4.72.3  Employee Contributions and Matching Contributions

4.72.3.1  (06-07-2010)
Overview of Section 3

  1. The information contained in this section 3 is designed primarily to assist EP examiners in identifying relevant issues relating to plans that provide for employee contributions or matching contributions (a "section 401(m) plan" ) for plan years beginning after December 31, 2001.

  2. Most plans covered by this section will also contain a cash or deferred arrangement (CODA). In such case, IRM section 4.72.2 (relating to CODAs) should be used along with this section. For ease of use, this section 3 has a similar structure to the CODA section, sometimes resulting in duplicative material. Also, most CODA-related guidance issued by the Service will include guidance relevant to section 401(m) plans, so this section 3 will often reference guidance that is directed mainly at CODAs.

  3. This section 3 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.

4.72.3.2  (06-07-2010)
Recent Changes to Section 401(m) Plans

  1. The statutes listed above in IRM 4.72.3.1 made the 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 additional catch-up contributions for individuals age 50 or over.

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

    3. 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.

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

    5. 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 401(a)(5)(G) of the Code was amended by section 861(a)(1) of PPA to provide that all governmental plans within the meaning of section 414(d) are treated as meeting the participation and nondiscrimination requirements of section 401(a)(3) and (4) of the Code. Prior to this change, only state and local government plans were so treated. Since the ACP test is how section 401(m) plans satisfy 401(a)(4), this means that all governmental plans within the meaning of section 414(d) are treated as satisfying the ACP test.

  4. Effective in 2007

    1. Section 411(a) of the Code was amended by section 904 of PPA to require faster vesting of employer nonelective contributions to defined contribution plans: 3-year cliff and 2-to-6-year graded vesting replaces 5-year cliff and 3-to-7-year graded vesting.

  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) was added to the Code 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 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(m) plans in the last few years:

    1. Rev. Rul. 2004-13, 2004-1 C.B. 485, provides guidance under section 416(g)(4)(H) of the Code 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).

    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 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(m) plan (or a section 401(k) plan) meets the requirements for minimum coverage specified in section 410(b).

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

    6. Proposed regulations under sections 401(k) and 401(m) were published on May 18, 2009 (74 FR 231345), permitting the suspension of safe harbor nonelective contributions under certain circumstances in a safe harbor 401(k) plan under section 401(k)(12) or a QACA under section 401(k)(13).

4.72.3.3  (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 4.72.3.3, but will be discussed in greater detail in the relevant parts of this section 3 and IRM 4.72.2. (Cash or Deferred Arrangements).

  2. "ECs," or "elective contributions, " are the contributions made to a plan pursuant to an employee’s CODA election. Elective contributions can be treated as matching contributions and used in the ACP test provided the ADP test is first satisfied using all elective contributions and continues to be satisfied after exclusion of those elective contributions used in the ACP test.

  3. "Employee contributions," sometimes referred to as "after-tax" employee contributions, are plan contributions from employees, either mandatory (meaning they are required in order to receive some benefit from the employer, such as matching contributions) or voluntary, that are allocated to a separate account. These contributions are treated at the time of contribution as after-tax employee contributions. The term does not include designated Roth contributions, loan repayments, repayments for the buy-back of cashed-out benefits (see section 411(a)(7)(C)), or amounts that are transferred or rolled over from another plan or IRA.

  4. "Matching contributions" are employer contributions made to a defined contribution plan on account of an employee’s employee contributions or elective contributions. The term also includes forfeitures allocated on the basis of matching contributions, employee contributions or elective contributions.

  5. "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.

  6. "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 antidiscrimination test contained in section 401(k)(3)(A)(ii).

  7. "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.

  8. "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 antidiscrimination test contained in section 401(m)(2)(A).

  9. "QNECs" (sometimes "QNCs" ), or "qualified nonelective contributions," are special employer contributions that are not subject to a cash or deferred 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.

  10. "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. If the only matching contributions under a plan containing a CODA were QMACs, and no employee contributions were permitted, the plan need not perform the ACP test, only the ADP test.

  11. ) "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.

  12. "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.

  13. "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.

  14. A "safe harbor 401(k) plan," as used in this section 3, means a plan that meets the requirements under section 401(k)(12) and, depending on the context in which used, section 401(m)(11).

