4.72.2 Cash or Deferred Arrangements

Manual Transmittal

September 05, 2017

Purpose

(1) This transmits revised IRM 4.72.2, Employee Plans Technical Guidelines, Cash or Deferred Arrangements (CODAs).

Material Changes

(1) This IRM is updated to add sections 4.72.2.1 (Program Scope and Objectives), 4.72.2.1.1 (Background), 4.72.2.1.2 (Authority), 4.72.2.1.3 (Responsibilities), and 4.72.2.1.4 (Acronyms and Definitions).

(2) This IRM is updated to add sections 4.72.2.7.4.2 and 4.72.2.20 to reflect the new substantiation guidelines for safe-harbor hardship distributions from section 401(k) plans as set forth in the Memorandum for Employee Plans Examination Employees on February 23, 2017 (Interim Guidance TE/GE-04-0217-0008).

(3) IRM sections 4.72.2.1.4(7) and (8), 4.72.2.2.1(3) and 4.72.2.8 were updated to reflect the Notice of Proposed Rulemaking published in the Federal Register on January 18, 2017 that proposes to change the definitions of Qualified Matching Contributions and Qualified Nonelective Contributions.

(4) This IRM is updated to make editorial changes, changes section numbers, and to reflect current versions of revenue procedures and IRM procedures.

Effect on Other Documents

This supersedes IRM 4.72.2, dated September 22, 2016.

Audience

Tax Exempt and Government Entities
Employee Plans

Effective Date

(09-05-2017)

Robert S. Choi
Director, Employee Plans
Tax Exempt and Government Entities

Program Scope and Objectives

  1. This IRM section helps EP specialists identify issues related to retirement plans with cash or deferred arrangements (CODAs).

  2. Audience: Tax Exempt and Government Entities, Employee Plans employees.

  3. Policy Owner: Director, Tax Exempt and Government Entities, Employee Plans.

  4. Program Owner: Tax Exempt and Government Entities, Employee Plans.

  5. Program Goal: To ensure continued compliance and qualification of retirement plans with cash or deferred arrangements.

Background

  1. A plan is qualified if it meets the requirements of IRC 401(a) in form and operation. A qualified plan is entitled to favorable tax treatment.

  2. The primary objective of an Employee Plans audit is to determine if the plan is operating in compliance with the Internal Revenue Code and if the terms of the written plan document are being followed.

  3. The technical guidelines in this IRM section summarize the law that agents must consider in determining whether a plan meets the requirements of the Internal Revenue Code for retirement plans with cash or deferred arrangements.

Authority

  1. Policy Statement 4-119 states that the primary objective of the Employee Plans audit program is regulatory, with emphasis on continued qualification of employee benefit plans. Plans will be examined to determine whether they meet the applicable qualification requirements in operation. See IRM 1.2.13.1.36.

  2. Delegation Order 8-3 gives the Director, Tax Exempt and Government Entities, Employee Plans, authority to enter into and approve a written agreement with any person relating to their tax liability. See IRM 1.2.47.4.

  3. A plan is qualified if it meets the requirements of IRC 401(a) in form and operation.

  4. A qualified cash or deferred arrangement (CODA) must meet the requirements of IRC 401 (a) and IRC 401(k).

Responsibilities

  1. Agents examine a plan to determine if the plan:

    • Meets the qualification requirements of IRC sections 401(a) and 501(a). See IRM 4.71.1.1.3 and IRM 4.71.1.4

    • Filed all required tax and information returns. See IRM 4.71.1.14

    • Reported information and excise tax liabilities correctly. See IRM 4.71.1.4

  2. In June 2014, the IRS adopted the Taxpayer Bill of Rights (TBOR). Agents must consider these rights when carrying out EP examinations. See Policy Statement 1-236 and the Taxpayer Bill of Rights (TBOR).

Acronyms and Definitions

  1. This subsection defines some abbreviations we use in this IRM, but the terms are also discussed in IRM 4.72.3, Employee Plans Technical Guidance, Employee Contributions and Matching Contributions.

    Term Acronym Definition
    Elective deferrals or
    Elective contributions
    ED Contributions made to a plan per an employee’s cash or deferred election. EDs are:
    • Included in the IRC 402(g) definition of elective deferrals.

    • Treated as employer contributions for most purposes of the Code, including IRC 401(a), IRC 401(k), IRC 402, IRC 404, IRC 409, IRC 411, IRC 412, IRC 415, IRC 416, and IRC 417.

    • Counted as part of the employee’s wages for FICA withholding, FUTA, and Railroad Retirement tax.

    • Treated as plan assets for the Department of Labor, ERISA Title 1 rules.

    Actual deferral ratio ADR An employee’s EDs (and amounts treated as EDs) for a plan year divided by his/her compensation for the plan year.
    Actual deferral percentage ADP The average of the ADRs for the relevant group of employees. ADP is used in the ADP test, an anti-discrimination test in IRC 401(k)(3)(A)(ii).
    Actual contribution ratio ACR The sum of an employee’s employee contributions and matching contributions (and amounts treated as matching contributions) for a plan year divided by his/her compensation for the plan year.
    Actual contribution percentage ACP The average of the ACRs for the relevant group of employees. It is used in the ACP test, an anti-discrimination test in IRC 401(m)(2)(A)
    Qualified nonelective contributions QNECs (or QNCs) Special employer contributions not subject to a CODA election.
    • Always fully vested

    • Subject to certain distribution restrictions

    • May be treated as elective deferrals or matching contributions in the ADP test or the ACP test respectively.

    Qualified matching contributions QMACs Employer matching contributions:
    • Always fully vested

    • Subject to certain distribution restrictions

    • Counted in the ACP test unless they are treated as elective deferrals, in which case they are counted in the ADP test.

    Automatic contribution arrangement, ACA An arrangement within a CODA under which, if a covered employee doesn't affirmatively elect a different percentage (including 0), the plan sponsor withholds a certain percentage of compensation from the employee’s compensation and contributes it to the plan as an elective contribution.
    Qualified automatic contribution arrangement QACA A type of safe harbor 401(k) plans in IRC 401(k)(13) that includes an ACA and satisfys other requirements. A QACA has minimum contribution requirements and isn't subject to the ADP or ACP test if the plan/plan sponsor satisfies additional requirements in IRC 401(m)(12).
    Eligible automatic contribution arrangement EACA A type of ACA in IRC 414(w). An EACA may permit covered employees to withdraw initial amounts they contribute under a default election. EACAs alone don’t automatically satisfy the nondiscrimination requirements under IRC 401(k)(3).
  2. A "safe harbor 401(k) plan" means a plan that isn’t subject to the:

    1. ADP test because it meets the requirements of IRC 401(k)(12) or 401(k)(13).

    2. ACP test if it meets the safe harbor requirements of IRC 401(m)(11) or 401(m)(12), as applicable.

Overview of CODAs

  1. A CODA is an arrangement that allows eligible employees to make a cash or deferred election (before the taxable benefit is currently available to him/her) for contributions, benefits or accruals in a plan intended to satisfy IRC 401(a). A cash or deferred election is an employee’s direct or indirect election (or modification of an earlier election) to have the employer either:

    1. Give the employee an amount in cash or some other taxable benefit that is not currently available.

    2. Contribute an amount to a trust, or give an accrual or other benefit, to a plan deferring the employee’s receipt of compensation.

  2. A cash or deferred election includes "deemed" elections made under an automatic contribution arrangement (ACA), (also known as "automatic-enrollment" ). In an ACA, if an employee doesn’t affirmatively elect not to contribute, or contribute a different amount, the plan applies a default election, so that, the employer can treat an employee as having made an election to have a specified contribution made on his/her behalf to the plan.

  3. A CODA that is not qualified is one that doesn’t satisfy the requirements of IRC 401(k). Except where clearly specified, these guidelines assume a CODA is intended to be a qualified CODA, using the term "CODA" to mean a qualified CODA because only qualified CODAs get the benefit of tax deferral. An employee’s contributions made per a cash or deferred election to a qualified CODA aren’t treated as distributed or made available to the employee. So, they are not included in the employee’s gross income until distributed (unless they are designated Roth contributions). See IRC 402(e)(3).

CODA Changes

  1. This IRM reflects statutory changes made by these laws and reflects all current guidance as of this IRM’s effective date:

    • Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA)

    • Pension Protection Act of 2006 (PPA)

    • Worker, Retiree, and Employer Recovery Act of 2008 (WRERA)

    • Small Business Jobs Act of 2010 (SBJA)

    • Patient Protection and Affordable Care Act (PPACA)

    • American Taxpayer Relief Act of 2012 (ATRA)

  2. The statutes listed below made the following changes to CODAs:

    Year
    Effective
    Law
    Section
    IRC
    Section
    Changes
    2002 EGTRRA 631 414(v) Adds catch-up contributions for individuals age 50 or over.
    2002 EGTRRA 646 401(k)(2)(B)(i)(I) Replaces "separation from service" with "severance from employment" to eliminate the "same desk rule."
    2002 EGTRRA 646 401(k)(10) Removes certain corporate dispositions from the list of distributable events for elective deferrals, because these dispositions are now covered by a "severance from employment."
    2002 EGTRRA 666 401(m)(9) Eliminates the multiple use test.
    2002 EGTRRA 636 401(k)(2) Directs the Secretary of the Treasury to modify deemed hardship rules to reduce the suspension period after a hardship distribution from 12 months to six months,
    2002 EGTRRA 611(d) 402(g) Increases the maximum limit for elective deferrals and changed the method for determining COLAs.
    2002 EGTRRA 611(f) 401(k)(11) Refers to IRC 408(p) for the maximum amount of elective deferrals that can be made to a SIMPLE 401(k) plan.
    2002 EGTRRA 613(b) 416(c)(2)(A) Stated that matching contributions are used to satisfy the top heavy minimum contribution requirement.
    2002 EGTRRA 613(d) 416(g)(4)(H) Exempts certain safe harbor 401(k) plans from the top heavy rules.
    2002 PPA 904(a) 411(a)(2)(B) Changes the minimum vesting requirements for matching contributions to either three-year cliff or six-year graded.
    2006 EGTRRA 617 402A Permits optional treatment of elective deferrals as Roth contributions.
    2006 PPA 826 401(k), 403(b), 409A and 457(b) Directs the Secretary of the Treasury to modify deemed hardship rules so that a participant’s beneficiary is treated the same as the participant’s spouse or dependent when deciding whether the participant has incurred a hardship or unforeseeable financial emergency.
    2006 PPA 861(a)(2) 401(k)(3)(G) States that all governmental plans (per IRC 414(d)) are treated as meeting the participation and nondiscrimination requirements of IRC 401(k)(3). Before this change, only state and local government plans were so treated.
    2007 PPA 904 411(a) Changes the minimum vesting requirements for employer nonelective contributions to defined contribution plans to either 3-year cliff or 6-year graded.
    2008 PPA 902(a) and (b) 401(k)(13) and 401(m)(12) Permits qualified automatic contribution arrangements (QACAs) as alternative ways of satisfying the ADP and ACP tests.
    2008 PPA 902(d) 414(w), 401(k)(8)(E) and 411(a)(3)(G) Allows eligible automatic contribution arrangements (EACA)
    Allows plans to forfeit matching contributions associated with permissible withdrawals under IRC 414(w).
    2008 PPA 902(e)(3)(A) &(B) 401(k)(8)(A)(i), 401(m)(6)(A) and 4979(f)(1) Eliminates the "gap-period earnings" rule for excess and excess aggregate contributions. Gap-period earnings are earnings from the end of the year in which the excess arose to the date of distribution.
    2008 WRERA 109(b)(3) 402(g)(2)(A)(ii) States that a corrective distribution of excess deferrals may not include gap-period earnings.
    2008 PPA827(b) 401(k)(2)(B)(i) States that elective deferrals may be distributed as a "qualified reservist distribution" defined in IRC 72(t)(2)(G), effective for distributions after September 11, 2001.

    Note:

    HEART section 107(a) extends the applicability of the qualified reservist distribution to individuals ordered or called to active duty after December 31, 2007

    .
    2008 PPA 902(e)(2) 4979(f)(2) States 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.
    2010 PPA 903(a) 414(x) Allows "eligible combined plans (" a "DB-K plan)" - a plan that has defined benefit plan that meets certain specified benefit and vesting requirements and a CODA that meets certain specified contribution, vesting, nondiscrimination and notice requirements.
    2010 SBJPA 2112 402A(c)(4) States amounts can be rolled into an employee’s designated Roth account from another account in the same plan if the amount was otherwise eligible for rollover.

    Reminder:

    The taxable part of the "in-plan Roth rollover" made in 2010 could have been deferred. Half of the taxable part could've been included in income in 2011 and the other half in 2012.

    2011 SBJPA 2111 402A(e)(1) Stated that a governmental IRC 457(b) plan could include a designated Roth program.
    2013 PPACA 9013 213 Amends the deductible medical expense amount from amounts exceeding 7.5 percent to amounts exceeding 10 percent of adjusted gross income. There is a transition rule for individuals age 65 and older.

    Note:

    The only effect this has on 401(k) plans is a reference to the old 7.5 percent limit in the Treasury regulations dealing with deemed hardship standards. See IRM 4.72.2.7.2.2, Deemed Hardship Distribution Standards

    .
    2013 ATRA 902 402A(c)(4)(E) Expands amounts eligible for in-plan Roth rollovers. A plan can now permit amounts not otherwise eligible for rollover to be rolled over to an employee’s designated Roth account.
  3. The IRS issued these guidance items on IRC 401(k):

    Guidance IRC Section(s)
    affected
    Guidance provided:
    Rev. Rul. 2004-13 , 2004-1 C.B. 485 416(g)(4)(H) Whether certain safe harbor 401(k) plans are subject to the top heavy rules.
    Treasury regulations published on December 29, 2004, 69 CFR 78144 401(k) and 401(m) Sets comprehensive requirements (including the nondiscrimination requirements) for 401(k) and 401(m) plans
    Treasury regulations published on January 3, 2006, 71 CFR 6 401(k) and 401(m) Explains Designated Roth contributions for plan qualification purposes.
    Treasury regulations published on April 5, 2007, 72 CFR 16878 415 and 401(k) Adds paragraph (e)(8) to CFR 1.401(k)-1, requiring deferral elections to be made only from compensation defined in IRC 415(c)(3) and CFR 1.415(c)-2 . Elective deferrals may be made from severance pay if this pay would otherwise be paid by the later of:
    • 2 1/2 months after severance from employment

    • the end of the year that includes the date of severance from employment.

    See 26 26 CFR 1.415(c)-2(e)(3)(ii) or (iii) minimum coverage requirements in IRC 410(b).
    Treasury regulations published on April 30, 2007, 72 CFR 21103 401(k), 402(g), 402A and 408A Addresses Designated Roth contributions.
    Treasury regulations published on July 21, 2006, 71 CFR 41357 401(k), 401(m) and 410(b) Permits the exclusion of certain employees of a tax-exempt organization described in IRC 501(c)(3) for purposes of determining whether an IRC 401(k) plan (or an 401(m) plan) meets the minimum coverage requirements in IRC 410(b).
    Announcement 2007-59, 2007-1 C.B. 1448 401(k) States that a plan will not fail to satisfy the requirements to be a safe harbor 401(k) just because it adds a designated Roth contribution program or the deemed hardship rules for the designated beneficiary of a participant mid-year (under PPA section 826).
    Notice 2007-7, Part III, 2007-1 C.B. 395 401(k) Contains guidance on PPA section 826 for 401(k) plan distributions on account of the hardship of a participant’s beneficiary
    Treasury regulations published on February 24, 2009, 74 CFR 8200 401(k)(13), 401(m)(12) and 414(w) Adds QACAs and EACAs.
    Rev. Rul. 2009-30, 2009-39 IRB 391 401(k) and 414(w) Explains how automatic enrollment in an IRC 401(k) plan can work when it includes an escalator feature.
    Rev. Rul. 2009-31, 2009-39 IRB 395 and Rev. Rul. 2009-32, 2009-39 IRB 398 401(k) States that plan sponsor may contribute the dollar equivalent of any unused paid time off to a profit-sharing plan on either an annual basis or upon termination of employment.
    Notice 2009-65, 2009-39 IRB 413 401(k) and 414(w) Contains two sample amendments 401(k) plan sponsors can use to add automatic enrollment features to their plans.
    Notice 2010-84, 2010-51 IRB 872 402A(c)(4), 401(k), 403(b) and 408A Contains guidance on in-plan Roth rollovers under SBJPA.
    Treasury regulations published on November 15, 2013, 78 CFR 68735 401(k) and 401(m) Expands the reasons for suspending safe harbor contributions in a safe harbor IRC 401(k) (IRC 401(k)(12)) or a QACA (IRC 401(k)(13)).
    Notice 2013-74, 2013-52 IRB 819 402A(c)(4)(E), 401(k), 403(b) and 457(b) Contains guidance on in-plan Roth rollovers under ATRA.
    Notice 2014-19, 2014-17 IRB 979 401(a), 401(k), 417(a)(4) and other related sections Contains guidance on applying the decision in United States v. Windsor, 570 U.S. 12 (2013), and the holdings of Rev. Rul. 2013-17, 2013-38 IRB 201 to retirement plans
    Notice 2014-37, 2014-24 IRB 1100 401(k) and 401(m) Provides guidance on a mid-year amendment to a safe harbor plan under IRC 401(k) and 401(m) to reflect the outcome of United States v. Windsor, per Notice 2014-19.
    Notice 2016-16, 2016-7 IRB 318 401(k) and 401(m) Contains guidance on a mid-year change to a safe harbor plan under IRC 401(k) and 401(m).
    Notice of Proposed Rulemaking REG-131643-15, 2017-6 I.R.B. 865, 401(k) and 401(m) Proposed regulations on the definitions of QNEC and QMAC.

