4.72.2  Cash or Deferred Arrangements (Cont. 1)

4.72.2.10 
CODA Nondiscrimination

4.72.2.10.1 
ADP Test

4.72.2.10.1.4  (06-07-2010)
Limits on Double Counting of Certain Contributions

  1. When a plan changes from current year testing to prior year testing, contributions on behalf of many, if not all, NHCEs are likely to be double counted. For example, if a plan used current year testing in 2008, and then changed to prior year testing in 2009, elective contributions on behalf of NHCEs for 2008 will be counted twice; once in 2008 in calculating the NHCE ADP under the current year testing method, and again in 2009 in calculating the NHCE ADP under the prior year testing method. To limit double counting, section 1.401(k)-2(a)(6)(vi) of the Regulations provides that QNECs and QMACs cannot be used in prior year testing if they were used in current year testing in the preceding year.

4.72.2.10.1.5  (06-07-2010)
Plan Provisions Regarding Testing Method

  1. A plan must specify which of the two testing methods (current year or prior year) it is using. If the employer changes the testing method under a plan, the plan must be amended to reflect the change.

  2. The regulations under section 401(k) and (m) permit a plan to incorporate by reference the nondiscrimination tests in section 401(k)(3) and (m)(2) and the underlying regulations. A plan that incorporates these provisions by reference may continue to do so, but must specify which of the two testing methods (current year or prior year) it is using. Further, for purposes of the first plan year rule, a plan that incorporates these provisions by reference must specify whether the ADP/ACP for NHCEs is 3% or the current year's ADP/ACP. See sections 1.401(k)-1(e)(7) and 1.401(m)-1(c)(2) of the Regulations.

4.72.2.10.1.6  (06-07-2010)
Correction of ADP Test

  1. The final sections 401(k) and 401(m) regulations provide the following methods for correcting excess contributions:

    1. making QMACs or QNECs,

    2. distribution, and

    3. recharacterization.

    A plan may provide for the use of any of the correction methods described above, may limit elective contributions in a manner designed to prevent excess contributions from being made, or may use a combination of these methods, to avoid or correct excess contributions.

  2. If the plan uses a combination of correction methods, any contribution of QNECs or QMACs must be taken into account before application of the distribution and recharacterization correction methods.

  3. If designated Roth contributions are made to the plan, it may permit HCEs to have excess contributions distributed from his or her designated Roth account.

  4. To avoid a discriminatory rate of match, a plan generally must forfeit matching contributions (even QMACs) that relate to contributions treated as excess contributions or excess aggregate contributions. Such forfeitures will not cause the plan to violate section 411.

  5. A plan may contain a fail-safe formula or a procedure for prospectively reducing HCEs’ elective contributions so that no excess contributions arise.

  6. Excess contributions for a plan year may not remain unallocated or be allocated to a suspense account for allocation to one or more employees in any future year. In addition, excess contributions may not be corrected using the retroactive correction rules of section 1.401(a)(4)-11(g) of the Regulations. See section 1.401(a)(4)-11(g)(3)(vii) and (5) of the Regulations.

  7. Excess contributions allocated to a HCE may be treated as catch-up contributions under section 414(v) and, thus, ignored for ADP purposes.

  8. If correction is made by distribution, the distribution must be made within 2 1/2 months (6 months in the case of certain EACAs) after the close of the plan year for which the excess contributions are made or the employer will be liable for a 10% excise tax on the amount of the excess contributions. See section 4979 of the Code and section 54.4979-1 of the Regulations. If the ADP test is not corrected within the 12-month period following the end of the failed plan year, the CODA is not qualified and the plan may be disqualified. Failure to correct excess contributions will result in the CODA being nonqualified not only for the plan year for which the excess contributions were made but also all subsequent plan years during which the excess contributions remain in the trust.

4.72.2.10.1.6.1  (06-07-2010)
Determination of Excess Contributions

  1. "Excess contributions" are the aggregate amount of employer contributions made to the plan on behalf of HCEs for a plan year over the maximum amount of such contributions permitted under the ADP test.

  2. The amount of excess contributions is determined using a leveling method based on HCEs' ADRs, beginning with the HCE with the highest percentage and continuing in descending order of ADR percentages until the target HCE ADP is reached. (See below.)

4.72.2.10.1.6.2  (06-07-2010)
Distribution of Excess Contributions

  1. Correction through a distribution from the plan generally involves a 4-step process:

    1. determine the total amount of excess contributions that must be distributed under the plan.

    2. apportion the total amount of excess contributions among HCEs.

    3. determine the income allocable to excess contributions.

    4. Distribute the apportioned excess contributions and allocable income.

  2. The amount of excess contributions is the amount of elective contributions that would have to be returned to HCEs in order to pass the ADP test, starting with the HCE with the largest deferral percentage (ADR) and continuing, by leveling, to the HCE(s) with the next highest ADR(s) until the plan would pass the ADP test. On the other hand, the identity of the HCEs who will actually have excess contributions distributed to them is determined based on the dollar amount of their contributions, beginning with the HCE with the largest dollar amount of deferrals.

  3. If the HCE targeted for distribution has not reached his or her catch-up contribution limit for the year, the plan may not distribute the excess contributions to the extent of the unused catch-up contributions.

  4. Example:

    Employee Compensation Deferral ADR ADP
    A $100,000 $7,000 7.00%  
    B $90,000 $6,500 7.22% 6.41%
    C $80,000 $4,000 5.00%  
    D $20,000 $0 0.00%  
    E $10,000 $0 0.00% 3.33%
    F $10,000 $1,000 10.00%  

    D, E, and F are NHCEs. All employees are under age 50. Under the ADP test, the greatest acceptable ADP for HCEs (A, B and C) is 5.33% (3.33% plus 2). Since 6.41% is greater than 5.33%, there are excess contributions. The plan provides that excess contributions will be distributed.
    In determining the amount of excess contributions, the proper procedure is to hypothetically reduce the highest HCE ADR until the maximum allowed ADP (5.33%) is achieved, or until the next highest HCE ADR is reached, whichever occurs first ("ratio leveling method" ). In this case, if B’s ADR is reduced to 7.00%, the ADP will be 6.33%. Since this is not sufficient to satisfy the ADP test, A’s and B’s ADRs must be further reduced to 5.50%. The amount of excess contributions is the difference between the contributions at the old ADRs ($7,000 and $6,500) and the contributions at the new ADRs ($5,500 and $4,950), for a total amount of $3,050. This amount must then be distributed from the account(s) of the HCE with the highest dollar amount of contributions used in the ADP test for the plan year until the contributions remaining in such employee’s account equals the plan-year contributions in the HCE’s account(s) with the next highest dollar amount and so on until the total is distributed ("dollar leveling method" ). Therefore, $500 must first be distributed to A, to make A’s contributions level with B’s, and the remaining amount of excess contributions, $2,550, is then allocated equally to A and B, so that each has $5,225 of elective contributions remaining for the year. The excess contributions distributed to A and B must be adjusted for any earnings. (Note that the ADP test is deemed passed after these corrections even though running the test then would not produce a passing ADP for the HCEs.)

  5. Any distribution of excess contributions must be reduced by the amount of excess deferrals previously distributed to the HCE for the same year. Similarly, a distribution of excess deferrals must be reduced by the amount of excess contributions previously distributed to the HCE for the same year. See section 1.401(k)-2(b)(4)(i) of the Regulations.

  6. The distribution of excess contributions must include any income allocable thereto. The income allocable to excess contributions includes income for the plan year for which the excess contributions were made and, for plan years beginning on or after January 1, 2006, and before January 1, 2008, for the period between the end of the plan year and the date of distribution (the "gap period" ). See section 1.401(k)-2(b)(2)(iv) of the Regulations.

  7. For plan years beginning on or after January 1, 2008, the income allocable to excess contributions is equal to the allocable gain or loss only through the end of the plan year.

  8. A failed ADP test can be corrected by distributing excess contributions, adjusted for earnings, to certain HCEs by no later than 12 months after the close of the testing year, regardless of whether the plan is using the prior year or current year testing method. However, if a distribution of an excess contribution is not made before the end of the 12 months following the end of the plan year in which they were made, the CODA will fail to be qualified for the year in which the excess contributions were made and all subsequent years until corrected.

  9. If excess contributions are not distributed or recharacterized within 2 1/2 months (6 months in the case of certain EACAs) of the end of the plan year, the employer will be liable for a 10-percent excise tax on these contributions. See also IRM section 4.72.2.10.1.7 below.