4.72.3.4  (06-07-2010)
Summary of Section 401(m) Plan Requirements

  1. If a plan provides for employee contributions or matching contributions, it must satisfy the requirements of section 401(m), in addition to the other requirements under section 401(a). In this text such a plan is referred to as a "section 401(m) plan," whether or not any other types of contributions are provided for in the plan; but in the regulations, a "section 401(m) plan" means only the portion of a plan that consists of employee contributions and employer matching contributions.

  2. Essentially, the only requirement imposed by section 401(m) is the ACP test, which, if passed, will satisfy the nondiscrimination requirement under section 401(a)(4) with respect to the amount of employee contributions and employer matching contributions.

  3. A section 401(m) plan must also satisfy the requirements of section 401(a)(4) relating to benefits, rights and features in addition to the requirement regarding amounts described above. For example, the right to make each level of employee contributions and the right to each level of matching contributions under the plan are benefits, rights or features subject to the requirements of section 401(a)(4). See section 1.401(a)(4)-4(e)(3)(i) and (iii)(F) through (G) of the Regulations.

  4. Under section 1.410(b)-7(c) of the Regulations the portion of a plan consisting of employee and matching contributions must separately satisfy the section 410(b) coverage requirements.

  5. Note that employee contributions and attributable earnings must be nonforfeitable at all times, whereas matching contributions (other than QMACs) may be subject to a vesting schedule. But vested matching contributions, including QMACs, may be forfeited under the plan if the contributions to which they relate are treated as excess deferrals (deferrals in excess of the section 402(g) limit), excess contributions (deferrals over the ADP test limit), excess aggregate contributions (amounts in excess of the ACP test limit), or a permissible withdrawal under section 414(w). See sections 401(k)(8)(E) and 411(a)(3)(G) of the Code and section 1.414(w)-1(c) of the Regulations.

4.72.3.5  (06-07-2010)
Coverage and Participation

  1. The portion of the plan consisting of employee contributions and employer matching contributions, 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, such portion may be aggregated with a similar portion in the same or another plan 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.

  2. Each employee who is eligible to make an employee contribution or receive a matching contribution (an "eligible employee" ) is treated as "benefiting" (i.e., covered), regardless of whether the employee elects to make employee contributions or have deferrals made on his or her behalf (and, potentially, receive matching contributions on these amounts). The term "eligible employee" also includes certain employees who are temporarily prohibited under the plan from making contributions, such as a suspension following a hardship distribution. See the discussion later under "ACP 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 10 1/2 months after the plan year in which there is a coverage problem. Under this regulation, if a plan 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 ACRs of NHCEs who were eligible. This retroactive correction feature cannot be used to correct other defects, such as a failure to satisfy the ACP test.

  4. Employees covered by a collective bargaining agreement must be disaggregated from employees not covered by a collective bargaining agreement for purposes of the ACP test. Separate collective bargaining units within the same plan may be disaggregated, but are not required to be, for purposes of the ACP 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.

  5. 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 section 401(m) plans. 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 section 401(m) rules, even if the ESOP and non-ESOP are in different plans of the employer.

4.72.3.5.1  (06-07-2010)
Examination Tip

  1. Verify the portion of the plan that is subject to section 401(m) satisfies the coverage requirements of section 410(b).

4.72.3.6  (06-07-2010)
Nondiscrimination

  1. Under section 401(m)(2), an employer maintaining a section 401(m) plan must annually compare the employee and matching contributions of eligible HCEs with those made by eligible NHCEs and, if certain limits are exceeded by the HCEs, must take corrective action to bring the plan within the limits. This testing for nondiscrimination (the ACP test) is the exclusive nondiscrimination test for amounts of employee and matching contributions contributed to a plan, that is, this test is used instead of any amounts test under section 401(a)(4). QNECs and elective contributions that are treated as matching contributions are also counted in the ACP test.

  2. Employee and matching contributions under a collectively bargained plan that automatically satisfies section 410(b) are treated as satisfying section 401(m). Also, pursuant to section 401(a)(5)(G), a governmental plan within the meaning of section 414(d) is exempt from the requirements of section 401(m). See sections 1.401(m)-1(b)(2), 1.401(a)(4)-1(c)(5) and 1.410(b)-2(b)(7) of the Regulations.

  3. There are three alternatives a plan may use instead of the ACP 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.

    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).

    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) of the Code.