Eligible Employer and Plan

  1. Employers/entities that can establish a CODA:

    Employer/Entity Delineated Dates Cite
    Sole Proprietors, Partnerships, Corporations and Federal Government Agencies N/A 26 CFR 1.401(k)-1(a)(6)
    Tax-Exempt Organizations Effective January 1, 1997

    Note:

    between May 6, 1986 and December 31, 1996, tax-exempt organizations (other than rural co-ops) could not establish a CODA

    IRC 401(k)(4)(B)(i)
    Tax Reform Act of 1986, section 1116
    Indian Tribal Governments (and related entities) Effective January 1, 1997 IRC 401(k)(4)(B)(iii)
    State or Local Governments Only those with a CODA on May 6, 1986, may continue or establish a new CODA 26 CFR 1.401(k)-1(e)(4)
  2. An employer who establishes a SIMPLE 401(k) plan under IRC 401(k)(11) must be an "eligible employer" (in addition to meeting the requirements in IRM 4.72.2.3 (1)). That is, 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 (IRC 408(p)(2)(C)(i)).

  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 IRC 401(k)(1), (2), (6) and (7). If a CODA doesn't satisfy IRC 401(k), it won't always disqualify the plan of which it is a part of.

    Example:

    A CODA in a profit-sharing plan fails the ADP test. This doesn't automatically disqualify the plan, although the plan will most likely have failed to follow its terms, which is ground for disqualification. But, a CODA that is part of a defined benefit plan would disqualify the entire plan because defined benefit plans are not permitted to contain CODAs.

    Exception:

    An "eligible combined plan" is a combination of a defined benefit plan that meets certain specific benefit and vesting requirements and a separate defined contribution plan containing a CODA that meets certain specific contribution, vesting, nondiscrimination and notice requirements. See IRC 414(x).

  4. Sometimes the term "401(k) plan" is used to refer to a plan that contains a CODA. However, the plan may offer one or more types of other contributions, such as employee (after-tax) contributions, and employer matching and nonelective contributions.

CODA Defined

  1. A CODA is any arrangement under which an eligible employee may elect between receiving a current compensation amount or a deferred compensation benefit in a plan subject to IRC 401(a) plan.

  2. Only certain plans may contain CODAs (see IRM 4.72.2.3 (3)) and only certain employers may maintain plans with CODAs (see IRM 4.72.2.3 (1).)

  3. A CODA doesn’t include arrangements that:

    • Treat amounts contributed at an employee’s election at the time of contribution as after-tax employee contributions. (A designated Roth contribution isn’t treated as an after-tax employee contribution for the CODA rules.)

    • Distribute or invest ESOP dividends under either participants or beneficiaries elections following the rules of IRC 404(k)(2)(A)(iii).

Cash or Deferred Election

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

    1. Give an amount to him/her in cash or some other taxable benefit not currently available to the employee at the time of the election.

    2. Contribute an amount to a trust, or give 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 either:

    1. It has been paid to the employee.

    2. The employee is able currently to receive the cash or other taxable benefit at his/her discretion.

  3. An amount is not currently available to an employee if either:

    1. There is a significant limitation or restriction on his/her right to receive the amount currently.

    2. He/she may under no circumstances receive the amount before a particular time in the future.

      Note:

      The determination as to whether an amount is "currently available" for CODA purposes doesn’t depend on whether it is also "constructively received" for purposes of IRC 451.

  4. Participants can elect to defer only compensation they earn that would, but for the election, become currently available after the later of the date the CODA is:

    1. adopted.

    2. effective

  5. A participant’s salary deferral election uses a salary reduction agreement in which an eligible employee agrees to reduce his/her cash compensation, or forgo an increase in cash compensation, in exchange for the employer contributing that amount to the plan. But, the election may also be made under an ACA. Under these "automatic enrollment plans," employees must be given a reasonable opportunity to elect to have a different amount or no amount contributed to the plan. Under 26 CFR 1.401(k)-1(a)(3)(ii) , when you decide if an election is a cash or deferred election, it doesn’t matter whether the plan default (absent an affirmative election) is:

    • The participant receives cash.

    • The plan makes an elective contribution on his behalf.

Certain One-Time Elections

  1. One-time irrevocable non-participation elections are not considered CODA elections.

    Example:

    A plan permits employees to make an irrevocable election to contribute or not contribute to the plan or any of the other employer’s plans (including plans not yet established) for their employment with that employer on their hire date or when they first becomes eligible under any of the employer’s plans.

    Note:

    So, if these were the only elections available under a plan, the plan wouldn’t be considered to contain a CODA because employees are given a one-time, irrevocable election. Contributions employees made to a plan by this election wouldn’t be considered EDs.

  2. Plans that use a one-time election can’t permit employees to do a one-time election:

    • If they’ve participated in any of the employer’s plans.

    • When they change jobs with the same employer, such as from associate to partner, or union employee to manager.

  3. Plans that give this one-time irrevocable election must follow the regular, non-CODA nondiscrimination rules. So, they must offer the one-time election to a nondiscriminatory group, and the plan as a whole must satisfy the regular nondiscrimination rules.

CODAs of Self-Employed Individuals

  1. Under the partnership taxation rules, when a partnership plan sponsor makes a contribution on behalf of a partner:

    • The contribution is allocated to that partner.

    • The contribution is deducted on the partner’s individual income tax return.

    • The contribution is deducted from the partner’s distributive share of the partnership income.

    • The remaining portion of the partner’s distributive share of partnership income is payable directly to the partner.

  2. Because a partner can choose to vary the plan contribution the partnership makes for him/her, this is a cash or deferred election. Rev. Proc. 91-47, 1991-2 C.B. 75 gave limited relief for partnership plans that allowed partners to individually vary their plan contributions, but plans had to be amended by the end of the 1992 plan year to become either a qualified CODA or a plan without variable contributions.

  3. For plan years beginning after 1997, matching contributions of self-employed individuals, including partners, are no longer treated as EDs (Taxpayer Relief Act of 1997, Pub. L. 105-34, section 1501, added IRC 402(g)(9) (now IRC 402(g)(8)).

  4. Self-employed participant compensation is deemed currently available for a cash or deferred election for:

    1. A partner - on the last day of the partnership taxable year. So, a partner can make a cash or deferred election for a year’s compensation any time before (but not after) the last day of the year, even though the partner takes drawsagainst his/her expected share of partnership income throughout the year. See 26 CFR 1.401(k)-1(a)(6) .

    2. A sole proprietor - on the last day of the individual’s taxable year.

Qualified CODAs

  1. To be a qualified CODA under IRC 401(k), the arrangement must meet these requirements:

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

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

    3. EDs aren’t distributable before certain events.

    4. EDs are nonforfeitable at all times.

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

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

    7. Benefits, other than matching contributions, must not be contingent on an employee’s choosing or not choosing to make a deferral.

    8. The plan can’t require more than one year of service before an employee is eligible to make a cash or deferred election.

  2. A governmental plan (under IRC 414(d)) meets requirements (e) and (f), above.

Nonqualified CODAs

  1. A nonqualified CODA is one that fails to meet one or more of the requirements listed in IRM 4.72.2.4.4, Qualified CODAs. An employee includes his/her elective deferrals in a nonqualified CODA in gross income at the time they would’ve been included if not for the cash or deferred election.

  2. If the CODA is nonqualified because it is part of an ineligible plan, then the entire plan is not qualified.

  3. But, if the nonqualified CODA is part of a plan permitted to include a CODA (such as, a profit-sharing plan), then the entire plan may still satisfy IRC 401(a). However, a nonqualified CODA invariably violates the terms of the plan document and causes the entire plan to be nonqualified. Treat and test the elective deferrals in a nonqualified CODA as employer nonelective contributions. And, to determine if the plan satisfies the nondiscrimination requirements of IRC 401(a)(4), the plan can’t use the ADP and ACP tests.

  4. Nonelective employer contributions under a nonqualified CODA satisfy IRC 401(a)(4) if the arrangement is part of a collectively bargained plan that automatically satisfies the requirements of IRC 410(b). Also, IRC 401(a)(4) and IRC 410(b) don’t apply to a IRC 414(d) governmental plan.

Examination Steps

  1. Review corporate and other documents to verify that the plan sponsor adopted the CODA and made it effective before any deferral elections took effect.

  2. Verify that 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 regularly elect in and out of the plan in return for changes in compensation. This is a cash or deferred election unless it fits the one-time irrevocable election exception in IRM 4.72.2.4.2.

  3. Review Forms W-2 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 have one (for example, a profit-sharing plan). If the employer isn’t eligible (see IRM 4.72.2.3 (1)), the entire plan is not qualified.

  5. If the plan is eligible to have a CODA, determine if the CODA is qualified or not qualified. If not qualified, verify:

    1. The EDs were reported in participants’ wages in the year they were withheld from compensation. Research IDRS if necessary. See IRM 4.72.2.4.5 (1).

    2. The plan satisfied the coverage and nondiscrimination rules of IRC 410(b) and IRC 401(a)(4), counting the EDs as employer nonelective contributions. See IRM 4.72.2.4.5 (3) for further explanation.

Coverage and Participation

  1. The CODA portion of the plan, by itself, must satisfy one of the IRC 410(b) coverage tests:

    • The ratio percentage test

    • The average benefits test

  2. Plans containing CODAs may be permissively aggregated for coverage and can satisfy the ratio percentage test if they have the same plan year and use the same testing method (prior year or current year). CODA plans can’t be aggregated with a non-CODA plan.

  3. Eligible employees are

    • Employees who are eligible to make an ED.

    • Employees who are temporarily prohibited under the plan from making deferrals, such as a suspension following a hardship distribution. See IRM 4.72.2.9.1, ADP Test.

      Note:

      Eligible employees are considered to "benefit" in the plan (in other words, are covered) even if they choose not to make deferrals.

  4. Under 26 CFR 1.401(a)(4)–11(g)(3):

    1. Plan sponsors may retroactively amend their IRC 401(k) and 401(m) plans to meet coverage by extending eligibility to employees for the preceding plan year. They must amend within 10 1/2 months after the plan year.

    2. If a CODA needs to add NHCEs to satisfy IRC 410(b), the employer must make a QNEC contribution to them equal to the NHCE ADR average.

      Note:

      Plans can’t use the above retroactive correction feature for other defects, such as a failed ADP test.

  5. A CODA can’t have more than one year as its minimum service requirement for participation (IRC 401(k)(2)(D)). The IRC 410(b)(1)(B) eligibility rules (up to two years if immediate vesting) apply for other contributions, such as matching contributions or QNECs.

  6. For the ADP test:

    • Employees covered by a collective bargaining agreement must be disaggregated from employees not covered by a collective bargaining agreement.

    • Separate collective bargaining units within the same plan may be disaggregated, but are not required to be.

    • Combining bargaining units for testing must be reasonable and reasonably consistent from year to year.

    • Equivalent rules apply to multiemployer plans.

  7. CODAs aren’t subject to the rules requiring mandatory disaggregation of ESOP and non-ESOP portions of a plan (26 CFR 1.410(b)-7(c)). So, despite the rule prohibiting permissive aggregation of plans or portions of plans that are mandatorily disaggregated (26 CFR 1.410(b)-7(d)(2 )), an employer may aggregate plans containing ESOP features with those that do not for purposes of CODA testing, even if the ESOP and non-ESOP are in different plans of the employer.

Examples

  1. An employer has Division A and B as its workforce. The plan document states that only employees of Division A are eligible to participate in the 401(k) plan. Division A employs 80 employees: five highly compensated employees (HCEs) and 75 NHCEs. All Division A employees satisfy the 401(k) plan’s participation requirements. Division B employs 25 employees and all are NHCEs. The plan benefits at least 70 percent of total NHCEs (75/100 divided by 5/5=75 percent); so, the plan passes coverage without having to use the average benefits test.

  2. Employer C’s plan allows elective deferrals, matching contributions and employer discretionary profit-sharing contributions. Under the plan terms, all employees are eligible to make elective deferrals and to receive matching and discretionary profit sharing contributions. Employer C makes a matching contribution for all employees making elective deferrals. Employer C also made a discretionary profit-sharing contribution of five percent of each employee’s compensation. Under the disaggregation rules, each portion of the plan must be separately tested for and meet coverage.

    Part of plan that must satisfy coverage Conclusion
    401(k) portion Satisfies coverage as 100 percent of non-excludable employees benefit
    401(m) portion Satisfies coverage as 100 percent of non-excludable employees benefit
    Profit sharing portion Satisfies coverage as 100 percent of non-excludable employees benefit

Examination Steps

  1. Inspect the plan document and review all eligibility sections (define eligible employees, age and service requirements and entry dates). A plan can have separate eligibility requirements for EDs, matching contributions and nonelective contributions.

    Reminder:

    A plan can’t require an employee to complete more than one year of service to be eligible to make EDs.

  2. Eligibility, participation and coverage - review these records to determine who should or shouldn’t be included in the plan. Review any related entities’ records if the entity is a member of a controlled group or part of an affiliated service group.

    1. Inspect the Form 5500 lines that list the total number of employees, excluded employees and employees benefiting. Compare these numbers with the payroll records to determine if the plan/return considers all employees.

    2. Inspect employer payroll records for the total employees, birth dates, hire dates, hours worked, collective bargaining 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 considered for the coverage test.

    4. Inspect participant election forms to verify the names of eligible employees who elected not to participate in the plan (have EDs made to the plan). Include these employees: as eligible employees with a zero percentage in the ADP calculations (and in the ACP calculations but not if they make after- tax employee contributions) and as eligible employees for receiving an allocation of other, non-ED, employer contributions if they are eligible.

    5. Inspect payroll records and extract the names of those employees who terminated employment during the year. Many plans require an employee to be employed on the last day of the plan year to receive an allocation of an employer nonelective contribution. Many small plans have a last-day requirement and could fail coverage if this condition prevents a necessary allocation. Include any terminated employee with more than 500 hours of service in the coverage test.

    6. Inspect Form 1125-E, Compensation of Officers, to gather names of officers and ownership percentages to help identify related entities.

    7. Inspect any Form 851, Affiliations Schedule, attached to the corporate 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 he/she owns and operates any other entities. The self- employed individual should file separate Schedules Cs, Profit or Loss from Business, for each business.

    9. Inspect the plan document to determine whether the plan covers leased employees. Obtain contracts the employer has with any leasing organization and information/records for the leased employee’s benefits in the leasing organization’s retirement plans. If the employer has leased employees, the plan may state that these employees are excluded, however, the employer will generally have to include leased employees in the test when the leased employee is performing services on a substantially full-time basis and when the total number of leased employees is more than 20 percent of the employer’s NHCE workforce. If this is the case, consider the leased employees for the code sections noted under IRC 414(n) . If leased employees are eligible to participate per plan terms, ensure the plan includes them. Determine if the plan passes coverage when it’s required to include them in the coverage test. An employer may include the leased employee’s benefits from the leasing organization as though the employer provided them when testing for coverage.

  3. Ensure the plan passes one of the IRC 410(b) tests:

    1. The ratio percentage test

    2. The average benefits test

  4. Include all employees of the employer, including controlled group or affiliated service group member employees in the coverage test. See IRC 414(b), IRC 414(c) and the Treasury regulations for controlled group rules. See IRC 414(m) for affiliated service group rules. The three common forms of controlled groups are:

    • Parent-subsidiary

    • Brother-sister

    • Combined groups

Contribution Limitation

  1. IRC 402(g)(1)(A) and (B) sets the maximum elective deferrals (other than catch-up contributions) an employee can make for a tax year. The amount may be increased, in $500 increments, in future years for cost-of-living increases. See annual dollar limits.

