Safe Harbor 401(k) Plans for 2006
Rev. 02/09/06, E-mail Alert 2006-3

Safe Harbor 401(k) Plan for 2006
The recently issued final 401(k) and 401(m) regulations are effective for plan years beginning on or after January 1, 2006 unless the sponsor elects to implement them sooner. For the first time, we will have regulations that address the operation of safe harbor 401(k) plans. All prior guidance had been issued in the form of IRS Notices. Regulation 1.401(k)-3 is specifically entitled safe harbor requirements and it incorporates prior safe harbor guidance from Notices 98-52 and 2000-3, as well as EGTRRA and JCWAA safe harbor provisions. The regulation also introduces changes to the safe harbor rules, which are addressed in this article.

Tax code section 401(k)(12), as implemented by the final regulations, provides a design-based safe harbor method under which a cash or deferred arrangement (CODA) is treated as satisfying the discrimination testing if the arrangement meets certain contribution and notice requirements. Thus, a plan satisfies the section 401(k) safe harbor if it either makes specified Qualified matching contribution (QMAC) or Qualified Nonelective contribution (QNEC) for all eligible nonhighly compensated employees (NHCEs). Thus, a matching contribution may either be made under a basic matching formula that provides for a QMAC equal to 100% of the first 3% of elective contributions and 50% of the next 2% or an enhanced matching formula that is at least as generous in the aggregate, provided the rate of matching contributions under the enhanced matching formula does not increase as the employee’s rate of elective contributions increases.

Alternately, the plan may provide a qualified nonelective contribution equal to 3% (or more) of compensation for all eligible NHCEs. The foregoing contributions may also be made available to the plan sponsor's HCEs. A notice must be provided to each eligible employee, within a reasonable time before the beginning of the plan year, of the employee’s right to defer under the plan.

Notice may be provided electronically
Section 401(k)(12)(D) of the tax code contains a requirement that each eligible employee be provided with a written notice of the employee’s rights and obligations under the plan. The final regulations provide that the notice may be provided in writing or through another medium that is prescribed by the Commissioner as satisfying the requirement for a written notice. The IRS and Treasury recently issued proposed regulations setting forth the extent to which the 401(k) safe harbor notice, as well as other notices under the various requirements relating to qualified retirement plans, can be provided electronically, taking into account the effect of the Electronic Signatures in Global and National Commerce Act (E-SIGN). Until that guidance is finalized, plan administrators and employers may continue to rely on the interim guidance in Q&A-7 of Notice 2000-3 on the use of electronic media. This guidance provides the following rules: “… the employee receives the notice through an electronic medium reasonably accessible to the employee, provided that (1) the system under which the electronic notice is provided is reasonably designed to provide the notice in a manner no less understandable to the employee than a written paper document and (2) under such system, at the time the notice is provided, the employee is advised that the employee may request and receive the notice on a written paper document at no charge, and, upon request, that document is provided to the employee at no charge.”

Reason for 12 month requirement
The final regulations specify that a section 401(k) safe harbor plan must generally be adopted before the beginning of the plan year and be maintained throughout a full 12-month plan year. This requirement is consistent with the notion that the statute specifies a certain contribution level for NHCEs in order to be deemed to pass the nondiscrimination requirements. If the contribution level is not maintained for a full 12-month year, the employer contributions made on behalf of NHCEs should not support what could be a full year’s contribution by the HCEs.

Exceptions to 12 month requirement
The final regulations adopt the exceptions to this 12-month rule that were set forth in the proposed regulations. Thus, a section 401(k) safe harbor plan may have a short plan year in the year the plan terminates, provided the plan termination is in connection with a merger or acquisition involving the employer, or the employer incurs a substantial business hardship comparable to a substantial business hardship described in section 412(d). Thus, in such a case, the employer would make the safe harbor allocation for the short plan year and avoid testing.

A section 401(k) safe harbor plan may also have a short plan year in the year the plan terminates (without regard to the reason for the termination or the financial condition of the employer) if the employer makes the safe harbor contributions for the short year, employees are provided notice of the change, and the plan passes the ADP test. In either case, the employer must make the safe harbor contributions through the date of plan termination.

In addition, a safe harbor plan could have a short plan year if it is preceded and followed by plan years during which the plan is a section 401(k) safe harbor plan. The following plan year may be shorter than 12 months, if the subsequent short plan year is the result of a plan termination (whether or not the plan termination is in connection with a merger or acquisition involving the employer). However, the final regulations clarify that this treatment is unavailable if in the following plan year safe harbor matching contributions are reduced or suspended. In the event that the initial short plan year is followed by a second short plan year, this treatment is available if the plan satisfies the 401(k) safe harbor requirements for the 12-month period immediately following the first short plan year.

Example
A safe harbor 401(k) plan has a plan year of July 1 to June 30. The safe harbor plan decides to switch to a calendar plan year. The plan provides the 3% safe harbor nonelective contribution for the July 1, 2008 to June 30, 2009 plan year. The plan is amended to run a short plan year from July 1, 2009 to December 31, 2009. The plan provides the safe harbor 3% qualified nonelective contribution from January 1, 2010 to December 31, 2010. This would satisfy the requirement in the regulation to change plan years as a safe harbor 401(k) plan and would not have to perform testing.

Additional Matching Contributions
Within limits, a safe-harbor plan may make additional matching contributions. An allocation of discretionary matching contributions may not exceed 4% of compensation. Furthermore, matching contributions may not be made on deferrals that exceed 6% of a participant’s compensation. The rate of match for any HCE may not be more than that of any NHCE. Failure to comply with these restrictions will not be an operational issue but rather require the plan to run an ACP test.

The final regulations contain a provision that clarifies that all matching contributions exempt from discrimination testing must be allocated in a nondiscriminatory manner. An employer may not have an allocation restriction, such as a last-day rule or a 1,000 hours-of-service requirement, on any matching contributions that will be exempt from testing, unless all the non-highly compensated participants satisfy the restrictions; otherwise it would result in a discriminatory allocation.

Example
A 401(k) safe harbor plan with a 3% NEC safe harbor contribution and a discretionary match of 50 cents on a dollar up to 6% deferred will satisfy the ADP test and the ACP test safe harbor, provided there is neither a last day rule nor a 1,000 hours-of-service requirement to receive the discretionary match. If a last day rule or an hours–of-service requirement were imposed on the discretionary match, the plan may still satisfy the ACP test safe harbor, but only IF all of the NHCEs satisfied the last day and 1000 hour requirements. If not, the plan is subject to the ACP test. Practitioners should review the allocation requirements for “other matching contributions” in plans that include safe harbor matching contributions to see if an amendment is needed before the beginning of the 2006 plan year.

The final regulations also add that in the case of an HCE who moves from one plan within the same employer to another, will not invalidate the rate of match rule if the matching allocation formula in one plan is different from the other.

Failure to Provide Notices or Make Contributions
Plans that fail to provide the safe harbor contributions or fail to distribute the required notice may not contain language that defaults the plan to ADP/ACP testing in such situations. Failure to follow the terms of the plan document constitutes an operational error that may jeopardize the qualification of the plan. We hope that the IRS update to its EPCRS program will include a correction method for these types of operational failures.

Bill Grossman, QPA