  4. Although a section 401(m) plan must satisfy the ACP test (or be deemed to satisfy the ACP test because it is part of a SIMPLE 401(k) plan, a safe harbor 401(k) plan, or a QACA) with respect to the amount of employee and matching contributions, the right to make each level of employee contributions and the right to each level of matching contributions is a benefit, right or feature that must satisfy the nondiscriminatory availability requirement of section1.401(a)(4)-4(e)(3) of the Regulations.

  5. A plan that fails the ACP test does not meet the requirements for a qualified plan under section 401(a).

4.72.3.6.1  (06-07-2010)
ACP Test

  1. Under the ACP test, set forth at section 401(m)(2)(A), the ACP of the eligible HCEs cannot exceed the greater of:

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

    2. the lesser of 2 + the ACP of the eligible NHCEs or 2 x the ACP of the eligible NHCEs.

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

  3. Only "eligible employees" are included in the ACP test. ("eligible employees" are also counted as "benefiting" for purposes of satisfying the section 410(b) coverage requirements.) An " eligible employee" is one who is eligible under the plan to make an employee contribution or to receive an allocation of matching contributions, whether or not the employee actually makes any employee contributions or receives any matching contributions. If an eligible employee chooses not to make employee contributions, and no matching contributions (or elective contributions or QNECs treated as matching contributions) are allocated to the employee's accounts, the employee must be included in the ACP test with an ACR of zero. The term also includes an employee who:

    1. must perform purely ministerial or mechanical acts in order to make an employee contribution or receive an allocation of matching contributions,

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

    3. may not make additional employee contributions or receive additional employer contributions because of the limits imposed by section 415(c).

  4. An employee who cannot make employee contributions or receive matching 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 section 401(m) plan of the employer and elected not to be eligible to make employee contributions or receive an allocation of matching contributions for the duration of employment with the employer is not an eligible employee.

  5. The ACP 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.

  6. If a plan is disaggregated into separate plans for purposes of section 410(b), the portion consisting of employee and matching contributions 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 ACP 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(m)(5)(C) of the Code provides a special rule for early participation. An employer may exclude from the ACP test all eligible employees (other than HCEs) who have not met the minimum age and service requirements of section 410(a)(1)(A). A similar rule applies for purposes of the ADP test.

  8. If an HCE is eligible to participate in more than one plan of an employer to which employee or matching contributions may be made, the HCE's contributions under all such plans of the employer must be combined to determine the HCE's ACR. This combination ACR is then used in the ACP test under each plan.

  9. The compensation used to calculate ACRs is limited to the section 401(a)(17) amount and must also satisfy section 414(s). The definition of compensation used by the plan 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 contribu-tions. Recharacterized amounts are then counted in the ACP test.

  11. Contributions on behalf of HCEs that exceed the limits imposed by the ACP test are called excess aggregate contributions, that is, they are the amount of contributions used to calculate the HCE ACP that exceeds the amount of such contributions permitted if the ACP test were passed. A plan must dispose of excess aggregate contributions by distributing them to certain HCEs or forfeiting certain matching contributions. QNECs and certain elective contributions contributed on behalf of NHCEs can be used to raise the NHCE ACP, thereby reducing or eliminating HCE contributions that might otherwise become excess aggregate contributions.

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

4.72.3.6.1.1  (06-07-2010)
Current Year Testing

  1. Under the current year testing method, the applicable year for determining the ACP for eligible NHCEs is the same plan year as the plan year for which the ACP test is being performed. Employee contributions of an employee are taken into account for a plan year in current year ACP testing for the plan year in which they are made to the trust. A payment to an agent of the plan, such as the employer, is at that time treated as made to the trust if the agent remits such funds to the trust within a rea-sonable time after receipt. (Note that under Department of Labor regulations, employee 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. 2510.3-102.). Excess contributions that are recharacterized as employee contributions are taken into account for the plan year in which the excess contribution is included in the HCE's gross income.

  2. Matching contributions are taken into account in determining the ACR for an eligible employee for a plan year only if:

    1. under the terms of the plan they are allocated to the employee’s account as of a date within the plan year,

    2. they are paid to the trust no later than 12 months after the close of the plan year, and

    3. they are made on account of the employee’s elective contributions or employee contributions for the plan year.

