• Alternative Means To Satisfy The Nondiscrimination Requirement Imposed by the Internal Revenue Code On 401(k) Plans
  • September 24, 2003 | Author: Michael R. McEvoy
  • Law Firm: Harter Secrest & Emery LLP - Rochester Office
  • Any employer who maintains a qualified 401(k) plan knows that the plan is an important tool for retaining employees and provides extraordinary tax benefits to the employer and the employee. The employer receives a current deduction for amounts it contributes to the plan and the employee can elect to defer income by contributing "pre-tax" dollars to it. The assets grow inside the plan tax-free, and the employee does not recognize income until he or she actually receives distributions from the plan. In exchange for these tax benefits, the Internal Revenue Code imposes certain limitations on qualified plans. One of these limitations is a nondiscrimination requirement.

    The nondiscrimination rule generally limits the amounts that highly compensated employees ("HCEs") may defer under a 401(k) plan. A highly compensated employee is one who is a 5% owner of the employer or earns more than $80,000 per plan year. The limits on HCEs are designed to ensure that the average amount deferred by the HCEs is in rough parity with the average amount deferred by non-highly compensated employees ("NHCEs").

    In order to ensure that a plan complies with these limits, plans are required to conduct discrimination testing. The tests measure the average deferrals of HCEs as compared to NHCEs. If the results are within prescribed limits, the plan remains qualified and the employer has no further obligations. However, if the average deferrals of HCEs are out of line with those of the NHCEs, the employer may be required to return deferrals to the HCEs or make corrective contributions to the plan on behalf of the NHCEs. For example, if HCEs average a deferral of 10 % of their compensation while NHCEs average only 3%, the employer may need to take corrective action.

    Failing nondiscrimination tests can be an expensive proposition. At the very least, nondiscrimination testing places a significant administrative burden on employers, as the tests are quite complex to apply in many real life situations. Often, employers are forced to turn to third-party administrators, hire additional staff, or purchase expensive software to perform the tests.

    This article discusses two recent developments which provide employers with options to satisfy the nondiscrimination requirements, or at least reduce the chance the plan will fail the tests. Specifically, the Internal Revenue Service (the "IRS") has prescribed a "safe harbor" for employers who satisfy certain contribution thresholds that eliminates the need for nondiscrimination testing and has also approved a "negative" deferral election that can be used to increase the deferral percentages of NHCEs and thereby decrease the likelihood that the plan will fail the tests.

    Safe Harbor

    For plan years beginning on or after January 1, 1999, the new safe harbor provides that a 401(k) plan can satisfy the nondiscrimination requirement without the need to do any testing if it meets a notice requirement and either one of two contribution requirements.

    The notice requirement will be met if each employee eligible to participate in the plan is, within a reasonable period before any plan year (usually at least 30 days), given a written notice of his or her rights and obligations under the plan. The reason for the notice is to advise employees that the plan will be relying on the safe harbor in order to meet the nondiscrimination requirement. It tells them how the contribution requirement will be met while they still have ample time to change their deferral elections.

    The safe harbor requires both the notice requirement and one of two contribution requirements. The first approach for meeting the contribution requirement is the "matching contribution" requirement. The matching contribution requirement will be met if the employer makes a matching contribution on behalf of each NHCE equal to 100% of the employee's elective contributions up to 3% of compensation plus 50% of the employee's elective contributions between 3% and 5% of compensation. Under this rule, the matching rate for HCE's cannot be greater than the matching rate for NHCE's at any level of compensation.

    The matching contribution requirement allows variations in plan design other than the precise statutory formula if the total amount of matching contributions at any contribution rate level at least equals the total amount that would have been made under the general formula. For instance, if the employer matched at a rate of 100% of the first 4% of contributions and nothing above that level, the match would always at least equal what would be required under the statutory formula.

    The second alternative to meeting the contribution requirement is for the employer to make a "non-elective contribution" of at least 3% of an employee's compensation, either to the 401(k) plan or to another defined contribution plan, on behalf of each NHCE who is eligible to participate in the 401(k) plan regardless of whether the employee is making deferrals under the plan. The contribution can be made for all eligible employees including HCEs.

    The IRS has provided some flexibility for employers who are unsure whether they will use the non-elective contribution alternative for the upcoming plan year. According to a recent IRS pronouncement, employers contemplating the adoption of the safe harbor non-elective contribution method for the upcoming plan year may wait until 30 days before the end of that plan year to formally adopt the safe harbor method if they notify all employees eligible to participate in the plan of their intentions in the form of the notice described above and they provide all eligible employees a supplemental notice prior to formal amendment of the plan. This "wait and see" relief cannot be used with the matching contribution alternative.

    All employer contributions under either contribution alternative for the safe harbor method must be 100% vested at all times.

    If an employer utilizes one of these design-based safe harbor methods to meet the nondiscrimination requirements, it will know at the beginning of a plan year that the nondiscrimination requirement has been satisfied and will have eliminated the administrative burden of testing. In addition, these features allow HCEs to defer the maximum permitted by law regardless of what the NHCEs choose to contribute. Of course, the negative aspect of using the safe harbor method is the additional costs that will usually be incurred for increased employer contributions on behalf of all employees.

    Negative Elections

    As an alternative to the safe harbor method, an employer can reduce the likelihood of failing the nondiscrimination tests by including a negative election provision in its 401(k) plan. A negative election is a default election whereby each participant is deemed to have elected to defer a stated percentage of his or her compensation for the year unless the employee has otherwise affirmatively made a deferral election. For instance, the plan would provide that each employee, upon becoming eligible to participate in the plan, shall elect to defer 3% of his or her compensation for the year. The IRS has recently approved negative elections if the employee receives notice of the election within a reasonable time before the deferral is made. The reason for the notice here is to give the employee time to rescind the negative election completely and receive cash compensation or modify the deferral percentage to the desired level.

    Employers deciding to adopt a negative election provision should provide employees with notice before they become participants in the plan explaining the automatic compensation reduction and informing them of their right to modify the election and the procedure and time limits for doing so. Also, employers should confirm that the negative election does not run afoul of state law limiting the employer's ability to withhold money from employee paychecks.

    Inserting a negative election provision into a 401(k) plan will usually reduce the likelihood that the plan will fail the nondiscrimination tests. The reason a plan fails to satisfy the nondiscrimination requirement is the average deferrals of NHCEs is too low in comparison to the average deferrals of the HCEs. The average deferrals of the NHCEs are often skewed by employees who fail to defer anything. The negative election fixes this problem for "passive" employees by requiring them to defer a certain amount unless they affirmatively elect not to do so. Thus, if a plan contains a negative election provision, the average deferrals of the NHCEs is usually higher, the plan will more likely pass nondiscrimination testing, and the HCEs will be permitted to defer more. Of course, the employees must have the right to modify the negative election, but hopefully, the slight nudge provided by the negative election will encourage recalcitrant employees to continue to defer compensation for their retirement.

    The rules governing 401(k) plans are quite extensive. If you are considering any of the options discussed in this article, please consult a tax professional.