McKay Hochman - Commentary

Commentary

New Exceptions to the Safe Harbor 401(k) Plan's 12-Month Plan Year Requirement

October 27, 2005

Background
For a plan to pass nondiscrimination requirements using a safe harbor design as provided for under the Tax Code, a certain employer contribution level for nonhighly compensated employees (NHCEs) is necessary. The final regulations specify that a 401(k) safe harbor plan must generally be adopted before the beginning of the plan year and maintained throughout a full 12-month plan year. Thus, the employer would provide a level of safe harbor contributions on behalf of NHCEs that is nondiscriminatory.

Under the original safe harbor plan rules, the only short plan year allowed for safe-harbor plans was the first plan year. Unless an employer organization was in existence less than three months, the first plan year had to be at least three months long. The Final Regulations have added additional opportunities to use a short-plan year (a plan year of less than 12 months) for safe-harbor plans.

The following exceptions to the 12-month rule are part of the Final 401(k) regulations (and were adopted from the proposed regulations).

A safe harbor 401(k) plan may have a short plan year in the year the plan terminates as long as the termination is in connection with a merger or acquisition involving the employer, or if the employer incurs a substantial business hardship comparable to that described in section 412(d) (for a minimum funding requirement waiver). The employer in a hardship situation must make a safe harbor allocation for the short plan year to avoid testing.

A safe harbor 401(k) plan may have a short plan year in the year the plan terminates for reasons other than merger, acquisition or hardship. However, the employer must make the safe harbor contributions for the short period, provide employees notice of the change, and the plan must pass the actual deferral percentage (ADP) test and actual percentage test (ACP). Whether or not the plan passes the ADP/ACP test, the employer must make safe harbor contributions through the plan termination date. If the plan provided a safe harbor matching contribution, it would follow the procedure to suspend the safe harbor matching contributions, by 30-day advance notice to participants providing the participants with reasonable opportunity to stop deferring and ADP/ACP testing of the short plan year.

A safe harbor 401(k) plan may have a short plan year as long as it is a safe harbor plan in both the preceding and following plan years. This permits a plan to run a short plan year to change from a fiscal plan year to a calendar plan year or vice versa.

Example: A safe harbor 401(k) plan has a plan year of July 1 to June 30. The employer wants to switch to a calendar plan year. The plan provides the 3% safe harbor nonelective contribution for the July 1, 2005, to June 30, 2006, year. The plan is then amended to run a short plan year from July 1, 2006, to December 31, 2006 during which the safe harbor contribution is made. Then, the plan provides the safe harbor 3% qualified nonelective contributiuon from January 1, 2007, to December 31, 2007. This would satisfy the requirement in the regulation for changing plan years as a safe harbor 401(k) plan, and no testing would be necessary

The Exceptions for a New 401(k) Plan
Safe-harbor 401(k) plans are generally required to be established for the entire plan year (before the plan year starts). Mid-year adoption of a safe harbor 401(k) plan is possible for a brand new 401(k) plan or for a profit-sharing plan that adds a 401(k) feature mid-year. However, there must be at least three months remaining in the plan year for a new plan or profit sharing plan to which the 401(k) feature has been added to make elective deferrals. NOTE: there is a special exception for a brand new business entity permitting an initial plan year as short as one month. Employee notice may be made as late as at the time the safe-harbor plan design is adopted.

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