4.72.2  Cash or Deferred Arrangements

4.72.2.1  (06-07-2010)
Overview of Section 2

  1. The information contained in this section 2 is designed primarily to assist EP examiners in identifying relevant issues relating to cash or deferred arrangements (CODAs) for plan years beginning after December 31, 2001.

  2. This section 2 reflects statutory changes made by the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), Pub. L. 107-16, the Pension Protection Act of 2006 (PPA), Pub. L. 109-280, the Worker, Retiree, and Employer Recovery Act of 2008 (WRERA), Pub. L. 110-458, and the Heroes Earnings Assistance and Relief Tax Act of 2008 (HEART), Pub. L. 110-245. In addition, this section also reflects all guidance issued by the Service prior to January 1, 2010, as well as certain changes in administrative policy.

4.72.2.2  (06-07-2010)
Overview of CODAs

  1. A CODA is an arrangement that allows eligible employees to make a cash or deferred election with respect to contributions to, or accruals or benefits under, a plan intended to satisfy the requirements of section 401(a). A cash or deferred election is any direct or indirect election by an employee (or modification of an earlier election) to have the employer either: (1) provide an amount to the employee in the form of cash or some other taxable benefit that is not currently available; or (2) contribute an amount to a trust, or provide an accrual or other benefit, under a plan deferring the receipt of compensation. The election must be made before the taxable benefit is "currently available" to the participant.

  2. A cash or deferred election includes a "deemed" election made under an automatic contribution arrangement (an "ACA" , sometimes referred to as "automatic enrollment" ). Under an ACA, in the absence of an affirmative election by an eligible employee, a default election applies under which the employee is treated as having made an election to have a specified contribution made on his or her behalf to the plan.

  3. A nonqualified CODA is one that does not satisfy the requirements of section 401(k).of the Code. Except where clearly specified, these guidelines assume a CODA is intended to be a qualified CODA (and will use the term "CODA" to mean a qualified CODA), since only qualified CODAs get the benefit of tax deferral. Under section 402(e)(3), contributions made pursuant to a CODA election to a qualified CODA are not treated as distributed or made available to the employee and, thus, they are not included in the employee’s gross income until distributed (unless they are designated Roth contributions).

4.72.2.2.1  (06-07-2010)
Recent Changes to CODAs

  1. The statutes listed above in IRM 4.72.2.1 made the CODA-related changes listed in (2), (3), (4), (5) and (6) below.

  2. Effective in 2002:

    1. Section 414(v) was added to the Code by section 631 of EGTRRA, providing for catch-up contributions for individuals age 50 or over.

    2. Section 401(k)(2)(B)(i)(I) of the Code was amended by section 646 of EGTRRA to replace "separation from service" with " severance from employment," thereby eliminating the so-called "same desk" rule. Section 646 of EGTRRA also amended section 401(k)(10) of the Code to remove certain corporate dispositions from the list of distributable events for elective deferrals, since such dispositions are now covered under a "severance from employment."

    3. Section 401(m)(9) of the Code was amended by section 666 of EGTRRA to eliminate the multiple use test.

    4. Section 636 of EGTRRA directed the Secretary of the Treasury to modify the rules on deemed hardships to reduce the suspension period after such a hardship distribution from 12 months to 6 months.

    5. Section 402(g) of the Code was amended by section 611(d) of EGTRRA to increase the maximum limit for elective deferrals and to change the method for determining COLAs.

    6. Section 401(k)(11) of the Code was amended by section 611(f) of EGTRRA to refer to section 408(p) of the Code for the maximum amount of elective deferrals that can be made under a SIMPLE 401(k) plan.

    7. Section 411(a)(2) (obsoleted by section 904(a) of PPA) was added to the Code by section 633 of EGTRRA, requiring faster vesting for matching contributions: either 3-year cliff or 6-year graded.

    8. Section 416(c)(2)(A) was amended by section 613(b) of EGTRRA to provided that matching contributions are taken into account for purposes of satisfying the top heavy minimum contribution requirement.

    9. Section 416(g)(4)(H) was added to the Code by section 613(d) of EGTRRA, exempting certain safe harbor 401(k) plans from the top heavy rules.

  3. Effective in 2006:

    1. Section 402A was added to the Code by section 617 of EGTRRA, providing for designated Roth contributions.

    2. Section 826 of PPA directed the Secretary of the Treasury to modify the 401(k) deemed hardship rules to include a hardship of the participant’s beneficiary in circumstances where a participant’s spouse or dependent would qualify.

    3. Section 401(k)(3)(G) of the Code was amended by section 861(a)(2) of PPA to provide that all governmental plans (within the meaning of section 414(d) of the Code) are treated as meeting the participation and nondiscrimination requirements of section 401(k)(3) of the Code. Prior to this change, only state and local government plans were so treated.

  4. Effective in 2007

    1. Section 411(a) of the Code was amended by section 904 of PPA , requiring faster vesting of employer nonelective contributions to defined contribution plans: either 3-year cliff or 6-year graded.

  5. Effective in 2008:

    1. Sections 401(k)(13) and 401(m)(12) were added to the Code by section 902(a) and (b) of PPA, permitting qualified automatic contribution arrangements (QACAs) as alternative means of satisfying the ADP and ACP tests.

    2. Section 414(w) of the Code was added by section 902(d) of PPA, providing for eligible automatic contribution arrangements (EACAs). Section 902(d) also amended sections 401(k)(8)(E) and 411(a)(3)(G) of the Code to allow the forfeiture of matching contributions associated with permissible withdrawals under section 414(w).

    3. Sections 401(k)(8)(A)(i) and 401(m)(6)(A) of the Code were amended by section 902(e)(3)(B) of PPA to provide that a corrective distribution of excess contributions and excess aggregate contributions cannot include earnings from the end of the year in which the excess arose to the date of distribution ("gap-period earnings" ). Section 902(e)(3)(A) made a coordinating change to section 4979(f)(1) of the Code.

    4. Section 402(g)(2)(A)(ii) was amended by section 109(b)(3) of WRERA to provide that a corrective distribution of excess deferrals may not include gap-period earnings. (See above.)

    5. Section 401(k)(2)(B)(i) of the Code was amended by section 827(b) of PPA to provide that elective deferrals may be distributed as a " qualified reservist distribution" defined in section 72(t)(2)(G) of the Code, effective for distributions after September 11, 2001. Section 107(a) of the HEART Act extends the applicability of the qualified reservist distribution to individuals ordered or called to active duty after December 31, 2007.

    6. Section 4979(f)(2) of the Code was amended by section 902(e)(2) of PPA to provide that a distribution of excess contributions or excess aggregate contributions, plus attributable earnings on each, is includible in the recipient’s gross income in the year distributed.

  6. Effective in 2010

    1. Section 414(x) was added to the Code by section 903(a) of PPA, providing for "eligible combined plans." An eligible combined plan, sometimes referred to as a "DB-K plan." or similar name, is a plan consisting of a defined benefit plan that meets certain specified benefit and vesting requirements and a CODA that meets certain specified contribution, vesting, nondiscrimination and notice requirements.

  7. In addition to the statutory changes, the Service released the following guidance on section 401(k) plans in the last few years:

    1. Rev. Rul. 2004-13, 2004-1 C.B. 485, provides guidance under section 416(g)(4)(H) on whether certain safe harbor 401(k) plans are subject to the top heavy rules.

    2. Final Regulations under sections 401(k) and 401(m) were published on December 29, 2004, 69 FR 78144, setting forth the Comprehensive requirements (including the nondiscrimination requirements) for section 401(k) and 401(m) plans.

    3. Final Regulations under sections 401(k) and 401(m) were published on January 3, 2006, 71 FR 6, providing guidance on designated Roth contributions for plan qualification purposes.

    4. Final Regulations under sections 401(k), 402(g) 402A and 408A were published on April 30, 2007, 72 FR 21103, addressing designated Roth contributions.

    5. Final Regulations under section 410(b) were published on July 21, 2006, 71 FR 41357, permitting the exclusion of certain employees of a tax-exempt organization described in section 501(c)(3) for purposes of determining whether a section 401(k) plan (or a section 401(m) plan) meets the requirements for minimum coverage specified in section 410(b).

