IRS Eases Requirements for 401(k) Safe Harbors

In 1996 Congress amended the tax code to provide that employers who provide a certain amount of matching or profit-sharing contributions under a "safe harbor" formula get a free pass on the "actual deferral percentage" ("ADP") and "actual contribution percentage" ("ACP") nondiscrimination tests. As the Internal Revenue Service (the "IRS") is prone to do, it promptly issued a notice (IRS Notice 98-52) that imposed onerous rules for using the safe harbor formulas. After receiving negative feedback, the IRS lifted some of the more burdensome requirements in a notice issued earlier this year (IRS Notice 2000-3). The following are the most important changes made in Notice 2000-3:

• Safe harbor contributions can be discontinued mid-year if participants are notified 30 days in advance of the discontinuance and other requirements are met.
• Employers can wait up to December 1 of the testing year to adopt a nonelective contribution safe harbor of 3% of compensation.
• No year-end "true-up" contributions are required to satisfy the matching safe harbor if matching contributions are made on a payroll, monthly or quarterly basis, so long as contributions are deposited no later than the last day of the following plan year quarter.
• Employers can use electronic media to satisfy the notice requirements.
• A plan that covers employees who are under age 21 and who have less than one year of service ("excludable employees") can adopt a matching or nonelective contribution safe harbor that makes safe harbor contributions only to employees who are over age 21 and who have one year of service or more. Safe harbor contributions need not be made for excludable employees. However, 401(k), matching and after-tax contributions on behalf of the excludable employees must independently satisfy the ADP test and, if applicable, the ACP test.

Below is a summary of the rules for using a safe harbor formula, as modified by the IRS in Notice 2000-3.

Nonelective Contributions Safe Harbor

• Amount of Contributions. A 401(k) plan automatically satisfies the ADP and ACP tests if the employer makes nonelective contributions to the accounts of non-highly compensated employees ("NHCEs") in an amount equal to 3% of their compensation. If desired, nonelective contributions need not be made on behalf of highly compensated employees ("HCEs").
• Timing of Decision to Use Safe Harbor. Employers may decide to use the safe harbor as late as 30 days prior to the end of the plan year being tested. For example, a calendar-year plan could wait as late as December 1, 2000 to amend its 401(k) plan to provide the safe harbor contribution and to avoid ADP/ACP testing for 2000. However, the employer would have to provide participants with a notice prior to January 1, 2000 that the plan may be amended to provide the safe harbor nonelective contribution of 3% for the plan year. Also, a supplemental notice must be provided to eligible employees no later than 30 days prior to the last day of the plan year notifying them of the safe harbor amendment. This rule is of particular importance to employers who periodically test during the year and discover that significant refunds will be required to pass the ADP or ACP test. Such an employer could take advantage of the nonelective contribution safe harbor and avoid year-end refunds.
• Exiting the Safe Harbor Is Permitted. An employer is not required to continue using the nonelective contribution safe harbor for future plan years and is not limited in the times that it can take advantage of the December 1 amendment process.
• Vesting and Distribution Requirements. Safe harbor contributions must be fully vested at all times and may not be made available as an in-service distribution prior to age 59=, regardless of whether the employee wishes to make a hardship withdrawal.
• 1,000 Hours/Last Day Rules. Employers commonly require participants to have 1,000 hours in the plan year or to be employed on the last day of the plan year in order to be eligible for a contribution. These rules cannot be imposed for safe harbor contributions.
• Required Notice to Participants. At least 30 days prior to the beginning each year (but not more than 90 days before the beginning of each year), employers must distribute a notice that contains, among other things, a description of the nonelective contribution formula. Under Notice 2000-3, the notice can be provided through an electronic medium that is reasonably accessible to employees. Employees must be able to understand the notice provided through an electronic medium as well as a written document. The employer must inform employees that the notice is available on paper and must provide such paper notice upon request at no charge. Electronic distribution of notices can save copying and mailing costs (as well as being environmentally friendly). The notice requirement can be met by cross-referencing a summary plan description that contains all of the requisite information, provided that the notice describes, among other things, the contribution formula under the plan, directions to make 401(k) contribution elections and the periods for making such elections.

Matching Contribution Safe Harbor

• Amount of Contributions. A 401(k) plan automatically satisfies the ADP and ACP tests if the employer makes a matching contribution to each NHCE that is equal to 100% of the portion of his or her 401(k) contributions that do not exceed 3% of his or her compensation, plus 50% of the next 2% of compensation. Alternatively, the employer may provide an "enhanced" matching contribution, provided certain rules are met. Under an enhanced formula:
• 1. the rate of matching contributions may not increase as an employee’s rate of 401(k) contributions increases;
  2. the matching percentage for an HCE cannot exceed the percentage for an NHCE with the same 401(k) contribution percentage; and
  3. the match must be at least as great as the minimum, for every 401(k) contribution percentage.
• Exiting the Safe Harbor. An employer may discontinue safe harbor matching contributions if certain conditions are met.
• • First, the employer must provide employees with a supplemental notice of the amendment eliminating the match.
  • Second, the amendment may not become effective earlier than 30 days after the supplemental notice has been given to employees.
  • Third, eligible employees must be given a reasonable amount of time to change their 401(k) contribution elections.
  • Fourth, the plan must be amended to state that it will satisfy the ADP and ACP tests on the current year testing method. The IRS adopted this exit strategy to alleviate employers’ concerns that they would be bound to make the safe harbor contributions for the entire year, even if it were financially infeasible to do so.
• Basis for Matching Contributions. One of the most significant changes made by Notice 2000-3 is that matching contributions can be made on a payroll-by-payroll basis provided that the contributions are made by the last day of the following plan year quarter. Notice 98-52 required employers to make safe harbor contributions on a plan year basis, which would require a year-end true-up contribution or make-up contributions throughout the year by looking at year-to-date deferrals.
• 401(k) Deferral Percentages. The plan sponsor can require participants to make 401(k) contributions in either whole percentages or whole dollar amounts.
• Withdrawal Rules. If a participant withdraws his or her 401(k) contributions on account of a hardship (as defined by the regulations) or after-tax contributions, the plan sponsor can suspend the participant’s ability to make contributions for a 12-month period without falling outside of the safe harbor.
• Match on Pre- and After-Tax Contributions. An employer is allowed to make safe harbor matching contributions on either pre-tax (401(k)) or after-tax employee (or both) if two conditions are met. First, the matching contributions provided with respect to any employee’s 401(k) contributions cannot be affected by the amount of the employee’s after-tax contributions. Second, matching contributions must be made based on the sum of the employee’s 401(k) contributions and after-tax contributions under the same terms as matching contributions are made on 401(k) contributions.
• Vesting, Notice and Distribution Requirements. Safe harbor matching contributions are subject to the same vesting, notice and distribution rules applicable to safe harbor nonelective contributions. See explanation above.