One of the more frustrating aspects for the small business maintaining a 401(k) plan is satisfying the special nondiscrimination requirements. The tests require adequate participation by “non-highly compensated employees” (NHCEs) in order for the “highly compensated employees” (HCEs) to maximize their own salary deferrals. Failure to satisfy the tests requires a correction which often means the painful process of returning salary deferrals to the HCEs.
For a number of years, employers have had the option to simplify this process and avoid the tests altogether by providing a “safe harbor” contribution for NHCEs. Beginning in 2008, plans that use automatic enrollment have a new, somewhat more flexible, safe harbor option.
To help those employers still struggling with the nondiscrimination tests or for those who have chosen a safe harbor design and would like to consider the new option, this article will review and contrast the various safe harbor options that are now available, as well as discuss automatic enrollment as a method of solving testing problems.
Testing Requirements
Absent a safe harbor contribution, a 401(k) plan must satisfy the ADP test each plan year. This requires calculating each eligible participant’s deferral percentage and comparing the average percentage of the HCEs to the average percentage of the NHCEs. HCEs are employees who:
- Owned more than 5% of the employer in the current or previous year, or
- Earned more than a specified limit in the previous year ($100,000 for 2007).
Employer matching contributions and after-tax employee contributions must satisfy a similar ACP test. Failure to satisfy either test requires either returning excess deferrals or contributions to the HCEs (within 2½ months of the end of the plan year) or making additional employer contributions (within 12 months after the end of the plan year).
In addition, a “top heavy plan” (more than 60% of the benefits under the plan belong to “key employees”) must satisfy special contribution requirements. Even if the sponsor makes matching contributions, additional top heavy contributions may have to be made to ensure that all non-key participants receive the required contribution which, in most cases, is 3% of compensation.
Traditional Safe Harbor Options
If a qualifying safe harbor contribution is made to a 401(k) plan, the plan is deemed to satisfy the ADP test. This means the HCEs may make the maximum allowable deferral of compensation ($15,500 in 2008 plus $5,000 catch up contribution if age 50 or over).
In most cases the ACP test is also avoided and the plan is deemed to have satisfied the top heavy requirements. The safe harbor contributions must be 100% vested and are not available for hardship or other in-service withdrawals before age 59½.
The employer must adopt a safe harbor provision prior to the beginning of the plan year. Also, participants must be notified of the employer’s intent to make safe harbor contributions within 30 to 90 days prior to the beginning of the plan year. There are several types of employer contributions that can satisfy the safe harbor.
Nonelective Contributions
One option is to make a 3% nonelective contribution for all NHCEs eligible to participate in the plan. Contributions must be made for all eligible participants regardless of whether the participant has worked 1,000 hours during the year or was employed on the last day of the plan year.
Matching Contributions
As an alternative, the employer can make a basic matching contribution for all eligible NHCEs who choose to make salary deferrals at the following rate: 100% of the first 3% of compensation deferred, plus 50% of the next 2% deferred. The sponsor may contribute an “enhanced” match equal to at least the amount of the basic match (e.g., 100% of the first 4% deferred). Under the enhanced match, the contribution rate cannot increase as an employee’s deferral rate increases, and the contribution rate for HCEs cannot exceed the contribution rate for the NHCEs.
Qualified Automatic Contribution Arrangement
For plan years beginning in 2008, the Pension Protection Act established a “qualified automatic contribution arrangement (QACA) that acts as an additional type of safe harbor design (meaning the plan automatically satisfies the ADP and ACP tests as well as top heavy requirements).
Under a QACA, an eligible employee automatically has a specified percentage of compensation withheld unless he makes an affirmative election either not to participate or to change the amount of the default election. A QACA can allow automatic deferrals of up to 10% of compensation but, as a minimum, the plan must require automatic deferral of 3% the first year, 4% the second, 5% the third and 6% thereafter.
The employer can make either:
- A 3% nonelective contribution for each NHCE, or
- A match contribution of 100% of the first 1% deferred and 50% of the next 5% deferred.