    6. Final Regulations under section 415 published on April 5, 2007, 72 FR 16878, included the addition of paragraph (e)(8) to section 1.401(k)-1 of the Regulations, requiring deferral elections to be made only from compensation within the meaning of section 415(c)(3) of the Code and section 1.415(c)-2 of the Regulations.

    7. 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). (See below.)

    8. Notice 2007-7, Part III, 2007-1 C.B. 395, provides guidance under PPA section 826 relating to distributions from a section 401(k) plan on account of the hardship of a participant’s beneficiary.

    9. Final regulations on QACAs and EACAs were published on February 24, 2009, 74 FR 8200.

    10. Proposed regulations under sections 401(k) and 401(m) were published on May 18, 2009, 74 FR 23134, permitting the suspension of safe harbor nonelective contributions under certain circumstances in a safe harbor 401(k) plan (section 401(k)(12)) or a QACA (section 401(k)(13)).

    11. 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.

    12. Rev. Rul. 2009-31. 2009-39 I.R.B. 395, and Rev. Rul. 2009-32, 2009-39 I.R.B. 398, provide guidance on contributing the dollar equivalent of any unused paid time off to a profit-sharing plan on either an annual basis or upon termination of employment.

    13. 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.

4.72.2.3  (06-07-2010)
Eligible Employer and Plan

  1. Any employer, other than a State or local government, can establish a CODA and a State or local government that had a CODA on May 6, 1986, can continue it and even establish new ones. (See the Field Directive on grandfathered CODAs, issued on March 12, 1992.) A tax-exempt organization, other than a rural co-op, could not establish a CODA during the period between May 6, 1986, and January 1, 1997. (See section 1116 of the Tax Reform Act of 1986.) Indian tribal governments and related entities can also establish a CODA (see section 401(k)(4)(B)(iii)). Thus, sole proprietors, partnerships, corporations, and agencies of the Federal government are all eligible to establish CODAs.

  2. In addition to meeting the requirements in (1) above, an employer intending to establish a SIMPLE 401(k) plan as described in section 401(k)(11) must be an "eligible employe," as described in section 408(p)(2)(C)(i) of the Code, i.e., the employer must have had no more than 100 employees who received $5,000 or more in compensation from the employer for the preceding calendar year.

  3. A CODA must be part of a profit-sharing plan, a stock bonus plan, a pre-ERISA money purchase plan, or a rural cooperative plan. See section 401(k)(1), (2), (6) and (7). Since a CODA is part of a qualified plan, the failure of the CODA to satisfy section 401(k) will not always result in the failure of the plan to satisfy section 401(a). For example, a CODA in a profit-sharing plan does not automatically disqualify the plan merely because the CODA failed the ADP test, although, in such case, the plan will most likely have failed to follow its terms, providing alternative grounds for disqualification. On the other hand, a CODA that is part of a defined benefit plan would disqualify the entire plan because such plans are not permitted to contain CODAs. Note that under new Code section 414(x), an "eligible combined plan" is a combination of a defined benefit plan that meets certain specified benefit and vesting requirements and a separate defined contribution plan containing a CODA that meets certain specified contribution, vesting, nondiscrimination and notice requirements.

  4. Sometimes the term "section 401(k) plan" is used to denote a plan that properly contains a CODA and that may or may not provide for one or more types of other contributions, such as employee (after-tax) contributions, and employer matching and nonelective contributions. However, under the regulations, a "section 401(k) plan" is the portion of a plan consisting only of elective contributions, and a " CODA" is the portion of a plan consisting of elective contributions plus QNECs and QMACs that are treated as elective contributions. Automatic contribution arrangements under section 401(k)(13) will be deemed as elective contributions effective for plan years beginning on or after January 1, 2008

4.72.2.4  (06-07-2010)
Common Abbreviations

  1. For brevity, this text uses some common abbreviations for frequently used terms. Such terms are briefly defined in this IRM 4.72.2.4, but will be discussed in greater detail in the relevant parts of this section 2 and IRM 4.72.3 (Employee Contributions and Matching Contributions).

  2. "ECs," or "elective contributions, " are the contributions made to a plan pursuant to an employee’s CODA election. These contributions are included in the definition of elective deferrals under section 402(g) and are treated as employer contributions for most purposes under the Code, including sections 401(a), 401(k), 402, 404, 409, 411, 412, 415, 416, and 417. However, ECs are counted as part of the employee’s wages for FICA withholding, FUTA, and Railroad Retirement tax, and are treated as plan assets for purposes of Title I of ERISA under the Department of Labor’s rules.

  3. "ADR," or "actual deferral ratio," is an employee’s ECs (and amounts treated as ECs) for a plan year divided by the employee’s compensation for the plan year.

  4. "ADP," or "actual deferral percentage, " is the average of the ADRs for the relevant group of employees. It is used in discussions about the ADP test, an anti-discrimination test contained in section 401(k)(3)(A)(ii).

  5. "ACR," or "actual contribution ratio, " is the sum of an employee’s employee contributions and matching contributions (and amounts treated as matching contributions) for a plan year divided by the employee’s compensation for the plan year.

  6. "ACP," or "actual contribution percentage, " is the average of the ACRs for the relevant group of employees. It is used in discussions about the ACP test, an anti-discrimination test contained in section 401(m)(2)(A).

  7. "QNECs" (sometimes "QNCs" ), or "qualified nonelective contributions," are special employer contributions that are not subject to a CODA election. They are always fully vested and are subject to certain distribution restrictions. They may be treated as ECs or matching contributions in the ADP test or ACP test, respectively.

  8. "QMACs," or "qualified matching contributions, " are employer matching contributions that are always fully vested and are subject to certain distribution restrictions. They are counted in the ACP test unless they are treated as ECs, in which case they are counted in the ADP test.

  9. "ACA," or "automatic contribution arrangement," is an arrangement within a CODA under which, in the absence of an affirmative election by a covered employee, a certain percentage of compensation will be withheld from the employee’s compensation and contributed to the plan as an elective contribution.

  10. "QACA," or "qualified automatic contribution arrangement," is a type of ACAs described in section 401(k)(13). A QACA has certain minimum contribution requirements and is not subject to the ADP test, nor to the ACP test if additional requirements in section 401(m)(12) are satisfied.

  11. "EACA," or "eligible automatic contribution arrangement," is a type of ACAs described in section 414(w). An EACA may permit covered employees to withdraw amounts contributed under a default election. However, the EACAs alone do not automatically satisfy the nondiscrimination requirements under section 401(k)(3) of the Code.

  12. A "safe harbor 401(k) plan," as used in this section 2, means a plan that meets the requirements under section 401(k)(12) and, depending on the context in which used, section 401(m)(11).

4.72.2.5  (06-07-2010)
CODA Defined

  1. A CODA is an arrangement under which an eligible employee may make a cash or deferred election with respect to contributions to, or accruals or other benefits under a section 401(a) plan. It does not include an arrangement under which amounts contributed at an employee's election are treated at the time of contribution as after-tax employee contributions. A designated Roth contribution is not treated as an after-tax employee contribution for purposes of the CODA rules. A CODA does not include an arrangement under an ESOP under which dividends are either distributed or invested pursuant to an election made by participants or their beneficiaries in accordance with section 404(k)(2)(A)(iii).

  2. Any plan which allows a participant an election between receiving cash (or some other taxable benefit) and having an amount contributed on his or her behalf to a plan has a CODA. As noted above, only certain plans may contain CODAs and only certain employers may maintain plans with CODAs. If the employee is not permitted to receive cash as one of the choices, then the CODA does not satisfy section 401(k).

4.72.2.5.1  (06-07-2010)
Cash or Deferred Election

  1. A cash or deferred election is any direct or indirect election (or modification of a previous election) by an employee to have the employer either:

    1. provide an amount to the employee in the form of cash or some other taxable benefit that is not currently available to the employee at the time of the election, or

    2. contribute an amount to a trust, or provide an accrual or other benefit, under a plan deferring the receipt of compensation.