  10. For plan years beginning on or after January 1, 2008, a corrective distribution of excess contributions (and allocable income) is includible in the employee's gross income for the employee's taxable year in which distributed (except to the extent they consist of designated Roth contributions) and must be reported on Form 1099-R using the appropriate code. Such distributions are not subject to the consent rules under sections 411(a)(11) and 417 nor to the early withdrawal tax under section 72(t). See section 1.401(k)-2(b)(5)(iii) of the Regulations for additional rules relating to the employer excise tax on amounts distributed more than 2 1/2 months (6 months in the case of certain plans that include an EACA) after the end of the plan year. See also section 1.402(c)-2, Q&A-4 of the Regulations for restrictions on rolling over distributions that are excess contributions.

4.72.2.10.1.6.3  (06-07-2010)
Recharacterization of Excess Contributions

  1. Under section 401(k)(8)(A)(ii) of the Code, a CODA can correct an excess contribution by "recharacterizing" an employee's excess contributions as an employee after-tax contribution. Recharacterization involves treating excess contributions as distributed to HCEs and then recontributed to the plan as employee contributions. The total amount of excess contributions and the HCEs to whom they are allocated are determined in the same manner as for distributions of excess contributions, except the amount treated as distributed and recontributed is not adjusted for earnings.

  2. Recharacterized excess contributions are treated as employee contributions for purposes of sections 72, 401(m) and 401(a)(4) and for the ADP test and the restrictions on the distribution of elective contributions. For all other purposes, including section 404, recharacterized amounts continue to be treated as employer contributions.

  3. Excess contributions that are recharacterized are reported and appropriately coded on Form 1099-R and are included in gross income according to the same rules that apply for actual distributions of excess contributions.

  4. Recharacterization is permitted only if employee contributions are otherwise permitted under the plan. The amount recharacterized, when added to the other employee contributions for the HCEs, may not exceed the limits under the plan relating to employee contributions, both under the ACP test and separate from the ACP test. See section 1.401(k)-2(b)(3)(iii)(B) of the Regulations.

  5. The amount to be recharacterized is offset by any amounts previously distributed as excess deferrals.

  6. Plans may only recharacterize excess contributions within the first 2 1/2 months after the plan year during which the excess arose. The employer or plan administrator must notify the HCEs to whom the excess contributions are allocated that the excess contributions are being recharacterized and must inform them of the tax consequences of the recharacterization. The date of the recharacterization (used to determine whether the 2 1/2 month rule has been satisfied) is the date on which the last affected HCE receives notification.

4.72.2.10.1.7  (06-07-2010)
IRC section 4979 Tax

  1. Section 4979 imposes a tax on the employer equal to 10% of any excess contributions not corrected within 2 1/2 months (6 months in the case of certain EACAs) after the end of the plan year to which they relate. However, the tax does not apply if corrective QNECs or QMACs (current year testing plans only) are made within 12 months after the end of the plan year. If the QNECs or QMACs were insufficient to fully satisfy the ADP test, the tax will apply to the remaining excess contributions.

  2. The plan has 12 months after the end of the plan year being tested to correct excess contributions. The plan can distribute excess contributions any time during the 12-month period, but the employer will still be subject to the 10% tax if the distribution is made after the 2 1/2 -month period.

  3. The tax is reported on Form 5330 and is due 15 months after the end of the plan year. See section 54.4979-1 of the Regulations. Any extension of time to pay the tax is not an extension of time to correct the ADP test.

  4. The tax is a one-time tax, meaning if excess contributions are not timely corrected for a plan year, the tax applies only for that year.

4.72.2.10.1.8  (06-07-2010)
Examination Steps

  1. Review the plan language to identify eligibility requirements and ensure that the plan is operating in accordance with the plan document.

  2. Review plan financial audit reports and corporate minutes for comments relating to eligibility provisions.

  3. Review plan financial audit reports and corporate minutes for comments on ADP testing and correction.

  4. Have the plan administrator explain policy/procedures for ADP/ACP/402(g) testing (including correction). Analyze the testing methodology and results confirming the accuracy of each ADP test.

  5. If the plan is a SIMPLE 401(k) plan, a safe harbor 401(k) plan or a QACA, review the plan language and verify the employer distributed the proper notices and made the required matching or nonelective contributions. In the case of a QACA, verify that the plan satisfies the uniform minimum default contribution requirement.

  6. Establish that all employees who are eligible under the plan to make ECs are counted in the ADP test, even if some do not make ECs.

    1. Check the overall group of eligible employees to determine whether those who have satisfied the plan’s age and service requirements are allowed to make deferrals. Also ask if any other benefits are contingent on a contribution to the CODA.

    2. Determine whether employees who are eligible to make a deferral but cannot because they have been suspended from making deferrals (e.g. because of receiving a hardship distribution), and who are allocated no QNECs or QMACs that are treated as ECs, have been included as "eligible" with a deferral percentage of "0" when running the ADP test.

  7. Compare the total number of eligible employees (including those who would be eligible but for a plan provision requiring a ministerial or mechanical act) with the number of employees used to run the ADP test. They should be the same.

  8. Examine payroll records, Forms W-2, time cards and personnel records, to verify employee compensation. If the plan year is not a calendar year, review the plan document to determine which period should be used and verify the operation of those provisions. If the employer limits compensation to the portion of the year in which the employee was eligible, verify that the plan’s terms allow for such limitation and examine employees with such limited compensation. If limited, the amount of compensation should be that earned since participation in the plan.

  9. Verify that all compensation figures are limited in accordance with section 401(a)(17). If the plan is not a safe harbor plan, examine the ADP test to verify that each individual’s ADR is calculated using the properly limited compensation.

    Note:

    Compensation used in the ADP test can either include or exclude elective contributions deferred during the year. The definition of compensation in section 1.414(s)-1 of the Regulations makes reference to section 415(c)(3), which includes elective deferrals in compensation (section 415(c)(3)(D)). However, section 1.414(s)-1(c)(3) of the Regulations contains a safe harbor alternative definition of compensation that satisfies section 414(s) and does not count deferred compensation.

  10. Reconcile the total participant deferral contributions shown on Forms W-2 to the total deferral amount shown on the ADP test.

  11. Test check whether the HCE group was properly determined, using payroll and organization data. Verify that an employee was considered an HCE if he or she was a 5% owner during the year or preceding year, or had compensation above $80,000 (indexed) for the preceding year, and if the employer so elected, was in the top-paid group that year.

  12. ) If a plan is disaggregated under section 410(b), make sure that the ADP test is also run separately on each disaggregated plan. Apply the aggregation and disaggregation rules of section 1.410(b)-7, as modified by section 1.401(k) -1(b)(4) of the Regulations, to find the "plan" (or plans) so that the ADP and ACP tests (or safe harbor, QACA or SIMPLE rules) can be applied to the proper employees. Ensure only plans with the same PYE are aggregated, if otherwise permitted.

    1. Review the plan document to determine the eligibility requirements for the CODA. If the eligibility requirements are less than 1 year of service and/or less than age 21, the nondiscrimination testing may be applied on a disaggregation basis. Separate tests may be run; one for employees with less than 1 year of service and less than age 21, and one for all other employees.

    2. Determine if any employees of the employer are covered by a collective bargaining agreement. If so, these employees must be disaggregated from employees not covered by a collective bargaining agreement for purposes of the ADP test. Review any lists, which identify employees covered by a collective bargaining agreement, such as reports prepared for payment of union dues or payroll records showing union dues deductions. Compare these employees to the separate ADP testing for employees under the collective bargaining agreement.

    3. While inspecting the 5500 returns for all plans, determine if any other plan maintained by the employer contains a CODA. If so, the plans may be aggregated for purposes of the ADP testing, but only if they have the same plan year. If two or more plans are aggregated for the ADP test, they must also be aggregated for coverage and discrimination testing. Inquire of the employer which plans were aggregated, if any. Verify from payroll records whether employees counted for the coverage and discrimination testing are the same employees in the ADP test if the plans were aggregated.

  13. Determine if any HCE is participating in more than one CODA of the employer. If yes, the elective contributions for each HCE must be combined for purposes of determining ADRs. This ADR is then used in the ADP test for all CODAs.

  14. Compare ADP calculations to compensation and deferral amounts shown on Forms W-2 (or payroll records if the plan year is a fiscal year). Trace the individual entries to source documents.

  15. Verify that the ADP test for each group (HCE and NHCE) has been properly determined and that the ADP test was satisfied in accordance with the plan provisions describing the testing method (current year or prior year).