  3. Matching contributions that do not meet the requirements in (2) above may not be taken into account in the ACP test for the plan year with respect to which the contributions were made, or for any other plan year. Such contributions must satisfy the requirements of section 401(a)(4) (without regard to the ACP test) for the plan year for which they are allocated under the plan as if they were nonelective contributions and were the only nonelective contributions allocated for that year. See sections 1.401(m)-2(a)(5)(i), 1.401(a)(4)-1(b)(2)(ii)(B) and 1.410(b)-7(c)(1) of the Regulations.

  4. A matching contribution that is forfeited because the contribution to which it relates is treated as an excess deferral, an excess contribution, an excess aggregate contribution or a permissible withdrawal under section 414(w) is not counted in the ACP test. Also, QMACs used in the ADP test are not counted in the ACP test.

  5. To prevent the abuses arising from so-called "targeted QNECs and QMACs," the final section 401(k) and (m) regulations, published on December 29, 2004, provide that QNECs and QMACs may not be used in the ADP/ACP 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/ACP so that more can be deferred or contributed to 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/ACP 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. Under section 401(m)(3), an employer may take into account QNECs in calculating the ACP, 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 ACP test, must satisfy section 401(a)(4). A QNEC used in the ADP test cannot again be used for the ACP test.

  7. Also, under section 401(m)(3), an employer may take into account elective contributions in calculating the ACP, but the ADP test must be passed both with and without the elective contributions used in the ACP test.

  8. 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.

4.72.3.6.1.2  (06-07-2010)
Prior Year Testing

  1. Under the prior year testing method, the applicable year for determining the ACP for the eligible NHCEs is the plan year immediately preceding the plan year for which the ACP test is being calculated.

  2. Generally, the rules that apply to calculating ACRs and ACPs in current year testing also apply to prior year testing. Prior year testing simplifies plan administration because an employer can determine the percentage of employee and matching 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 section 401(m) plan that provides that distribution of excess aggregate contributions is the only method under the plan to correct ACP test failures. The plan has a calendar-year plan year, uses the current year testing method and both HCEs and NHCEs make employee contributions to the plan. In January 2010, Employer X determines that the plan fails the ACP test for 2009, and that a corrective distribution of excess aggregate contributions must be made to appropriate HCEs by March 15, 2010, to avoid all penalties.

    2. Same facts as above, except that the plan is using the prior year testing method. The ACP 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.

  3. The eligible employees taken into account in determining the prior year's ACP for NHCEs are those eligible employees who were NHCEs during the preceding year, without regard to the employee's status in the testing year. A special rule applies for the first plan year. In the case of the first plan year of any plan (other than a successor plan), the amount taken into account as the ACP for NHCEs for the preceding plan year is deemed to be 3 percent, unless an election is made to use the actual ACP data for the first plan year.

  4. 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 ACP for Employer X's section 401(m) 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.(5) Plan provisions must specify whether the plan is using current year or prior year testing, and if the latter, whether the NHCEs’ ACP for the first year is 3% or the first year’s ACP. See section 1.401(m)-1(c)(2) of the Regulations.

4.72.3.6.1.2.1  (06-07-2010)
Use of QNECs and QMACs in Prior Year Testing

  1. To be taken into account for the NHCE ACP for the prior year, a QNEC or QMAC must be allocated to the employee's account as of a date within that year (within the meaning of section 1.401(k)-2(a)(4)(i)(A) of the Regulations), 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 ACP or ADP test because the employer won't know until after the testing year whether or not the ACP or ADP 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 ACP 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 section 404(a)(6) period 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.

4.72.3.6.1.2.2  (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 ACP for NHCEs for the prior year is deemed to be 3% or, if specified in the plan document, the NHCE ACP is equal to the NHCE ACP for that first plan year (i.e., the current year). See section 401(m)(3) of the Code and section 1.401(m)-2(c)(2) of the Regulations.

  2. For ACP testing purposes, the "first plan year" is the first year in which the plan provides for employee or matching 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 employee or matching 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 section 401(m) plan maintained by the employer in the prior year.

4.72.3.6.1.2.3  (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 ACP 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 ACP for the prior year is the weighted average of the ACPs 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(I);

    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 section 401(m) plan 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 ACPs for the prior year subgroups " is the sum for all prior year subgroups of the "adjusted ACPs."

  5. The "adjusted ACP" for each prior year subgroup is the ACP 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 ACP for NHCEs of the plan that included that single prior year subgroup. See section 1.401(m)-2(c)(4)(ii) of the Regulations.

4.72.3.6.1.3  (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).