  2. Cash or another taxable benefit is currently available to an employee if it has been paid to the employee or if the employee is able currently to receive the cash or other taxable benefit at the employee's discretion. An amount is not currently available to an employee if there is a significant limitation or restriction on the employee's right to receive the amount currently. Similarly, an amount is not currently available as of a date if the employee may under no circumstances receive the amount before a particular time in the future. The determination of whether an amount is currently available to an employee does not depend on whether it has been constructively received by the employee for purposes of section 451. Also, an election can only be made with respect to amounts that would become currently available after the later of the date the CODA is adopted or the date it first becomes effective.

  3. Usually the election is in the form of a salary reduction agreement, where an eligible employee agrees to reduce his or her cash compensation, or forgo an increase in cash compensation, in exchange for the employer making a plan contribution in an amount equal to the reduction. However, the election may also be made under an ACA. Under these so-called "automatic enrollment" plans, employees must be given a reasonable opportunity to elect to have a different amount or no amount at all contributed under the arrangement. For purposes of determining whether an election is a cash or deferred election, it is irrelevant whether the default that applies in the absence of an affirmative election is the receipt of cash by the employee or an elective contribution made to the plan on the employee’s behalf.

4.72.2.5.2  (06-07-2010)
Certain One-Time Elections

  1. A cash or deferred election does not include a one-time irrevocable election upon an employee’s commencement of employment with the employer, or upon the employee’s first becoming eligible under any plan of the employer, to have or not to have a specified amount contributed to the plan and to any other plan of the employer (including plans not yet established) for the duration of the employee’s employment with the employer. Thus, if these were the only elections available under a plan, such plan would not be considered to contain a CODA, and contributions made to a plan pursuant to such an election would not be considered to be elective contributions.

  2. Once an employee has participated in any plan of the employer, he or she cannot make this one-time election. In addition, a change in status, such as from associate to partner, or union employee to manager, does not give rise to a new one-time election.

  3. A plan giving this one-time irrevocable election is subject to the regular, non-CODA nondiscrimination rules. Thus, such one-time election must be offered to a nondiscriminatory group, and the plan as a whole must satisfy the regular nondiscrimination rules.

4.72.2.5.3  (06-07-2010)
CODAs of Self-Employed Individuals

  1. Under the partnership taxation rules, a contribution made on behalf of a partner to a plan of a partnership is allocated to that partner and deducted on his or her income tax return. The remaining portion of the partner’s distributive share of partnership income is payable directly to the partner. Thus, if a partner can individually choose to vary the plan contribution made on his or her behalf, this is a cash or deferred election. Rev. Proc. 91-47, 1991-2 C.B.757, provided limited relief for partnership plans that allowed partners to individually vary their plan contributions. The plan had to be amended by the end of 1992 to become either a qualified CODA or a plan without variable contributions.

  2. Also due to the nature of the partnership taxation rules, and the definition of elective contributions, in a partnership CODA, matching contributions made to partners fall within the definition of elective contributions, because, by varying a partner's elective contributions, any match on such elective contributions would reduce the partner's compensation. (It is a cash or deferred election because a partner can choose, indirectly, to have an amount contributed to the plan -- in this case matching contributions -- or receive the amount in cash simply by varying the amount of his or her elective contributions.) The same principles apply in the case of a CODA maintained by a sole proprietor. This was changed for plan years beginning after December 31, 1997, when section 1501 of Taxpayer Relief Act of 1997, Pub. L. 105-34, added section 402(g)(9) (now section 402(g)(8)) to provide that matching contributions of self-employed individuals, including partners, are not treated as elective contributions.

  3. The regulations under section 401(k) provide that for purposes of a cash or deferred election a partner's compensation is deemed currently available on the last day of the partnership taxable year and a sole proprietor’s compensation is deemed currently available on the last day of the individual’s taxable year. Thus, a partner can make a cash or deferred election with respect to a year's compensation any time before (but not after) the last day of the year, even though the partner takes "draws" against his or her expected share of partnership income throughout the year. See section 1.401(k)-1(a)(6) of the Regulations.

4.72.2.5.4  (06-07-2010)
Qualified CODAs

  1. As already mentioned, this section of the IRM assumes a qualified CODA is intended. To be a qualified CODA, the arrangement must satisfy the requirements specified in IRC section 401(k). These are:

    1. The CODA must be part of an eligible plan maintained by an eligible employer.

    2. The employee’s election must be between cash (rather than some other taxable benefit) and deferral.

    3. Elective contributions are not distributable prior to certain events.

    4. Elective contributions are nonforfeitable at all times.

    5. The CODA satisfies the participation requirements of section 410(b)(1).

    6. The CODA satisfies either the ADP test set forth in section 401(k)(3) or one of the design-based alternatives in section 401(k)(11), (12), or (13).

    7. Benefits, other than matching contributions, must not be contingent on an employee’s choosing or not choosing to have elective contributions made to the plan.

    8. No more than 1 year of service is required for eligibility to elect to make a cash or deferred arrangement.

  2. A governmental plan within the meaning of section 414(d) is treated as meeting requirements e and f, above.

4.72.2.5.5  (06-07-2010)
Nonqualified CODAs

  1. A nonqualified CODA is one that fails to meet one or more of the requirements listed above in IRM 4.72.2.5.4. The elective contributions in a nonqualified CODA are included in an employee’s gross income at the time the amount would have been (but for the cash or deferred election) included in the employee’s gross income.

  2. If the CODA is nonqualified because it is part of an ineligible plan, then the entire plan is not qualified. However, if the nonqualified CODA is part of a plan that is permitted to include a CODA (e.g., a profit-sharing plan), then it's possible, although unlikely, the entire plan may still satisfy section 401(a). In such case, the elective contributions are treated and tested as employer nonelective contributions. In determining whether the plan satisfies the nondiscrimination requirements of section 401(a)(4), the ADP and ACP tests may not be used.

  3. The amount of nonelective employer contributions under a nonqualified CODA is treated as satisfying section 401(a)(4) if the arrangement is part of a collectively bargained plan that automatically satisfies the requirements of section 410(b). Additionally, the requirements of sections 401(a)(4) and 410(b) do not apply to a governmental plan within the meaning of section 414(d).

  4. A CODA that is intended to satisfy section 401(k) but for some reason fails and becomes a nonqualified CODA will invariably violate the terms of the plan document and so cause the entire plan to be nonqualified.

4.72.2.5.6  (06-07-2010)
Examination Steps

  1. Review corporate documents or other enabling instruments to verify that the CODA was adopted and effective prior to any deferral elections taking effect.

  2. Determine whether the plan allows participants the right to elect to have contributions made to the plan in lieu of cash or some other taxable benefit. Also determine whether there is a pattern of allowing employees (including partners in a partnership plan) to elect, on a regular basis, into and out of plan participation in return for changes in compensation. This is a cash or deferred election unless it fits the one-time irrevocable election exception.

  3. Review W-2s and payroll records to verify that contributions are not designated or treated as after-tax employee contributions.

  4. If a CODA exists, determine whether the plan is eligible to include a CODA (e.g., a profit-sharing plan). If the plan is not eligible to include a CODA, the entire plan is not qualified.

  5. If the plan may have a CODA, determine whether the CODA is qualified or non-qualified. If non-qualified:

    1. Check whether the ECs were reported as wages in the year withheld from compensation. Use IDRS search if necessary.

    2. Check whether the plan satisfied the regular coverage and nondiscrimination rules of sections 410(b) and 401(a)(4), rather than the special section 401(k) coverage nondiscrimination rules, counting the ECs as employer contributions.

4.72.2.6  (06-07-2010)
Coverage and Participation

  1. The CODA portion of the plan, by itself, must satisfy one of the coverage tests under section 410(b), either the ratio percentage test or the average benefits test. To satisfy the ratio percentage test, a CODA may be aggregated with another CODA if it has the same plan year, uses the same testing method (prior year or current year) and may be permissively aggregated under the section 410(b) regulations, but may not be aggregated with any non-CODA.

  2. In a CODA, each employee who is eligible to make an EC (an " eligible employee" ) is treated as "benefiting," (i.e., covered), regardless of whether the employee elects to have deferrals made to the plan. The term "eligible employee" also includes certain employees who are temporarily prohibited under the plan from making deferrals, such as a suspension following a hardship distribution. See the discussion later under "ADP Test."