  16. For ADP test failures, verify proper and timely correction. Consider:

    1. Whether the correction method was specified in the plan document and whether the method was followed; and

    2. Whether the amount of excess contributions was calculated using the correct leveling procedure.

  17. For correction by distribution:

    1. Inspect cancelled checks or trust statements to determine the date of distribution of the excess contributions (plus attributable earnings).

    2. Inspect Form(s) 1099-R issued for distribution of excess contributions. Amounts distributed should include any gains or losses.

    3. If the distribution was made after 2 1/2 months following the end of the plan year in which the excess arose, the IRC section 4979 tax applies. Inspect or solicit Form 5330 and verify remittance of the excise tax.

  18. If correction was made by recharacterization, consider:

    1. Recharacterization must occur within 2 1/2 months following the end of the plan year in which the excess arose. Inspect recharacterization notices issued to HCEs. Recharacterization is "deemed" to have occurred on the date of the last notice.

    2. Inspect Forms 1099-R to verify that recharacterized amounts were correctly reported. Earnings or losses on recharacterized amounts are not taxable and should not be included in the amount reported on the Form 1099-R.

  19. If correction was made by contribution of QNECs and/or QMACs, determine whether the contributions were made within 1 year after PYE by inspecting cancelled checks or trust statements.

    Note:

    This correction method is not available for plans using the prior year testing method.

4.72.2.11  (06-07-2010)
Catch-Up Contributions

  1. Section 414(v) of the Code, added by section 631 of EGTRRA, allows a plan to permit plan participants who are age 50 or older to make additional elective deferrals, called "catch-up contributions," effective for tax years beginning after December 31, 2001.

  2. Besides section 401(k) plans, other plans that can permit catch-up contributions are:

    1. section 403(b) plans,

    2. governmental section 457(b) plans,

    3. SARSEPs, and

    4. SIMPLE IRAs.

  3. Before an eligible employee can make catch-up contributions, he or she must have reached the limit on regular elective contributions, e.g., section 401(a)(30) or 415, the ADP limit, or a plan-provided limit.

  4. In a 401(k) plan, catch-up contributions are not taken into account in applying the limits of section 401(a)(30) or 415(c), nor in determining an employee’s ADR for the ADP test. They are not taken into account in determining the average benefit percentage test under section 1.410(b)-5 of the Regulations if benefit percentages are determined based on current year contributions. However, catch-up contributions for prior year would be included in the account balances that are used in determining the average benefit percentages if allocations for prior years are taken into account. Also, catch-up contributions for the current year are not taken into account for purposes of section 416, but catch-up contributions for prior years are included in the account balances that are used in determining whether a plan is top-heavy under section 416(g). For all other purposes, they are treated just like other elective contributions: they are subject to the same nonforfeitability and distribution rules and they can be pre-tax or designated Roth contributions.

  5. Catch-up contributions must satisfy a universal availability requirement, where all catch-up eligible participants under all 401(k) plans maintained by the employer are provided with an effective opportunity to make the same dollar amount of catch-up contributions. This rule is not violated if an employer restricts the amount available for deferral to an employee’s compensation remaining after other reductions (e.g., for applicable employment taxes). The regulations provide a safe harbor that plans can use of 75% of compensation.

4.72.2.11.1  (06-07-2010)
Catch-Up Contribution Limits

  1. There are separate dollar limits on catch-up contributions for SIMPLE plans (SIMPLE 401(k) plans and SIMPLE IRA plans) and non-SIMPLE plans. Each such limit is subject to annual COLA increases, but any increase that is not a multiple of $500 is rounded down to the next lower multiple of $500. The annual limits are determined for each calendar year by the IRA and Treasury and apply to the employee’s taxable year that begins with or within the calendar year. The following table shows both the SIMPLE plan catch-up limit and the non-SIMPLE plan catch-up limit:

    Calendar Year Non-SIMPLE Plan limit SIMPLE Plan limit
    2002 $1,000 $500
    2003 $2,000 $1,000
    2004 $3,000 $1,500
    2005 $4,000 $2,000
    2006 $5,000 $2,500
    2007 $5,000 $2,500
    2008 $5,000 $2,500
    2009 $5,500 $2,500
    2010 $5,500 $2,500

4.72.2.12  (06-07-2010)
SIMPLE 401(k) Plans

  1. Sections 401(k)(11) and 401(m)(10) of the Code provide for SIMPLE section 401(k) plans. SIMPLE 401(k) plans must be maintained on a calendar-year basis. A SIMPLE 401(k) plan is deemed to satisfy the ADP and ACP tests and is not subject to the top-heavy requirements. SIMPLE 401(k) plans closely follow the requirements for SIMPLE IRA plans described in IRC section 408(p), but SIMPLE IRA plans are far more popular with employers because the IRA plans are less burdensome to set up and maintain; for example, Form 5500s are not required for SIMPLE IRA plans.

  2. A SIMPLE 401(k) plan can only be established by an employer that had no more than 100 employees who each received at least $5,000 of SIMPLE compensation (see below) from the employer for the prior calendar year. Also, no employee covered under the SIMPLE 401(k) plan can be covered under another plan of the employer.

  3. The maximum amount that employees can contribute to their SIMPLE 401(k) accounts is $10,000 in 2006, plus an additional $2,500 if the employee is age 50 or older. (Each of these amounts is adjusted in the same manner as catch-up contributions discussed above.) For years after 2006, annual cost-of-living updates can be found at EP website: . See also IRM 4.72.2.20.

  4. Each year the employer must contribute either:

    1. matching contributions equal to the lesser of the eligible employee's elective contributions for the year or 3% of the eligible employee's SIMPLE compensation for the entire calendar year; or

    2. nonelective contributions equal to 2% of the eligible employee's SIMPLE compensation for the entire calendar year, but the plan can limit the nonelective contribution to those eligible employees who received at least $5,000 of SIMPLE compensation from the employer for the entire calendar year.

  5. There are special election and notice requirements for SIMPLE 401(k) plans:

    1. For an employee’s initial year of participation, he or she must be permitted to make a cash or deferred election under the plan during a 60-day period that includes either the day the employee becomes eligible or the day before.

    2. For each subsequent year, the employee must be permitted to make or modify his or her cash or deferred election during the 60-day period immediately preceding such calendar year.

    3. An eligible employee must be permitted to terminate his or her cash or deferred election at any time.

    4. The employer must notify each eligible employee within a reasonable time prior to each 60-day election period that he or she can make or modify a cash or deferred election and whether the employer will be making matching or nonelective contributions for the year.

  6. All contributions to the plan must be fully vested at all times and no contributions other than those described above and rollover contributions can be made to the plan.

  7. A special, inclusive definition of compensation applies to SIMPLE 401(k) plans. See section 408(p)(6) of the Code and section 1.401(k)-4(e)(5) of the Regulations. Basically, SIMPLE compensation is what is reported on an employee's Form W-2 for the year, including elective contributions. Also, compensation is limited to the section 401(a)(17) amount which is indexed annually. See IRM 4.72.2.20.

4.72.2.13  (06-07-2010)
Safe Harbor 401(k) Plans

  1. Section 401(k)(12) of the Code provides a design-based safe harbor method under which a CODA is treated as satisfying the ADP test if the arrangement meets certain contribution and notice requirements under section 1.401(k)-3(a) through (h) of the Regulations. If the plan also satisfies the requirements of section 401(m)(11) of the Code and doesn’t provide for employee contributions, it will be treated as satisfying the ACP test as well. See section 1.401(m)-3 of the Regulations.

  2. For purposes of this IRM section, the term "safe harbor 401(k) plan" means a plan meeting the requirements of section 401(k)(12) (and section 401(m)(11), if applicable) of the Code and not a QACA described in section 401(k)(13) (and section 401(m)(12), if applicable). For QACAs, see IRM 4.72.2.14.1.

  3. A plan that uses the safe harbor methods to satisfy the ADP or ACP test is treated as using the current year testing method for that plan year. A plan can satisfy the ADP safe harbor without satisfying the ACP safe harbor, but a plan cannot satisfy the ACP safe harbor without satisfying the ADP safe harbor.

4.72.2.13.1  (06-07-2010)
Plan Provisions for Safe Harbor Plans

  1. Generally, an employer that intends to use the safe harbor provisions for a plan year must adopt those provisions before the first day of that plan year and such provisions must remain in effect for an entire 12-month plan year.

