Sec. 401(k) nondiscrimination safe harbors.

New design-based safe harbor methods for meeting the nondiscrimination rules for cash or deferred arrangements (CODAs) became effective Jan. 1, 1999 for calendar-year plans. These new methods, enacted by the Small Business Job Protection Act of 1996 (SBJPA), allow many organizations to adopt or expand their use of CODAs.

Prior to the SBJPA, employers maintaining a Sec. 401(k) plan had to calculate the average deferral percentage (ADP) of the highly compensated employees (HCEs) and the non-highly compensated employees (non-HCEs) for the plan year. Tests were then performed to determine whether the HCEs' deferrals were nondiscriminatory. If they were, corrections were required (e.g., return of excess amounts to the HCEs or additional employer contributions to non-HCEs' accounts). Similar testing (average contribution percentage (ACP) test) and corrections were required for employer matching contributions and employee nondeductible (after-tax) contributions.

Other SBJPA changes simplified the definition of HCEs and provided for the use of the prior plan year's nonHCE ADP and ACP test results to determine the current plan year's nondiscriminatory percentages for HCEs.

If met, the new safe harbors, Sec. 401(k)(12) and (m)(11) (added by SBJPA Section 1433), generally allow an employer to avoid the ADP and ACP tests. In October 1998, the IRS released Notice 98-52, providing additional guidance.

New Sec. 401(k)(12) provides that, if an employer makes either (1) a nonelective contribution of 3% of compensation for all eligible non-HCEs (regardless of whether they make elective contributions) or (2) non-discretionary matching contributions of 100% of the first 3% of employee elective contributions and 50% of the next 2%, the safe harbor is met for the cash or deferred portion of the plan. These contributions must be non-forfeitable, contributed within 12 months after the close of the plan year and subject to the same withdrawal rules that apply to employee elective contributions. In addition, the plan may not use the permitted disparity rules (i.e., providing additional contributions above the Social Security wage base) for safe harbor contributions.

If an employer elects the matching contribution safe harbor, the rate of any HCE matching contribution cannot exceed the rate used for any non-HCE. However, an employer may use an alternative plan design for matching contributions, as long as the matching percentage does not increase for higher deferral amounts and the total matching contribution at least equals the above rates at the specified elective contribution percentage. Further, to ensure that the non-HCEs can take full advantage of matching contributions, the elective contributions generally cannot be restricted. However, this requirement does not override the limits (1) on contributions following a hardship distribution or (2) of Sec. 402(g) or 415.

The employer must provide eligible employees written notice of their rights and obligations under the plan. Such notice must be written in a manner reasonably expected to be understood by the average eligible employee and must accurately and comprehensively explain rights and obligations. Notice 98-52 indicates that the notice must be provided to eligible employees no less than 30 nor more than 90 days before each plan year. It also sets out seven required disclosures (although it does not provide model language), including the matching or non-elective safe harbor contribution formula; the plan to which the safe harbor contributions will be made; the type and amount of compensation that may be deferred under the plan; as well as the withdrawal and vesting requirements.

Both the contribution and notice requirements must be met during the entire plan year; this would bar making contributions only for employees employed on the last day of the plan year. This provision could result in contributions not being made for all eligible employees for the plan year. Lastly, the CODA will be deemed to meet the safe harbor requirements if another plan maintained by the employer meets the requirements for eligible employees under the arrangement.

To meet the safe harbor for ACP purposes, the CODA rules must be met. Additionally, matching contributions may not exceed 6% of any employee's compensation, the match rate may not increase at higher deferral rates and the rate of matching contribution for any HCE may not be greater than the rate for any non-HCE. If the plan allows for after-tax contributions, those contributions will be subject to the general ACP testing requirements, whether or not the plan is otherwise treated as meeting the safe harbor for matching contributions.

The safe harbor rules presume that the plan meets all of the Code's other relevant tax qualification requirements. This includes adopting any necessary amendments to effectuate these rules within the remedial amendment period (e.g., Dec. 31, 1999, for most calendar-year plans).

While using the safe harbor methods could create new financial burdens for some companies, many companies currently provide significant profit-sharing contributions that are non-forfeitable. Other companies may have avoided Sec. 401(k) plans, because of concerns about compliance with the nondiscrimination rules. For these organizations and those implementing new plans, the safe harbors provide exciting new planning opportunities.

FROM ROBERT A. LAVENBERG, J.D., LL.M., CPA, PHILADELPHIA, PA