restriction the potential for a discriminatory rate exists, if all the participants don’t satisfy the restrictions.

SIMPLE 401(k)
The final regulations applicable to SIMPLE 401(k) plans generally follow the principles applicable to safe-harbor plans subject to the lower contribution requirements applicable to these plans.

Items Not Addressed in the Final Regulations
The final regulations were not all inclusive and resulted in gaps. Thus, guidance was not given with respect to the following issues:
● A definitive timeframe for amending plans to adopt the revised ADP/ACP prior/current year testing provisions
● Further guidance on the ability to defer or not defer severance payments. The IRS has indicated that this will in fact be released “soon.”
● Regulations regarding the implementation and administration of Roth 401(k) contributions.
     
     
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