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In the past, targeted qualified nonelective contributions (QNECs) have been used to correct plans that fail the average deferral percentage (ADP) test. Are targeted QNECs permissible under the final 401(k) regulations? Email Alert 2005-5 3/17/05

The final regulations do not eliminate the use of the targeted QNEC but restrict their usage. If a targeted QNEC has been selected as part of the plan’s design, it may still be used without restriction until the effective date of the final regulations -- which is for plan years starting on or after January 1, 2006. Once the final regulations are effective, targeted QNECs will be subject to new more limiting rules that will require a broader number of nonhighly compensated employees to receive the QNEC.

BACKGROUND

In the legislative history of EGTRRA, Congress requested that the Secretary of the Treasury exercise his regulatory authority to eliminate situations where a high percentage of compensation QNEC is targeted to a small number of participants with low income in the affected year. A bottom-up or targeted QNEC allows an employer to make a relatively small contribution as a QNEC that inflates the targeted participants’ ADR to an extremely high level, previously nearing 25%, but with the change in Code Section 415 limits now often nearing 100%. This narrowly targeted contribution allows for a dramatic increase in the entire NHCE group’s ADP allowing passage of the ADP while effectively circumventing the spirit of the law.

To prevent such abuse, the IRS added administratively complex requirements to prevent targeting of a high percentage of compensation QNEC to a small number of individuals. The IRS would treat the plan as providing an impermissible targeted QNEC if targeted QNECs are provided in excess of the following IRS rules.

THE NEW TARGETED QNEC RULES FOR ADP TESTING
  1.  
QNECs may be made up to 5% of compensation before being treated as targeted QNECs. QNECs that exceed 5% of compensation will be treated as targeted QNECs. At the 401(k) hearings held back in 2003, McKay Hochman testified that the 5% rate was too low and a higher rate, possibly 10% was more appropriate. .

MHC Commentary: A 5% QNEC would need to be provided to a much larger number of individuals to increase the average of all NHCEs as significantly as targeting a 100% QNEC to one or two individuals.

  2.   In order to exceed a 5% QNEC to a NHCE and have it included in the ADP test, the QNEC may not be more than two times the plan’s representative contribution rate.

  3.   The plan’s representative contribution rate is defined as the greater of:
      a.   The lowest applicable contribution rate of any eligible NHCE among a group of eligible NHCEs that consists of half of all the eligible NHCEs, OR
      b.   The lowest applicable contribution rate of any eligible NHCE in the group of all eligible NHCEs for the plan year and who are employed by the employer on the last day of the year.
          i.   The definition of applicable contribution rate for an eligible NHCE is the sum of all of the QMACs and QNECs taken into account for ADP testing for that eligible NHCE for the plan year, divided by that eligible NHCEs compensation for the same period.

  NOTE: The regulations provide an exception for Davis-Bacon plans. Because Davis Bacon plans make prevailing wage contributions to certain employees, the maximum percentage that may be used in testing is increased from 5% to 10%. This exception applies to both the ADP and ACP test.

THE NEW TARGETED QNEC RULES FOR ACP TESTING
The targeted QNECs rule would also apply to the ACP test.

  1.   The 5% of compensation QNEC limit is applied separately to the ADP and ACP test. Therefore, the employer may make a 5% of compensation QNEC for ADP test purposes and a 5% QNEC for ACP test purposes to the same NHCEs without regard to which or how many receive each 5%.
  2.   The regulations restrict the ability to exceed 5% of compensation QNEC for ACP testing purposes by stating that QNECs are not to be taken into account in the ACP test to the extent such contributions exceed the product of that NHCEs compensation and the greater of 5% or 2 times the plan’s representative contribution rate.

  3.   The plan’s representative contribution rate is defined as the greater of:
      a.   The lowest applicable contribution rate of any eligible NHCE among a group of eligible NHCEs that consists of half of all the eligible NHCEs, OR
      b.   The lowest applicable contribution rate of any eligible NHCE in the group of all eligible NHCEs for the plan year and who are employed by the employer on the last day of the year.
          i.   The definition of applicable contribution rate for an eligible NHCE is the sum matching contributions taken into account for the employee for the plan year and the QNECs made for the employee for the plan year, divided by that eligible NHCEs compensation for the same period.

Differences in the ADP and ACP tests include:
  • In the ACP test, the lowest contribution for NHCEs would be based on the sum of QNECs and those matching contributions that are taken into account for the ACP test. (For the ADP test, QNECs and QMACs were taken into account.)

  • QNECs taken into account in the parallel ADP test may not be used in this ACP test.

  • Only employees actually deferring may be counted in the ACP test.
               
               
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