Gap Period Income
Rev. 09/12/07, E-mail Alert 2007-12

GAP period income is required on ADP, ACP refunds, as well as on the return of excess deferrals. The final 401(k) regulations introduced GAP period income effective for plan years beginning after December 31, 2005. The Pension Protection Act has eliminated GAP period income starting with plan year 2008 for ADP and ACP refunds. Thus, we must continue to calculate GAP income until then. As of plan year 2008, GAP period income calculations cease for ADP and ACP test corrections, but it continues for excess deferrals. Following is how GAP period income is to be calculated in regard to a failed ADP or ACP test refund.

The final 401(k) regulations require that ADP/ACP corrective distributions include gap income, earnings (if any), that accrue in participant accounts between the end of the plan year and the date of the correction. In some cases, no adjustment may be necessary.

If earnings are posted quarterly, for example, and a corrective distribution is made before the end of the first quarter, then there would be no gap income to include.

For plans that are valued daily, the amount of earnings would be easy to calculate if the distribution were made immediately after the calculation. Unfortunately, that does not always occur in the real world. In many firms, the area that calculates interest, is not the area that makes the distribution, and the area that makes the distribution, is not always the same area that creates the actual check. Because of the potential lag between the time of the calculation and the time of the actual distribution, the regulations provide a seven-day processing window. Specifically, the calculation of gap income will be considered correct provided it is within seven days of the distribution.

The regulations contain a safe-harbor method of allocating gap period income that uses 10% of the participant's plan earnings from the preceding plan year for each month in the gap period. For example, if the participant's earnings were 25% for the prior plan year, then gap income would be calculated at 2.5% of the prior year's earnings for each month of the gap period. If the corrective distribution occurs within the first 15 days of the month, that month is ignored.

Note: This could have the interesting outcome of posting earnings even though the participant really incurred a loss in the year of distribution. Especially since the safe-harbor method assumes a 20% gain over the prior year's return (10% x 12 months).

The obvious way to avoid the entire GAP income situation is to use a plan design that is safe harbor from having to run the ADP/ACP tests.