The Internal Revenue Service has at long last issued final regulations under sections 401(k) and 401(m) of the Internal Revenue Code. The regulations, issued on December 29, 2004, make some significant changes to the proposed regulations issued in 2003, and update the final regulations issued back in 1994. Since that time, numerous statutory changes have taken place, as well as revenue rulings and procedures which are all reflected in the new regulations.
The final regulations are quite extensive. This article will review some of the most significant provisions and their impact on the administration of 401(k) plans.
Nondiscrimination Testing
Most 401(k) plans must pass annual nondiscrimination tests regarding employee deferrals and employer matching contributions. The tests compare contributions made on behalf of “highly compensated employees” (HCEs) with contributions made on behalf of “non-highly compensated employees” (NHCEs). HCEs are defined as more than 5% owners of the employer in the current or the previous plan year and those who received compensation in the previous plan year in excess of a specified level ($90,000 for 2004 and $95,000 for 2005).
The nondiscrimination tests require average contributions for the HCE group to be within a certain range of the average contributions for the NHCE group. The maximum average HCE contribution, as a percentage of compensation, is based on the average NHCE percentage as follows:
| NHCE Percentage |
Maximum HCE Percentage |
|
| 2% or less | NHCE % x 2 | |
| 2% – 8% | NHCE % + 2 | |
| 8% or more | NHCE % x 1.25 |
Plans that do not pass the test must take some action, such as making corrective distributions or additional employer contributions.
Testing Method
Plans may choose current year testing, where current year contributions are used to compare the percentages of both HCEs and NHCEs, or prior year testing, where the contributions for NHCEs in the prior year are compared with HCE contributions in the current year. The prior year testing method gives employers the average contribution limitations for the HCEs in advance and reduces the chances of a failed test.
Another option exists for the first year of a plan utilizing the prior year method. It can choose to use 3% for the average contributions for NHCEs, or it can use actual NHCE contributions in the first year.
The regulations provide that a plan does not have to use the same testing method for deferrals (the ADP test) as it does for matching and voluntary after-tax contributions (the ACP test). This may be relevant where a plan allows for discretionary matching contributions but chooses not to make any in certain years. Such a plan would have to use current year testing for the ACP test but might prefer prior year testing for deferrals.
Whatever testing methods are chosen, the regulations require them to be specified in the plan document. The testing methods may only be changed by amendment, subject to certain restrictions on changing from current year to prior year testing. The regulations also provide that changes in testing methods or procedures cannot be done in such a manner as to be abusive in benefiting HCEs.
QNECs and QMACs
One method of correcting a failed nondiscrimination test is having the employer make a “qualified nonelective contribution” (QNEC) or “qualified matching contribution” (QMAC). QNECs and QMACs are required to be immediately 100% vested and subject to withdrawal restrictions. These contributions must be deposited by the last day of the following plan year. For that reason, these contributions are not very practical with the prior year testing method, because the deposit would have to be made by the last day of the testing year, which is usually before the tests can even be performed.
There are a number of ways that QNECs and QMACs can be allocated to participants. One of the more controversial ways is referred to as a “bottom-up” or “targeted” QNEC. Additional contributions are made to one or more of the NHCEs with the lowest compensation. The contribution can be a very large percentage of the compensation for these individuals and still not cost the employer a lot of money. These large percentages can have a big impact in helping the plan pass the nondiscrimination tests.
However, the final regulations have added restrictions which severely limit the impact of these types of allocations. Under the new rules, QNECs in excess of 5% of compensation for any individual may only be used for testing purposes if additional requirements are met. Here is a comparison of the old and new rules:
The ADP for Hobbit Company is 3% for its 50 NHCEs and 6% for its 5 HCEs. The test is failed since the maximum ADP permitted for HCEs is 5% (3% NHCE + 2). Under the prior rules, Hobbit Company could make a QNEC of 25% of compensation for 2 employees earning $1,000 which would increase the NHCE ADP to 4% and only cost the employer $500 to pass the test.