Unlike the traditional safe harbor design, contributions do not have to be fully vested until an individual has earned two years of service.
A QACA is similar to a traditional safe harbor design in several respects. Contributions are required to be subject to withdrawal restrictions and cannot be restricted to those meeting an eligibility requirement (1,000 hours of service or employment on the last day of the plan year). Also the same rules apply concerning the timing of the plan amendment and annual notice to participants about the safe harbor contributions.
There is also an annual required notice about the automatic enrollment feature that must notify participants of:
- The level of elective contributions under the default;
- The employee’s right to elect out of or change the amount of the deferral election; and
- How contributions will be invested in the absence of an employee investment election.
Choosing a Safe Harbor Option for the First Time
A 401(k) plan sponsor struggling with testing issues should seriously consider one of the safe harbor designs. An employer reluctant to make the required contributions should also consider automatic enrollment (without a safe harbor contribution) as a method to increase participation and thereby improve test results.
Automatic Enrollment
Based on evidence that automatic enrollment can increase participation significantly, the Pension Protection Act included several automatic enrollment options to encourage this practice. The concept is simple: automatic enrollment brings in those who fail to participate simply because of inertia. This is likely to have the biggest impact on the young, a group that benefits the most from compounding returns over an accumulation period of 30 years or more.
An “eligible automatic contribution arrangement” (EACA), which is also new for 2008, can be an effective approach that does not require a safe harbor contribution. With an EACA, the sponsor sets the default deferral percentage at any level and does not have to increase it each year as under a QACA.
The program requires the use of a qualified default investment arrangement, and the sponsor has the option to allow new enrollees the option to withdraw contributions within 90 days of enrollment. The EACA has one other advantage: the 2½ month correction period under the ADP and ACP tests is extended to 6 months.
Electing a Safe Harbor Design
Other employers will want to consider adopting either a traditional safe harbor or QACA. It’s important to understand that each of these options provides the sponsor design flexibility. In addition to the safe harbor contribution, the sponsor can make an additional discretionary matching contribution and still avoid the ACP test as long as certain requirements are met.
It can also be meaningful that the safe harbor options, in most cases, eliminate the complication of any top heavy problems. However, if the plan uses a matching contribution to satisfy the safe harbor and any other employer contributions are made, the plan must still demonstrate compliance with the top heavy rules.
When selecting one of the options there are several clear differences between the traditional safe harbor and the new QACA. First, the QACA does not require immediate full vesting—two years of service can be required. Second, the maximum required matching contribution is effectively 3.5% of compensation and not 4%. This can reduce the employer’s contribution cost somewhat, but this advantage may be offset by a higher rate of participation under a plan that has automatic enrollment.
Plans Currently Using a Safe Harbor Design
If an employer is currently using a traditional safe harbor design with the 3% nonelective contribution, a QACA with a nonelective contribution is a good alternative. The contribution cost is the same, but added participation means more retirement security. Some employers will appreciate the ability to have a vesting provision, although changing the vesting provision does complicate administration.
As discussed above, a QACA with a matching contribution may be more or less expensive than the current safe harbor, depending upon the circumstances. If the safe harbor plan currently has a high level of participation or if it is not expected that automatic enrollment will have much of an impact on participation levels, then the QACA safe harbor contribution will cost less than the traditional approach. Even if the cost is a bit more, due to increased participation, an employer motivated by the other benefits of automatic enrollment may still choose to switch.
Finally, note that an employer that appreciates the benefits of automatic enrollment but is satisfied with the current safe harbor can also choose to add an automatic enrollment feature and maintain the current safe harbor design.
Conclusion
With the introduction of new options, it is a good time for a 401(k) plan sponsor to review current plan design. Testing problems can now be addressed with automatic enrollment either with or without a safe harbor contribution. Some employers concerned about the retirement preparedness of employees may choose to add automatic enrollment, even if the plan doesn’t have testing problems.
Current safe harbor designs should also be reviewed to determine whether it’s appropriate to switch to the QACA approach, either as a way to save on the cost of the required contribution, the ability to have vesting or simply out of concern for the well-being of the participants.
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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