  2. Deferrals in excess of the 402(g) limit are called excess deferrals.

    1. Employees include elective deferrals they make in excess of the annual limit in their gross income for the year and again, when they receive their account as a plan distribution. See IRC 402(g) .

    2. To avoid double income inclusion of excess deferrals, an employee may inform an employer of the amount of excess deferrals in their plan and request them to distribute it with attributable earnings through the end of the year. See 26 CFR 1.402(g)-1.

    3. If the plan returns excess deferrals by April 15 after the year of the excess, they won’t be included in the participant’s gross income when distributed. The employer is not required to honor a request, although most plans do.

    4. Conversely, the employee can’t refuse a distribution if the excess deferrals arose under plans of one employer. (See IRM 4.72.2.6 (5) and IRM 4.72.2.6 (6) below.) However, If a plan has undistributed excess deferrals that aren’t 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. IRC 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. So, 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. The maximum elective deferral amount is increased by the permitted amount of catch-up contributions. See IRC 402(g)(1)(C) and IRC 414(v) . Participants age 50 or older can make catch-up contributions. See IRM 4.72.2.10, Catch-Up Contributions.

  5. A plan can’t accept elective deferrals from an employee in excess of the 402(g) limit, counting only plans of that employer. So, if an employee defers more than the 402(g) limit, in the aggregate, in one or more plans maintained by the employer group, all of these plans could be disqualified (IRC 401(a)(30)).

    Example:

    An employee works for Company Y from January to June, then transfers to related Company Z for the next six months. His deferrals into Company Y’s plan and into Company Z’s plan for the calendar year are aggregated to determine if the 402(g) limit has been exceeded. Both plans will fail qualification requirements if they accept excess deferrals and don’t correct the problem.

  6. A plan must distribute excess deferrals and their earnings (calculated through the end of the year) by April 15 following the year of the excess to avoid failing IRC 401(a)(30). If a participant has excess deferrals, she is deemed to request a distribution and the plan isn’t required to secure employee or spousal consent.

  7. Unless they can be recharacterized as catch-up contributions, HCE elective deferrals in excess of the 402(g) limit are still counted for ADP testing purposes, even if they are timely distributed. Conversely, timely distributed NHCE excess deferrals over the 402(g) limit are not counted. See 26 CFR 1.402(g)-1(e)(1)(ii).

  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 it must make to that employee to correct the ADP test.

  9. The IRC 402(g) limit:

    1. Applies only to elective deferrals.

    2. Doesn’t affect other contributions included in the ADP test.

    3. Must be stated in plan but may be incorporated by reference.

Example

  1. Employer A maintains a 401(k) plan that allows participants to elect to defer up to a maximum of 15 percent of their compensation for the year. The plan year is the calendar year. For calendar year 2017, Participant B elects to defer 15 percent of his compensation. Participant B, a HCE, age 40, receives $140,000 of compensation during the year. The total elective deferrals made on behalf of Participant B for calendar year 2017 was $21,000. The IRC 402(g) limit for a person under age 50 for 2017 is $18,000. So, Participant B had an excess deferral of $3,000. The employer must distribute the excess, plus attributable earnings through the end of 2017, by April 15, 2018, for the plan to remain qualified.

    Note:

    If Participant B was age 50 or older in 2017 and the plan permitted catch-up contributions, he wouldn’t have excess deferrals because the total elective deferral limit for 2017, including catch-ups, is $24,000 ($18,000 + $6,000).

Examination Steps

  1. Inspect the plan document to determine the maximum elective deferrals an employee can defer.

  2. Inspect records to ensure each participant complies with the IRC 402(g) limit in effect for the year.

    1. Inspect the Form W-2, Wage and Tax Statement for all employees.

    2. Compare Form W-2 (Box #12 - code "D" for elective deferrals or "AA" for designated Roth contributions) with payroll records and account statements to reconcile the reported amounts and ensure they are accurate.

    3. Inspect all Forms W-2 of a controlled group to ensure participants haven’t exceeded the limit if they participate in more than one of the controlled group’s 401(k) plans during the year. IRC 402(g) follows the individual and all his/her deferrals must be aggregated to ensure compliance with IRC 402(g) and IRC 401(a)(30).

      Note:

      It’s common for an employee in a mid-size or a large company to split time between different companies in a controlled group of corporations having separate 401(k) plans. The individual can’t defer more than the IRC 402(g) limit to the employer’s plans. The employee’s deferrals must be aggregated to determine whether he/she exceeded the limit. Ask your contact person if employees work for more than one company in the controlled group.

    4. Ask a Computer Audit Specialist (CAS) for help to download the data to an Excel spreadsheet or Access Database if a large employer gives you payroll data on electronic media. The CAS can also help you test or query data for different limits such as IRC 402(g).

    5. Ensure that the plan sponsor properly and timely corrected any excesses by April 15th of the following year if you find excesses when you test the plan for IRC 402(g) and IRC 401(a)(30). Inspect Forms 1099-R for distributions and cancelled checks to determine when the distribution was actually made.

Restricted Distributions

  1. Contributions that a plan may distribute:

    1. Elective contributions on death, disability, severance from employment, an event described in IRC 401(k)(10) (plan termination) or as a qualified reservist distribution described in IRC 72(t)(2)(G) (IRC 401(k)(2)(B)).

      Note:

      The one event described in IRC 401(k)(10) is termination of the plan without the establishing or maintaining another defined contribution plan other than an ESOP.

    2. Contributions made to a CODA that is part of a profit-sharing, stock bonus or rural cooperative plan, when the participant is age 59 1/2 or older.

    3. Elective contributions (and grandfathered earnings, QNECs, QMACs and earnings on these QNECs and QMACs) to a profit-sharing, stock bonus or rural cooperative plan may be distributed on account of hardship.

      Note:

      Because the "grandfathered" amounts referred to in the preceding sentence were accrued, in most cases, before 1988 or 1989, most plans will only have elective deferrals available for hardship distribution.

  2. Contributions that a plan can’t distribute in a hardship distribution:

    1. QNECs and QMACs, unless grandfathered.

    2. Safe harbor contributions in 401(k)(12) and 401(k)(13) plans.

  3. An employee has a severance from employment when the employee ceases to be an employee of the employer maintaining the plan. An employee doesn’t have a severance from employment if the new employer either:

    • Continues the prior employer’s plan.

    • Accepts a transfer of plan assets or liabilities (within the meaning of IRC 414(l)) for that employee.

  4. Plans may also make distributions, when legislation is enacted to respond to natural disasters, in the amounts and during the periods specified in the legislation.

Plan Termination

  1. Under IRC 401(k)(10)(A), a 401(k) plan can make a distribution to employees if:

    1. The plan is being terminated.

    2. The employer doesn’t maintain another defined contribution plan (other than an ESOP) from the date of termination to 12 months after all assets have been distributed from the terminating plan.

    3. It distributes in a lump sum.

  2. A plan can make a termination distribution even if the employer maintains or establishes any of these plans:

    • SEP

    • SIMPLE IRA

    • 403 (b)

    • 457 (b) or (f)

  3. 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.

    Note:

    See 26 CFR 1.401(k)-1(d)(4) for special rules on how to determine whether the employer (or employer group) maintains another defined contribution plan.

  4. The terminating plan, can however, distribute to participants if less than 2 percent of its employees have been or will become eligible for the other plan in the 24-month period that begins 12 months before the date of termination.

  5. A plan subject to the joint and survivor annuity rules can satisfy the lump-sum distribution requirement by distributing an immediate annuity that satisfies the qualified joint and survivor annuity requirements in IRC 401(a)(11) and IRC 417.

Hardship Distribution

  1. The following plans may distribute elective deferrals on account of hardship:

    1. Profit-sharing

    2. Stock bonus

    3. Rural cooperative plan

  2. A hardship distribution must be limited to the maximum distributable amount. The maximum distributable amount is the employee’s total elective deferrals as of the distribution date less previous distributions of elective deferrals. So, unless grandfathered, the maximum distributable amount doesn’t include:

    1. Earnings

    2. QNECs

    3. QMACs

      Note:

      The regulations permit a plan to provide a grandfather rule to include earnings, QNECs and QMACs accrued no later than December 31, 1988 (or, if later, the end of the last plan year ending before July 1, 1989) in a hardship distribution. Determine an employee’s elective deferrals, QNECs and QMACs on the applicable date and use it as a frozen amount. Don’t reduce this amount by losses after that date.

  3. Other employer contributions, outside the CODA, are not subject to these restrictions. Therefore, 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 allow hardship distributions.

  4. Under 26 CFR 1.401(k)-1(d)(3), hardship distributions must meet two requirements:

    1. They must be made on account of an employee’s immediate and heavy financial need.

    2. The hardship amount must be necessary to satisfy the financial need.

  5. Plan sponsors can use either general hardship distribution standards or deemed hardship distribution standards, in the IRC 401(k) Treasury regulations to determine if the hardship distribution meets the requirements in IRM 4.72.2.7.2 (4). They must follow nondiscriminatory and objective standards in the plan to determine if the participant meets the hardship requirements. Most 401(k) plans, including all 401(k) pre-approved plans (i.e., Volume Submitter or Master and Prototype), use the deemed standards.

  6. An employee’s hardship amount can be increased for any taxes or penalties that may result from the distribution.

  7. A 401(k) plan may not have a "catch-all" hardship category (26 CFR 1.411(d)-4 ).

    Example:

    The plan can’t use words such as "and other events which the plan administrator deems to be hardships." This would be impermissible employer discretion.

  8. The plan sponsor may amend a plan to add or eliminate a hardship category or change the conditions for receiving a hardship distribution and this will not violate IRC 411(d)(6). Hardship categories (general or deemed) must be both currently and effectively available to a group of participants that satisfies 26 CFR 1.401(a)(4)-4 .

General Hardship Distribution Standards
  1. Under the general hardship distribution standards, a plan/plan sponsor must determine:

    1. Whether an employee has an immediate and heavy financial need based on all the relevant facts and circumstances.

      Example:

      Funeral expenses of a family member would qualify, but the need for a television would not generally qualify.

    2. What other assets the employee has, such as vacation homes, insurance policies, availability of plan or bank loans (at reasonable rates), etc. because a distribution is not considered necessary to satisfy an immediate and heavy financial need of the employee if the participant can obtain other reasonably available resources.

      Note:

      The plan sponsor is permitted to rely on an employee’s written statement that a hardship can’t be satisfied by the employee’s other reasonably available means.

      Caution:

      The plan sponsor can’t rely on the employee’s written statement if they have actual knowledge that the need can be reasonably relieved through reimbursement from insurance, by liquidation of the employee’s assets, by cessation of elective deferrals, or by other distributions or nontaxable loans under plans of the employer or other employers of the employee.

      Note:

      A participant need not consider commercial loans unless he can reasonably obtain the full amount from the lender. A participant must obtain a plan loan (if available) to offset his/her need for a hardship distribution unless taking a loan would disqualify the employee from obtaining other funds necessary to alleviate the hardship.

Deemed Hardship Distribution Standards
  1. Under the deemed hardship distribution standards, a distribution is considered made on account of "an immediate and heavy financial need" if it’s made for any of the following reasons:

    1. Medical care expenses deductible under IRC 213(d) (determined without considering whether the expenses exceed 10 percent of adjusted gross income) for the employee or the employee’s spouse, children or dependent (as defined in IRC 152) or primary beneficiary under the plan.

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

    3. Payments of tuition, related educational fees, and room and board expenses, for up to the next 12 months of post-secondary education for the employee, or the employee’s spouse, children, or dependents (as defined in IRC 152).

    4. Payments necessary to prevent the eviction of the employee from the employee’s principal residence or foreclosure of the mortgage on that residence.

    5. Payment for burial or funeral expenses for the employee’s deceased parents, spouse, children or dependents (as defined in IRC 152), or primary beneficiary under the plan.

    6. Repair expenses for damage to the employee’s principal residence that qualify for the casualty deduction under IRC 165 (don’t consider whether the loss exceeds 10 percent of adjusted gross income).

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

    1. The distribution amount doesn’t exceed the amount needed.

    2. No alternative means available, such as the employee has obtained all distributions and nontaxable loans currently available in all of his employer’s plans.

    3. The plan prohibits the employee from making elective deferrals and employee contributions to any of the employer’s plans for at least six months after receiving the distribution.

Examples

  1. Employer A maintains a 401(k) plan that permits hardship distributions under the deemed standards. The plan permits participant loans. In 2017, Participant B submits an application requesting a $20,000 hardship distribution 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. The total amount of elective contributions Participant B made is $30,000, and no outstanding plan loans. The plan administrator approved the hardship distribution request and distributed $20,000.

    Note:

    The plan administrator should not have approved this hardship distribution because participant B may be relieved from other resources that are reasonably available ( IRM 4.72.2.7.2.2 (2)(b)), such as a nontaxable loan from the plan. The plan should make nontaxable loans to the participant before making any hardship distributions.

Examination Steps for General Hardship

  1. Inspect the plan language to determine if the plan permits hardship (and distributions in general) and, if so, under what circumstances (general or deemed standards).

  2. Review the plan document sections for allowable distributions. If the plan has QNECs and QMACs, then it must apply the same restrictions to them as elective deferrals. See IRM 4.72.2.7 (2). Unlike elective deferrals, plans can’t distribute QNECs and QMACs on account of hardship, unless grandfathered.

  3. Compare the amount distributed as a hardship to the participant’s total elective deferrals to ensure the distribution doesn’t exceed total elective deferrals.

    Note:

    See participant account statements for a breakdown of the types of contributions.

  4. Inspect copies of hardship application documents to determine if the reason the distribution was made meets the hardship distribution standards.

  5. Inspect the plan document to determine whether loans are available. If so, the plan should make nontaxable loans to the participant before making any hardship distributions, unless that would have the effect of increasing the amount of the need.

  6. Interview the plan administrator to determine the facts and circumstances for questionable distributions.

  7. Request copies of Forms 1099-R for all distributions including hardship distributions.

Examination Steps For Deemed Hardship
  1. If the plan uses the deemed hardship distribution standards, follow these steps to determine whether distributions are made on account of a deemed immediate and heavy financial need.

  2. Step 1:

    1. Determine whether the employer or third-party administrator, before making a distribution, obtains either:

      1. source documents (such as estimates, contracts, bills and statements from third parties)

      2. a summary (in paper, electronic format, or telephone records) of the information contained in source documents.

    2. If the employer/third party uses a summary of information on source documents, determine whether they provides the employee notifications required on Attachment One, in Exhibit 4.72.2-2, before making a hardship distribution.

  3. Step 2:

    1. If the employer/ third-party obtains source documents under Step 1(1)(a), review the documents to determine if they substantiate the hardship distribution.

    2. If the employer/ third-party administrator obtains a summary of information on source documents under Step 1(1)(b), review the summary to determine whether it contains the relevant items listed in Exhibit 4.72.2-2

    3. If the notification provided to employees in Step 1(2) or the information reviewed in Step 2(2) is incomplete or inconsistent on its face, you may ask for source documents from the employer/ third-party administrator to substantiate that a hardship distribution is deemed to be on account of an immediate and heavy financial need.

    4. If the summary of information reviewed in Step 2(2) is complete and consistent but you find employees who have received more than 2 hardship distributions in a plan year, then, in the absence of an adequate explanation for the multiple distributions and with managerial approval, you may ask for source documents from the employer or third-party administrator to substantiate the distributions.

      Example:

      Examples of an adequate explanation include follow-up medical or funeral expenses or tuition on a quarterly school calendar.

    5. If a third-party administrator obtains a summary of information contained in source documents under Step 1(1)(b), determine whether the third-party administrator provides a report or other access to data to the employer, at least annually, describing the hardship distributions made during the plan year.

  4. If you determine that all applicable requirements in Step 1 and Step 2 are satisfied, treat the plan as satisfying the substantiation requirement for making hardship distributions deemed to be on account of an immediate and heavy financial need. You may also inspect the employee’s individual account statement for the six months following the hardship distribution to make sure the employee didn’t make elective deferrals (and after-tax employee contributions).