However, the final regulations will limit the QNEC in the above example to 5% of compensation. Therefore, 10 NHCEs will need to receive 5% of compensation to pass the test which may considerably increase the cost of passing the test compared to the prior rules.
An exception was made for prevailing wage plans (under the Davis-Bacon Act) that allows QNECs of up to 10% to be used for testing purposes.
The new provisions could also impact QNECs and QMACs allocated on a flat dollar basis since a specific dollar amount will represent a higher percentage of a lower-paid employee’s compensation than a higher-paid employee’s compensation.
Similar rules apply for QMACs with some variations concerning the matching contribution.
Gap Period Earnings
The most common method used to correct a failed nondiscrimination test is to make corrective distributions of excess contributions to HCEs. The excess contributions are required to be adjusted for related investment earnings or losses. These contributions are presumed to be the first deposits made during the plan year, and under prior rules, did not have to be adjusted for earnings from the end of the plan year until the distribution date (referred to as the “gap period”).
Under the final regulations, earnings during the gap period can no longer be ignored for certain plans. Earnings for the gap period must be included if there was a valuation date during the period, e.g., daily valued plans. If there is no valuation date within the gap period, no gap period earnings are required. For example, a calendar year plan that has quarterly valuation dates will not need to include gap period earnings for a distribution made in February since there was no valuation since the end of the plan year.
Plans with daily valuations must calculate income within seven days of the distribution date. But since it is extremely difficult to estimate exactly when the distribution will actually be processed, some plans may want to use the safe harbor calculation provided in the regulations. Under this method, 10% of the income for the preceding plan year is multiplied by the number of months in the gap period, including the month of payment if the corrective distribution is made after the 15th of the month. For example, corrective distributions made on March 15th would have a gap period adjustment of 20% of the preceding plan year earnings.
Safe Harbor 401(k) Plans
Safe harbor 401(k) plans are exempt from nondiscrimination testing if they satisfy certain contribution and notice requirements. These plans must provide either a 3% nonelective contribution to eligible employees or a minimum matching contribution of 100% of the first 3% of compensation deferred and 50% of the next 2% of compensation deferred.
The final regulations provide that the plan document must contain the relevant provisions if a plan chooses to avoid nondiscrimination testing by making safe harbor contributions. The plan cannot state that it will revert to testing if the contribution or notice requirements are not met.
The regulations also allow safe harbor plans to have short plan years under certain circumstances involving plan terminations for business hardship, mergers or acquisitions. In addition, the rules regarding safe harbor matching contributions apply to catch-up contributions as well as other elective deferrals.
Hardship Distributions
The final regulations expand the list of safe harbor hardship events to include:
- Burial or funeral expenses for the employee’s parent, spouse, child or dependent; and
- Repair of damage to the employee’s principal residence that would qualify as deductible casualty expenses.
For hardships pertaining to medical expenses, the definition of dependent has been expanded to include a non-custodial child.
Other Provisions
Guidance was also provided for the following issues:
Automatic Enrollments
Plans may provide for a default deferral election if no affirmative election is made by a participant (e.g., an election form is not returned). There is no limit on the amount of the default election.
One-Time Irrevocable Election
Under the final regulations, an employee can make a one-time irrevocable election not to participate in a retirement plan up until the date of participation. The election applies for the duration of employment with the employer.
Timing of Deferral Contributions
In general, elective deferral and matching contributions cannot be funded prior to the performance of services for which compensation is being deferred or matched. However, an exception was established for occasional administrative necessities, such as when a bookkeeper will be out of the office when the contributions must be deposited.
Effective Date
The final regulations are effective for plan years beginning on or after January 1, 2006. However, plan sponsors can apply the new rules for any plan year ending after December 29, 2004, provided the plan applies all of the rules of the final regulations, to the extent applicable, for that plan year and all subsequent plan years.