  2. A section safe harbor 401(k) plan can have a short plan year: (i) in the first year of the plan or CODA, (ii) if the plan changes plan years and (iii) for the plan’s final plan year. (See section 1.401(k)-3(e) of the Regulations.)

  3. Section 1.401(k)-3(f) of the Regulations provides for what’s sometimes called a "maybe safe harbor plan," whereby a notice is distributed to employees at the normal time prior to a plan year stating that the plan may be amended before the end of the plan year to become a safe harbor plan providing for safe harbor nonelective contributions. To become a safe harbor plan, the plan must be amended no later than 30 days prior to the end of the plan year and distribute a new notice to employees explaining the amendment.

  4. Section 1.401(k)-3(g) of the Regulations provides that a safe harbor 401(k) plan using safe harbor matching contributions may be amended during a plan year to suspend or reduce the matching contributions prospectively for that plan year. A new notice must be provided to employees and the plan is subject to the ADP (and ACP) test for the entire plan year.

  5. Proposed Regulations, 74 FR 23134, under sections 401(k) and 401(m) permit a safe harbor plan using safe harbor nonelective contributions to be amended to reduce or suspend such contributions mid-year if the employer incurs a substantial business hardship and satisfies certain other requirements. See sections 1.401(k)-3(g)(1)(ii) and 1.401(m)-3(h)(1)(ii) of the Proposed Regulations.

  6. Announcement 2007-59, 2007-1 C.B. 1448, provides that a plan will not fail to satisfy the requirements to be a safe harbor section 401(k) merely because of the mid-year addition of a designated Roth contribution program or of the deemed hardship rules for the designated beneficiary of a participant (under PPA section 826).

4.72.2.13.2  (06-07-2010)
Special Compensation Definition for Safe Harbor Plans

  1. Generally, the same definitions apply as are used in other CODAs. However for determining safe harbor matching and nonelective contributions, "safe harbor compensation" must be used. This is the normal definition of compensation, which incorporates the definition of compensation in section 1.414(s)-1 of the Regulations, except that the last sentence in section 1.414(s)-1(d)(2)(iii) of the Regulations (permitting a plan to disregard all compensation that exceeds a specified dollar amount) does not apply. Note that the annual compensation limit under section 401(a)(17) still applies.

  2. Also, a safe harbor 401(k) plan can restrict the type of compensation that can be deferred as long as each eligible NHCE may make elective contributions under a "reasonable definition" of compensation as defined under section 1.414(s)-1(d)(2) of the Regulations. Such definition is not required to satisfy the nondiscrimination requirement of section 1.414(s)-1(d)(3). However, the plan must permit each eligible NHCE to make elective contributions in an amount that is at least sufficient to receive the maximum amount of matching contributions under the plan for the plan year and the employee must be permitted to elect any lesser amount of elective contributions.

  3. Example:

    (illustrating compensation): An employer's section 401(k) plan defines compensation as "all salary, wages, bonuses, and other remuneration not exceeding $75,000." The plan does not satisfy the ADP/ACP test safe harbors because the definition of compensation excludes compensation over $ 75,000.

  4. Example:

    (illustrating compensation): An employer's section 401(k) plan allows employees to make elective contributions only from basic compensation, defined as salary, regular time wages, bonuses and commissions, and excluding overtime pay. This is a reasonable definition of compensation within the meaning of section 1.414(s)-1(d)(2) of the Regulations, but is not necessarily nondiscriminatory. The plan provides for a required matching contribution equal to 100 percent of each eligible employee's elective contributions, up to 4 percent of compensation. For purposes of the matching formula, compensation is defined as compensation under section 415(c)(3). Under the plan, each NHCE who is an eligible employee is permitted to make elective contributions equal to at least 4 percent of the employee's compensation under section 415(c)(3) (that is the amount of elective contributions sufficient to receive the maximum amount of matching contributions available under the plan). This plan's definitions of compensation satisfy the safe harbor rules.

4.72.2.13.3  (06-07-2010)
ADP Test Safe Harbor Requirements

  1. To satisfy the ADP safe harbor, a CODA must satisfy the safe harbor contribution requirement and the notice requirement of section 401(k)(12) and section 1.401(k)-3 of the Regulations.

  2. The safe harbor contribution requirement is satisfied for a plan year if the plan satisfies either the matching contribution requirement or the nonelective contribution requirement. Safe harbor matching or safe harbor nonelective contributions, whichever is used, must be made on behalf of all eligible employees under the plan; meaning, for example, that the plan cannot restrict these contributions to employees employed on the last day of the plan year or to employees who have at least 1,000 hours of service in the plan year. The safe harbor contribution requirement must be satisfied without regard to the integration provisions of section 401(l).

  3. A plan may satisfy the matching contribution requirement by providing for either the basic matching formula or an enhanced matching formula.

    1. The basic matching formula provides qualified matching contributions (QMACs) on behalf of each eligible NHCE in an amount equal to 100 percent of the employee’s elective contributions up to 3 percent of the employee’s compensation, and 50 percent of the employee’s elective contributions that exceed 3 percent of the employee’s compensation but do not exceed 5 percent of the employee’s compensation.

    2. An enhanced matching formula provides QMACs for each eligible NHCE under a formula that provides an aggregate amount of QMACs at least equal to the aggregate amount that would have been provided under the basic matching formula at any elective contribution rate, and the rate of matching contributions may not increase as an employee’s rate of elective contributions increases.

  4. For example, a plan provides that QMACs will be made at the following rates: 100 percent of an employee's elective contributions that do not exceed 2 percent of compensation and 75 percent of the employee's elective contributions that exceed 2 percent but do not exceed 5 percent of compensation. This formula does not satisfy the enhanced matching formula since the aggregate amount that is provided by this formula is not at least equal to the amount that would have been provided under the basic matching formula at all rates of elective contributions. Under the basic matching formula, QMACs of 100 percent would be made on the amount of the employee's elective contributions that do not exceed 3 percent of compensation. Under the plan's formula, the amount of QMACs at 3 percent is less than 100 percent. For additional examples, see section 1.401(k)-3(c)(7) of the Regulations.

  5. Note that a plan that contains a formula that satisfies the ADP test safe harbor will not fail the ADP test safe harbor because the plan also provides for discretionary matches, as long as the discretionary matches are limited to 4% of each employee’s compensation. See below and section 1-401(m)-3(d)(3) of the Regulations.

  6. A matching formula does not satisfy the safe harbor if, at any rate of elective contributions, the rate of matching contributions for an eligible HCE is greater than the rate of matching contributions for an eligible NHCE at the same rate of elective contributions. For example, a plan covers Divisions A and B, both of which have NHCEs and HCEs. If the plan provides for a basic matching formula for Division A and an enhanced matching formula for Division B, (such as 100 percent match of each employee's elective contributions up to 4 percent of a Division B employee's section 415(c)(3) compensation), the rate of match for a Division B HCE at a rate of elective contributions of 4 percent is greater than the rate of match for a Division A NHCE at the same rate of elective contributions; therefore, the plan would not satisfy the ADP test safe harbor. However, a plan may provide for matching contributions to be made on a payroll-period basis without having to "true-up" for the whole year (see section 1.401(k)-3(c)(5)(ii)).

  7. Generally, the matching contribution requirement is not satisfied if elective contributions by NHCEs are restricted. However, the following restrictions on elective contributions are permitted:

    1. certain reasonable limits on the periods during which employees can make or change their deferral elections;

    2. certain limits on the amount of elective contributions that can be made, for example, an employer can require that elective contributions be made in whole percentages of pay or in whole dollar amounts;

    3. certain limits on the types of compensation that may be deferred; and

    4. limits on elective contributions to satisfy section 402(g) or 415 or, after a hardship distribution, to satisfy the 6-month suspension period in section 1.401(k)-1(d)(3)(iv)(E) of the Regulations.

  8. Despite all of the restrictions just described, there are certain conditions that must be satisfied. For example, as discussed earlier, although a plan sponsor may limit the amount of elective contributions, the employer must permit each eligible NHCE to make sufficient elective contributions to receive the maximum amount of matching contributions available under the plan. For an explanation of restrictions on types of compensation that may be deferred, see the definition of compensation above.

  9. In lieu of safe harbor matching contributions, an employer can make safe harbor nonelective contributions. The nonelective contribution requirement is satisfied if, under the terms of the plan, the employer is required to make qualified nonelective contributions (QNECs) on behalf of each eligible NHCE in an amount equal to at least 3 percent of the employee's compensation.