4.72.3.6.1.4  (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, employee contributions on behalf of NHCEs for 2008 will be counted twice; once in 2008 in calculating the NHCE ACP under the current year testing method, and again in 2009 in calculating the NHCE ACP under the prior year testing method. To limit double counting, section 1.401(m)-2(a)(6)(vi) of the Regulations provides that QNECs cannot be used in prior year testing if they were used in current year testing in the preceding year.

4.72.3.6.1.5  (06-07-2010)
Plan Provisions Regarding Testing Method

  1. A plan must state that the nondiscrimination requirements of section 401(m) will be met and 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 401(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.

4.72.3.6.1.6  (06-07-2010)
Correction of ACP Test

  1. The final section 401(m) regulations provide two methods to correct excess aggregate contributions:

    1. making QMACs or QNECs, and

    2. distributing or forfeiting the amounts in excess of the ACP limits.

    A plan may use a combination of these methods to avoid or correct excess aggregate contributions. Alternatively, a plan may contain provisions that limit employee contributions or matching contributions in a manner that prevent excess aggregate contributions from occurring.

  2. Excess aggregate contributions may not be corrected by:

    1. forfeiting vested matching contributions,

    2. distributing nonvested matching contributions,

    3. recharacterizing matching contributions, or

    4. not making matching contributions required under the terms of the plan.

    .

  3. Excess aggregate 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 aggregate contributions may not be corrected using the retroactive correction rules of section 1.401(a)(4)-11(g). See sections 1.401(m)-2(b)(1)(iii) and 1.401(a)(4)-11(g)(3)(vii) and (5) of the Regulations.

  4. If corrective QNECs or QMACs (for section 401(m) plans using current year testing) do not bring the plan within the ACP limits, the plan must distribute the excess aggregate contributions along with attributable earnings and/or forfeit excess aggregate contributions that are matching contributions, according to the terms of the plan. If a plan corrects by distributing employee contributions, any associated match must also be distributed (or forfeited) to prevent the plan from failing the current and effective availability requirement of section 1.401(a)(4)-4(e)(3) of the Regulations with respect to the remaining matching contributions.

  5. ) If the ACP test is not corrected within the 12-month period following the end of the failed plan year, the plan is not qualified.

4.72.3.6.1.6.1  (06-07-2010)
Determination of Excess Aggregate Contributions

  1. "Excess aggregate contributions" are the aggregate amount of matching contributions and employee contributions made to the plan on behalf of HCEs for a plan year over the maximum amount of such contributions permitted under the ACP test. Excess aggregate contributions are determined after first determining the amount of excess deferrals (if any) and then determining the amount of excess contributions (if any).

  2. The amount of excess aggregate contributions is determined using a leveling method based on HCEs' ACRs, beginning with the HCE with the highest percent-age and continuing in descending order of ACR percentages until the target HCE ACP is reached. The sum of all reductions for all HCEs is the total amount of excess aggregate contributions for the plan year. (See below.)

4.72.3.6.1.6.2  (06-07-2010)
Distribution of Excess Aggregate Contributions

  1. Correction through distribution involves a 4-step process:

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

    2. Apportion the total amount of excess aggregate contributions among the HCEs.

    3. Determine the income allocable to excess aggregate contributions.

    4. Distribute the apportioned contributions, together with allocable income (or forfeit the apportioned matching contributions, if forfeitable).

    .

  2. The amount of excess aggregate contributions is the amount of matching contributions and employee contributions that would have to be returned to HCEs in order to pass the ACP test, starting with the HCE with the highest contribution percentage (ACR) and continuing, by leveling, to the HCE(s) with the next highest ACR(s) until the plan would pass the ACP test (" ratio leveling method" ). On the other hand, the identity of the HCEs who will actually have excess aggregate contributions distributed to them is determined based on the dollar amount of their contributions, beginning with the HCE with the largest dollar amount ("dollar leveling method" ).

  3. Example:

    Employee Comp E'ee Contrib Match ACR ACP
    A $100,000 $4,000 $2,000 6.00%  
    B $90,000 $3,900 $1,950 6.50% 5.4%
    C $80,000 $2,200 $1,100 4.13%  
               
    D $20,000 $1,000 $500 7.50%  
    E $10,000 0 0 0 2.5%
    F $10,000 0 0 0  

    A, B and C are HCEs; D, E and F are NHCEs. The plan matches 50 cents for every dollar of employee contributions and all employees are fully vested in their accounts. Under the ACP test, the greatest acceptable ACP for HCEs is 4.50% (2.50% +2%). Since 5.54% is greater than 4.50%, there are excess aggregate contributions. The plan provides that excess aggregate contributions will be distributed or, if forfeitable, forfeited.