Conclusion
The final 401(k) and 401(m) regulations address an extensive number of issues involving plan administration. For the 2005 plan year, plan sponsors may continue to operate their plans under the prior regulatory guidance. However, plan sponsors should consult with their advisors to determine how the final regulations will affect their plans beginning in 2006.
This newsletter is intended to provide general information on matters of interest in the area of qualified retirement plans and is distributed with the understanding that the publisher and distributor are not rendering legal, tax or other professional advice. Readers should not act or rely on any information in this newsletter without first seeking the advice of an independent tax advisor such as an attorney or CPA.
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Spring will arrive soon, promising new growth and a fresh beginning. It could also be the perfect time to do some spring cleaning for your plan. Let’s look at some areas that you might consider reviewing to ensure your retirement plan is operating efficiently.
Document your processes and procedures to make certain that plan tasks can be handled in case of any absences during an enrollment or pay period. Having a backup in place can prevent errors and delays that could lead to penalties.
Make sure to have a process in place to notify all new enrollments of their eligibility, regardless of whether the plan has automatic enrollment. Depending on the timing for plan entry, including the plan enrollment paperwork with the new hire paperwork could make entry easier for you. Please reach out with any questions regarding when an employee enters the plan.
Deposits of employee deferrals and loan repayments must be submitted to the plan as soon as possible to avoid penalties and corrections. For plans with less than 100 participants, a safe harbor rule allows deposits to be made within seven business days. For larger plans, the expectation is that the money will be deposited more quickly. Depositing these funds on the pay date will avoid the possibility of being late.
Monitoring deferral contribution limits during the calendar year will avoid refunds after year end. Make sure that your payroll is set up to stop deferrals once the limit is reached, including any catch-up contributions for those who have reached age 50.
To keep the plan in compliance, employer contributions must be deposited timely. Due dates are impacted by the type of contributions, required status and tax deductibility. If you have questions on when to deposit your employer contribution or even whether to make an employer contribution, please contact us.
Most plans must be covered by a fidelity bond. The minimum coverage is 10% of plan assets (rounded up to the next $1,000) and the maximum coverage is $500,000. Additional requirements apply to plans with employer securities or non-publicly traded assets. If your fidelity bond is insufficient, now is the time to raise the coverage. Inflation clauses that increase the bond amount as the plan assets increase can ensure that your bond coverage is always adequate. Contact us or your insurance provider if you don’t have a fidelity bond.
Another area to review is communication with participants. Helping your employees understand and trust the plan can increase their contributions. Be sure that your procedures include distributing any plan-related communications—including required participant notices.
Distributions also involve communication, including some of the aforementioned notices. Discussing distribution options with terminated participants, possibly as part of an exit interview, can help to reduce risk of lost participants. We’ll provide instruction on distributions for force-out distributions for small balances, testing corrections and required minimum distributions.
Your plan document is the legal source on how the plan should be administered; operating within its parameters is critical. It’s always worth taking time to review the plan document to ensure that you fully understand and are following its provisions. We’ll cover more details about the plan document later in this newsletter. We’re here to support you in keeping your plan in compliance. Please feel free to reach out with any questions.
Addressing the Challenge of Uncashed Distribution Checks
Uncashed distribution checks present a persistent and often overlooked challenge for retirement plan sponsors. Despite the best efforts of plan administrators, some participants fail to cash their distribution checks, leading to administrative burdens, fiduciary concerns and potential compliance issues. A recent publication by Retirement Management Services (RMS) sheds light on this issue and offers practical guidance for employers seeking to manage and mitigate the risks associated with uncashed checks.
Uncashed checks can arise for various reasons. Participants may have moved without updating their contact information, may not recognize the check as legitimate or may simply forget to deposit it. Regardless of the cause, the responsibility for addressing these uncashed funds ultimately falls on the plan sponsor. This creates a fiduciary obligation to act in the best interest of the participant while ensuring compliance with IRS and Department of Labor (DOL) regulations.