  3. Section 1.401(a)(4)–11(g)(3) of the Regulations provides that section 401(k) and section 401(m) plans may be retroactively amended to extend eligibility to employees for coverage purposes within 101⁄2 months after the plan year in order to be taken into account for the preceding plan year. Under this regulation, if a CODA needs to add some nonhighly compensated employees (NHCEs) to satisfy section 410(b), the employer must make a QNEC contribution to each of the added employees equal to the average of the ADRs of NHCEs who were eligible. This retroactive correction feature cannot be used to correct other defects, such as a failure to satisfy the ADP test.

  4. Section 401(k)(2)(D) of the Code provides that a CODA may not have a minimum service requirement for participation that is greater than 1 year. The general rules under section 410(b) (up to 2 years if immediate vesting) apply for other contributions, such as matching contributions or QNECs.

  5. Employees covered by a collective bargaining agreement must be disaggregated from employees not covered by a collective bargaining agreement for purposes of the ADP test. Separate collective bargaining units within the same plan may be disaggregated, but are not required to be, for purposes of the ADP test. The combination of bargaining units used for testing must be reasonable and reasonably consistent from year to year. Equivalent rules apply to multiemployer plans.

  6. The rules in section 1.410(b)-7(c) of the Regulations relating to the mandatory disaggregation of ESOP and non-ESOP portions of a plan do not apply to CODAs. Thus, notwithstanding the rule in section 1.410(b)-7(d)(2) (prohibiting permissive aggregation of plans or portions of plans that are mandatorily disaggregated), an ESOP and a non-ESOP are permitted to aggregated in applying the CODA rules, even if the ESOP and non-ESOP are in different plans of the employer.

4.72.2.6.1  (06-07-2010)
Examples

  1. The plan document contains language stating that only employees of division A are eligible for participation in the section 401(k) plan. The only other division of the employer is division B. The employees of these two divisions make up the total number of employees of the employer's workforce. Division A employs a total of 80 employees, 5 are highly compensated employees (HCEs) and 75 are NHCEs. All employees of division A have satisfied the participation requirements for the section 401(k) plan. Division B employs 25 employees and all are NHCEs. The plan benefits at least 70% of employees who are NHCEs (75/75+25 or 75/100=75%); therefore, the plan passes coverage without having to use the average benefits test.

  2. Employer A maintains a plan which allows for elective contributions, matching contributions and employer discretionary profit-sharing contributions. Under the terms of the plan, all employees are eligible to make elective contributions and to receive matching contributions. The employer makes a matching contribution on behalf of all employees making elective contributions. In addition, the employer made a discretionary profit-sharing contribution equal to 5% of each employee’s compensation. Under the disaggregation rules, each portion of the plan must be separately tested for coverage. In this case, the 401(k) portion satisfies coverage as 100% of all employees are benefiting. The 401(m) portion satisfies coverage as 100% of all employees are benefiting. The profit sharing portion satisfies the coverage rule as 100% of all employees are benefiting. All portions of the plan must satisfy coverage separately.

4.72.2.6.2  (06-07-2010)
Examination Steps

  1. Inspect the plan document and review the sections concerning eligibility. An employer can have separate eligibility requirements for ECs, matching contributions and discretionary contributions. Thus, review plan sections that define eligible employees and that specify age and service requirements and entry dates. A CODA cannot require that an employee complete more than 1 year of service in order to be eligible to make ECs.

  2. When testing the plan for coverage, the following records should be reviewed to determine proper inclusion or exclusion of employees. The records for any related entities should be included in the review if the entity is a member of a controlled group or part of an affiliated service group.

    1. Inspect the Form 5500 series return and extract the total number of employees of the employer, employees excluded and employees benefiting. Compare these numbers with the numbers from the employer’s payroll records to determine if all employees have been accounted for on the return.

    2. Inspect employer payroll records to extract the total employees, birth dates, hire dates, hours worked, union status and other pertinent information.

    3. Inspect Form(s) W-2 and State Unemployment Tax Returns (compare the employees on these records with the employer’s payroll records) to ensure all employees of the employer are counted for the coverage test.

    4. Inspect participant election forms to verify the names of eligible employees who have elected not to have ECs made to the plan. These employees are considered as eligible employees with a zero percentage in the ADP calculations (and in the ACP calculations if no after-tax employee contributions are made). These employees also must be included for purposes of receiving an allocation of other, non-EC, employer contributions if they are otherwise eligible.

    5. Inspect payroll records and extract the names of those employees who terminated employment during the year. Many plans will require an employee to be employed on the last day of the plan year in order to receive an allocation of an employer discretionary contribution. Any terminated employee with 500 or more hours of service must be included in the coverage test. Many small plans have a last-day requirement in their plans and can easily fail coverage because of it.

    6. Inspect Schedule E, Compensation of Officers, of Form 1120 to gather names of officers and ownership percentages to help identify related entities.

    7. Inspect any Form 851, Affiliations Schedule, attached to the Corporate Income Tax return to determine if there are any related entities.

    8. Inspect a self-employed individual's Form 1040 income tax return to determine whether there are any other entities operated and owned by the self-employed individual. Separate Schedule Cs, Profit or Loss from Business, should be filed for each business.

    9. Inspect the plan document to determine whether the plan covers leased employees. If the employer has leased employees the plan may state that these employees are excluded, however, certain rules apply under section 414(n) that may require the employer to include these leased employees for purposes of certain code sections, such as coverage and discrimination. Obtain contracts of the employer with any leasing organization and information/records for pension benefits received by the leased employee under the leasing organization’s retirement plans.

  3. Ensure the plan passes either the ratio percentage test or the average benefits test under section 410(b). For purposes of the coverage test all employees of the employer must be considered, including all employees of entities that are part of a controlled group of corporations or affiliated service group that includes the employer. (See section 1563(a) of the Code and the regulations thereunder for rules on aggregation of stock ownership for controlled group rules. See section 414(m) of the Code and the regulations thereunder for rules pertaining to affiliated service groups.) There are three common forms of controlled groups: parent-subsidiary, brother-sister and combined groups.

  4. ) Ensure the plan includes leased employees if defined as eligible under the terms of the plan. Ensure that the plan passes coverage when leased employees are required to be included in the coverage test. Generally, the employer will have to include a leased employee in the test when the leased employee is performing services on a substantially full-time basis and when the total number of leased employees constitutes more than 20% of the NHCEs workforce of the employer. In these instances, these employees must be considered for the code sections noted under section 414(n). However, an employer may include the benefits that the leased employee received from the leasing organization as being provided by the employer when testing for coverage.

4.72.2.7  (06-07-2010)
Contribution Limitation

  1. Section 402(g)(1) of the Code sets forth the maximum dollar amount of elective deferrals (other than catch-up contributions) that can be made for an employee’s taxable year: See following table:

    For Taxable Years Beginning in Calendar Year Maximum Amount
    2002 $11,000
    2003 $12,000
    2004 $13,000
    2006 $14,000
    2006 or thereafter $15,000

    For taxable years beginning after December 31, 2006, the $15,000 amount above is increased in $500 increments for any cost-of-living increases. However, the increase from 2008 to 2009 was $1,000. Annual cost-of-living updates can be found at EP website . See also IRM 4.72.2.20.

  2. Section 402(g) provides that elective deferrals in excess of the maximum amount for a year are included in the employee's gross income for the year and are included in gross income again when distributed from the plan. Deferrals in excess of the 402(g) limit are called "excess deferrals. " To avoid double income inclusion of excess deferrals, an employee may inform an employer of the amount of excess deferrals in that employer's plan and request the return of them together with attributable earnings. (See section 1.402(g)-1 of the Regulations.) If returned by April 15 following the year of the excess, such deferrals will not be included in gross income when distributed. The employer is not required to honor such a request, although most plans do provide for such distributions. However, if the excess deferrals arose under plans of one employer, the employee cannot refuse a distribution. (See (5) and (6) below.) If excess deferrals are not distributed and are not disqualifying (i.e., they are made to plans of unrelated employers) they must remain in the plan until there is a permitted distributable event.

  3. Section 402(g) is applied to each employee, rather than to a plan, and for the employee’s taxable year, which is nearly always the calendar year. Thus, it’s possible that an employee can have deferrals to a plan equal to two times the 402(g) limit if the plan year is not the calendar year, although most are.