  10. Safe harbor matching and nonelective contributions can be used to satisfy the safe harbor requirements for only one plan and the safe harbor contribution requirements must be satisfied without regard to section 401(l).

4.72.2.13.4  (06-07-2010)
Notice Requirement

  1. The second requirement necessary to satisfy the ADP test safe harbor is the notice requirement, which is satisfied if each eligible employee for the plan year is given written notice of the employee's rights and obligations under the plan and the notice satisfies the content requirement and the timing requirement of section 1.401(k)-3(d) of the Regulations. The notice must be in writing or in such other form as may be approved by the Commissioner.

  2. The content requirement requires that the notice must be sufficiently accurate and comprehensive to inform the employee of the employee's rights and obligations under the plan and written in a manner calculated to be understood by the average employee eligible to participate in the plan.
    The notice must accurately describe:

    1. the safe harbor matching contribution or safe harbor nonelective contribution formula used under the plan (including a description of the levels of safe harbor matching contributions, if any, available under the plan);

    2. any other contributions under the plan or matching contributions to another plan on account of elective contributions or employee contributions under the plan (including the potential for discretionary matching contributions) and the conditions under which such contributions are made;

    3. the plan to which safe harbor contributions will be made (if different than the plan containing the CODA);

    4. the type and amount of compensation that may be deferred under the plan;

    5. how to make cash or deferred elections, including any administrative requirements that apply to such elections;

    6. the periods available under the plan for making cash or deferred elections;

    7. withdrawal and vesting provisions applicable to contributions under the plan;

    8. information that makes it easy to obtain additional information about the plan (including an additional copy of the summary plan description) such as telephone numbers, addresses and, if applicable, electronic addresses, of individuals or offices from whom employees can obtain such plan information.

  3. The timing requirement requires that the plan sponsor must provide notice within a reasonable period before each year. This requirement is deemed to be satisfied if the notice is given to each eligible employee at least 30 days and not more than 90 days before the beginning of each plan year. In the case of an employee who does not receive the notice because the employee becomes eligible after the 90th day before the beginning of the plan year, the timing requirement is deemed to be satisfied if the notice is provided no more than 90 days before the employee becomes eligible (and no later than the date the employee becomes eligible). However, if it is not practical to provide the notice on or before the date an employee becomes eligible, a notice will nonetheless be deemed timely if it is provided as soon as practical after that date and the employee is permitted to defer from all compensation earned form his or her eligibility date. This means, in the case of a new employee who is immediately eligible to participate in the plan, that, if it is not practical to give this employee a notice on or before his or her hire date, the notice must be given (and the employee able to make a deferral election) before the employee’s first payday.

4.72.2.13.5  (06-07-2010)
ACP Test Safe Harbor

  1. To satisfy the ACP test safe harbor with respect to matching contributions, a plan must satisfy the ADP test safe harbor and limit matching contributions in accordance with section 401(m)(11) and section 1-401(m)-3(d) of the Regulations.

  2. There are three ways to satisfy the matching contribution limitations:

    1. The plan can provide for the "basic matching formula," described above in the ADP test safe harbor, and for no other matching contributions.

    2. The plan can provide for an "enhanced matching formula, " described above in the ADP test safe harbor, but under which matching contributions are only made with respect to elective contributions that do not exceed 6 percent of the employee’s compensation, and no other matching contributions are provided under the plan.

    3. In the case of any other plan, the matching contribution limitations satisfy the ACP test safe harbor if matching contributions are not made with respect to elective contributions or employee contributions that in the aggregate exceed 6 percent of the employee’s compensation, the rate of matching contributions does not increase as the rate of employee contributions or elective contributions increases, and for employees at the same rate of elective contributions or employee contributions, the rate of matching contributions for an HCE does not exceed the rate of matching contributions for an NHCE.

  3. The elective contributions or employee contributions that are used for determining the matching contributions may be restricted only as permitted under the rules for the ADP test safe harbor, above.

  4. A plan that provides for discretionary matches (in addition to nondiscretionary matches needed to satisfy the ADP test safe harbor) can satisfy the ACP test safe harbor if the discretionary matches in the aggregate do not exceed a dollar amount equal to 4 percent of the employee's compensation.

  5. The ACP test (not the safe harbor) still applies to a plan with respect to employee contributions and matching contributions that fail to satisfy the ACP test safe harbor. However, if such plan satisfies the ACP safe harbor, the ACP test can be performed only counting employee contributions (i.e., ignoring all matches). See section 1-401(m)-2(a)(5)(iv) of the Regulations.

4.72.2.13.6  (06-07-2010)
Multiple CODAs and Multiple Plans

  1. ADP test safe harbor matching contributions or nonelective contributions may be made to the plan that contains the CODA or to another defined contribution plan that satisfies section 401(a) or section 403(a). If safe harbor contributions are made to another defined contribution plan, the safe harbor contribution requirement must be satisfied in the same manner as if the contributions were made to the plan that contains the CODA. Consequently, each employee eligible under the plan containing the CODA must be eligible under the same conditions under the other defined contribution plan (that is, both plans must have identical eligibility/participation requirements).

  2. In order for safe harbor contributions to be made to another defined contribution plan, that plan must be permitted to be aggregated with the plan containing the CODA, for example, the plans must have the same plan year.

  3. The rules for aggregating and disaggregating CODAs and plans also apply for purposes of the ADP/ACP test safe harbor requirements. Thus, all CODAs included in a plan are treated as a single CODA that must satisfy the safe harbor contribution requirement and the notice requirement. Two plans (within the meaning of section 1.410(b)-7(b)) that are treated as a single plan under permissive aggregation are treated as a single plan for purposes of the safe harbor methods. Conversely, a plan (within the meaning of section 414(l)) that includes a CODA covering both collectively bargained employees and noncollectively bargained employees is treated as two separate plans for purposes of section 401(k), and the ADP test safe harbor need not be satisfied with respect to both plans in order for one of the plans to take advantage of the ADP test safe harbor. However, the rule in section 401(k)(3)(F) (permitting a plan to disregard certain employees) does not apply to safe harbor plans. See section 1-401(k)-3(h) of the Regulations.

  4. If an HCE is simultaneously an eligible employee under two plans maintained by an employer for a plan year, only one of which is intended to satisfy the ADP/ACP test using the safe harbor methods, and the matching contribution formula of the plan that is not using the safe harbor methods provides greater matching contributions than the formula under the plan that is intended to satisfy the ADP/ACP test using the safe harbor methods, the rules prohibiting an HCE from receiving a greater rate of matching contributions than an NHCE could be violated.

4.72.2.14  (06-07-2010)
Automatic Contribution Arrangements (ACAs)

  1. An automatic contribution arrangement (ACA), also known as " automatic enrollment," is a feature in a plan whereby a plan participant has his or her compensation reduced by a specified amount that is contributed to the plan unless the participant elects not to have compensation reduced or to have it reduced by a different amount. In a CODA, the amounts are contributed to the plan as elective contributions In 2006, section 902 of PPA (as amended by WRERA), added sections 401(k)(13), 401(m)(12), and 414(w) to the Code to facilitate the automatic enrollment of more employees.

  2. Sections 401(k)(13) and 401(m)(12) of the Code, effective for plan years beginning on or after January 1, 2008, provide an alternative design-based safe harbor for a CODA that provides for automatic contributions at a specified level and meets certain employer contribution, notice, and other requirements. A CODA that satisfies these requirements, referred to as a qualified automatic contribution arrangement (QACA), is treated as satisfying the ADP test (and ACP test with respect to matching contributions).

  3. Section 414(w) of the Code, effective for plan years beginning on or after January 1, 2008, further facilitates automatic enrollment by providing limited relief from the distribution restrictions under section 401(k)(2)(B) in the case of an EACA described in section 414(w).

  4. Final Regulations on automatic contribution arrangements, 74 FR 8200, published on February 24, 2009, contains amendments to regulations under sections 401(k), 401(m) of the Code and new regulations under section 414(w) in order to reflect PPA changes.

  5. Rev. Rul. 2009-30, 2009-39 I.R.B 391, provides guidance on how automatic enrollment in a section 401(k) plan can work when there is an escalator feature included. An escalator feature means that the amount of an employee’s compensation that is contributed to the plan, without the employee’s affirmative election, is increased periodically according to the terms of the plan. Notice 2009-65, 2009-39 I.R.B. 413, provides two sample amendments that sponsors of section 401(k) plans can use to add automatic enrollment features to their plans. The first sample amendment can be used to add a basic ACA with an escalation feature. The second sample amendment can be used to add an EACA with an escalation feature.