Nonforfeitability

  1. All employee elective deferrals, QNECs, and QMACs are 100 percent vested at all times, So, an employer can’t:

    1. Redesignate a contribution as a nonforfeitable contribution and call it a QNEC to satisfy the ADP test for a year.

    2. Use forfeitures as QNECs or QMACs, because they aren’t nonforfeitable when made to the plan

      Note:

      On January 18, 2017, IRS and Treasury issued proposed regulations that changed the definitions of QMACs and QNECs (26 CFR 1.401(k)-(6) and 26 CFR 1.401(m)-(5)). Under the current regulations, employer contributions that qualify as QMACs and QNECs must be nonforfeitable when contributed to the plan. Under the proposed regulations, employer contributions to a plan will qualify as QMACs and QNECs if they satisfy applicable nonforfeitability and distribution requirements when they are allocated to participants’ accounts, but need not be when contributed to the plan. The proposed regulations apply to taxable years beginning on or after they are finalized. Taxpayers may however, rely on the proposed regulations before the effective date, but not earlier than January 18, 2017.

  2. However, a plan may forfeit any of the following vested or non-vested matching contribution made on account of an elective or employee contribution (IRC 401(k)(8)(E) and IRC 411(a)(3)(G)):

    1. An excess deferral under IRC 402(g)(2)(A)

    2. An excess contribution (amounts in excess of what is permitted under the ADP test)

    3. An excess aggregate contribution (amounts in excess of what is permitted under the ACP test)

    4. A permissible withdrawal under IRC 414(w)

  3. Plans that keep matching contributions in HCEs’ accounts for their distributed excess contributions (or excess aggregate contributions) (sometimes called "orphan matches" ) will cause the HCEs to have a higher rate of match than NHCEs, resulting in discrimination (26 CFR 1.401(a)(4)-4) . If the plan isn’t required to distribute this matching contribution as an excess aggregate contribution under the ACP test, the plan should forfeit it because there is no mechanism for distributing amounts that fail the 26 CFR 1.401(a)(4)-4 availability test. Of course, the plan can only forfeit the matching contribution if the plan document allows the forfeiture. See 26 CFR 1.401(m)- 2(b)(3)(v)(B) .

Examination Steps

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

  2. Check that the plan forfeits or distributes matching contributions that relate to corrective distributions of elective or employee contributions to satisfy the ADP or ACP test.

CODA Nondiscrimination

  1. A 401(k) plan must satisfy the ADP test annually. See IRC 401(k)(3). The test compares eligible HCEs elective deferrals to 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 of IRC 401(a)(4). Count QNECs and QMACs that the plan treats as elective deferrals in the ADP test.

  2. Annually computing the ADP test and correcting it when it fails can be costly for employers, so Congress enacted three alternatives to the ADP test:

    • SIMPLE 401(k) plans, modeled after SIMPLE IRA plans in IRC 408(p) (for plan years beginning in 1997 and later). See IRC 401(k)(11), IRC 401(m)(10) and IRM 4.72.2.11, SIMPLE 401(k) Plans.

    • Safe harbor 401(k) plans in IRC 401(k)(12) and IRC 401(m)(11) (for plan years beginning in 1999 and later). See IRM 4.72.2.12, Safe Harbor 401(k) Plans.

    • Qualified automatic contribution arrangement (QACA) in IRC 401(k)(13) and IRC 401(m)(12) (for plan years beginning in 2008 and later). See IRM 4.72.2.13, Automatic Contribution Arrangements (ACAs).

  3. Although a CODA must satisfy the ADP test (or be deemed to satisfy the ADP test because it’s part of a SIMPLE 401(k) plan, a safe harbor 401(k) plan or a QACA) for the amount of elective deferrals, the plan must satisfy the nondiscriminatory availability requirement of 26 CFR 1.401(a)(4)-4(e)(3) because the right to make each level of elective deferrals under a CODA is a benefit, right or feature.

  4. A governmental plan under IRC 414(d) is treated as meeting the ADP test (IRC 401(k)(3)(G)).

ADP Test

  1. Under IRC 401(k)(3)(A)(ii) ADP test, the ADP of the eligible HCEs can’t exceed the greater of:

    1. 1.25 x the eligible NHCEs ADP.

    2. The lesser of: i) 2 + the eligible NHCEs ADP or ii) 2 x the eligible NHCEs ADP.

      Note:

      If the only eligible employees under the CODA are HCEs, the plan automatically passes the ADP test.

  2. The ADP for a group (either HCE or NHCE) is the average of the individual ADRs of that group. An eligible employee’s ADR is:

    1. His/her allocated elective deferrals and QNECs and QMACs treated as elective deferrals

    2. Divided by his/her compensation

      Note:

      ADRs and ADPs, expressed as a percentage, must be rounded to the nearest one-hundredth of a percent.

  3. Include only "eligible employees" in the ADP test. ("Eligible employees" are also counted as "benefiting" for the IRC 410(b) coverage requirements.) An "eligible employee" is one who is eligible under the plan to make an elective contribution, whether or not they make them. If an eligible employee chooses not to make elective deferrals, and doesn’t receive QNECs or QMACs 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.

    3. Has been suspended from making elective deferrals under the plan (for example, for having taken a hardship distribution).

    4. May not receive additional contributions because of IRC 415(c) limits.

  4. Employees who can’t make elective deferrals because they were given a one- time election when they commenced employment or upon first becoming eligible under any of the employer’s CODAs and elected not to be eligible to make elective deferrals for the duration of employment with the employer is not an eligible employee.

  5. First identify the plan because the ADP test is performed on the plan level. See IRM 4.72.2.5, Coverage and Participation. If a plan contains more than one CODA, the CODAs must be aggregated for the ADP test.

  6. If a plan is disaggregated into separate plans for IRC 410(b), the CODA must also be disaggregated.

    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 one year of service or are less than age 21, and one covering all other employees, the employer would run two ADP tests. One test for the employees with less than one year of service or less than age 21, and the other test for all other employees.

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

  8. If an HCE is eligible to participate in more than one of an employer’s CODAs, his/her elective deferrals under all the employer’s CODAs are combined to determine the HCE’s ADR. Then, use this ADR in the ADP test under each CODA.

  9. Participant compensation used to calculate ADRs:

    • Is limited to the IRC 401(a)(17) amount.

    • Must satisfy IRC 414(s).

    • May include or exclude elective deferrals.

  10. Elective deferrals for HCEs that exceed the ADP test limits are "excess contributions." A plan must dispose of excess contributions by one or more of the following:

    1. Distribute them to certain HCEs

    2. Recharacterize them as employee after-tax contributions

    3. Recharacterize them as catch-up contributions, if applicable

  11. Plans can contribute QNECs and QMACs to NHCEs to raise the NHCE ADP. By contributing to NHCEs, the plan can reduce or eliminate excess contributions.

  12. A plan can choose, by specifying in the plan document, whether it will perform the ADP test by comparing the HCE ADP for a plan year with the NHCE ADP:

    • For the same plan year (current year testing).

    • For the prior plan year (prior year testing).

Current Year Testing
  1. For the current year testing method, use the same plan year as the one for which the ADP test is being performed to determine the eligible NHCEs ADP. But, 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 the plan from having excess contributions. In calendar-year 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. Plans take employees’ elective deferrals 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 that plan year and paid to the trust no later than 12 months after the end of the plan year to which the contributions relate.

      Note:

      Department of Labor regulations require elective deferrals to 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 Reg. section 2510.3-102.

    2. The contributions must relate to compensation that, if the employee hadn’t elected to defer it, would’ve been received either in the plan year or, if the plan so provides and the compensation is for services performed in the plan year, within 2 1/2 months after the plan year.

  3. Plans don’t take employee elective deferrals into account for the ADP test for a plan year if they:

    1. Don’t satisfy the requirements above in IRM 4.72.2.9.1.1 (2).

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

    3. Are treated as catch-up contributions under IRC 414(v).

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

    5. Are made per IRC 414(u) because of an eligible employee’s qualified military service.

  4. Employers may take into account QNECs and QMACs to calculate the ADP (IRC 401(k)(3)(D)) if the contributions satisfy the:

    1. Nonforfeitability requirement

    2. Distribution limitations

    3. 12-month contribution-to-the-trust rule that applies to elective deferrals in IRM 4.72.2.9.1.1 (2)(a).

      Note:

      QNECs must satisfy IRC 401(a)(4) both before and after the plan uses them in the ADP test.

  5. The plan can’t use QNECs and QMACs in the ADP test for a plan year:

    • If they’re used in the ACP test

    • For a NHCE in amounts exceeding that NHCE’s compensation x the greater of: i) five percent or 2 x the plan’s representative contribution rate.

      Note:

      This is to prevent the abuses arising from "targeted QNECs and QMACs" (also called "bottom-up leveling" ) when the plan sponsor targets certain NHCEs with the lowest compensation and contributes corrective QNECs to them, and limits the total corrective contributions necessary to correct the ADP failure. This method causes the lowest paid employees to have the highest ADRs (up to 100 percent), and when averaged with the ADRs of the remaining NHCEs, permits the plan to pass the ADP test.

Prior Year Testing
  1. Generally, the rules to calculate 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 NHCEs’ ADP early in the plan year, allowing time to avoid a failed ADP test.”

    Example:

    Employer X’s plan calendar-year 401(k) plan states distributing excess contributions is the only method the plan uses to correct ADP test failures. In January 2017, Employer X determines that the plan fails the ADP test for 2016 and that the plan must make corrective distributions of excess contributions to appropriate HCEs by March 15, 2017 to avoid all penalties.

    Example:

    Same facts as above, except that the testing year is 2017 and the plan is using the prior year testing method. Employer X can determine the NHCEs ADP for 2016 early in 2017 because it has the necessary data on prior year NHCE status, contributions and compensation by January 2017. This simplifies plan administration for Employer X.

  2. Consider the eligible employees who were NHCEs during the preceding year, without considering their status in the testing year, to determine the prior year’s NHCEs ADP.

    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. To determine the prior year’s ADP for Employer X’s 401(k) plan for the Year Two testing year, Employee A is taken into account. Employee A would also be taken into account if still employed by Employer X but became an HCE in Year Two.

  3. Plan language must specify whether the plan is using current year or prior year testing. The first plan year rule requires plans that incorporates these provisions by reference to specify whether the ADP/ACP for NHCEs is three percent or the first year’s ADP/ACP. See 26 CFR 1.401(k)-1(e)(7) .

Use of QNECs and QMACs in Prior Year Testing
  1. Plans that take into account QNEC or QMACs for the NHCE ADP for the prior year must:

    • Allocate them as of a date within that prior year.

    • Pay them to the trust by 12-months after the end of that prior year. In other words, the plan sponsor must actually pay them to the trust by the end of the testing year.

      Note:

      Therefore, if a plan is using prior year testing and QNECs/QMACs for ADP correction, it will probably miss the deadline to make QNECs or QMACs. So, an employer must use other methods to correct a failed ADP test. However, if the employer pays the QNECs and QMACs by the 12 months, it can use them to satisfy a failed ADP test.

      Example:

      A plan uses the prior year testing method for the 2017 testing year. In February 2018, it discovered the plan failed the ADP test. The applicable year for the NHCE ADP is 2016. As a result, the deadline to allocate QMACs to NHCEs’ accounts is the last day of 2017. The deadline for allocating QNECs has passed because the plan didn’t complete the ADP test until February 2018. If the employer contributed QMACs by the last day of 2017, they could have been allocated to NHCEs’ accounts and considered when calculating the NHCE ADP.

      Note:

      This 12-month rule does not change the rule under IRC 415: employer contributions are not treated as credited to a participant’s account for a particular limitation year unless actually made by 30 days after the end of the IRC 404(a)(6) period for the tax year with or within which the particular limitation year ends. See 26 CFR 1.415(c)-1(b)(6)(i)(B) .

First-Year Rule for Prior Year Testing
  1. Under IRC 401(k)(3)(E) and 26 26 CFR 1.401(k)-2(c)(2), a plan (other than a successor plan, see IRM 4.72.2.9.1.2.2 (2)) using prior year testing is deemed to have as its first plan year, a prior year NHCEs ADP of:

    • Three percent, or

    • If specified in the plan document, the NHCE ADP for that first plan year (i.e., the current year).

  2. For ADP testing, the first plan year is the first year in which the plan provides for elective deferrals. A plan doesn’t have a first plan year if, for that year, it’s aggregated under the Treasury regulations with any other plan that provided elective deferrals in the prior year.

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

Changes in the Group of NHCEs in Prior Year Testing
  1. Disregard subsequent changes in the group of NHCEs. Determine the NHCEs ADP for the prior year based on eligible employees who were NHCEs in that prior year. Don’t consider changes to the eligible NHCEs group, in the testing year, such as:

    • NHCEs in the prior year who became HCEs in the testing year

    • NHCEs in the prior year who are no longer eligible employees under the plan

    • NHCEs in the prior year who were not eligible but are in the testing year.

  2. If a plan results from or is affected by a plan coverage change effective during the testing year, it must use the weighted average of the NHCEs ADPs for the prior year subgroups. A "plan coverage change" is a change in the group(s) of eligible employees because of:

    1. The establishment or amendment of a plan.

    2. A plan merger or spinoff under IRC 414(l).

    3. A change in the way plans are (or are not) permissively aggregated under 26 CFR 1.410(b)-7(d).

    4. A reclassification of employees that has the same effect as amending the plan.

    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’ve been eligible employees under the plan being tested if the plan coverage change was 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 prior year NHCEs ADP for the specific
    plan whose prior year subgroup members NHCEs in prior year subgroup
    were eligible employees Total NHCEs in all prior year subgroups
  6. Optional rule for minor plan coverage change: The employer may elect to use the prior year ADP for NHCEs of the plan that included that single prior year subgroup, if there is a plan coverage change, and 90 percent or more of all NHCEs from all prior year subgroups are from a single prior year subgroup. See 26 CFR 1-401(k)-2(c)(4)(iv) for examples on plan coverage changes.

Changing Testing Method
  1. Plans using the prior year testing method may adopt the current year testing method for any subsequent testing year without notifying or seeking IRS approval. Safe harbor 401(k) plans, QACAs and SIMPLE 401(k) plans are treated as using the current year testing method.

  2. Plans using current year testing may change to prior year testing in the three situations in 26 CFR 1.401(k)-2(c)(1)(ii):

    1. The plan isn’t the result of aggregating two or more plans, and used current year testing for five plan years before the year of the change (or, if lesser, the number of years the plan has existed).

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

    3. A transaction occurs as described in IRC 410(b)(6)(C)(i) (i.e., the employer becomes or ceases to be a member of an IRC 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 IRC 410(b)(6)(C)(ii) (i.e., by the last day of the first plan year beginning after the transaction).

Limits on Double Counting of Certain Contributions
  1. When a plan changes from current year to prior year testing, NHCEs contributions are likely to be double counted.

    Example:

    If a plan used current year testing in 2016 then changed to prior year testing in 2017, the NHCEs 2016 elective deferrals are counted twice: They’re counted once in 2016 in calculating the NHCE ADP under the current year testing method, and again in 2017 in calculating the NHCE ADP under the prior year testing method.

    Note:

    To limit double counting, plans can’t use the QNECs and QMACs in prior year testing that were used in the preceding year’s current year testing (26 CFR 1.401(k)-2(a)(6)(vi)).

Plan Provisions Regarding Testing Method
  1. A plan must specify which of the two testing methods (current year or prior year) it’s using. If the employer changes a plan’s testing method, it must amend the plan.

  2. Plans can incorporate the nondiscrimination tests in IRC 401(k)(3) and (m)(2) by reference. However, the plan must specify:

    1. Which of the two testing methods (current year or prior year) it’s using.

    2. If using prior year testing: for the first plan year rule, whether the NHCEs’ ADP is three percent or the current year’s ADP.

Correction of ADP Test
  1. Plans may correct excess contributions in these ways:

    • QMACs or QNECs

    • Distribution

    • Recharacterization

  2. A plan may:

    • Use any of the above correction methods.

    • Limit elective deferrals to prevent HCEs from making excess contributions.

    • Use a combination of these methods to avoid or correct excess contributions.

      Note:

      If the plan uses a combination of correction methods, it must take into account any QNECs or QMACs made before it makes any distributions or recharacterizations.

  3. Plans allowing designated Roth contributions may permit HCEs to have excess contributions distributed from their designated Roth accounts.

  4. Plans, generally must forfeit matching contributions (even QMACs) made for excess contributions or excess aggregate contributions to avoid having a discriminatory rate of match. The forfeitures won’t cause the plan to violate IRC 411.

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

  6. Plans can’t do these actions for excess contributions for a plan year:

    • Keep them unallocated for a plan year.

    • Allocate them to a suspense account for future allocation.

    • Correct them using the retroactive correction rules of 26 CFR 1.401(a)(4)-11(g). See 26 CFR 1.401(a)(4)-11(g)(3)(vii).

