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Safe-harbor sec. 401(k) Plans.

Sec. 401(k)(12) safe-harbor plans first became available to sponsors of Sec. 401(k) plans for plan years beginning in 1999. Until recently, the only IRS guidance on these safe-harbor provisions was. Notice 98-52. This year, however, the Service issued Notice 2000-3, which provides several changes governing Sec. 401(k) safe-harbor plans. Generally, retirement plans that allow employees to make salary deferral contributions (Sec. 401(k) plans) are subject to special nondiscrimination testing, to ensure that highly compensated employees (HCEs) do not benefit to a greater extent than nonhighly compensated employees (NHCEs). Additionally, any employer contributions allocated based on an employee's contribution level (i.e., matching contributions) are also subject to similar nondiscrimination testing. Certain changes in retirement plan laws now allow companies to adopt plan document provisions that eliminate nondiscrimination testing requirements. This could have many benefits, with HCEs maximizing pretax deferrals, employers saving on plan administration costs and eliminating the return of excess contributions.

For plan years beginning after 1998, Notice 98-52 provides that nondiscrimination testing will not be necessary if a plan meets three "safe-harbor" conditions. The three conditions relate to the amount of the employer contribution, the vesting schedule used for employer contributions and an annual employee notification.

To meet the safe-harbor contribution requirement, an employer must make either a matching (allocated to participants based on the Sec. 401(k) deferrals made) or nonelective (allocated to all eligible participants) contribution to all eligible NHCEs. Additionally, the employer may, but is not required to, provide the minimum contribution to all eligible HCEs. For either contribution, the employer cannot require a participant to be employed on the last day of the plan year. This may deter some plan sponsors (who currently have this requirement) from adopting these safe-harbor provisions.

If an employer elects to make a safe-harbor matching contribution, it must be no less than 100% of the first 3% of an employee's deferred compensation, plus an additional 50% match on the next 2% of the employee's deferred compensation. An employer may choose other formulas, such as matching 100% of the first 4% of compensation deferred, as long as the contributions are not less than the contributions the safe-harbor formula would provide. An employer can enhance the matching formula, as long as the rate of matching contributions does not increase as the deferral rate increases. Also, to meet the safe-harbor for matching contributions, the safe-harbor formula cannot match employee deferrals in excess of 6% of compensation. No other tiered formulas are deemed to meet the safe-harbor requirement.

If an employer instead chooses to make a nonelective contribution, it must allocate at least 3% of compensation to all eligible NHCEs. Unlike the matching contribution, participants need not make Sec. 401(k) deferrals to receive an employer contribution. As with a match, it is at the employer's discretion whether to make contributions on behalf of HCEs. Additionally, safe-harbor nonelective contributions may be considered for purposes of meeting the top-heavy requirements under Sec. 416. Thus, if a plan is already making top-heavy contributions, plan sponsors may use these allocations (with only minor adjustments) to meet the contribution requirement under these safe-harbor provisions.

In addition to minimum employer contribution requirements, employers must adopt a safe-harbor vesting schedule that automatically vests employees 100% in the employer contributions made under the safe-harbor provisions, regardless of years of service. While many plans may already allocate contributions that meet the safe-harbor requirement on contributions, few have 100% vesting provisions. To automatically fully vest a participant in employer contributions means that, on termination, participants are entitled to 100% of the contributions and earnings thereon in their individual accounts. Thus, plans adopting the safe-harbor provisions will no longer have forfeited balances or forfeiture reallocations with respect to balances attributable to safe-harbor contributions.

The final safe-harbor requirement is an annual employee notice. A safe-harbor plan must provide an annual written notice to all eligible employees at least 30 days (but not more than 90 days) before the start of a new plan year. The notice's purpose is to accurately describe employee rights and employer obligations under the safe-harbor provisions. A notice must include:

* Description of the safe-harbor nonelective or matching contribution formula;

* Explanation of any other contributions the plan provides;

* Description of the amount and type of compensation eligible for deferral;

* Details on how to make cash or deferred elections, including administrative requirements;

* Indication of the periods available for making cash or deferred elections; and

* Explanation of the plan's withdrawal and vesting provisions.

Generally, the safe-harbor provisions must be adopted before the first day of the plan year in which they are to be used.

Notice 2000-3 provides certain plan sponsors with additional time to decide whether to incorporate these safe-harbor provisions for a particular plan year. If a non-safe-harbor Sec. 401(k) plan uses the current-year testing method for actual deferral percentage (ADP) and actual contribution percentage (ACP) testing, it may be incorporated into a safe-harbor plan as late as 30 days before the end of the plan year. However, the safe-harbor contribution must be a 3% nonelective contribution, not a matching contribution. Also, eligible employees must have received notice before the beginning of the plan year, advising them that the plan sponsor might choose to amend the plan in this manner. If the plan is in fact amended, participants must receive an amendment notice at least 30 days before the end of the plan year.

Notice 2000--3 indicates that a simplified amendment to accomplish this result will be available under the master and prototype plan document program. A plan sponsor will not be limited in the number of times it can take advantage of this option.

Notice 2000-3 also provides additional flexibility to safe-harbor plan sponsors that choose the matching contribution approach. An employer must begin the year by making matching contributions outlined in the safe-harbor plan document and disclosed to participants in the safe-harbor notice distributed before the year began. Thereafter, if the plan sponsor wishes, it can choose to abandon safe-harbor status by amending the plan to suspend or reduce matching contributions, but only on a prospective basis. Employers must give participants notice of the change; the suspension of matching contributions cannot take effect earlier than the later of 30 days after the employer gave notice or the date of the plan amendment. After employers distribute the suspension notice, participants must have the opportunity to change their deferral elections. The plan must then satisfy the ADP and ACP tests, using the current-year testing method based on contributions for the entire year (including contributions made before suspension of matching contributions).

Importantly, Notice 2000-3 changes the method for determining matching and elective contributions for a safe-harbor plan. Under Notice 98-52, the rate at which a participant receives matching contributions was determined by taking into account contributions and compensation for the entire plan year. Often, a plan sponsor who determined the matching rate on a payroll-period basis was obligated to make additional matching contributions at year-end, to "true-up" the matching rate. This will no longer be necessary; employers may determine matching contribution requirements for each payroll period, provided plan language to that effect exists.

While this discussion touches on the general requirements of safe-harbor Sec. 401(k) plans and the changes from Notice 2000-3, there are other technical requirement clarifications that should be closely followed by plan sponsors that elect to take advantage of the safe-harbor opportunity.


Frank J. O'Connell, Jr., CPA, J.D. Crowe Chizek Oak Brook, IL
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Title Annotation:safe harbor plans
Author:O'Connell, Frank J., Jr.
Publication:The Tax Adviser
Geographic Code:1USA
Date:Sep 1, 2000
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