Combining a "safe harbor" sec. 401(k) plan with a new comparability defined contribution plan.

In general, Sec. 401(k) plans with both participant "elective deferrals" (as defined in Sec. 402(g)) and employer matching contributions (under Sec. 401(m)), must prove annually that these deferrals and contributions do not discriminate against nonhighly compensated employees (NHCEs) in favor of highly compensated employees (HCEs). Performing the actual deferral percentage (ADP) test under Sec. 401(k)(3) and the actual contribution percentage (ACP) test under Sec. 401(m)(2) accomplishes this. Both sections provide the same two arithmetic algorithms to calculate whether participant elective deferrals or employer matching contributions are discriminatory.

Unfortunately, the calculations are time consuming; further, negative results need to be repaired as quickly as possible to avoid excise taxes and undesirable individual income tax and retirement planning results. To avoid the excise tax, the excesses must be cured by March 15 of the year following the year of failure for a calendar-year plan, under Sec. 4979(f).

The Safe-Harbor Sec. 401(k) Plan

Sec. 401(k)(12) describes a "safe harbor Sec. 401(k) plan." It provides for a mandatory, fully vested employer nonelective contribution or matching contribution that will result in the plan automatically passing the ADP and ACP tests.

There are two statutory requirements for a Sec. 401(k) plan to meet the safe-harbor standards:

1. A contribution requirement under Sec. 401(k)(12)(A)(i); and

2. A notice requirement under Sec. 401(k)(12)(a)(ii) .

Sec. 401(k)(12)(C) and (B) mandate that a safe-harbor Sec. 401(k) plan sponsor generally make one of two types of contributions, at least for NHCEs:

1. A 3% of compensation, fully vested nonelective contribution, to all eligible plan participants (the 3% QNEC); or

2. A fully vested matching contribution (the QMAC) equal to the sum of:

a. 100% of the first 3% of compensation deferred; plus

b. 50% of the next 2% of compensation.

Although a 3% QNEC to all NHCEs will satisfy the Sec. 401(k) safe-harbor contribution requirement, the plan may still not satisfy the top-heavy minimum contribution requirement to the extent there are nonkey HCEs who do not receive the 3% QNEC.

Under the Sec. 401(k)(12)(D) notice requirement, the plan sponsor must notify eligible participants in writing of their plan rights and obligations, at least 30 days before the beginning of a new plan year.

The New Comparability Plan

A new comparability defined contribution plan establishes that contributions are nondiscriminatory without reference to their compensation percentage. Instead, the plan uses regulatory cross-testing methodology to demonstrate that contributions do not discriminate because of "equivalent benefits" rules (Regs. Sec. 1.401(a)(4)8(b)(1)(i)). Cross-testing essentially determines the annual benefit, as a percentage of compensation, that each employee's allocation (plus future interest) is likely to purchase at normal retirement age. This hypothetical annual benefit is tested for nondiscrimination, not the actual allocation. These techniques are similar to those used in defined benefit plans (Regs. Sec. 1.401(a)(4)-8).

Under cross-testing, the same allocation for a younger employee will be projected to earn more interest, and thus convert to a larger annual benefit as a percentage of compensation, than for an older employee. Thus, a plan may provide a lower allocation rate for younger employees and a higher rate for older employees and still be nondiscriminatory, because the resulting equivalent benefit accrual rates will be nondiscriminatory.

Because this method can provide higher contribution percentages to HCEs (e.g., 20% of compensation), while providing de minimis contribution rates for NHCEs (i.e., less than 3%), Kegs. Sec. 1.401(a)(4)-8(b)(1)(iv) mandates a "minimum allocation gateway" of the lesser of (1) 5% of compensation or (2) one third of the highest allocation rate for the HCEs.

Notice 98-52 indicates that the 3% safe-harbor QNEC may be taken into account in meeting the new comparability plan-5% minimum allocation gateway. Thus, at the maximum cost of an additional 2% of compensation, the employer may implement a very powerful, actuarially driven profit-sharing plan, while eliminating many Sec. 401(k) plan pitfalls.

Thus, a plan sponsor whose profit-sharing plan includes a salary-deferral Sec. 401(k) feature and a cross-tested discretionary nonelective employer contribution can benefit by using a safe-harbor Sec. 401(k) plan, because:

1. The plan is deemed to satisfy the ADP and ACP tests.

2. The 3% QNEC will solve any top-heavy issues that might apply to the nonelective source of contributions, if allocated to all nonkey employees.

3. The 3% QNEC counts toward satisfying the minimum allocation gateway for cross-testing purposes.

4. The plan sponsor may implement a new comparability plan at reasonable expense.

FROM DAVID WASSERSTRUM, CPA, MBA, NEW YORK, NY