  7. Plans may be able to treat excess contributions allocated to a HCE as catch-up contributions under IRC 414(v) and ignore them for the ADP test.

  8. Plans using distribution to correct excess contributions must distribute them within 2 1/2 months (six months for certain EACAs) after the end of the plan year end of excess to avoid a 10 percent excise tax on the excess contributions. See IRC 4979 and 26 CFR 54.4979-1.

  9. If the ADP test isn’t corrected within 12 months after the end of the failed plan year, the CODA is not qualified and the plan may be disqualified. Not correcting excess contributions will make the CODA nonqualified not only for the excess contribution plan year but also for all subsequent plan years the excess contributions remain in the trust.

Determination of Excess Contributions
  1. "Excess contributions" are the aggregate amount of employer contributions made to the plan for HCEs for a plan year less the maximum amount of HCE contributions permitted under the ADP test.

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

Distribution of Excess Contributions
  1. Correcting excess contributions by distributing them generally involves four steps:

    1. Determine the total amount of excess contributions that the plan must distribute.

    2. Divide the excess contributions among HCEs.

    3. Determine the income on the excess contributions.

    4. Distribute the portion of excess contributions and income to each HCE identified in step two using the ratio leveling method, then dollar leveling method.

  2. The amount of excess contributions is the amount of elective deferrals the plan must return to HCEs to pass the ADP test. Start with the HCE with the largest ADR percentage and continue, by leveling, to the HCE(s) with the next highest ADR(s) until the plan passes the ADP test.

    Note:

    To identity the HCEs who will receive a distribution of excess contributions, begin with the HCE with the largest dollar amount of deferrals.

  3. Plans may be able to recharacterize catch-up eligible HCE excess contributions as catch-up contributions (up to the catch-up limit) and not distribute them.

  4. See this example which shows how to calculate the amount of excess contributions the plan must distribute to pass the ADP test.

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

    D, E, and F are NHCEs. All employees are under age 50. Per the ADP test, the greatest acceptable ADP for HCEs (A, B and C) is 5.33 percent (3.33 percent plus 2). Since 6.41 percent is greater than 5.33 percent, the plan has excess contributions. The plan states that excess contributions will be distributed.

    1. Determine the amount of excess contributions; use the ratio leveling method. This method reduces the highest HCE ADR until the maximum allowed ADP (5.33 percent) is achieved, or until the next highest HCE ADR is reached, whichever occurs first.

    2. Start with B because he has the highest ADR and reduce his ADR to the next highest percentage, 7 percent. The HCE ADP is now 6.33 percent. This still doesn't satisfy the ADP test, so reduce A and B’s ADRs so the maximum HCE ADP is achieved - 5.33%.

    3. Reduce both A and B’s ADR to 5.33% using a formula: (x + x + 5%) ÷ 3 = 5.33%. The answer will show the what percentage A and B must have to produce an HCE ADP of 5.33% (5.50 + 5.50 + 5 = 16; 16 ÷ 3 = 5.33).

    4. Calculate the total HCEs’ excess contributions:

      HCE Contributions at the old ADR Contributions at the new ADR - 5.33% Excess Contributions
      A 7,000 5,500 2,500
      B 6,500 4,950 1,550
      Total excess contributions: 2,500 + 1,550 = 4,050
    5. Distribute the excess contribution using the dollar leveling method which distributes it from the HCEs’ account(s) who has the highest dollar amount of contributions in the plan year until the contributions remaining in such employee’s account equals the plan-year contributions in the HCE’s account(s) with the next highest dollar amount and so on until the total is distributed. Distribute $500 from A’s account to make it level with B’s account ($7,000 - $6,500 = $500).

    6. Divide the remaining excess contributions ($4,050 - $500 = $2,550) equally to A and B, so that each has $5,225 of elective deferrals for the year.

    7. Adjust A and B’s distributed excess contributions for earnings.

    Note:

    The ADP test is deemed passed after these corrections even though running the test then wouldn’t produce a passing ADP for the HCEs.

  5. Reduce any excess contributions distribution by excess deferrals previously distributed to the HCE for the same year. Similarly, reduce an excess deferral distribution by excess contributions previously distributed to the HCE for the same year. See 26 CFR 1.401(k)-2(b)(4)(i).

  6. Include distributed excess contributions’ allocable gain or loss only through the end of the plan year.

    Exception:

    For plan years beginning before 2008, include income for the plan year excess contributions from the plan year end to the distribution date (the "gap period" ). See 26 CFR 1.401(k)-2(b)(2)(iv).

  7. Individuals include corrective distributions of excess contributions and allocable income (except for the part that consists of designated Roth contributions) in their gross income in the tax year distributed, for plan years beginning on or after January 1, 2008. Plan trustees report the distribution on Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit- Sharing Plans, IRAs, Insurance Contracts, etc., using the appropriate code.

  8. Excess contributions/earnings distributions aren’t subject to:

    • Consent rules under IRC 411(a)(11) and IRC 417.

    • Early withdrawal tax under IRC 72(t).

  9. See 26 CFR 1.402(c)-2, Q&A-4 for restrictions on individuals rolling over distributions of excess contributions.

Recharacterization of Excess Contributions
  1. Plans can correct excess contributions by "recharacterizing" them as employee after-tax contributions. See IRC 401(k)(8)(A)(ii). Recharacterization treats excess contributions as though the plan distributed them to HCEs and then the HCE recontributed them to the plan as employee contributions. Determine excess contributions and the HCEs to whom they are allocated the same way as for distributions of excess contributions, except don’t adjust the recharacterized amounts for earnings.

  2. Excess contributions, once recharacterized, are treated as voluntary after-tax employee contributions for ACP testing (26 CFR 1.401(k)-2(b)(3)). For most other compliance and testing purposes, recharacterized contributions remain treated as elective deferrals (26 CFR 1.401(k)-2(b)(3)(iii)(C)).

    Note:

    Before a plan can use recharacterization, the plan document must both permit employee contributions and state it as an available correction method.

  3. Excess contributions that are recharacterized are reported and appropriately coded on Form 1099-R. Individuals include them in gross income according to the same rules for actual distributions of excess contributions. See IRM 4.72.2.9.1.6.2 (8).

  4. Plans may use recharacterization only if it permits employee contributions. The amount recharacterized, when added to the HCE’s other employee contributions, may not exceed the employee contributions limit stated in the plan separate from the ACP test. See 26 CFR 1.401(k)-2(b)(3)(iii)(B).

  5. Offset recharacterized amounts by any excess deferrals the plan previously distributed to HCEs.

  6. Plans may only recharacterize excess contributions by 2 1/2 months after the plan year of the excess. The employer or plan administrator must notify the affected HCEs that both:

    • The excess contributions are being recharacterized.

    • There are tax consequences of the recharacterization.

      Note:

      The date the last affected HCE receives notification is the recharacterization date. Use this date to determine if the plan satisfies the 2 1/2 month rule.

IRC 4979 Tax
  1. The plan has 12 months after the end of the plan year being tested to correct excess contributions. The plan can distribute excess contributions any time during the 12-month period. However, if the employer doesn’t distribute/ recharacterize excess contributions by 2 1/2 months (six months for certain EACAs) after the plan year of excess, the employer is liable for a 10 percent excise tax on excess contributions (IRC 4979 and 26 CFR 1.401(k)- 2(b)(5)).

    Exception:

    The tax doesn’t apply if the plan sponsor makes corrective QNECs or QMACs (current year testing plans only) within 12 months after the end of the plan year. However, if the QNECs or QMACs are insufficient for the CODA to pass the ADP test, the tax applies to the remaining excess contributions.

  2. Plan sponsors report the tax on Form 5330, Return of Excise Taxes Related to Employee Benefit Plans and must pay it by 15 months after the plan year end. See 26 CFR 54.4979-1. If the employer has an extension of time to file the form, this is not an extension of time to correct the ADP test.

  3. The tax is a one-time tax, meaning if the plan sponsor doesn’t correct the excess contributions for a plan year, the tax applies only for that year and doesn’t continue to the next tax year.

Examination Steps
  1. Review the plan’s eligibility requirements and ensure that the plan is operating per the plan document.

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

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

  4. Ask the plan administrator about the plan policy/procedures for ADP/ACP/ 402(g) testing (including correction).

    1. Analyze the testing method and results.

    2. Confirm the accuracy of each test.

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

  6. Verify that all employees who are eligible to make EDs are counted in the ADP test, even if they don’t make them.

    Note:

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

  7. Verify that these employees have been included as eligible with a deferral percentage of 0 in the ADP test - employees who:

    • Are eligible to make a deferral but can’t because they’re suspended from making deferrals (e.g., because of receiving a hardship distribution).

    • Didn’t receive QNECs or QMACs treated as EDs.

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

  9. Examine these documents to verify employee compensation:

    • Payroll records

    • Forms W-2

    • Time cards

    • Personnel records

      Note:

      If the plan year isn’t a calendar year, review the plan document to determine the period used and verify that the plan operates with those provisions. If the employer limits compensation to the part of the year in which the employee was eligible, verify that the plan’s terms allow it. Examine employees having limited compensation and verify that the plan used compensation earned since the employee participated in the plan.

  10. Verify that all compensation amounts are limited per IRC 401(a)(17). If the plan is not a safe harbor plan, examine the ADP test to verify that each individual’s ADR is calculated using the properly limited compensation.

    Note:

    Compensation used in the ADP test can either include or exclude elective deferrals deferred during the year. The definition of compensation in IRC 414(s) references IRC 415(c)(3), which includes elective deferrals (IRC 415(c)(3)(D)). But, IRC 414(s)(2) permits a plan to use a definition of compensation that excludes elective deferrals.

  11. Reconcile the Forms W-2 total participant deferral contributions to the ADP test total deferral amount.

  12. Using payroll and organization data, test check to see if the plan correctly determined the HCE group. Verify that an employee was considered an HCE if he/she met any of the following:

    1. Five percent owner during the year or preceding year.

    2. Compensation above the indexed dollar amount ($120,000 for 2015 through 2017) for the preceding year.

    3. Was in the top-paid group that year, if the employer so elected.

  13. If a plan is disaggregated under IRC 410(b), make sure the employer runs the ADP test on each disaggregated plan. Apply the aggregation and disaggregation rules of 26 CFR 1.410(b)-7, as modified by 26 CFR 1.401(k)-1(b)(4), to find the plan (or plans) so that the ADP and ACP tests (or safe harbor, QACA or SIMPLE rules) can be applied to the proper employees. Ensure only plans with the same plan year end (PYE) are aggregated, if otherwise permitted.

    1. Review the plan document to determine the CODA eligibility requirements. If they are less than one year of service and/or less than age 21, the plan sponsor may apply the nondiscrimination testing on a disaggregation basis: run one ADP test for employees with less than one year of service and less than age 21, and another test for all other employees.

    2. Determine if any employees are covered by a collective bargaining agreement. If so, disaggregate these employees from employees not covered by a collective bargaining agreement for the ADP test. Review any lists identifying employees covered by a collective bargaining agreement, such as union due payment reports or payroll records showing union dues deductions. Compare the collectively bargained employees to the employees listed in the ADP test for that group.

    3. When you inspect the 5500 returns for all plans, determine if any other employer plan contains a CODA. If so, the plan sponsor may aggregate them for the ADP test, but only if they have the same plan year. The plan sponsor must aggregate any plans aggregated for the ADP test for coverage and discrimination tests. Ask the employer which plans were aggregated, if any. Verify from payroll records whether employees counted for the coverage and discrimination testing are the same employees in the ADP test if the plans were aggregated.

  14. Determine if any HCE participates in more than one of the employer’s CODAs. If yes, combine his/her elective deferrals to determine ADRs. Use this ADR in the ADP test for all CODAs.

  15. Compare ADP calculations to Form W-2 (or payroll records if the plan year is a fiscal year) compensation and deferral amounts. Trace compensation and deferral amounts to source documents.

  16. Verify that the plan sponsor properly determined the ADP test for each group (HCE and NHCE) and the plan satisfied the ADP test following the testing method (current year or prior year) specified in the plan.

  17. For ADP test failures, verify that the plan sponsor accurately and timely corrected the failure.

    1. Review the plan document to see if it specified the correction method and if the plan sponsor followed it.

    2. Determine if the plan sponsor calculated the amount of excess contributions using the ratio leveling method.

  18. If the plan sponsor corrected the ADP test failure by distribution:

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

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

    3. If the distribution was made after 2 1/2 months following the excess plan year end, the IRC 4979 tax applies. Verify whether the employer filed Form 5330 and paid the excise tax. If not, solicit both.

  19. If the plan sponsor corrected the ADP test failure by recharacterization:

    1. Verify that the plan sponsor recharacterized excess contributions within 2 1/2 months following the excess plan year end by inspecting recharacterization notices issued to HCEs. Recharacterization is "deemed" to have occurred on the date of the last notice.

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

  20. If the plan sponsor corrected a failed ADP test by contributing QNECs and/or QMACs, inspect cancelled checks or trust statements to determine whether they made the contributions within one year after the PYE.

    Note:

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

Catch-Up Contributions

  1. Plans may permit participants age 50 or older to make additional elective deferrals, called catch-up contributions, for tax years beginning after December 31, 2001 (IRC 414(v)).

  2. These plans can permit catch-up contributions:

    1. 401(k) plans

    2. 403(b) plans

    3. Governmental 457(b) plans

    4. SARSEPs

    5. SIMPLE IRAs

  3. An eligible employee can make catch-up contributions only after reaching one of these limits:

    • The limit on regular elective deferrals, e.g., IRC 401(a)(30) or IRC 415.

    • The ADP limit.

    • A plan-provided limit.

  4. In 401(k) plans, ignore catch-up contributions for:

    1. IRC 401(a)(30) limits.

    2. IRC 415(c) limits.

    3. Determining an employee’s ADR for the ADP test.

    4. Determining the average benefit percentage test under 26 CFR 1.410(b)-5 if the plan determines benefit percentages based on current year contributions.

      Exception:

      Include prior years’ catch-up contributions in the account balances used to determine:

      • The average benefit percentages if the plan takes into account allocations for prior years.

      • If a plan is top-heavy under IRC 416(g).

  5. Catch-up contributions:

    1. Are treated just like other elective deferrals.

    2. Are subject to the same nonforfeitability and distribution rules as other elective deferrals.

    3. Can be pre-tax or designated Roth contributions.

  6. Catch-up contributions must satisfy a universal availability requirement. This means all catch-up eligible participants in all of an employer’s 401(k) plans must be given an effective opportunity to make the same dollar amount of catch-up contributions. Employers may restrict employees’ available amounts from which they can defer to participant compensation after other reductions (e.g., for applicable employment taxes) without violating the universal availability rule. The regulations offer a safe harbor that permit plans to use 75 percent of participants’ compensation.

Catch-Up Contribution Limits

  1. There are separate dollar limits (determined by the IRS and Treasury) for catch-up contributions for SIMPLE plans (SIMPLE 401(k) plans and SIMPLE IRA plans) and non-SIMPLE plans.

  2. Each limit is subject to annual COLA increases, but if an increase is not a multiple of $500, it’s rounded down to the next lower multiple of $500.

  3. The limits apply to the employee’s taxable year that begins with or within the calendar year.

  4. See COLA Increases for Dollar Limitations on Benefits and Contributions for annual catch-up limits for SIMPLE plans and 401(k), 403(b) and profit sharing plans.

SIMPLE 401(k) Plans

  1. SIMPLE 401(k) plans, described in IRC 401(k)(11) and IRC 401(m)(10):

    1. Can only be set up by employers with 100 or fewer employees earning at least $5,000 of SIMPLE compensation (see IRM 4.72.2.11 (7) below) in the prior calendar year.

    2. Must be maintained on a calendar-year basis.

    3. Are deemed to satisfy the ADP and ACP tests.

    4. Aren’t subject to the top-heavy requirement.

    5. Closely follow the requirements for SIMPLE IRA in IRC 408(p).

      Note:

      SIMPLE IRA plans are more popular with employers because the IRA plans are less burdensome to set up and maintain and have less administrative tasks. For example, SIMPLE IRAs aren’t required to file Forms 5500.

  2. Employees covered under the SIMPLE 401(k) plan can’t be covered under another plan of the employer.

  3. Employees can contribute up to the annual limit to their SIMPLE 401(k) accounts ($12,500 in 2016, plus an additional $3,000 if the employee is age 50 or older). See Exhibit 4.72.2-1.

  4. Employers must contribute each year, either:

    1. Matching contributions: the lesser of the eligible employee’s elective deferrals for the year or three percent of the eligible employee’s SIMPLE compensation for the entire calendar year.

