The IRS made it just under the wire. To be effective in time for the initial round of EGTRRA amendments (which are scheduled to start in 2006), the 401(k) final regulations had to be issued before January 1, 2005. For the first time in more than 10 years, the IRS issued comprehensive final regulations for 401(k) and 401(m) plans. Many items from the proposed regulations are incorporated as proposed. Many others were changed following the IRS’s review of comments it received.

401(k) and 401(m) Final Regulations Issued
On December 29, 2004 the IRS issued final regulations for 401(k) plans, which are available by clicking here, incorporate a variety of IRS pronouncements and law changes that occurred after 1994 — the last time the 401(k) regulations were amended. In the new comprehensive regulations, the IRS addressed the comments received on the proposed regulations but retained most of the rules from the proposed regulations.

The Effective Date
The final 401(k) 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 to apply the rules early are not permitted to apply them selectively. 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 Explanation of Provisions Section of the Regulations The regulations contain an eight-part explanation of provisions. We will address the parts in separate articles The eight parts are:
1.		Rules applicable to all cash or deferred arrangements
2.		Qualified CODAs
3.		The Actual Deferral Percentage (ADP) Test
4.		Safe Harbor Section 401(k) Plans
5.		SIMPLE 401(k) Plans
6.		Matching Contributions and Employee Contributions
7.		ACP Test for Matching Contributions and Employee Contributions
8.		Changes to other regulations

The highlights of the first part, Rules Applicable to all cash or deferred arrangements, follow.

The CODA Definition from the proposed regulations has been retained with minor modifications:
A CODA is an arrangement under which employees can make a cash or deferred election with respect to contributions to, or accruals or benefits under, a plan intended to satisfy Code section 401(a).

Definition of a cash or deferred election: A cash or deferred election is any direct or indirect election by an employee (or modification of an earlier election) to have the employer either:
1.		provide an amount to the employee in the form of cash or some other taxable benefit; or
2.		contribute an amount to a trust, or provide an accrual or other benefit, under a plan deferring the receipt of compensation.

The Final Regulation minor modifications to the definition of CODA are:
1.		To permit the Roth 401(k) plan to be included under the definition of a CODA; a designated Roth contribution is an elective contribution that is included in income.
2.		The final rules clarify that the only means of providing a cash or deferred election to an employee -- without violating the constructive receipt rules -- is limited to CODA elections in which the contributions or accruals are made to a qualified plan or trust in compliance with 401(k) and 402(e)(3). These code sections encompass 401(k) plans and 403(b) plans.
Automatic Enrollment The final regulations retain earlier guidance on automatic enrollment. Thus, a CODA can specify that if the employee does not make an affirmative election to defer, a plan default may apply as described in Rev. Rul, 2000-8. Click here for Rev Rul 2000-8. The final regulations reiterates the rule that it is critical for the employee to have the opportunity to receive cash in lieu of the deferral as indicated in Rev. Rul 2000-8. Modification of Rev. Rul 2000-8 The final regulations clarify that the default percentage to be deferred in Rev. Rul 2000-8 was merely an example and that the plan may specify a different percentage. There is also a footnote about the DOL advisory to the Treasury about ERISA 404(c), indicating that the participant will not be deemed to have exercised control of the investments merely by being informed of the investments selected in the absence of contrary instructions. One-time Irrevocable Election Clarification The final regulations change the timing of the irrevocable election from the date of hire to the date of first becoming eligible to participate under the plan, or any plan, of the employer. The irrevocable election must be made no later than when the employee first becomes eligible under the plan or any plan. The regulations define that “any other plan of the employer” includes: 457(b) governmental plans, 403(b) plans and all qualified plans. (Note: There is a typo in the final regulations referring to Code Section 219(g)(5)(D) which does not exist.) Contributions only after relevant election has been made The basic concept that an elective deferral election must be on file before an elective deferral contribution can be made to the trust has been retained by the final regulations. An elective deferral contribution made in anticipation of an elective deferral election is not permitted. Prefunding of Contributions Before Work Performed Prefunding of elective deferrals and matching contributions is not permitted. The basic principle behind elective contributions is that they are contributions paid to a plan instead of paying the cash earned to the employee, due to the employee’s prior election to defer the amounts to the plan. The basic rule is elective deferral contributions can only be made after the employee performs the service to earn the compensation being deferred. An employer is not permitted to prefund contributions for the purpose of accelerating the deduction of elective contributions. The fact set under Notice 2002-48 is no longer permitted, i.e. employer contributions are no longer to be included in ADP/ACP test and do not satisfy any plan requirement to provide elective contributions or matching contributions, if the payments are made to the trust prior to the time they are earned by the employee. Such contributions are deemed to be discretionary profit-sharing amounts. Notice 2002-48 is linked for reference: The regulations clearly prohibit the deduction of amounts as elective deferrals that are accrued after the close of the tax year, but before the tax-filing deadline. For example, the employer has a calendar year plan, but pays taxes on a fiscal year ending June 30 th. Amounts earned July through mid-September, (before the tax return is filed) can not be deducted as elective contributions on the return for the period ending that prior June 30. Compensation Paid Just Before Performance of Services The basic rule is that amounts paid in anticipation of future service are not permitted to be elective deferrals.