Sponsors are encouraged to maintain up-to-date contact information for all plan participants and to follow up promptly when checks remain uncashed. This may involve sending reminder letters, making phone calls or using certified mail to confirm receipt. In some cases, plan sponsors may also consider using electronic payment methods to reduce the likelihood of checks going uncashed in the first place.
The IRS and DOL have issued guidance on how to handle these situations, including the use of forfeiture accounts and escheatment to state unclaimed property programs. However, these options come with their own set of rules and potential pitfalls. For example, using a forfeiture account may require the plan document to explicitly allow for such treatment. Escheatment laws, which allow the government to assume control of unclaimed property, vary by state. As such, plan sponsors must carefully evaluate their options and consult with legal or compliance experts as needed.
Another important consideration is the documentation of all the efforts made to contact participants and resolve uncashed checks. Maintaining a clear audit trail can help demonstrate fiduciary prudence and protect the plan sponsor in the event of an audit or legal challenge. It is extremely important to have a written policy in place that outlines the steps to be taken when a check remains uncashed beyond a certain period.
By taking a proactive, well-documented and compliant approach, employers can fulfill their fiduciary duties, reduce administrative burdens and ensure that participants receive the benefits they are entitled to.
Source: Retirement Management Services – “Uncashed Distribution Checks” https://www.consultrms.com/Resources/59/Plan-Sponsor-Tips-and-Help/212/Uncashed-Distribution-Checks
Divorce and the Retirement Plan
When a participant in a qualified retirement plan undergoes a divorce, the participant’s account balance may be an asset that is split with the former spouse. As the plan exists for the exclusive benefit of its participants, a court order is required to transfer the participant’s benefits to the ex-spouse. Once approved by the plan administrator, this court order is called a Qualified Domestic Relations Order (QDRO).
The QDRO is a judgment, decree or order that must be issued by a state authority (usually a court). It can be part of the divorce settlement or it may be a separate document. Because of the serious nature of separating the participant’s account balance, the QDRO is more than just an agreement made by both parties — it must also be signed by a judge.
A QDRO will describe how to divide the participant’s account balance between the participant and the ex-spouse, referred to as the alternate payee. In some cases, a set dollar amount will be allocated; in others, a percentage of the account may be designated. In the latter case, the amount assigned to the alternate payee represents the given percentage of the participant’s total vested account balance as of a specified valuation date. This percentage will apply to all sources — such as deferrals, matching or profit sharing — unless specified by the QDRO. Any interest and investment gains/losses that accrue between this valuation date and the date the funds are separated into an account for the alternate payee are often factored into this final calculation. If the participant has outstanding loans, the QDRO will usually indicate how the loans are handled.
Contributions such as deferrals and employer matching made after the valuation date are credited to the participant’s account. Earnings and losses are applied to the account balances. Once the division is complete, the alternate payee’s portion (either dollars or shares) is transferred to an account in the alternate payee’s name.
If the plan allows, the alternate payee may be paid out in a cash or rollover distribution. Not all plan documents allow the alternate payee to receive a distribution before reaching normal retirement age, so it’s important to follow the terms of the plan. In addition, the QDRO cannot violate the provisions of the plan document by requiring a plan to provide an alternate payee or participant with any type or form of benefit not otherwise provided under the plan.
Although the most common situation for a QDRO is a divorce, it can be issued in other situations, such as to a dependent in the case of child support. If the alternate payee is a minor child or legally incompetent, the order can also require payment to the individual with legal responsibility for the alternate payee. If a participant or their attorney provides you with a copy of a divorce decree that references the plan or a QDRO, please contact us immediately, and we will work with you to ensure it meets the requirements of the plan.
Important note for defined benefit plans: For 2025 plan years, PBGC premiums are due one month earlier than usual, specifically on the 15th day of the ninth month after the beginning of the plan year. For calendar year plans, this means the premium is due on September 15, 2025, instead of the usual October 15. This accelerated deadline is due to a provision in the Bipartisan Budget Act of 2015.
Upcoming Compliance Deadlines for Calendar-Year Plans
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