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

  5. Employers must notify employees each year and allow them certain elections:

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

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

    3. For subsequent years, the employee must be permitted to make or modify his/her cash or deferred election during the 60-day period before that calendar year.

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

  6. All contributions to the plan must be fully vested at all times. The plan can’t accept any contributions other than those described in IRM 4.72.2.11 (4) and rollover contributions.

  7. SIMPLE 401(k) plans must use a special, inclusive definition of compensation. See IRC 408(p)(6) and 26 CFR 1.401(k)-4(e)(5) . SIMPLE compensation is the Form W-2 amount, including elective deferrals limited to the IRC 401(a)(17) amount which is indexed annually. See Exhibit 4.72.2-1.

Safe Harbor 401(k) Plans

  1. Under IRC 401(k)(12), CODAs are treated as meeting the ADP test if they meet certain contribution and notice requirements. See 26 CFR 1.401(k)- 3 (a) through (h). If the plan also satisfies the requirements of IRC 401(m)(11) and doesn’t permit employee contributions, it is treated as satisfying the ACP test as well. See 26 CFR 1.401(m)-3 .

  2. For this IRM section, the term" safe harbor 401(k) plan" means a plan that meets the requirements of IRC 401(k)(12) (and IRC 401(m)(11), if applicable). We discuss another type of safe harbor plan, a QACA that meets the requirements of IRC 401(k)(13) (and IRC 401(m)(12), if applicable) in IRM sections IRM 4.72.2.13.1, through IRM 4.72.2.13.5.

  3. Plans that use the safe harbor methods to satisfy the ADP or ACP test are treated as using the current year testing method for that plan year. A plan:

    1. Can satisfy the ADP safe harbor without satisfying the ACP safe harbor.

    2. Can’t satisfy the ACP safe harbor without satisfying the ADP safe harbor.

Plan Provisions for Safe Harbor Plans

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

  2. A safe harbor 401(k) plan can have a short plan year: (i) in the first year of the plan or CODA; (ii) if the plan changes plan years, but only if certain conditions are met; and (iii) for the plan’s final plan year. See 26 CFR 1.401(k)-3(e) .

  3. Employers may have what is sometimes called a maybe safe harbor plan per 26 CFR 1.401(k)-3(f). The plan sponsor distributes a notice to employees before a plan year stating that the plan may be amended before the end of the plan year to become a safe harbor plan with safe harbor nonelective contributions, effective as of the first day of the plan year. Then, to become a safe harbor plan, the plan sponsor must amend the plan by 30 days before the plan year end and distribute a new notice to employees explaining the amendment.

  4. Plan sponsors can generally, after May 18, 2009, amend their safe-harbor plans mid-year to reduce or suspend safe harbor contributions under certain circumstances. See 26 CFR 1.401(k)-3(g). To suspend or reduce safe harbor contributions:

    1. An employer must either be operating at an economic loss per IRC 412(c)(2)(A) or have disclosed to employees in the annual notice that it’s possible that they may reduce or suspend safe harbor contributions during the year.

    2. The notice must state that the plan sponsor won’t suspend or reduce contributions until at least 30 days after they give a supplemental notice and that employees will be given a reasonable opportunity to change their deferral (or employee contributions, if applicable).

    3. If a reduction or suspension occurs, the plan is subject to the ADP (and ACP) test for the entire plan year.

  5. Plan sponsors could’ve amend mid-year for:

    1. In-plan Roth rollovers (Notice 2010-84 and Notice 2013-74) during transition periods.

    2. Changes resulting from United States v. Windsor in Notice 2014-37.

  6. A plan doesn’t violate the safe harbor rules if it made a "mid-year change" to a IRC 401(k) or 401(m) safe harbor plan, as long as the sponsor satisfies the notice and election opportunity conditions and the mid-year change isn’t a prohibited mid-year change as described in the notice (Notice 2016-16 , 2016-7 IRB 318, effective for mid-year changes made on or after January 29, 2016).

    1. The notice defines a "mid-year change" as either:

      1. A change first effective during a plan year, but not effective as of the beginning of the plan year.

      2. A change effective as of the beginning of the plan year, but adopted after the beginning of the plan year.

    2. A mid-year change must meet the following conditions:

      1. The sponsor must provide an updated safe harbor notice that describes the mid-year change and its effective date to each eligible employee within a reasonable period before the effective date of the change. This timing requirement is met is based on all of the relevant facts and circumstances, but is deemed to be satisfied if the sponsor provides it between 30 and 90 before the effective date of the change. If not practical to provide the updated safe harbor notice before the effective date of the change, it is treated as provided timely if provided as soon as practical, but by 30 days after the date the change is adopted. However, if the required information about the mid-year change and its effective date was provided with the pre-plan year annual safe harbor notice, an updated safe harbor notice is not required.

        Example:

        It may not be practical to provide an updated notice for a mid-year change to increase matching contributions retroactively for the entire plan year.

      2. The sponsor must give each eligible employee a reasonable opportunity (including a reasonable period after receiving an updated notice) before the effective date of the mid-year change to change his cash or deferred election (and/or any after-tax employee contribution election). For this purpose, a 30-day election period is deemed to be a reasonable period to make or change a cash or deferred election. If not practical for the sponsor to provide the election opportunity before the effective date of the change, an employee is treated as having a reasonable opportunity to make or change an election if the election opportunity begins as soon as practical after the date the sponsor provides the updated notice, but by 30 days after the date the change is adopted.

    3. These are prohibited mid-year changes, unless the change is required by applicable law or court decision: Mid-year changes to:

      1. Increase the years of service for full vesting of safe harbor contributions in a QACA.

      2. Reduce or narrow the group of employees eligible to receive safe harbor contributions; however, the employer may amend a plan mid-year to change service-crediting or entry-date rules for employees who have not yet become eligible to receive safe harbor contributions.

      3. A mid-year change to the type of safe harbor.

        Example:

        A change from a traditional safe harbor to a QACA, or vice versa.

        Exception:

        Adding an automatic enrollment feature to a traditional safe harbor plan is permitted.

      4. To modify (or add) a formula to determine matching contributions (or the definition of compensation used to determine matching contributions) if the change increases the amount of matching contributions, or to permit discretionary matching contributions.

    4. The mid-year change is also subjected to other applicable law:

    Example:

    IRC 411(d)(6) (anti-cutback restrictions), IRC 401(a)(4) (nondiscrimination restrictions), and 26 CFR 1.401(k)-1(b)(3) (anti-abuse provisions).

Special Compensation Definition for Safe Harbor Plans

  1. Generally, apply the same definitions as used in other CODAs, including the annual compensation limit in IRC 401(a)(17). But, to determine safe harbor matching and nonelective contributions, plans must use "safe harbor compensation." This is the normal definition of compensation, which incorporates the compensation definition in 26 CFR 1.414(s)-1.

    Exception:

    Disregard the last sentence in 26 CFR 1.414(s)-1(d)(2)(iii) which permits a plan to disregard all compensation that exceeds a specified dollar amount for the compensation definition.

  2. Also, a safe harbor 401(k) plan can restrict the type of compensation from which participants can defer if each eligible NHCE may make elective deferrals under a "reasonable definition" of compensation per 26 CFR 1.414(s)-1(d)(2). The definition is not required to satisfy the nondiscrimination requirement of 26 CFR 1.414(s)-1(d)(3). But, the plan must permit each eligible NHCE to make elective deferrals that are sufficient to receive the maximum matching contributions under the plan for the plan year, and the employee must be permitted to elect any lesser amount of elective deferrals.

    Example:

    A safe harbor 401(k) plan defines compensation as" all salary, wages, bonuses, and other remuneration not exceeding $75,000" . The plan does not satisfy the safe harbor definition of compensation because it excludes compensation over $75,000.

    Example:

    A safe harbor 401(k) plan allows employees to make elective deferrals only from basic compensation, defined as salary, regular wages, bonuses and commissions, and excluding overtime pay. This is a reasonable definition of compensation per 26 CFR 1.414(s)-1(d)(2), but could be discriminatory. The plan’s safe harbor matching contribution is 100 percent of the employee’s elective deferrals that do not exceed four percent of the employee’s safe harbor compensation. Compensation for the matching formula is defined as compensation under IRC 415(c)(3). Per the plan, each NHCE who is an eligible employee is permitted to make elective deferrals of at least four percent of the employee’s compensation under IRC 415(c)(3) (that is the amount of elective deferrals sufficient to receive the maximum amount of matching contribution available under the plan). This plan’s definitions of compensation satisfy the safe harbor rules.

ADP Test Safe Harbor Requirements

  1. To satisfy the ADP safe harbor, a CODA must satisfy both:

    • Safe harbor contribution requirement

    • Notice requirement of IRC 401(k)(12) and 26 CFR 1.401(k)-3 .

  2. Plans satisfy the safe harbor contribution requirement if they contribute matching or nonelective contributions to all eligible employees under the plan. This means, for example, that the plan can’t state it’ll pay contributions to only employees employed on the last day of the plan year or to employees who have at least 1,000 hours of service in the plan year. The safe harbor contribution requirement must be satisfied without considering permitted disparity in IRC 401(l).

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

    1. The basic matching formula requires qualified matching contributions (QMACs) to each eligible NHCE of 100 percent of his/her elective deferrals up to three percent of her compensation, and 50 percent of her elective deferrals over three percent and below five percent of her compensation.

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

      Example:

      A plan states that it makes QMACs at the following rates: 100 percent of an employee’s elective deferrals that do not exceed two percent of compensation and 75 percent of the employee’s elective deferrals that exceed two percent but do not exceed five percent of compensation. This formula doesn’t satisfy the enhanced matching formula because the aggregate amount provided by this formula is not at least equal to the amount the basic matching formula would’ve provided at all rates of elective deferrals. The basic matching formula requires the plan to make QMACs of 100 percent on the amount of the employee’s elective deferrals that do not exceed three percent of compensation. Under the plan’s formula, however, the amount of QMACs at three percent is only 75 percent, and therefore, less than 100 percent. See 26 CFR 1.401(k)-3(c)(7) for additional examples.

      Note:

      Plans that contain a formula that satisfies the ADP test safe harbor will still pass the ADP test safe harbor if they also give discretionary matches. But, the discretionary matches must be limited to four percent of each employee’s compensation. See 26 CFR 1-401(m)-3(d)(3).

  4. A matching formula doesn’t satisfy the safe harbor test if, at any rate of elective deferrals, its rate of matching contributions for an eligible HCE is greater than its rate of matching contributions for an eligible NHCE at the same rate of elective deferrals.

    Example:

    A plan covers Divisions A and B, both of which have NHCEs and HCEs. The plan has a basic matching formula for Division A and an enhanced matching formula for Division B, (100 percent match of each employee’s elective deferrals up to four percent of a Division B employee’s IRC 415(c)(3) compensation). The rate of match for a Division B HCE at the elective deferrals rate of four percent is greater than a Division A NHCE’s rate of match at the same rate of elective deferrals. So, the plan wouldn’t satisfy the ADP test safe harbor

    .

  5. Plans may make matching contributions on a payroll-period basis without having to" true-up" for the whole year if the plan sponsor contributes them by the end of the immediately following plan year quarter. (See 26 CFR 1.401(k)-3(c)(5)(ii)).

  6. Generally, plans don’t meet the matching contribution requirement if they restrict NHCEs elective deferrals. However, plans may limit elective deferrals:

    1. To a maximum amount.

    2. To whole percentages of pay or whole dollar amounts.

    3. By the types of compensation that may be deferred.

    4. For IRC 402(g) or IRC 415 or, after a hardship distribution, to satisfy the 6-month suspension period in 26 CFR 1.401(k)-1(d)(3)(iv)(E) .

  7. If a plan sponsor uses any of the restrictions in IRM 4.72.2.12.3 (6), they must follow certain conditions.

    Example:

    A plan limits the amount of elective deferrals a participant can make. The employer must permit each eligible NHCE to make sufficient elective deferrals to receive the plan’s maximum amount of matching contributions. See IRM 4.72.2.12.2 (2) for an explanation of restricting types of compensation that a participant may defer.

  8. Instead of making safe harbor matching contributions, an employer can make safe harbor nonelective deferrals. This contribution requirement is satisfied if the plan terms require the employer to make qualified nonelective contributions (QNECs) for each eligible NHCE of at least three percent of his/her compensation.

  9. Employers can use the safe harbor matching and nonelective contributions to satisfy the safe harbor requirements for only one plan.

Notice Requirement
  1. The ADP test safe harbor notice requirement requires a plan sponsor to provide a written notice to each eligible employee for the plan year that:

    1. Describes the participants rights and obligations under the plan

    2. Satisfies the content and timing requirement of 26 CFR 1.401(k)-3(d).

    3. Is in writing or another form approved by the IRS Commissioner. See 26 CFR 1.401(a)-21 for using electronic media to provide applicable notices in retirement plans.


  2. The notice must be:

    1. Accurate and comprehensive enough so that employees know their rights.

    2. Written in a way so that the average employee eligible to participate in the plan understands it.

  3. The notice must accurately describe:

    1. The plan’s safe harbor matching contribution or safe harbor nonelective contribution formula (including a description of the safe harbor matching contribution levels, if any).

    2. Any other plan contributions or matching contributions to another plan on account of elective deferrals or employee contributions under this plan (including the potential for discretionary matching contributions) and the conditions when the plan makes these contributions.

    3. The plan that the employer will make the safe harbor contributions to (if different than the plan containing the CODA).

    4. The type and amount of compensation that participants may defer under the plan.

    5. How to make cash or deferred elections, including any administrative requirements that apply to elections.

    6. The periods available to make cash or deferred elections.

    7. Withdrawal and vesting provisions applicable to contributions.

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

  4. Plan sponsors must give the notice to each eligible employee between 30 and 90 days before each plan year begins. If an employee becomes eligible after the 90th day before the plan year begins, the plan sponsor is deemed to satisfy the timing requirement if they give the notice by 90 days before the employee becomes eligible (and by the date the employee becomes eligible).

    Exception:

    But, if not possible for the sponsor to provide the notice on or before the date an employee becomes eligible, a notice will be deemed timely if they provide it as soon as practical after that date and the employee is permitted to defer from all compensation earned from his/ her eligibility date. This means, for a new employee who is immediately eligible to participate in the plan, if it is not practical for the plan sponsor to give this employee a notice on or before his/her hire date, they must give the notice (and allow the employee to make a deferral election) before the employee’s first payday.

  5. If a plan sponsor makes a mid-year change to a safe harbor plan as permitted in Notice 2016-16, they must provide an updated safe harbor notice that describes the mid-year change and its effective date if the change affects a provision required to be included in the safe harbor notice.

ACP Test Safe Harbor

  1. Plans meet the ACP test safe harbor for their matching contributions if they satisfy the ADP test safe harbor and limit matching contributions per IRC 401(m)(11) and 26 CFR 1-401(m)-3(d).

  2. A plan can satisfy the matching contribution limits in one of three ways:

    1. Provide the "basic matching formula," described in the IRM 4.72.2.12.3 (3)(a) ADP test safe harbor and have no other matching contributions.

    2. Provide an "enhanced matching formula," described in IRM 4.72.2.12.3 (3)(b) ADP test safe harbor, but can’t make matching contributions for an employee’s contributions or elective deferrals above six percent of their compensation, and the plan can’t have other matching contributions.

    3. For any other plan, the plan can’t make matching contributions for elective deferrals or employee contributions that in the aggregate exceed 6 percent of the employee’s compensation; the rate of matching contributions doesn’t increase as the rate of employee contributions or elective deferrals increases, and the matching contribution for any HCE at any rate of an employee contribution or rate of elective deferral is not greater than that for an NHCE.

  3. Plans may restrict the elective deferrals or employee contributions used to determine matching contributions only as permitted under the rules for the ADP test safe harbor. See IRM 4.72.2.12.3 (6) above.

  4. Plans that provide discretionary matches (in addition to nondiscretionary matches needed to satisfy the ADP test safe harbor) can satisfy the ACP test safe harbor if the discretionary matches in the aggregate aren’t greater than four percent of the employee’s compensation.

  5. Plans that don’t meet the ACP test safe harbor must meet the ACP test for their employee contributions and matching contributions. But, if the plan satisfies the ACP safe harbor, but must perform the ACP test because it has employee contributions, it may use only the employee contributions and ignore all matches. See 26 CFR 1-401(m)-2(a)(5)(iv).