  4. Section 402(g)(1)(C) provides that the maximum amount of elective deferrals is increased by the amount of catch-up contributions permitted under section 414(v). Catch-up contributions are available to participants age 50 or older. See IRM 4.72.2.11 for a discussion of catch-up contributions.

  5. Section 401(a)(30) provides that an employer's plan cannot accept elective contributions ("elective deferrals") from an employee in excess of the 402(g) limit, counting only plans of that employer. Thus, if an employee defers more than the 402(g) limit, in the aggregate, spread among one or more plans maintained by the employer group, such plans are not qualified. For example, if an employee works for Company Y from January to June and then transfers to related Company Z for the next 6 months, his deferrals into Company Y's plan and into Company Z's plan for the calendar year are aggregated to determine whether the 402(g) limit has been exceeded. The plans will fail qualification requirements if they accept excess deferrals and fail to correct the problem. This limit must be stated in the plan.

  6. To avoid failing section 401(a)(30), a plan must distribute excess deferrals and related earnings by April 15 following the year of the excess. In such case, affected employees are deemed to have requested a distribution and no employee or spousal consent required.

  7. Excess deferrals that are timely distributed are still treated as employer contributions for most purposes of the Code, including the ADP test, but not section 415. However, excess deferrals of NHCEs that are timely distributed are not counted in the ADP test if they are prohibited by section 401(a)(30). See section 1.402(g)-1(e)(1)(ii) of the Regulations.

  8. If an excess deferral is distributed before April 15, the distributing plan counts that distribution as an offset against any distribution of excess contributions that must be made to that employee to correct the ADP test.

  9. The 402(g) limit only applies to elective deferrals (i.e., elective contributions, in a section 401(k) plan); it does not affect other contributions that may be included in the ADP test. The amount of the 402(g) limit may be incorporated by reference.

4.72.2.7.1  (06-07-2010)
Example

  1. Employer A maintains a section 401(k) plan that allows participants to elect to defer up to a maximum of 15% of their compensation for the plan year, which is a calendar year. For calendar year 2009, Participant B elects to defer 15% of her compensation for the year. Participant B, a HCE, age 40, received compensation during the year of $ 140,000. The total elective contributions made on behalf of Participant B for calendar year 2009 was $ 21,000. The section 402(g) limit for a person under age 50 for 2009 is $ 16,500; therefore, Participant B has an excess deferral in the amount of $ 4,500. Accordingly, the employer must distribute the excess, plus attributable earnings, by April 15, 2010, in order for the plan to remain qualified.

  2. ) If, in the example above, Participant B was age 51 in 2009 and the plan permitted catch-up contributions, there would be no excess deferrals made on behalf of Participant B because the total elective deferral limit for 2009, including catch-ups, is $22,000 ($16,500 + $5,500).

4.72.2.7.2  (06-07-2010)
Examination Steps

  1. Inspect the plan document to determine the maximum elective contributions that an employee can defer under the terms of the plan.

  2. When testing for compliance with section 402(g) limit in effect for the year, the following actions and inspection of records should be taken to ensure compliance.

    1. Inspect Form W-2’s for purposes of testing the plan for compliance with the section 402(g) limit. The 402(g) limit is measured on the individual’s tax year (normally the calendar year) rather than the plan year.

    2. Compare Form W-2 (Box #12 — coded "D" for elective deferrals or "AA" for designated Roth contributions) with payroll records and account statements for reconciliation and accuracy of the deferred amounts reported.

    3. Inspect all Form W-2s of each entity of a controlled group in order to ensure the limit has not been exceeded if an employee participates in more than one section 401(k) plan of the controlled group during the year. Section 402(g) follows the individual and all deferrals must be aggregated to ensure compliance with sections 402(g) and 401(a)(30). It is not unusual for an employee in a mid-size or a large company to split time between the different companies that comprise a controlled group of corporations and that may have separate 401(k) plans. In these instances, the individual cannot defer more than the 402(g) limit to the employer’s plans, therefore, the deferrals must be aggregated to determine whether the limit has been exceeded. Conduct an interview with your contact person to determine whether employees work for more than one company in the controlled group.

    4. If a larger employer gives you payroll data on electronic media you may need to solicit the help of a Computer Audit Specialist (CAS). Usually the CAS can assist you in downloading the data to an Excel spreadsheet or Access Database. The CAS can also help in conducting the testing or queries for different limitations such as section 402(g).

    5. After testing the section 401(k) plan for IRC sections 402(g) and 401(a)(30), it is important to ensure that any excesses were properly and timely corrected by April 15th of the following year. Inspect Form 1099-Rs for distributions made to correct, and inspect cancelled checks to determine when the distribution was actually made.

4.72.2.8  (06-07-2010)
Restricted Distributions

  1. Section 401(k)(2)(B) of the Code provides that elective contributions may only be distributed on death, disability, severance from employment, an event described in section 401(k)(10) (plan termination) or as a qualified reservist distribution described in section 72(t)(2)(G). Contributions made to a CODA that is part of a profit-sharing or stock bonus plan may be distributed upon attainment of age 59 1/2. Distribution of any contribution that could be used in the ADP test (i.e., QNECs or QMACs) must be similarly restricted. Elective contributions (and grandfathered earnings, QNECs, QMACs and earnings on such QNECs and QMACs) to a profit-sharing, stock bonus or rural cooperative plan may also be distributed on account of hardship. Since the "grandfather " date referred to in the preceding sentence was, in most cases, in 1988 or 1989, most plans will only have elective contributions available for hardship distribution.

  2. There is only one event now described in section 401(k)(10) and that is termination of the plan without the establishment or maintenance of another defined contribution plan other than an ESOP. (See below.)

  3. An employee has a severance from employment when the employee ceases to be an employee of the employer maintaining the plan. An employee does not have a severance from employment if the new employer continues the plan of the prior employer or accepts a transfer of plan assets or liabilities (within the meaning of section 414(l)) with respect to the employee.

  4. Distributions may also be made pursuant to legislation enacted in response to natural disasters, in the amounts and during the periods specified in such legislation. See section 1400Q of the Code.

4.72.2.8.1  (06-07-2010)
Plan Termination

  1. Section 401(k)(10)(A) of the Code provides that a section 401(k) plan can make a distribution to employees if the plan is being terminated and the employer does not maintain or establish another defined contribution plan (other than an ESOP) at any time beginning on the date of termination and ending 12 months after all assets have been distributed from the terminating plan. Such distribution must be in a lump sum. A termination distribution can be made even if the employer maintains or establishes a SEP, a SIMPLE IRA plan, a 403(b) plan or a plan described in section 457(b) or (f).

  2. Thus, generally, if any employer who is in the employer group at the effective date of the termination has a defined contribution plan (other than one listed above), the 401(k) plan assets must be transferred to that plan rather than distributed to the employees. However, distributions can be made if less than 2% of the employees of the terminating plan have been eligible or will become eligible for the other plan in the 24-month period that begins 12 months before the date of termination.

  3. In plans subject to the joint and survivor annuity rules, the lump-sum distribution requirement can be satisfied by the distribution of an immediate annuity that satisfies the qualified joint and survivor annuity requirements set forth in sections 401(a)(11) and 417 of the Code.

4.72.2.8.2  (06-07-2010)
Hardship Distribution

  1. A profit-sharing, stock bonus or rural cooperative plan may provide that elective contributions are available for distribution on account of hardship. A distribution on account of hardship must be limited to the maximum distributable amount. The maximum distributable amount is equal to the employee's total elective contributions as of the date of distribution, reduced by the amount of previous distributions of elective contributions. Thus, the maximum distributable amount does not include earnings, QNECs or QMACs, unless grandfathered. The regulations permit a plan to provide a grandfather rule for earnings, QNECs and QMACs accrued prior to December 31, 1988 (or, if later, the end of the last plan year ending before July 1, 1989). This is done by determining an employee's elective contributions, QNECs and QMACs on the applicable date and using this as a frozen amount. Losses after that date do not reduce this amount.

  2. Note that other employer contributions, outside the CODA, are not subject to these restrictive hardship rules. Thus, a profit-sharing plan could have one set of rules for hardship distributions from the CODA and another, less restrictive, set of rules for other non-CODA contributions. Although most do, a CODA is not required to provide for hardship distributions at all.