Exceptions:
1.		Retained from the proposed rules is the scenario in which compensation would have also been paid, but for the election, before the performance of services. Thus, sign-up bonuses could be included as elective deferrals.
2.		Bona fide administrative considerations, if an occasional pay period contribution is made before the services with respect to that pay period are performed, provided that the early contribution is made for bona fide administrative considerations and are not made principally to accelerate deductions. For example, if the bookkeeper responsible for transmitting the funds will be on vacation and the deposit is transmitted just before the bookkeeper’s vacation.
3.		Similar rules apply to the prefunding of matching contributions will be discussed in a later section.
Self-Employed Rules and Partner’s Draw

1.		A self-employed and a partner’s earned income is treated as being currently available on the last day of the individual’s taxable year.
2.		Thus, they have until their tax filing deadline to contribute the amount being deferred provided they complete an elective deferral form by the last day of the tax year declaring the dollar amount or percentage to be deferred.
3.		This restriction does not prevent a partner from deferring amounts that are paid during the year as a draw on account of services performed by the partner.
4.		Self-employed must make sure that amounts contributed during the year do not exceed statutory limits, such as the 415 limit, based on the individual’s actual earned income for the period.

Back to Commentary Index

The highlights of the first part, Rules Applicable to all cash or deferred arrangements, follow.

The CODA Definition from the proposed regulations has been retained with minor modifications:
A CODA is an arrangement under which employees can make a cash or deferred election with respect to contributions to, or accruals or benefits under, a plan intended to satisfy Code section 401(a).

The final regulations reiterates the rule that it is critical for the employee to have the opportunity to receive cash in lieu of the deferral as indicated in Rev. Rul 2000-8.

Modification of Rev. Rul 2000-8
The final regulations clarify that the default percentage to be deferred in Rev. Rul 2000-8 was merely an example and that the plan may specify a different percentage.

There is also a footnote about the DOL advisory to the Treasury about ERISA 404(c), indicating that the participant will not be deemed to have exercised control of the investments merely by being informed of the investments selected in the absence of contrary instructions.

Contributions only after relevant election has been made
The basic concept that an elective deferral election must be on file before an elective deferral contribution can be made to the trust has been retained by the final regulations.

An elective deferral contribution made in anticipation of an elective deferral election is not permitted.

The basic rule is elective deferral contributions can only be made after the employee performs the service to earn the compensation being deferred.

An employer is not permitted to prefund contributions for the purpose of accelerating the deduction of elective contributions.

Compensation Paid Just Before Performance of Services
The basic rule is that amounts paid in anticipation of future service are not permitted to be elective deferrals.

Back to Commentary Index

The highlights of the first part, Rules Applicable to all cash or deferred arrangements, follow.

The CODA Definition from the proposed regulations has been retained with minor modifications: A CODA is an arrangement under which employees can make a cash or deferred election with respect to contributions to, or accruals or benefits under, a plan intended to satisfy Code section 401(a).

The final regulations reiterates the rule that it is critical for the employee to have the opportunity to receive cash in lieu of the deferral as indicated in Rev. Rul 2000-8.

Modification of Rev. Rul 2000-8 The final regulations clarify that the default percentage to be deferred in Rev. Rul 2000-8 was merely an example and that the plan may specify a different percentage.

There is also a footnote about the DOL advisory to the Treasury about ERISA 404(c), indicating that the participant will not be deemed to have exercised control of the investments merely by being informed of the investments selected in the absence of contrary instructions.

Contributions only after relevant election has been made The basic concept that an elective deferral election must be on file before an elective deferral contribution can be made to the trust has been retained by the final regulations.

An elective deferral contribution made in anticipation of an elective deferral election is not permitted.

The basic rule is elective deferral contributions can only be made after the employee performs the service to earn the compensation being deferred. An employer is not permitted to prefund contributions for the purpose of accelerating the deduction of elective contributions.

Compensation Paid Just Before Performance of Services The basic rule is that amounts paid in anticipation of future service are not permitted to be elective deferrals.

Back to Commentary Index

The CODA Definition from the proposed regulations has been retained with minor modifications:
A CODA is an arrangement under which employees can make a cash or deferred election with respect to contributions to, or accruals or benefits under, a plan intended to satisfy Code section 401(a).

Modification of Rev. Rul 2000-8
The final regulations clarify that the default percentage to be deferred in Rev. Rul 2000-8 was merely an example and that the plan may specify a different percentage.

Contributions only after relevant election has been made
The basic concept that an elective deferral election must be on file before an elective deferral contribution can be made to the trust has been retained by the final regulations.

The basic rule is elective deferral contributions can only be made after the employee performs the service to earn the compensation being deferred.

An employer is not permitted to prefund contributions for the purpose of accelerating the deduction of elective contributions.

Compensation Paid Just Before Performance of Services
The basic rule is that amounts paid in anticipation of future service are not permitted to be elective deferrals.