4.72.2.14.1  (06-07-2010)
Qualified Automatic Contribution Arrangements (QACAs)

  1. A plan that meets the requirements under sections 401(k)(13) and 401(m)(12) is deemed to pass the ADP and ACP tests. Such a plan, or, more accurately, the arrangement within such a plan, is called a QACA. To be a QACA, the plan must provide for certain levels of automatic contributions, provide certain matching or nonelective contributions and satisfy a notice requirement. See section 1-401(k)-3 of the Regulations.

  2. The deferral percentage at which an employee is automatically enrolled in a QACA (sometimes referred to as the "default percentage " or "default deferral" ) must meet certain minimums that increase over time, assuming the employee doesn’t affirmatively elect something else. Generally, a QACA applies to all employees eligible to make deferrals under the plan, but automatic enrollment applies only to those eligible employees who don’t have an affirmative election regarding elective contributions in place. A plan may provide that employees’ affirmative elections regarding elective contributions expire after a certain period or event, so that unless the employee makes a new election he or she will be automatically enrolled at the appropriate default percentage.

  3. When a QACA is first added to a CODA, existing affirmative elections may be honored or the plan can provide that all employees must make new affirmative elections to avoid being automatically enrolled at the default percentage. See also the uniformity requirement discussed later.

4.72.2.14.2  (06-07-2010)
QACAs Default Percentage Requirements

  1. Section 401(k)(13)(C)(iii) of the Code sets forth a series of minimum default contribution percentages that a QACA must satisfy. The default percentages may not exceed 10% of an employee’s compensation and must be applied uniformly. The default percentage must be at least:

    1. 3% during the initial period,

    2. 4% during the first plan year following the initial period,

    3. 5% during the second plan year following the initial period, and

    4. 6% during the third and subsequent plan years following the initial period.

  2. An employee’s "initial period" begins when he or she first has default contributions made under the QACA and ends on the last day of the plan year following the plan year in which the employee first had such contributions made. If an employee makes an affirmative election before the default contribution would have begun, then the initial period has not begun for the employee. Note that a plan could simplify matters by having just one default percentage, for example, 6%, with no increase. The default percentage under the QACA is limited so as not to exceed the limits of sections 401(a)(17), 402(g) (determined with or without catch-up contributions described in section 402(g)(1)(C) or 402(g)(7)) and 415.

  3. The minimum percentages are based on the date the initial period begins, regardless of whether the employee is eligible to make elective contributions under the plan after that date. Thus, for example, if an employee is ineligible to make contributions under the plan for 6 months because the employee had a hardship withdrawal and the 6-month period includes a date as of which the default minimum percentage is increased, then the default percentage must reflect that increase when the employee is permitted to resume contributions. However, a plan is permitted to treat an employee who for an entire plan year did not have contributions made pursuant to a default election under the QACA as if the employee had not had such contributions for any prior plan year as well. For example, if an employee terminates in one plan year, remains terminated for a full plan year, and is rehired in a subsequent plan year, the plan is permitted to provide that a new initial period begins after the employee is rehired, regardless of whether the employee had in fact had contributions made pursuant to a default election under the QACA in some earlier plan year. See section 1.401(k)-3(j)(2)(iv) of the Regulations.

  4. For plan years beginning on or after January 1, 2010, compensation for purposes of determining default contributions means safe harbor compensation as defined in section 1.401(k)-3(b)(2) of the Regulations.

4.72.2.14.3  (06-07-2010)
QACAs Uniformity Requirements

  1. Section 401(k)(13)(C)(iii) of the Code provides that the default percentage must be applied uniformly to all eligible employees under the QACA.

  2. Section 1.401(k)-3(j)(2)(iii) of the Regulations provides that a plan will not fail to satisfy this uniformity requirement merely because

    1. the percentage varies based on the number of years (or portions of years) since the beginning of the initial period for an eligible employee;

    2. the rate of elective contributions under a cash or deferred election that is in effect for an employee immediately prior to the effective date of the default percentage under the QACA is not reduced;

    3. the rate of elective contributions is limited so as not to exceed the limits of sections 401(a)(17), 402(g) (determined with or without catch-up contributions described in section 402(g)(1)(C) or 402(g)(7)), and 415 of the Code; or

    4. the default election provided is not applied during the period an employee is not permitted to make elective contributions in order for the plan to satisfy the requirements of section 1.401(k)-3(c)(6)(v)(B) (6-month suspension following a hardship withdrawal) of the Regulations.

4.72.2.14.4  (06-07-2010)
QACAs Safe Harbor Contribution Requirements

  1. In order to satisfy QACA requirements, the employer is required to make:

    1. safe harbor matching contributions on behalf of each eligible NHCE in an amount equal to 100% of the first 1% of elective deferrals and 50% of elective deferrals in excess of 1% and up to 6%, or

    2. safe harbor nonelective contributions on behalf of each eligible NHCE in an amount equal to at least 3 percent of the employee's compensation without regard to whether the employee makes an elective contribution or employee contribution.

  2. The safe harbor contributions must be available to all NHCEs in the CODA, both those who are automatically enrolled and those who have affirmative elections in effect regarding deferrals. Also, although the statute specifies required contributions for NHCEs, most plans will provide safe harbor contributions to both HCEs and NHCEs equally.

  3. The QACA safe harbor matching and nonelective contributions must be nonforfeitable after no more than 2 years of service. Apart from the different matching formula and the 2-year vesting requirement, all the rules applicable to safe harbor contributions to a (section 401(k)(12)) safe harbor plan apply to a QACA. Thus, contributions are based on safe harbor compensation (defined previously), enhanced matching formulas may be provided and the safe harbor matching and nonelective contributions are subject to the same distribution restrictions that apply to QNECs and QMACs.

4.72.2.14.5  (06-07-2010)
QACAs Notice requirements

  1. A QACA must satisfy the same notice requirements that apply to safe harbor plans (section 401(k)(12)) but with some additional content and timing requirements.

  2. The additional content requirements for a QACA are that the notice must explain:

    1. the level of default contributions that will be made on the employee’s behalf in the absence of an affirmative election.

    2. the employee’s right to elect to have no elective contributions made to the plan or to have elective contributions made in a different amount than the default percentage, and

    3. how contributions under the QACA will be invested.

  3. The timing requirement for the QACA notice is satisfied only if it is provided early enough so that the employee has a reasonable period of time after receipt of the notice to a deferral election. This does not permit a plan to delay a default election beyond the earlier of:

    1. two paydays after receipt of the notice, and

    2. the first payday at least 30 days after the notice is provided.

4.72.2.14.6  (06-07-2010)
Eligible Automatic Contribution Arrangements (EACAs)

  1. An EACA is an automatic contribution arrangement that may permit a participant to withdraw default contributions without penalty and, under certain circumstances, permits an extra 3 1/2 months to distribute excess contributions and excess aggregate contributions. An EACA has a notice requirement and a uniformity requirement, but there are no mandatory employer contributions nor any required level of default contributions. See sections 1.414(w)-1 and 54.4979-1(c) of the Regulations.

  2. Unlike a QACA, an EACA need not cover all employees eligible to make deferrals under the CODA; only those specified in the plan are " covered employees." A "covered employees" is subject to default contributions if no affirmative election is made and will receive the annual EACA notice. The plan must state whether an employee who makes an affirmative election remains covered under the EACA. Thus, if a plan provides that an employee who makes an affirmative election is no longer a covered employee under the EACA, then the employee is not required to receive the notice after he or she makes an affirmative election.

  3. The default elective contribution under an EACA must be a uniform percentage of compensation; however, the percentage can vary in a similar manner to that permitted in a QACA. See section 1-414(w)-1(b)(2) of the Regulations.

  4. All automatic contribution arrangements that are intended to be EACAs within a plan (or within the disaggregated plan under section 1.410(b)-7, in the case of a plan subject to section 410(b)) must be aggregated. For example, if a single plan within the meaning of section 414(l) covering employees in two separate divisions has two different ACAs that are intended to be EACAs, the two ACAs can constitute EACAs only if the default elective contributions under the arrangements are the same percentage of compensation. However, if the different ACAs covered employees in mandatorily disaggregated portions of the plan, they could have different default percentages and be EACAs.

  5. The EACA notice requirements are similar to the notice requirements for a QACA (see section 1.414(w)-1(b)(3) of the Regulations). However, if the EACA permits withdrawal of default contributions, the notice must explain this to covered employees.