  3. To make a hardship distribution the plan must determine if:

    1. an employee has an immediate and heavy financial need, and

    2. a distribution from the plan, of the specified amount, is necessary to satisfy the financial need.

  4. The determinations in a. and b. above can be made using either general hardship distribution standards or deemed hardship distribution standards, both as described in the 401(k) regulations. The majority of section 401(k) plans, including all M & P section 401(k) plans, use the deemed standards. The determinations must be made in accordance with nondiscriminatory and objective standards set forth in the plan.

  5. The amount necessary to satisfy an immediate and heavy financial need of the employee can be grossed up to cover any taxes or penalties that may result from the distribution.

  6. Under section 1.411(d)-4 of the Regulations, a section 401(k) plan may not have a "catch-all" hardship category (for example, "and other events which the plan administrator deems to be hardships. " ) because this would be impermissible employer discretion. The plan may be amended to add or eliminate a hardship category or to change the conditions for receiving a hardship distribution and this will not violate section 411(d)(6). Hardship categories (general or deemed) must be both currently and effectively available to a group of participants that satisfies section 1.401(a)(4)-4 of the Regulations.

4.72.2.8.2.1  (06-07-2010)
General Hardship Distribution Standards

  1. Under the general hardship distribution standards, the determination of whether an employee has an immediate and heavy financial need is based on all the relevant facts and circumstances. Generally, for example, funeral expenses of a family member would qualify, whereas the need for a television would not.

  2. Under the general hardship distribution standards, a distribution is not treated as necessary to satisfy an immediate and heavy financial need of the employee to the extent the need can be satisfied from other resources that are reasonably available to the employee. The plan must determine what other assets the employee has, such as vacation homes, insurance policies, availability of loans from the plan or a bank (at reasonable rates), etc.

  3. The employer is permitted to rely on an employee’s written statement that an amount is necessary (and cannot be satisfied by other means that are reasonably available to the employee), unless the employer has actual knowledge to the contrary.

  4. A loan from a commercial source can be ruled out unless the full amount can be reasonably obtained from such lender. A plan loan (if available) must be obtained to offset the need for a hardship distribution unless such loan would disqualify the employee from obtaining other funds necessary to alleviate the hardship.

4.72.2.8.2.2  (06-07-2010)
Deemed Hardship Distribution Standards

  1. Under the deemed hardship distribution standards, a distribution is deemed to be on account of an immediate and heavy financial need of the employee if it is for any of the following:

    1. Medical expenses (as the term is defined in section 213(d) but without regard to whether the expenses exceed 7.5% of AGI) incurred by the employee, spouse, dependant or principal beneficiary, to the extent not reimbursed by insurance. A distribution necessary to pay for procedures that have not yet occurred is permitted.

    2. Costs directly related to the purchase of a principal residence for the employee. (This does not include making mortgage payments.)

    3. Payment of tuition, related educational fees, and room and board expenses for up to the next 12 months of post-secondary education for the employee, spouse, children, dependent or principal beneficiary.

    4. Payments necessary to prevent the eviction from or foreclosure on the employee's principal residence.

    5. Payments for burial or funeral expenses for the employee’s deceased parent, spouse, children, dependents or principal beneficiary.

    6. Expenses for the repair of damage to the employee’s principal residence that would qualify for the casualty deduction under section 165 (determined without regard to whether the loss exceeds 10% of AGI).

  2. Under the deemed hardship distribution standards, a distribution is deemed necessary to satisfy an immediate and heavy financial need of the employee if all of the following occur:

    1. The distribution is not in excess of the amount needed.

    2. The employee has obtained all distributions and nontaxable loans currently available under all plans maintained by the employer.

    3. The employee is prohibited from making elective contributions and employee contributions to any plan of the employer for at least 6 months after receiving the distribution.

4.72.2.8.3  (06-07-2010)
Example

  1. Employer A maintains a section 401(k) plan that provides for hardship distributions under the deemed standards. The plan document contains language permitting participant loans. In 2009, Participant B submits an application requesting a hardship distribution of $20,000 in order to make a down payment on a principal residence. At the time of the hardship distribution request, Participant B had an account balance of $ 50,000 and he did not have any outstanding loans from the plan. The plan administrator approved the hardship distribution request and made a distribution of $20,000.

  2. The hardship distribution should not have been approved because Participant B could have received a nontaxable loan from the plan before any hardship distributions were made.

4.72.2.8.4  (06-07-2010)
Examination Steps

  1. Inspect the language in the plan document to determine when and under what circumstances distributions can be made.

  2. Inspect the language in the plan document to determine if hardship distributions are allowed and under what circumstances (general or deemed standards).

  3. Examine the plan document provisions pertaining to allowable distributions. If the plan provides for QNECs and QMACs, then these contributions are subject to the same restrictions as elective contributions, except that they generally cannot be distributed on account of hardship.

  4. When hardship distributions are made from the plan, compare the amount distributed with the total elective contributions made by the participant to the plan to ensure the distribution was not in excess of total elective contributions. Participant account statements should provide a separate breakdown of the elective contributions from other types of contributions.

  5. Request from the Plan Administrator copies of hardship application files. Inspect these files to determine the reason the distribution was made.

  6. If the plan uses the deemed hardship distribution standards, inspect the employee's individual account statement for the 6 months following the receipt of the hardship distribution. The employee must be prohibited from making elective contributions (and after-tax employee contributions) for 6 months following receipt of the hardship distribution.

  7. Inspect the plan document to determine whether loans are available. If the plan provides for loans, then all nontaxable loans should be made prior to making any hardship distributions.

  8. A distribution generally may be treated as necessary to satisfy a financial need if the employer relies upon the employee's written representation, unless the employer has actual knowledge that the need can be reasonably relieved through reimbursement from insurance, by liquidation of the employee's assets, by cessation of elective contributions, or by other distributions or nontaxable loans from plans maintained by the employer. Interviewing the plan administrator may be necessary to determine the facts and circumstances surrounding questionable distributions.

  9. Request copies of Form 1099-Rs for all distributions including hardship distributions. The hardship distribution amount may be increased for federal, state and local taxes.

4.72.2.9  (06-07-2010)
Nonforfeitability

  1. Under sections 401(k)(2)(C) and 401(k)(3)(D)(ii) of the Code, an employee's interest in elective contributions, QNECs, and QMACs must be nonforfeitable when made. Thus, an employer may not redesignate a particular contribution as a nonforfeitable contribution and call it a QNEC as needed to satisfy the ADP test for a year. Nor may forfeitures be used as QNECs or QMACs, since they would not have been nonforfeitable when made to the plan.

  2. However, an exception to this nonforfeitability rule is provided in sections 401(k)(8)(E) and 411(a)(3)(G), which allows a plan to forfeit a vested or non-vested matching contribution made on account of an elective contribution or employee contribution that is treated as an excess deferral under section 402(g)(2)(A), an excess contribution (amounts in excess of what is permitted under the ADP test), an excess aggregate contribution (amounts in excess of what is permitted under the ACP test), or a permissible withdrawal under section 414(w).

  3. Under section 1.401(a)(4)-4 of the Regulations, a matching contribution that is still in the plan and that was matched to an excess contribution (or an excess aggregate contribution) that has been distributed (sometimes called "orphan matches" ) causes the plan to have a higher rate of match, when compared to the matched contributions remaining in the plan. This is most likely to be discriminatory because only HCEs get the higher rate of match, since only HCEs can have excess contributions. If this matching contribution is not required to be distributed as an excess aggregate contribution under the ACP test, it should be forfeited. It cannot be distributed because there is no mechanism for distributing amounts that fail section 1.401(a)(4)-4 availability test. Of course, an amount may only be forfeited if the plan has a provision allowing such forfeiture. See also section 1.401(m)-2(b)(3)(v)(B).

4.72.2.9.1  (06-07-2010)
Examination Steps

  1. Verify that any amounts used to satisfy the ADP test (ECs, QNECs, and QMACs) are 100% vested at all times.

  2. Check that matching contributions that relate to corrective distributions of elective or employee contributions to satisfy the ADP or ACP test are forfeited (or distributed, if necessary to satisfy the ACP test).