    In determining the amount of excess aggregate contributions, the proper procedure is to hypothetically reduce the highest HCE ACR until the maximum allowed ADP (4.50%) is achieved, or until the next highest HCE ACR is reached, whichever occurs first.

    In this case, if B’s ACR is reduced to 6.00%, the ACP will be 5.38%. Since this is not sufficient to satisfy the ACP test, A’s and B’s ACRs must be further reduced to 4.69% to produce a HCE ADP of 4.50% (4.69 + 4.69 + 4.13 = 13.51; 13.51 ÷ 3 = 4.50).

    The excess aggregate contributions is the difference between the contributions at the old ACPs ($6,000 and $5,850) and the contributions at the new ACPs ($4,690 and $4,221), for a total amount of $2,939. This amount must then be distributed from the account(s) of the HCE with the highest dollar amount of contributions used in the ACP test for the plan year until the contributions remaining in such employee’s account equal the plan-year contributions in the HCE’s account(s) with the next highest dollar amount and so on until the total is distributed. Therefore, $150 must first be distributed to A, to make A’s contributions level with B’s, and the remaining amount of excess aggregate contributions, $2,789, is then allocated equally to A and B, so that each has $4,455.50 of employee and matching contributions remaining for the year. (Note that the ACP test is deemed passed after these corrections even though running the test then would not produce a pass-ing average ACP for HCEs.)

  4. The distribution of excess aggregate contributions must include any income allocable thereto. The income allocable to excess aggregate contributions includes income for the plan year for which the excess aggregate 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(m)-2(b)(2)(iv) of the Regulations.

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

  6. A failed ACP test can be corrected by distributing excess aggregate 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 aggregate contribution is not made before the end of the 12 months following the end of the plan year in which they were made, the plan will fail to be qualified for the year in which the excess contributions were made and all subsequent years until corrected.

  7. In the event of a complete termination of the plan during the plan year in which an excess aggregate contribution arose, the corrective distribution must be made as soon as administratively feasible after the date of termination of the plan, but in no event later than 12 months after the date of termination.

  8. If excess aggregate contributions are not distributed 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 4.72.3.6.1.7 below.

  9. For plan years beginning on or after January 1, 2008, a corrective distribution of excess aggregate 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 employee contributions or 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(m)-2(b)(4)(i) 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 aggregate contributions.

4.72.3.6.1.6.3  (06-07-2010)
Forfeiture of Excess Aggregate Contributions

  1. A plan can correct a failed ACP test by forfeiting matching contributions (but not employee contributions), plus attributable earnings. Vested matching contributions, including QMACs, can only be forfeited to correct for ACP if they relate to employee contributions that have been distributed as excess aggregate contributions, an unlikely scenario: most likely the plan would correct by distributing the minimum amount of employee contributions, together with the related vested match, until the ACP test is satisfied.

4.72.3.6.1.7  (06-07-2010)
IRC section 4979 Tax

  1. Section 4979 of the Code imposes a tax on the employer equal to 10% of any excess aggregate 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 ACP test, the tax will apply to the remaining excess aggregate contributions.

  2. The plan has 12 months after the end of the plan year being tested to correct excess aggregate contributions. The plan can distribute excess aggregate 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 months (or 6-month in the case of certain EACAs) 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 ACP test.

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

4.72.3.6.1.8  (06-07-2010)
Examination Steps

  1. Review the plan to determine whether it permits employee and/or matching contributions. If so, look for the ACP test (section 401(m)(2)) stated in the plan or language stating that the test will be met.

  2. If a DB plan has separate DC accounts for employee contributions, section 401(m) is applicable to the employee contributions to these accounts.

  3. 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. If the plan satisfies the requirements of sections 401(m)(10), (11) or (12), the ACP test is not required. If the plan states that it is a SIMPLE 401(k) plan, a safe harbor 401(k) plan or a QACA, but in operation, the requirements of sections 401(m)(10), (11), or (12) are not met, the plan cannot use the ACP test instead and the plan is not qualified.

  4. If it is necessary to run the ACP test, have the plan administrator explain the policy/procedures for ACP testing, including correction.