  6. The principal value of an EACA is to let employees who had default deferrals made withdraw those amounts. Prior to EACAs, employers would have to deal with disgruntled employees who didn’t realize they were going to have their pay reduced under an ACA and who could not withdraw such deferrals because of the distribution restrictions applicable to elective contributions. And the plan, too, was disadvantaged, having to maintain small account balances when the employees who never wanted deferrals made stopped them with an affirmative election. An EACA provides limited relief from the distribution restrictions under section 401(k)(2)(B) of the Code, and permits employees to elect to withdraw amounts (permissible withdrawal) equal to the amount of default elective contributions (and attributable earnings) within a specific time period without penalty. The election must be made within 90 days after the date of the first default elective contribution with respect to the employee under the EACA. A plan is permitted to set an earlier deadline for the election to withdraw default elective contributions. However, if a plan offers a permissible withdrawal for covered employees, the election period for the covered employees must be at least 30 days. The latest effective date of a withdrawal election cannot be after the earlier of:

    1. two paydays after the date the election is made, and

    2. the first payday at least 30 days after the election is made.

  7. The permissible withdrawal amount is not taken into account for purposes of the ADP test nor in determining the limitation on elective deferrals under section 402(g). The withdrawn amount is includible in gross income for the taxable year in which the distribution is made (except to the extent the distribution consists of designated Roth contributions), but is not subject to the additional income tax under section 72(t). The plan may not charge a higher fee for a permissible withdrawal under section 414(w) than for other withdrawals.

  8. The section 4979 excise tax does not apply to an EACA if excess contributions and excess aggregate contributions for a plan year together with income allocable to the contributions are distributed within 6 months (instead of 2 1/2 months) after the close of the plan year. The extension to 6 months applies only if all eligible employees are covered under the EACA.

  9. Matching contributions that have already been allocated to default contributions withdrawn in a permissible withdrawal must be forfeited together with allocable income. The plan is permitted to provide that matching contributions will not be made with respect to any elective contributions withdrawn made under section 414(w).

4.72.2.15  (06-07-2010)
Designated Roth Contributions

  1. Section 402A was added to the Code by section 617 of EGTRRA, providing for designated Roth contributions, effective for taxable years beginning on or after January 1, 2006. Amendments to the final regulations under sections 401(k) and 401(m) relating to designated Roth contributions were published in the Federal Register on January 3, 2006, 71 FR 6, and these regulations were amended by final regulations published April 30, 2007, 72 FR 21103. With the introduction of designated Roth contributions, elective contributions can be either designated Roth contributions (after-tax elective contributions) or pre-tax elective contributions. See section 1.401(k)-1(f) of the Regulations.

  2. Under section 402A of the Code, a plan may permit an employee who makes elective contributions to designate some of the contributions as designated Roth contributions. Designated Roth contributions are elective contributions under a qualified CODA that are:

    1. designated irrevocably by the employee at the time of his or her cash or deferred election as designated Roth contributions that are being made in lieu of all or a portion of the pre-tax elective contributions the employee is eligible to make under the plan;

    2. treated by the employer as includible in the employee’s gross income at the time the employee would have received the contribution amount in cash if the employee had not made a cash or deferred election; and

    3. maintained by the plan in a separate account.

  3. Since designated Roth contributions are "after-tax," any distribution of such contributions will be tax-free. However, a distribution from a designated Roth account (including earnings) that is a "qualified distribution" is completely tax free. A qualified distribution is one that is made after 5-years of participation in the Roth arrangement and is made on or after age 59 1/2, after death or on account of being disabled. (See section 1.402A-1, Q&A-2 of the Regulations.) Corrective distributions and any other amounts described in section 1.402(c)-2, Q&A-4 (relating to amounts that cannot be rolled over) are not qualified distributions. (See section 1.402A-1, Q&A-2 and -11, of the Regulations.) Because all qualified distributions from a designated Roth account are tax-free, it’s important to ensure that no improper amounts find their way into the account, such as extra earnings or forfeiture allocations. In addition, losses and charges must be separately allocated on a reasonable and consistent basis to the designated Roth account and other accounts under the plan. The only contributions that can go into a designated Roth account are designated Roth contributions currently deducted from the employee’s pay and rollovers from another designated Roth account of the employee. (See sections 1.401(k)-1(f)(3) and 1.402A-1, Q&A-13 of the Regulations.)

  4. A plan is permitted to treat the balance of the participant's designated Roth account and the participant's other accounts under the plan as accounts held under two separate plans (within the meaning of section 414(l)) for purposes of applying the special rule in A-11 of section 1.401(a)(31)-1 of the Regulations (under which a plan will satisfy section 401(a)(31) even though the plan administrator does not permit any distributee to elect a direct rollover with respect to eligible rollover distributions during a year that are reasonably expected to total less than $200). Thus, if a participant's balance in the designated Roth account is less than $200, then the plan is not required to offer a direct rollover election with respect to that account or to apply the automatic rollover provisions of section 401(a)(31)(B) with respect to that account.

  5. In correcting an ADP test failure for a plan year, a plan may permit an HCE with elective contributions for a year that includes both pre-tax elective contributions and designated Roth contributions to elect whether the excess contributions are to be attributed to pre-tax elective contributions or designated Roth contributions. (See section 1.401(k)-2(b)(1)(ii) of the Regulations.) Also, if an employee has excess deferrals made to a plan, the employee may have some control over allocating the excess to designated Roth contributions. See section 1.402(g)-1(e)(2)(i) of the Regulations.

  6. Amounts in a designated Roth account can only be rolled over to another designated Roth account of the employee or to a Roth IRA of the employee.

  7. Except as described above, designated Roth contributions are treated like any other elective contributions in accordance with section 1.401(k)-1(f)(4) of the Regulations. They are counted in the ADP test; they can be catch-up contributions; they can be default elective contributions under an ACA; . they are subject to the required minimum distribution rules under section 401(a)(9); and they are treated as employer contributions for purposes of sections 401(a), 401(k), 402, 404, 409, 411, 412, 415, 416 and 417 of the Code.

    Note:

    Under section 408A of the Code, Roth IRAs are not subject to the rules of section 401(a)(9)(A). However, section 402A of the Code does not provide comparable rules regarding the application of section 401(a)(9) to designated Roth accounts under a CODA. Section 1.401(k)-1(f)(4)(i) of the Regulations provides that the designated Roth account under the plan is subject to the rules of section 401(a)(9)(A) and (B) in the same manner as an account that contains pre-tax elective contributions."

4.72.2.16  (06-07-2010)
Contingent Benefits

  1. An employer may not directly or indirectly condition another employer benefit (other than matching contributions) upon an employee's election to make or not make elective contributions. This includes benefits under a DB plan, nonelective employer contributions to a DC plan, benefits under a nonqualified plan, the right to make employee contributions, the right to health and life insurance, and the right to employment. If the employer has made an employer benefit conditioned upon elective contributions, the CODA is not qualified. This rule is in the statute to prevent employers from encouraging employees to make or not make elective contributions by linking valuable benefits to the contribution or lack of a contribution. See section 1.401(k)-1(e)(6) of the Regulations.

  2. Participation in a nonqualified plan is treated as a contingent benefit only to the extent an employee may receive additional deferred compensation under the nonqualified plan depending on the employee's making or not making elective contributions. However, participation in a nonqualified plan is not treated as a contingent benefit if an employee's participation is conditioned on making the maximum deferrals under section 402(g) or the terms of the plan. See section 1.401(k)-1(e)(6)(iii) and (iv) of the Regulations.

4.72.2.16.1  (06-07-2010)
Examination Steps

  1. Ask whether the employer ties any benefits other than matching contributions to elective contributions. In certain circumstances it may be appropriate to request an interview with employees who make or fail to make elective contributions to see if they get any special treatment from the employer.

  2. Determine whether there is a nonqualified plan linked with the CODA. If there is, ensure there are no conditions in the form or in the operation of the nonqualified plan that are dependent on participation, lack of participation, or reduced participation in the CODA.

4.72.2.17  (06-07-2010)
Cafeteria Plans

  1. Section 125 permits an employer to maintain a "cafeteria plan." A cafeteria plan allows an employee to select among various types of employer benefits by specifying where an employer contribution should be spent.

  2. Cafeteria plans are permitted to offer a contribution into a qualified CODA as one of the options, but if it does, another option in the cafeteria plan must be a cash payment to the employee equal to the amount contributed to the cafeteria plan.