4.72.2.10  (06-07-2010)
CODA Nondiscrimination

  1. Under section 401(k)(3) of the Code, a 401(k) plan must satisfy the actual deferral percentage (ADP) test annually. The test compares the elective contributions of eligible HCEs with those made by eligible NHCEs. The ADP test is the exclusive nondiscrimination test for amounts contributed to a CODA, that is, this test is used instead of any amounts test under section 401(a)(4). QNECs and QMACs that are treated as elective contributions are also counted in the ADP test.

  2. The ADP test and its correction mechanisms can be costly for employers, so Congress enacted three alternatives to the ADP test:

    1. For plan years beginning after December 31, 1996, employers could adopt SIMPLE 401(k) plans, modeled after SIMPLE IRA plans described in section 408(p). See sections 401(k)(11) and 401(m)(10) of the Code. See also IRM 4.72.2.12.

    2. For plan years beginning after December 31, 1998, employers could adopt safe harbor 401(k) plans described in sections 401(k)(12) and 401(m)(11). See also IRM 4.72.2.13.

    3. For plan years beginning after December 31, 2007, employers could adopt a qualified automatic contribution arrangement (QACA) described in sections 401(k)(13) and 401(m)(12). See also IRM 4.72.2.14.

  3. Although a CODA must satisfy the ADP test (or be deemed to satisfy the ADP test because the CODA is part of a SIMPLE 401(k) plan, a safe harbor 401(k) plan or a QACA) with respect to the amount of elective contributions, the right to make each level of elective contributions under a CODA is a benefit, right or feature that must satisfy the nondiscriminatory availability requirement of section 1.401(a)(4)-4(e)(3) of the Regulations.

  4. Section 401(k)(3)(G) of the Code provides that a governmental plan within the meaning of section 414(d) is treated as meeting the ADP test.

4.72.2.10.1  (06-07-2010)
ADP Test

  1. Under the ADP test, set forth at section 401(k)(3)(A)(ii), the ADP of the eligible HCEs cannot exceed the greater of:

    1. 1.25 x the ADP of the eligible NHCEs, or

    2. the lesser of 2 + the ADP of the eligible NHCEs or 2 X the ADP of the eligible NHCEs.

  2. The ADP for a group (either HCE or NHCE) is the average of the individual ADRs of the particular group. An eligible employee's ADR is the sum of the elective contributions and QNECs and QMACs that are treated as elective contributions allocated to the employee's account in the plan divided by the employee's compensation. ADRs and ADPs, expressed as a percentage, must be rounded to the nearest one-hundredth of a percent. If the only eligible employees under the CODA are HCEs, the plan automatically passes the ADP test.

  3. Only "eligible employees" are included in the ADP test. ("Eligible employees" are also counted as "benefiting" for purposes of satisfying the IRC section 410(b) coverage requirements.) An "eligible employee" is one who is eligible under the plan to make an elective contribution, whether or not the employee actually makes any deferrals. If an eligible employee chooses not to make elective contributions, and no QNECs or QMACs are made under the CODA, the employee must be included in the ADP test with an ADR of zero. The term also includes an employee who:

    1. must perform purely ministerial or mechanical acts in order to make an elective contribution,

    2. chooses not to make a mandatory after-tax employee contribution in a plan requiring after-tax contributions as a prerequisite to CODA participation,

    3. has been suspended from making elective contributions under the plan (e.g., for having taken a hardship distribution), or

    4. may not receive additional contributions because of the limits imposed by section 415(c).

  4. An employee who cannot make elective contributions because he or she was given a one-time election when the employee commenced employment with the employer or upon first becoming eligible under any CODA of the employer and elected not to be eligible to make elective contributions for the duration of employment with the employer is not an eligible employee.

  5. The ADP test is performed on the plan level, so identification of the "plan" is the first step to be performed. See the discussion under "Coverage and Participation" above. If a plan contains more than one CODA, the CODAs must be aggregated for purposes of the ADP test.

  6. If a plan is disaggregated into separate plans for purposes of IRC section 410(b), the CODA must also be disaggregated. For example, if a plan covers all employees, but, for testing purposes the plan is disaggregated into two plans, one covering employees who have less than 1 year of service or are less than age 21, and one covering all other employees, the employer would run two ADP tests, one for the employees with less than 1 year of service or less than age 21, and the other for all other employees.

  7. Section 401(k)(3)(F) provides a special rule for early participation. An employer may exclude from the ADP test all eligible employees (other than HCEs) who have not met the minimum age and service requirements of section 410(a)(1)(A).

  8. If an HCE is eligible to participate in more than one CODA maintained by the same employer, the HCE’s elective contributions under all of the employer’s CODAs must be combined to determine the HCE’s ADR. This combination ADR is then used in the ADP test under each CODA.

  9. The compensation used to calculate ADRs is limited to the IRC section 401(a)(17) amount and must also satisfy section 414(s). The definition of compensation used by the CODA must be nondiscriminatory, and elective deferrals may be included or excluded from the definition.

  10. Contributions on behalf of HCEs that exceed the limits imposed by the ADP test are called excess contributions, that is, they are the amount of contributions used to calculate the HCE ADP that exceeds the amount of such contributions permitted if the ADP test were passed. A plan must dispose of excess contributions by distributing them to certain HCEs or recharacterizing them as employee after-tax contributions or catch-up contributions if applicable. QNECs and QMACs contributed on behalf of NHCEs can be used to raise the NHCE ADP, thereby reducing or eliminating HCE contributions that might otherwise become excess contributions.

  11. A plan can choose, by specifying in the plan document, whether the ADP test will be performed by comparing the HCE ADP for a plan year with the NHCE ADP for the same plan year ("current year testing" ) or by comparing the HCE ADP for a plan year with the NHCE ADP for the prior plan year ("prior year testing" ).

4.72.2.10.1.1  (06-07-2010)
Current Year Testing

  1. Under the current year testing method, the applicable year for determining the ADP for the eligible NHCEs is the same plan year as the plan year for which the ADP test is being performed. However, the employer may not know for certain how much HCEs can defer for a particular plan year until the plan year is over, and by then it may be too late to have prevented excess contributions from arising. In calendar-year section 401(k) plans, the ADP test is usually performed around the end of January when the plan administrator receives all the necessary demographic and financial information.

  2. Elective contributions of an employee are taken into account for the ADP test for a plan year only if:

    1. They are allocated to the employee's account as of a date within that plan year and are paid to the trust no later than 12 months after the end of the plan year to which the contributions relate. (Note that under Department of Labor regulations, elective contributions must be paid into the trust by the earliest date such contributions can reasonably be segregated from the employer's general assets, with a safe harbor for small plans. See DOL Regs. section 2510.3-102.)

    2. The contributions must relate to compensation that, but for the employee's election to defer, would have been received by the employee in the plan year, or would have been received within 2 1/2 months after the plan year if the compensation is attributable to services performed in the plan year. Counting elective contributions in the year preceding the year the related compensation would have been received is permitted only if the plan specifies such treatment.

  3. Elective contributions of an employee are not taken into account for the ADP test for a plan year if

    1. They do not satisfy the requirements above in paragraph (2).

    2. They are excess deferrals of NHCEs that are prohibited by section 401(a)(30) (i.e., an NHCE is deferring more than the section 402(g) limit under one employer’s plan or plans).

    3. They are treated as catch-up contributions under section 414(v).

    4. They are used in the ACP test (although, before they can be used in an ACP test, they must satisfy the ADP test).

    5. They are made pursuant to section 414(u) by reason of an eligible employee's qualified military service.

  4. Under section 401(k)(3)(D), an employer may take into account QNECs and QMACs in calculating the ADP, but, in order to do so, the regulations provide that such contributions must satisfy the nonforfeitability requirement, the distribution limitations and the 12-month contribution-to-the-trust rule that apply to elective contributions. In addition, QNECs, both before and after some or all are used in the ADP test, must satisfy section 401(a)(4). QNECs and QMACs used in the ACP test cannot be used in the ADP test.