  5. Review financial audit reports and corporate minutes for comments on ACP testing and correction.

  6. Identify the employees who are eligible to make employee contributions and/or receive matching contributions.

  7. If an employee contribution is required as a condition of plan participation (i.e., a mandatory contribution) an employee who would be a participant in the plan if he or she made a contribution is treated as an eligible employee on behalf of whom no contributions are made. See section 401(m)(5)(B) of the Code. This means a nonparticipant is taken into account in computing the contribution percentage. Since the nonparticipant contributes nothing, the amount of contributions that can be made on behalf of HCEs may be affected.

  8. Check the plan’s definition of compensation to determine whether it meets the requirements of section 1.414(s)-1 of the Regulations.

  9. Verify employee contributions and/or matching contributions with source documents. Determine whether there has been any recharacterization of excess aggregate contributions.

  10. Analyze the testing methodology and results of the ACP test performed by the plan administrator, confirming the accuracy of the test. Ensure the correct year’s (or years’) data is used in the test.

  11. ) If the plan is disaggregated under section 410(b), make sure the ACP test is also run separately on each disaggregated plan. Apply the aggregation and disaggregation rules of section 1.410(b)-7 as modified by the section 401(m) regulations to find the plan (or plans) so that the ACP test can be applied to the proper employees. Make sure plans being aggregated are not prohibited from doing so under section 1.410(b)-7 of the Regulations.

  12. Determine the HCE and NHCE groups.

  13. Determine the ACR for each individual HCE and NHCE being tested.

  14. Verify that the ACP for each group has been properly determined in accordance with the plan provisions describing the testing method (current year or prior year).

  15. If the ACP test is not met, verify the amount of excess aggregate contributions and determine proper and timely correction has taken place.

  16. To be included under the ACP test, make sure the employer takes into account for a plan year only those employee and matching contributions paid to the trust within the proper time frames.

  17. Determine whether any recharacterized excess contributions should have been included in the ACP test.

  18. Verify that the proper leveling method was used to determine the amount of excess aggregate contributions allocated to each HCE. Verify proper and timely correction.

  19. Verify that the method used to correct excess aggregate contributions was specified in the plan document, and that the document was followed.

  20. Establish whether the corrections were made in a timely manner, and included applicable gains or losses.

    1. If excesses were distributed, determine whether the distributions were made within 2 1/2 months after the end of the plan year in which the excess arose. If not, verify that the 4979 tax was paid and Form 5330 filed. Regardless, the distribution must be made within 12 months after the close of the plan year.

    2. Determine whether the employer properly reported the distribution of excess aggregate contributions as taxable income (other than employee contributions) to the participant on Form 1099-R, and whether the employee properly included the distribution on his or her return.

    3. Determine whether forfeited matching contributions were reallocated to other participants’ accounts during the plan year. If so, for section 415 purposes, contributions are treated as annual additions for both the participants who receive them and the participants from whom the contributions are forfeited.

    4. Determine whether QNECs satisfy section 401(a)(4) both before and after any are used in the ACP test. If elective contributions are used in the ACP test, make sure the ADP test is passed both before and after some are moved to the ACP.

    5. Check whether a suspense account has been established to hold excess aggregate contributions or if such contributions remain unallocated. The regulations under section 401(m) provide that excess aggregate contributions may not remain unallocated or be allocated to a suspense account for allocation to one or more employees in any future year.

4.72.3.7  (06-07-2010)
SIMPLE 401(k) Plans

  1. Sections 401(k)(11) and 401(m)(10) of the Code provide for SIMPLE 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. See IRM 4.72.2.12 for details on SIMPLE 401(k) plans.

4.72.3.8  (06-07-2010)
Safe Harbor 401(k) Plans

  1. sections 401(k)(12) and 401(m)(11) provide a design-based safe harbor method under which a plan containing a CODA is treated as satisfying the ADP and ACP test if the arrangement meets certain contribution and notice requirements under sections 1.401(k)-3(a) through (h) and 1.401(m)-3(a) through (j) of the Regulations. If the plan is a safe harbor 401(k) plan, see IRM section 4.72.2.13.

4.72.3.9  (06-07-2010)
Qualified Automatic Contribution Arrangements

  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 sections 1-401(k)-3 and 1.401(m)-3 of the Regulations. For a plan containing a QACA, see IRM sec-tion 4.72.2.14.1 through 4.72.2.14.5.


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