4.72.2.17.1  (06-07-2010)
Examination Step

  1. Ask whether the employer has a cafeteria plan that allows a contribution to the CODA. Review the options available to the cafeteria plan participants to ensure that receiving cash is one of the listed options.

4.72.2.18  (06-07-2010)
Top-Heavy Rules

  1. CODAs (but not SIMPLE 401(k) plans, nor certain safe harbor 401(k) plans and QACAs) are subject to the top-heavy rules in section 416. If a plan containing a CODA is top-heavy, then the plan must provide each nonkey employee who is employed on the last day of the plan year with a contribution equal to 3 percent of the employee's compensation for the entire year or, if lesser, the same percentage as the key employee with the highest percentage contribution. Thus, if the highest percentage contribution given to a key employee was 4 percent, then nonkey employees must each receive a 3-percent contribution. But if the key employee with the highest percentage contribution got a 2-percent contribution, then nonkey employees need only be given a 2-percent contribution.

  2. Elective contributions on behalf of key employees must be taken into account in determining the minimum contribution required for nonkey employees, but elective contributions of nonkey employees do not count towards satisfying the minimum contribution. Thus, if the only contributions made to a profit-sharing plan for a year were elective contributions and all participants, keys and nonkeys, made deferrals of 2 percent, then, if the plan was top-heavy, the employer would have to make a 2-percent contribution to the plan for all the nonkey employees. See section 1.416-1, M-20, of the Regulations.

  3. Prior to 2002, matching contributions made for nonkey employees could not be counted towards satisfying the nonkey minimum contribution if they were used in the ACP or ADP test. See section 416(c)(2)(A) of the Code as amended by section 613 of EGTRRA.

  4. If it is determined that the top-heavy minimums are provided in another plan, and the eligibility requirements are not the same for both plans, then eligible participants in the section 401(k) plan may not be receiving the minimum benefit in the other plan and therefore must receive a minimum benefit in the section 401(k) plan.

4.72.2.18.1  (06-07-2010)
Examination Steps

  1. If another plan is maintained, determine which plan provides the top-heavy minimum benefit.

  2. Verify that all nonkey employees eligible to participate in the CODA who are employed on the last day of the plan year are receiving the top-heavy minimum benefit. If this benefit is provided in another plan, compare the allocation schedule to the list of eligible employees used for the ADP testing in the CODA plan. The list should include all employees who meet the eligibility requirements of the CODA including those who do not elect to contribute under the CODA. If discrepancies are noted, request a complete list of all employees employed on the last day of the plan year who met the eligibility requirements of the CODA. Inspect payroll or other employment records to verify information provided.

  3. Verify that all eligible nonkey employees under the plan are receiving an employer contribution of at least 3% of compensation, (or the highest contribution to any key employee, if less than 3%).

  4. Elective contributions of nonkey employees may not be counted to satisfy the top-heavy minimum contribution requirements. However, elective contributions made on behalf of key employees are counted to determine the percentage of compensation required under the top-heavy minimum contribution.

4.72.2.19  (06-07-2010)
Compensation and IRC Section 415

  1. A 401(k) plan may have several definitions of compensation, which must be reflected in plan terms. The general CODA definition of compensation (used, for example, in the ADP and ACP tests) is compensation as defined in section 414(s). (See section 1.401(k)-6 of the Regulations.) Section 414(s) states that compensation means compensation within the meaning of section 415(c)(3) with an option to exclude amounts contributed under a salary reduction agreement (such as elective contributions). Section 414(s) also states that the Secretary of the Treasury may provide alternative definitions of compensation that do not favor HCEs, and section 1.414(s)-1 of the Regulations provide such alternative definitions. However, as already discussed, the mandatory employer contributions in safe harbor 401(k) plans and QACAs must use "safe harbor compensation" and such plans may use a modified 414(s) definition of compensation for deferrals. (See section 1.401(k)-3(b)(2) and (c)(6)(iv) of the Regulations.) For plan years beginning on or after January 1, 2010, compensation for purposes of determining default contributions under a QACA must also use safe harbor compensation.

  2. Effective with respect to compensation payable in plan years beginning on or after July 1, 2007, a cash or deferred election can only be made with respect to amounts that are compensation within the meaning of section 415(c) of the Code and section 1.415(c)-2 of the Regulations. (See section 1.401(k)-1(e)(8) of the Regulations.) Section 1.415(c)-2(e)(3)(i) and (ii) of the Regulations requires certain post severance compensation to be included as 415 compensation if paid by the later of: (1) 2 1/2 months after severance from employment or (2) the end of the limitation year that includes the date of severance from employment. Under section 1.415(c)-2(e)(3)(iii) and (4) of the Regulations, a plan may provide that compensation includes certain leave cashouts and deferred compensation and certain salary continuation payments for military service and disabled participants. Rev. Ruls. 2009-31 and 2009-32 provide guidance on contributing the value of leave cashout amounts to 401(k) plans, on an annual basis and after severance from employment.

  3. Section 415(c) of the Code provides the maximum amount of "annual additions" that can be made to a participant’s account for a "limitation year." A limitation year is a 12-month period used by the plan for 415 purposes, but it is nearly always the plan year. Annual additions include employer contributions, employee contributions and forfeitures. Annual additions also include excess contributions and excess aggregate contributions, even if distributed. However, catch-up contributions are not annual additions, so if a plan recharacterizes a portion of a HCE’s elective contributions as catch-up contributions, they are not counted for purposes of the section 415 limits. (See section 1.415(c)-1(b)(1) and (2).). Excess deferrals distributed by the April 15 deadline are not annual additions. (See section 1.415(c)-1(b)(2)(ii)(D).)

  4. Excess annual additions are amounts by which a specific participant’s allocation exceeds the section 415 limitation. Prior to July 1, 2007, a plan was allowed to correct excess annual additions through certain allocation or distribution techniques prescribed in section 1.415-6(b)(6) of the 1981 Regulation under certain circumstances. Effective for limitation years beginning on or after July 1, 2007, the Employee Plans Compliance Resolution System (EPCRS) is the exclusive method for correcting excess annual additions. See Rev. Proc. 2008-50, 2008-35 I.R.B. 464.

4.72.2.19.1  (06-07-2010)
Examination Steps:

  1. Review Form 5500, Schedule H or I, Item 2(f), for disclosure of distributions made to correct section 415 excess annual additions.

  2. Review plan financial audit reports and corporate minutes for comments that address section 415 concerns.

  3. Check the W-2 information for section 415 excess amounts.

  4. Determine whether the employer maintains more than one plan. If yes, verify that annual addition calculations reflect contributions made to all defined contribution plans and employee contributions to defined benefit plans maintained by the employer. Ensure that the elective deferrals to all section 401(k) plans and similar arrangements and salary reduction contributions to cafeteria plans are included in compensation for purposes of section 415 testing.

  5. Review the plan document for section 415 limitation language. If there were section 415 excesses during the year, verify that the correction method was proper under EPCRS.

  6. Check the plan for proper definition(s) of compensation for allocation and elective contribution purposes and make sure such definitions are used in operation.

4.72.2.20  (06-07-2010)
Annual Statutory Limits Applicable to CODAs

  1. COLA Increases for Dollar Limitations on Benefits and Contributions

    Year 408(p)(2) 402(g) 401(a)(17) 414(q) 415(c) TWB 414(v)(2)(B)(i) 414(v)(2)(E)
    2010 11,500 16,500 245,000 110,000 49,000 106,800 5,500 2,500
    2009 11,500 16,500 245,000 110,000 49,000 106,800 5,500 2,500
    2008 10,500 15,500 230,000 105,000 46,000 102,000 5,000 2,500
    2007 10,500 15,500 225,000 100,000 45,000 97,500 5,000 2,500
    2006 10,000 15,000 220,000 100,000 44,000 94,200 5,000 2,500
    2005 10,000 14,000 210,000 95,000 42,000 90,000 4,000 2,000
    2004 9,000 13,000 205,000 90,000 41,000 87,900 3,000 1,500
    2003 8,000 12,000 200,000 90,000 40,000 87,000 2,000 1,000
    2002 7,000 11,000 200,000 90,000 40,000 84,900 1,000 500
    2001 6,500 10,500 170,000 85,000 35,000 80,400    
    2000 6,000 10,500 170,000 85,000 30,000 76,200    
    1999 6,000 10,000 160,000 80,000 30,000 72,600    
    1998 6,000 10,000 160,000 80,000 30,000 68,400    
    1997 6,000 9,500 160,000   30,000 65,400    
    1996   9,500 150,000   30,000 62,700    


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