  5. To prevent the abuses arising from so-called "targeted QNECs and QMACs," the final sections 401(k) and 401(m) regulations, published on December 29, 2004, provide that QNECs and QMACs may not be used in the ADP test if they are large when compared to the recipient’s compensation. Targeted QNECs and QMACs (sometimes called "bottom-up leveling" ) is the practice of giving a large QNEC or QMAC to one or more of the lowest paid NHCEs in order to raise the NHCE ADP so that more can be deferred by HCEs. For example, giving a $1,000 QNEC to an NHCE who made just $1,000 raises the ADP of 100 NHCEs by 1%, enabling a dozen well-paid HCEs to contribute an additional $58,000 (or more) for themselves. If a QNEC exceeds 5% of the employee’s compensation (or a QMAC exceeds the greater of 5% of compensation or the amount of the employee’s elective contribution) it can only be counted in the ADP test if it is not more than two times a representative rate as defined in the regulations. See sections 1.401(k)-2(a)(6)(iv) and (v) and 1-401(m)-2(a)(5)(ii) of the Regulations.

  6. Note that QNECs and QMACs made after the tax return filing date are not deductible for the prior taxable year. These contributions are counted, with other employer contributions, against the section 404 deduction limits for the year made.

4.72.2.10.1.2  (06-07-2010)
Prior Year Testing

  1. Generally, the rules that apply to calculating ADRs and ADPs in current year testing also apply to prior year testing. Prior year testing simplifies plan administration because an employer can determine the percentage of elective contributions that can be made on behalf of HCEs early in the plan year and have more time to plan for correction. Consider the following examples:

    1. Employer X maintains a plan containing a qualified CODA that provides that distribution of excess contributions is the only method under the plan to correct ADP test failures. The plan has a calendar-year plan year and both HCEs and NHCEs make ECs to the plan. In January 2009, Employer X determines that the plan fails the ADP test for 2008 and that a corrective distribution of excess contributions must be made to appropriate HCEs by March 15, 2009 to avoid all penalties.

    2. Same facts as above, except that the testing year is 2009 and the plan is using the prior year testing method. The ADP for the NHCEs for 2008 under the plan can be determined early in 2009 by Employer X because it has obtained the necessary data on prior year NHCE status, contributions and compensation by January 2009. This simplifies plan administration for Employer X.

  2. The eligible employees taken into account in determining the prior year's ADP for NHCEs are those eligible employees who were NHCEs during the preceding year, without regard to the employee's status in the testing year.

  3. Example:

    Employee A was employed by Employer X and was an NHCE in Year One. Employee A no longer works for Employer X in Year Two. For purposes of determining the prior year’s ADP for Employer X’s section 401(k) plan for the Year Two testing year, Employee A is taken into account. The result would be the same if Employee A were still employed by Employer X but had become a HCE in Year Two.

  4. Plan provisions must specify whether the plan is using current year or prior year testing, and if the latter, whether the NHCEs’ ADP for the first year is 3% or the first year’s ADP. See section 1.401(k)-1(e)(7) of the Regulations

4.72.2.10.1.2.1  (06-07-2010)
Use of QNECs and QMACs in Prior Year Testing

  1. To be taken into account for the NHCE ADP for the prior year, a QNEC or QMAC must be allocated as of a date within that prior year, and must actually be paid to the trust by the end of the 12-month period following the end of that prior year. In other words, it must actually be paid to the trust by the end of the testing year; thus, when using prior year testing, an employer cannot use QNECs or QMACs to correct a failed ADP or ACP test because the employer won’t know until after the testing year whether or not the ADP or ACP test is failed and by then the deadline for making corrective QNECs and QMACs has passed. Of course QNECs and QMACs made prior to the deadline can be counted.

  2. Example:

    A plan uses the prior year testing method for the 2009 testing year. QMACs that are allocated to NHCEs’ accounts as of the last day of the 2008 plan year may be taken into account in calculating the ADP only if those QMACs are actually contributed to the plan by the last day of the 2009 plan year.

  3. Note that this 12-month rule does not change the rule under section 415, that employer contributions shall not be deemed credited to a participant's account for a particular limitation year unless the contributions are actually made no later than 30 days after the end of the period described in section 404(a)(6) applicable to the taxable year with or within which the particular limitation year ends. See section 1.415(c)-1(b)(6)(i)(B) of the Regulations.

4.72.2.10.1.2.2  (06-07-2010)
First-Year Rule for Prior Year Testing

  1. For the first plan year of a plan (other than a "successor plan," see below) that uses prior year testing, the ADP for NHCEs for the prior year is deemed to be 3% or, if specified in the plan document, the NHCE ADP is equal to the NHCE ADP for that first plan year (i.e., the current year). See section 401(k)(3)(E) of the Code and section 1.401(k)-2(c)(2) of the Regulations.

  2. For ADP testing purposes, the "first plan year" is the first year in which the plan provides for elective contributions. A plan does not have a first plan year if for that year it is aggregated under the regulations with any other plan that provided for elective contributions in the prior year.

  3. A plan is a "successor plan" if 50% or more of the eligible employees for the first plan year were eligible employees under another CODA maintained by the employer in the prior year.

4.72.2.10.1.2.3  (06-07-2010)
Changes in the Group of NHCEs in Prior Year Testing

  1. In general, under the prior year testing method, subsequent changes in the group of NHCEs are disregarded. That is, the ADP for NHCEs for the prior year is determined with respect to eligible employees who were NHCEs in that prior year, and without regard to changes in the group of eligible NHCEs in the testing year. This is true even though some NHCEs in the prior year have become HCEs in the testing year, or are no longer eligible employees under the plan. It is also true even though some NHCEs in the testing year were not eligible employees in the prior year.

  2. However, if a plan results from or is affected by a " plan coverage change" that becomes effective during the testing year then the NHCE ADP for the prior year is the weighted average of the ADPs for the prior year subgroups. A "plan coverage change" is a change in the group(s) of eligible employees on account of:

    1. the establishment or amendment of a plan;

    2. a plan merger, consolidation, or spinoff under section 414(l);

    3. a change in the way plans are (or are not) permissively aggregated under section 1.410(b)-7(d) of the Regulations;

    4. a reclassification of employees that has the same effect as amending the plan; or

    5. any combination of the above.

  3. A "prior year subgroup" is all NHCEs for the prior year who were eligible employees under a specific CODA maintained by the employer, and who would have been eligible employees under the plan being tested if the plan coverage change had been effective as of the first day of the prior year.

  4. The "weighted average of the ADPs for the prior year subgroups " is the sum, for all prior year subgroups of the "adjusted ADPs."

  5. The "adjusted ADP" for each prior year subgroup is the ADP for the prior year for all NHCEs of the specific plan under which the members of the prior year subgroup were eligible employees, multiplied by a fraction, the numerator of which is the number of NHCEs in the prior year subgroup, and the denominator of which is the total number of NHCEs in all prior year subgroups.

  6. Optional rule for minor plan coverage change: If there is a plan coverage change, and 90% or more of all NHCEs from all prior year subgroups are from a single prior year subgroup, then the employer may elect to use the prior year ADP for NHCEs of the plan that included that single prior year subgroup. There are examples involving plan coverage changes at section 1-401(k)-2(c)(4)(iv) of the Regulations.

4.72.2.10.1.3  (06-07-2010)
Changing Testing Method

  1. A plan that uses the prior year testing method may adopt the current year testing method for any subsequent testing year. Notification to or prior approval of the Service is not required for the election to be valid. However, the employer may wish to apply for a determination letter on the plan amendment needed to implement the change. A plan that is a safe harbor 401(k) plan, a QACA or a SIMPLE 401(k) plan is treated as using the current year testing method.

  2. A plan that uses current year testing is permitted to change to prior year testing in three situations described in section 1.401(k)-2(c)(1)(ii) of the Regulations:

    1. The plan is not the result of the aggregation of two or more plans, and current year testing was used for each of the 5 plan years preceding the year of the change (or, if lesser, the number of years the plan has been in existence).

    2. The plan is the result of the aggregation of two or more plans and, for each of the aggregated plans, current year testing was used for each of the 5 plan years preceding the year of the change (or, if lesser, the number of years the plan has been in existence).

    3. A transaction occurs that is described in section 410(b)(6)(C)(i) (i.e., the employer becomes or ceases to be a member of a section 414(b), (c), (m) or (o) group) and, as a result, the employer maintains both a plan using prior year testing and a plan using current year testing, and the change occurs within the transition period described in section 410(b)(6)(C)(ii) (i.e., by the last day of the 1st plan year beginning after the transaction).


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