Multiple CODAs and Multiple Plans

  1. Employers with multiple plans may make the ADP test safe harbor matching contributions or nonelective contributions to the plan that contains the CODA or to another IRC 401(a) or IRC 403(a) defined contribution plan. If the employer makes safe harbor contributions to another defined contribution plan, they must satisfy the safe harbor contribution requirement in the same way as if the contributions were made to the CODA plan. Consequently, each employee eligible under the plan containing the CODA must be eligible under the same conditions under the other defined contribution plan (that is, both plans must have identical eligibility/participation requirements).

  2. If a plan sponsor makes safe harbor contributions to another defined contribution plan, that plan may (but is not required to) be aggregated with the plan containing the CODA. Both plans must have the same plan year.

  3. The rules for aggregating and disaggregating CODAs and plans also apply to the ADP/ACP test safe harbor requirements.

    1. All CODAs in a plan are treated as a single CODA that must satisfy the safe harbor contribution requirement and the notice requirement.

    2. Two plans (per 26 CFR 1.410(b)-7(b)) that are treated as a single plan under permissive aggregation are treated as a single plan for the safe harbor methods.

    3. Conversely, a plan (under IRC 414(l)) that includes a CODA covering both collectively bargained employees and noncollectively bargained employees is treated as two plans for IRC 401(k), and one can be a safe harbor plan without the other also being a safe harbor plan.

    4. The rule in IRC 401(k)(3)(F) (permitting a plan to disregard certain employees) doesn’t apply to safe harbor plans. See 26 CFR 1-401(k)-3(h).

  4. HCEs are prohibited from receiving a higher rate of match than an NHCE. Apply the rules under IRC 401(m)(2)(B) and 26 CFR 1.401(m)-2(a)(3)(ii) to determine the rate of matching contributions under 26 CFR 1.401(m)-3(d)(4).

    Caution:

    If an HCE participates in two plans of an employer, matching contributions under each are combined and treated as made under each plan. Make sure HCEs don’t receive a higher rate of match than NHCEs.

Automatic Contribution Arrangements (ACAs)

  1. An automatic contribution arrangement (ACA), also known as "automatic enrollment," or auto enroll, is a plan feature where the plan sponsor reduces a participant’s compensation by a specified amount and contributes it to the plan unless the participant elects not to have compensation reduced or to have it reduced by a different amount. In a CODA, the plan sponsor contributes these amounts as elective deferrals, an affirmative election. To encourage companies automatically enrolling more employees in plans, PPA section 902 (as amended by WRERA), added IRC 401(k)(13), IRC 401(m)(12), and IRC 414(w) in 2006.

  2. Recent statutes and guidance relating to automatic enrollment:

    Citation Effective Date IRC section Description
    PPA section 902 (as amended by WRERA) Plan years beginning on or after January 1, 2008 IRC 401(k)(13) and IRC 401(m)(12) Adds Qualified Automatic Contribution Arrangements (QACAs) - an alternative design-based safe harbor that requires automatic contributions at a specified level, certain employer contributions and notices. If met, CODA is deemed to pass the ADP test (and ACP test for matching contributions).
    PPA section 902 (as amended by WRERA) Plan years beginning on or after January 1, 2008 IRC 414(w) Gives auto enroll plans limited relief from the distribution restrictions under IRC 401(k)(2)(B)
    Treas. Regs. on ACAs, 74 FR 8200, pub. Feb. 24, 2009 401(k), 401(m), and 414(w) Contains amendments to IRC 401(k), IRC 401(m) and new rule for IRC 414(w) to reflect PPA changes.
    Rev. Rul. 2009-30, 2009-39 I.R.B 391 Provides guidance on how automatic enrollment in a 401(k) plan can work when it has an escalator feature.

    Note:

    An escalator feature means that the plan periodically increases the amount of an employee’s compensation contributed to the plan, without the employee’s affirmative election, per plan terms.

    Notice 2009-65, 2009-39 IRB 413 Provides two sample amendments that 401(k) plan sponsors can use to add auto enroll features to their plans:
    • Amendment to add a basic ACA with an escalation feature.

    • Amendment to add an EACA with an escalation feature.

  3. Safe harbor correction methods for ACAs.

    1. The employer is not required to contribute a QNEC for the missed elective deferrals if their failure to implement either:

      1. an automatic contribution feature for an affected eligible employee

      2. an affirmative election of an eligible employee who is otherwise subject to an automatic contribution feature

      doesn’t extend beyond the end of the 9½ month period after the end of the plan year of the failure.

    2. To use the safe harbor correction method, the plan/plan sponsor must meet several requirements:

      1. Correct deferrals must begin by the earlier of:

        1. the affected employee’s first payment of compensation on or after the last day of the 9½ month period after the end of the plan year in which the failure first occurred

        2. if the affected employee notified the plan sponsor, the first compensation payment made on or after the last day of the month after the month the employee notified.

      2. The sponsor must give the affected employee a notice of the failure by 45 days after the date correct deferrals begin.

      3. The sponsor must make corrective contributions to make up for any missed matching contributions (adjusted for earnings) per the timing requirements under Rev. Proc. 2013-12 , 2013-4 IRB 313.

    Note:

    The safe harbor correction method is available only for plans failures that begin on or before December 31, 2020.

Qualified Automatic Contribution Arrangements (QACAs)

  1. CODAs with QACAs that meet the requirements under IRC 401(k)(13) and IRC 401(m)(12) are deemed to pass the ADP and ACP tests. To be a QACA, the plan must under 26 CFR 1-401(k)-3(j) and (k):

    • Provide certain levels of automatic contributions

    • Provide certain matching or nonelective contributions

    • Satisfy a notice requirement

  2. In QACAs, the deferral percentage an employee is automatically enrolled at (sometimes referred to as the "default percentage" or "default deferral" ) must meet certain minimums that increase over time, assuming the employee doesn’t affirmatively elect something else. Generally, a QACA applies to all employees eligible to make deferrals under the plan, but automatic enrollment applies only to those eligible employees without an affirmative election for elective deferrals in place. A plan may provide that employees’ affirmative elections for elective contributions expire after a certain period or event, so that unless the employee makes a new election he/she will be automatically enrolled at the appropriate default percentage.

  3. When an employer first adds a QACA to a CODA, the plan can either:

    • Honor existing affirmative elections

    • Require all employees to make new affirmative elections to avoid being automatically enrolled at the default percentage. See IRM 4.72.2.13.3 for the uniformity requirement.

QACAs Default Percentage Requirements

  1. QACAs must satisfy a series of minimum default contribution percentages (IRC 401(k)(13)(C)(iii)). The default percentages can’t exceed 10 percent of an employee’s compensation and must be applied uniformly. The default percentage must be at least:

    1. Three percent during the initial period.

    2. Four percent during the first plan year following the initial period.

    3. Five percent during the second plan year following the initial period.

    4. Six percent during the third and subsequent plan years following the initial period.

  2. An employee’s "initial period" :

    1. Begins when they first make default contributions under the QACA.

    2. Ends on the last day of the plan year after the plan year they first made default contributions.

  3. If an employee makes an affirmative election before the default contribution would’ve begun, then the initial period hasn’t begun for the employee because no default contributions were made for him/her.

    Note:

    A plan could simplify matters by having just one default percentage, for example, six percent, with no increase. The default percentage under the QACA is limited so as not to exceed the limits of IRC 401(a)(17), 402(g) (determined with or without catch-up contributions in IRC 402(g)(1)(C) or IRC 402(g)(7)) and IRC 415.

  4. The minimum percentages are based on the date the initial period begins, regardless of whether the employee is eligible to make elective contributions under the plan after that date. See 26 CFR 1.401(k)-3(j)(2)(iv).

    Example:

    An employee is ineligible to make contributions under the plan for six months because the employee had a hardship withdrawal. But, during the six- month period, the employee’s default minimum percentage is set to increase. When the employee is permitted to resume contributions, his default percentage must reflect that increase.

    Note:

    But, a plan may treat an employee who didn’t have default contributions for an entire plan year as if he/she had not had any for any prior plan year as well.

    Example:

    An employee terminates and remains terminated for at least one full plan year and is rehired in a subsequent plan year. The plan can use the employee’s original initial period for default contributions or use a new initial period.

  5. For plan years beginning on or after January 1, 2010, use safe harbor compensation as defined in 26 CFR 1.401(k)-3(b)(2) to determine default contributions.

QACAs Uniformity Requirements

  1. The plan’s default percentage must be applied uniformly to all eligible employees under the QACA (IRC 401(k)(13)(C)(iii)).

  2. A plan will not fail to satisfy this uniformity requirement per 26 CFR 1.401(k)-3(j)(2)(iii) even if:

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

    2. The rate of elective deferrals under a cash or deferred election in effect for an employee immediately before the effective date of the QACA default percentage isn’t reduced.

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

    4. The default election provided isn’t applied during the period an employee is suspended from making elective contributions in order for the plan to satisfy the requirements of 26 CFR 1.401(k)-3(c)(6)(v)(B) (six-month suspension following a hardship withdrawal).

QACAs Safe Harbor Contribution Requirements

  1. To satisfy QACA requirements, the employer is required to make either of the below safe harbor contributions:

    1. Matching contributions for each eligible NHCE of 100 percent of the employee’s contribution up to 1 percent of compensation + a 50 percent matching contribution for the employee’s contributions above 1 percent of compensation and up to 6 percent of compensation.

    2. Nonelective contributions for each eligible NHCE of at least 3 percent of the employee’s compensation even if the employee doesn’t make an elective or employee contribution.

  2. The safe harbor contributions must be available to all NHCEs in the CODA including those who made affirmative elections. Also, although the statute specifies required contributions for NHCEs, most plans also provide safe harbor contributions to HCEs.

  3. The QACA safe harbor matching and nonelective contributions must be nonforfeitable after no more than two years of service. Apart from the different matching formula and the two-year vesting requirement, all the rules applicable to safe harbor contributions to a (IRC 401(k)(12)) safe harbor plan apply to a QACA:

    • Contributions are based on safe harbor compensation - see IRM 4.72.2.12.2.

    • The plan may have enhanced matching formulas.

    • The safe harbor matching and nonelective contributions are subject to the same distribution restrictions as QNECs and QMACs

QACAs Notice Requirements

  1. A QACA must satisfy the same notice requirements as safe harbor plans (IRC 401(k)(12)) but have some additional content and timing requirements.

  2. QACA’s additional content requirements are that the notice must explain:

    1. The level of default contributions that the employer/plan sponsor will make on the employee’s behalf absent his/her affirmative election.

    2. The employee’s right to elect not to have elective deferrals made to the plan or to have them made in a different amount than the default percentage.

    3. How the plan will invest contributions under the QACA.

  3. A CODA satisfies the QACA notice’s timing requirement only if the sponsor provides it early enough so that the employee has a reasonable period after receiving it to make a deferral election. After giving the notice to an employee, the plan must begin the default election by the earlier of:

    1. Two paydays after the notice.

    2. The first payday at least 30 days after the notice.

  4. If a plan sponsor makes a mid-year change to a QACA safe harbor plan as permitted in Notice 2016-16, they must give an updated safe harbor notice that describes the mid-year change and its effective date if the change affects a provision required to be included in the safe harbor notice. See IRM 4.72.2.12.1 (6) for details.

Eligible Automatic Contribution Arrangements (EACAs)

  1. An EACA is an automatic contribution arrangement that may permit a participant to withdraw default contributions without penalty and, under certain circumstances, permits an extra 3 1/2 months to distribute excess contributions and excess aggregate contributions. An EACA has a notice requirement and a uniformity requirement, but doesn’t have mandatory employer contributions or a required level of default contributions. See 26 CFR 1.414(w)-1 and 26 CFR 54.4979-1(c) .

  2. Unlike a QACA, an EACA doesn’t need to cover all employees eligible to make deferrals under the CODA; only those specified in the plan are "covered employees" . A "covered employee" receives the annual EACA notices and is subject to default contributions if he/she doesn’t make an affirmative election. The plan must state whether an employee who makes an affirmative election remains covered under the EACA. So, if a plan states that an employee who makes an affirmative election is no longer an EACA covered employee, then the employee isn’t required to receive the notice after he/she makes an affirmative election.

  3. An EACA’s default elective contribution must be a uniform percentage of compensation; however, the percentage can vary like in a QACA. See CFR 1.414(w)-1(b)(2).

  4. A plan must aggregate all automatic contribution arrangements intended to be EACAs within the plan (or within the disaggregated plan under 26 CFR 1.410(b)-7, for a plan subject to IRC 410(b)).

    Example:

    A single plan per IRC 414(l) covers employees in two divisions: Division A and Division B. Each division has two different ACAs that are intended to be EACAs. Division A and Division B’s ACAs can constitute EACAs only if their default elective deferrals are the same percentage of compensation. However, if portions of the plan are mandatorily disaggregated under the IRC 410(b) coverage tests, then the EACA in the disaggregated portion of the plan doesn’t need to be aggregated with those in the rest of the plan and they could have different default percentages and still be EACAs.

  5. The EACA notice requirements are similar to the QACA notice requirements. See 26 CFR 1.414(w)-1(b)(3). But, if the EACA permits participants to withdraw default contributions, the notice must explain this to covered employees.

  6. An EACA allows employees who had default deferrals withdrawn from their pay to get the money back.

    Note:

    Before EACAs, employees who didn’t realize they were going to have their pay reduced under an ACA often couldn’t take these deferrals because of the elective deferrals distribution restrictions. The plan was also at a disadvantage, having to maintain small account balances for employees who never wanted to make deferrals but didn’t make an affirmative election.

  7. An EACA provides limited relief from the distribution restrictions under IRC 401(k)(2)(B) and permits employees to elect to withdraw (permissible withdrawal) their default elective deferrals (and attributable earnings) within a specific time period without penalty. The employee must elect within 90 days after the employer makes their first default elective contribution. A plan may set an earlier deadline than 90 days but, it must be at least 30 days. The effective date of an employee’s withdrawal election must be by the earlier of:

    1. Two paydays after the date he/she elects to withdraw.

    2. The first payday at least 30 days after he/she elects to withdraw.

  8. Plans don’t use the permissible withdrawal amounts in the ADP test or to determine IRC 402(g) elective deferral limits. Employees include the withdrawn amount (except designated Roth contributions) in gross income for the tax year it’s distributed. It’s not subject to the additional income tax under IRC 72(t). The plan may not charge a higher fee for a permissible withdrawal under IRC 414(w) than for other withdrawals.

  9. The IRC 4979 excise tax doesn’t apply to an EACA if the plan distributes excess contributions and excess aggregate contributions plus their earnings within 6 months (instead of 2 1/2 months) after the plan year end. The extension to six months applies only if the EACA covers all eligible employees.

  10. Plans must forfeit matching contributions (and earnings) allocated to permissible withdrawn default contributions. The plan may state that the sponsor won’t make matching contributions for any withdrawn elective contributions under IRC 414(w).

Designated Roth Contributions

  1. Plans may permit designated Roth contributions for tax years beginning on or after January 1, 2006 (IRC 402A by EGTRRA Section 617).

  2. Amendments to the final IRC 401(k) and IRC 401(m) regulations for designated Roth contributions were published in the Federal Register on January 3, 2006, 71 FR 6, and these regulations were amended by final regulations published April 30, 2007, 72 FR 21103.

  3. With the introduction of designated Roth contributions, under IRC 402A and 26 CFR 1.401(k)-1(f), plans may permit participants to designate elective contributions as either:

    • Designated Roth contributions (after- tax elective contributions)

    • Pre-tax elective contributions

  4. Designated Roth contributions are elective contributions under a qualified CODA that are:

    1. Designated irrevocably by the employee at the time of his/her cash or deferred election as designated Roth contributions that are being made in lieu of all or a portion of the pre-tax elective contributions.

    2. Treated by the employer as includible in the employee’s gross income at the time he/she would’ve received the contribution in cash if he/she didn’t make a cash or deferred election.

    3. Maintained in a separate plan account.

  5. Because designated Roth contributions are "after-tax," any plan distribution of them is tax-free to the participant. But, a plan distribution from a Roth account (including earnings) that is a "qualified distribution" is completely tax-free. Under 26 CFR 1.402A-1, Q&A- 2, a qualified distribution is one that is made both:

    • After five years of participation in the Roth arrangement.

    • At or after age 59 1/2, after death or because the participant is disabled.

  6. The only contributions that can go into a designated Roth account are:

    • Designated Roth contributions currently deducted from the employee’s pay

    • Rollovers from an employee’s other designated Roth account

    • In-plan rollovers

      Note:

      See 26 CFR 1.401(k)-1(f)(3), 26 CFR 1.402A-1, Q&A-13, Notice 2010–84 and Notice 2013–74.

  7. Corrective distributions and any other amounts described in 26 CFR 1.402(c)-2, Q&A-4 (amounts that can’t be rolled over) aren’t qualified distributions. See 26 CFR 1.402A-1, Q&A-2 and -11. It’s important to ensure that the plan doesn’t allocate improper amounts into the designated Roth account, such as extra earnings or forfeitures, because all qualified distributions from a designated Roth account are tax-free. Also, the plan must separately allocate losses and charges on a reasonable and consistent basis to the designated Roth account and other accounts under the plan.

  8. An employee’s designated Roth account and other accounts in the plan are treated as accounts under two separate plans (per IRC 414(l)) to apply the rules for:

    • Restrictions on an employee’s direct rollover choices (26 CFR 1.401(a)(31)-1, Q&A-9, Q&A-10 and Q&A-11).

    • Automatic rollover rules for mandatory distributions under IRC 401(a)(31)(B)(i)(I).

  9. Plans correcting an ADP test failure for a plan year may permit an HCE who has elective contributions for a year of both pre-tax and designated Roth contributions to choose whether the excess contributions is pre-tax elective or designated Roth contributions. See 26 CFR 1.401(k)-2(b)(1)(ii). Also, if an employee has excess deferrals, the employee may allocate the excess to designated Roth contributions. See 26 CFR 1.402(g)-1(e)(2)(i).

  10. Amounts in a designated Roth account can only be rolled over to an employee’s other designated Roth account or Roth IRA.

  11. Except as described above, designated Roth contributions are treated like any other elective contributions following the rules in 26 CFR 1.401(k)-1(f)(4) . Designated Roth Contributions:

    • Are counted in the ADP test.

    • Can be catch-up contributions.

    • Can be default elective contributions under an ACA.

    • Are subject to the required minimum distribution rules under IRC 401(a)(9).

    • Are treated as employer contributions for purposes of IRC 401(a), IRC 401(k), IRC 402, IRC 404, IRC 409, IRC 411, IRC 412, IRC 415, IRC 416 and IRC 417.

    • Are subject to the IRC 401(a)(9)(A) and (B) rules in the same way as pre-tax elective contribution accounts (26 CFR 1.401(k)-1(f)(4)(i)).

    Note:

    Roth IRAs aren’t subject to IRC 401(a)(9)(A) (IRC 408A(c)(5)), but designated Roth accounts under a CODA are (see IRC 402A).

  12. Employees must include any pre-tax amounts they roll over from their plan accounts to their designated Roth account in the same plan (an "in-plan Roth rollover" ) in their gross income. After 2012, participants may directly roll over amounts which may not otherwise be distributable as an "in-plan Roth rollover."

    Example:

    Participant A may roll over an amount from his pre-tax elective deferral account to his Roth account in the same plan even if he is under 59 1/1 and otherwise ineligible to receive a distribution of elective deferrals.

    Note:

    Participant A must do a direct rollover (in other words, he can’t receive a distribution and then do a 60-day rollover). The amounts Participant A rolled over are still subject to the distribution restrictions that apply to elective deferrals. See Notice 2013-74.

Contingent Benefits

  1. An employer may not directly or indirectly condition another employer benefit (other than matching contributions) upon an employee’s election to make or not make elective contributions. If the employer conditions an employer benefit upon elective contributions, the CODA isn’t qualified. This rule prevents employers from encouraging employees to make or not make elective contributions by linking valuable benefits to their contribution or lack of a contribution. See 26 CFR 1.401(k)-1(e)(6).

  2. These other benefits include:

    • Benefits under a DB plan

    • Nonelective employer contributions to a DC plan

    • Benefits under a nonqualified plan

    • The right to make employee contributions

    • The right to health and life insurance

  3. Treat employee participation in a nonqualified plan as a contingent benefit only when the employee may receive additional deferred compensation under the nonqualified plan depending on the whether they make/don’t make elective contributions.

  4. Don’t treat an employee’s participation in a nonqualified plan as a contingent benefit if their participation is conditioned on making the maximum deferrals under IRC 402(g) or the plan terms. See 26 CFR 1.401(k)-1(e)(6)(iii) and (iv) .

Examination Steps

  1. Ask the employer if they tie any benefits other than matching contributions to elective contributions. In certain circumstances you may need to interview employees who make or fail to make elective contributions to see if they get any special treatment from the employer.

  2. Determine whether the employer links a nonqualified plan to the CODA. If they do, ensure the nonqualified plan doesn’t have conditions in its form or operation that are dependent on an employee’s participation, lack of participation, or reduced participation in the CODA.

Cafeteria Plans

  1. Employers may have "cafeteria plans" (IRC 125). A cafeteria plan allows an employee to select among various types of employer benefits by specifying where an employer contribution should be spent.

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

Examination Step

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

Top-Heavy Rules

  1. CODAs (but not SIMPLE 401(k) plans, certain safe harbor 401(k) plans or QACAs) are subject to the top-heavy rules in IRC 416. If a plan with a CODA is top-heavy, it must provide each non-key employee employed on the last day of the plan year a contribution of:

    • Three percent of the employee’s compensation for the entire year or,

    • If lesser, the same percentage as the key employee with the highest percentage contribution.

      Example:

      Key employee A received the highest percentage contribution among all key employees of 4 percent. Each non-key employee must receive a 3 percent contribution. But, if the highest key employee percentage contribution was 2 percent, then the plan sponsor only needs to give non-key employees a 2 percent contribution.

  2. To determine the top-heavy minimum contribution percentage, consider these key employee contributions:

    • IRC 401(k) deferrals

    • Matching contributions

    • Employer nonelective contributions

    • Forfeitures

    • QNECs

  3. Consider key employee elective contributions to determine the minimum contribution required for non-key employees. Don’t consider NHCE elective contributions to determine if the plan satisfies the minimum contribution.

    Example:

    A profit-sharing plan only has elective contributions, all participants made 2 percent deferrals and the plan was top-heavy. The employer must make a 2 percent contribution for all the non-key employees, because even though the non-keys made 2 percent deferrals, the employer can’t consider them as employer contributions for the top-heavy minimum. See IRC 416(c)(2)(B)(i) and 26 CFR 1.416-1, M-20.

  4. Plans can use any combination of these contributions to satisfy the top-heavy minimum contribution requirements:

    • Employer nonelective contributions

    • Forfeitures

    • Matching contributions

    • QNECs

      Caution:

      If another plan provides the top-heavy minimums, and the eligibility requirements are not the same for both plans, then the 401(k)’s eligible participants plan may not be receiving the minimum benefit in the other plan. Therefore, they must receive the minimum benefit in the 401(k) plan.

Examination Steps

  1. If the employer has another plan, determine which plan provides the top-heavy minimum benefit.

  2. Verify that all CODA-eligible non-key employees who are employed on the last day of the plan year receive the top-heavy minimum benefit. If this benefit is provided in another plan, verify all the CODA-eligible non-key employees receive a top-heavy minimum benefit under the other plan.

    Reminder:

    Include employees as "eligible employees" if they meet the plan’s eligibility requirements even if they choose not to make elective deferrals.

    If you find discrepancies, request a complete list of all employees employed on the last day of the plan year who met the CODA’s eligibility requirements. Inspect payroll or other employment records to verify eligible employees.

  3. Verify that all eligible non-key employees under the plan receive an employer contribution of at least 3 percent of compensation, (or the highest contribution to any key employee, if less than 3 percent).

Compensation and IRC 415

  1. A 401(k) plan may have several definitions of compensation, which must be stated in the plan document. The general CODA definition of compensation is compensation as defined in IRC 414(s). The IRC 414(s) definition of compensation is also used in the ADP and ACP tests. See 26 CFR 1.401(k)-6 .

  2. The IRC 414(s) compensation definition states:

    1. Compensation means IRC 415(c)(3) compensation with an option to exclude amounts contributed under a salary reduction agreement (such as elective contributions).

    2. The Secretary of the Treasury may provide alternative definitions of compensation that do not favor HCEs.

    3. 26 CFR 1.414(s)-1 gives these alternative definitions.

  3. But, as already discussed, these contributions must use safe harbor compensation and may use a modified 414(s) definition of compensation for deferrals. See 26 CFR 1.401(k)-3(b)(2) and 26 CFR 1.401(k)-3(c)(6)(iv).

    • Safe harbor 401(k)

    • QACA mandatory employer contributions

    • QACA default contributions (for plan years beginning on or after January 1, 2010)

  4. Beginning on July 1, 2007, plans must use compensation under IRC 415(c) and 26 CFR 1.415(c)-2 for a cash or deferred election. See 26 CFR 1.401(k)-1(e)(8).

  5. Plans must include, under 26 CFR 1.415(c)-2(e)(3)(i) and (ii), certain post severance compensation as IRC 415 compensation if the employer pays it by the later of:

    1. 2 1/2 months after an employee’s severance from employment.

    2. The end of the limitation year of the employee’s severance from employment date.

  6. Plans may include, under 26 CFR 1.415(c)-2(e)(3)(iii) and (4) in compensation, certain:

    • Leave cashouts and deferred compensation.

    • Salary continuation payment for military service and disabled participants.

      Note:

      See Rev. Rul. 2009-31 and Rev. Rul. 2009-32 for guidance on contributing the value of leave cashout amounts to 401(k) plans, on an annual basis and after severance from employment.

  7. The maximum "annual additions" that can be made to a participant’s account for a "limitation year" is in IRC 415(c). A limitation year is a 12- month period the plan uses for 415 purposes, but is almost always the plan year.

    Note:

    Carefully review plans with a limitation year different from the plan year when checking for timeliness of interim amendments for compensation changes. Most interim amendment due dates are tied to the due date of income tax returns corresponding to applicable plan years. However, changes to 415 requirements are generally determined instead with reference to corresponding limitation years.

  8. Annual additions include:

    • Employer contributions

    • Employee contributions

    • Forfeitures

      Note:

      Annual additions also include excess contributions and excess aggregate contributions, even if distributed.

  9. Annual additions don’t include:

    • Catch-up contributions. So if a plan recharacterizes a portion of a HCE’s elective contributions as catch-up contributions, they aren’t counted for IRC 415 limits. See 26 CFR 1.415(c)-1(b)(1) and (2).

    • Excess deferrals distributed by April 15. See 26 CFR 1.415(c)-1(b)(2)(ii)(D).

  10. Excess annual additions are amounts allocated to a participant in excess of the IRC 415 limit.

    1. For limitation years beginning on or after July 1, 2007, plans can correct excess annual additions only by using the Employee Plans Compliance Resolution System (EPCRS).

    2. Plan sponsors can use SCP to correct certain recurring excess annual additions as long as the plan corrects them by returning elective deferrals to affected employees within 9½ months after the end of the plan’s limitation year.

    3. See Rev. Rul. 2013-12 , section 6.06, 2013-4 IRB 313, and Rev. Proc. 2015-27, section 4, 2015-13 I.R.B. 816.

      Reminder:

      For limitation years beginning before July 1, 2007, plans were allowed to correct excess annual additions by allocating or distributing them per 26 CFR 1.415-6(b)(6) of the 1981 Regulation under certain circumstances.

Examination Steps:

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

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

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

  4. Determine whether the employer maintains more than one plan. If yes, verify that annual addition calculations include:

    • All contributions for an individual to all the employer’s defined contribution plans.

    • All employee contributions to all the employer’s defined benefit plans.

  5. Ensure that a participant’s elective deferrals to all 401(k) plans and similar arrangements and his/her salary reduction contributions to cafeteria plans are included in compensation for IRC 415 testing.

  6. Review the plan document for appropriate 415 limitation and correction language. Appropriate correction language for 415 purposes would require a Voluntary Correction Program submission. Under post-2007 final 415 Regs., EPCRS is the only applicable 415 correction. If there were IRC 415 excesses during the year, verify that the correction method was acceptable under EPCRS.

  7. Check the plan for compensation definition(s) for allocations and elective contributions and make sure the plan sponsor used these definitions in operation.

Annual Statutory Limits Applicable to CODAs

COLA Increases for Dollar Limitations on Benefits and Contributions

Year IRC 408(p)(2) IRC 402(g) IRC 401(a)(17) IRC 414(q) IRC 415(c) Taxable Wage Base IRC 414(v)(2)(B)(i) IRC 414(v)(2)(B)(ii)
2017 12,500 18,000 270,000 120,000 54,000 127,200 6,000 3,000
2016 12,500 18,000 265,000 120,000 53,000 118,500 6,000 3,000
2015 12,500 18,000 265,000 120,000 53,000 118,500 6,000 3,000
2014 12,000 17,500 260,000 115,000 52,000 117,000 5,500 2,500
2013 12,000 17,500 255,000 115,000 51,000 113,700 5,500 2,500
2012 11,500 17,000 250,000 115,000 50,000 110,100 5,500 2,500
2011 11,500 16,500 245,000 110,000 49,000 106,800 5,500 2,500
2010 11,500 16,500 245,000 110,000 49,000 106,800 5,500 2,500
2009 11,500 16,500 245,000 110,000 49,000 106,800 5,500 2,500
2008 10,500 15,500 230,000 105,000 46,000 102,000 5,000 2,500
2007 10,500 15,500 225,000 100,000 45,000 97,500 5,000 2,500
2006 10,000 15,000 220,000 100,000 44,000 94,200 5,000 2,500
2005 10,000 14,000 210,000 95,000 42,000 90,000 4,000 2,000
2004 9,000 13,000 205,000 90,000 41,000 87,900 3,000 1,500
2003 8,000 12,000 200,000 90,000 40,000 87,000 2,000 1,000
2002 7,000 11,000 200,000 90,000 40,000 84,900 1,000 500
2001 6,500 10,500 170,000 85,000 35,000 80,400
2000 6,000 10,500 170,000 85,000 30,000 76,200
1999 6,000 10,000 160,000 80,000 30,000 72,600
1998 6,000 10,000 160,000 80,000 30,000 68,400
1997 6,000 9,500 160,000 30,000 65,400
1996 9,500 150,000 30,000 62,700

Attachment One – Hardship Substantiation Information and Notifications for Summary of Source Documents

I. Notifications that the Employer/Administrator Must Provide to the Employee
  • The hardship distribution is taxable and additional taxes could apply

  • The amount of the distribution cannot exceed the immediate and heavy financial need.

  • Hardship distributions cannot be made from earnings on elective contributions or from QNEC or QMAC accounts, if applicable.

  • The recipient agrees to preserve source documents and to make them available at any time, upon request, to the employer or administrator.

II. General Information for All Hardship Requests
  • Participant’s name

  • Total cost of the event causing hardship (for example, total cost of medical care, total cost of funeral/burial expenses, payment needed to avoid foreclosure or eviction)

  • Amount of distribution requested

  • Certification by the participant that the information provided is true and accurate

III. Specific Information on Deemed Hardships
A. Medical Care
  • Who incurred the medical expenses (name)?

  • What is the relationship to the participant (self, spouse, dependent, or primary beneficiary under the plan)?

  • What was the purpose of the medical care (not the actual condition but the general category of expense, for example, diagnosis, treatment, prevention, associated transportation, long-term care)?

  • Name and address of the service provider (hospital, doctor/dentist/chiropractor/other, pharmacy)

  • Amount of medical expenses not covered by insurance

B. Purchase of Principal Residence
  • Will this be the participant’s principal residence?

  • Address of the residence

  • Purchase price of the principal residence

  • Types of costs and expenses covered (down-payment, closing costs and/or title fees)

  • Name and address of the lender

  • Date of the purchase/sale agreement

  • Expected date of closing

C. Educational Payments
  • Who are the educational payments for (name)?

  • What is the relationship to the participant (self, spouse, child, dependent, or primary beneficiary under the plan)?

  • Name and address of the educational institution

  • Categories of educational payments involved (post-high school tuition, related fees, room and board)

  • Period covered by the educational payments (beginning/end dates of up to 12 months)

D. Foreclosure/Eviction from Your Principal Residence
  • Is this the participant’s principal residence?

  • Address of the residence

  • Type of event (foreclosure or eviction)

  • Name and address of the party that issued the foreclosure or eviction notice

  • Date of the notice of foreclosure or eviction

  • Due date of the payment to avoid foreclosure or eviction

E. Funeral and Burial Expenses
  • Name of the deceased

  • Relationship to the participant (parent, spouse, child, dependent, or primary beneficiary under the plan)

  • Date of death

  • Name and address of the service provider (cemetery, funeral home, etc.)

F. Repairs for Damage to Principal Residence
  • Is this the participant’s principal residence?

  • Address of the residence that sustained damage

  • Briefly describe the cause of the casualty loss (fire, flooding, type of weather-related damage, etc.), including the date of the casualty loss

  • Briefly describe the repairs, including the date(s) of repair (in process or completed)