[16324]
July 18, 2003
TO: PENSION MEMBERS No. 34-03
PENSION OPERATIONS ADVISORY COMMITTEE No. 44-03
RE: IRS ISSUES COMPREHENSIVE PROPOSED REGULATIONS ON 401(k) PLANS
The Internal Revenue Service has issued proposed regulations setting forth the
requirements for cash or deferred arrangements under Code section 401(k) and matching or
employee contributions under section 401(m).1 These proposed regulations are generally
intended to restate and consolidate prior guidance on 401(k) plans, as well as reflect the
legislative changes that have been enacted since the existing final regulations were last
amended in December 1994. Treasury and the IRS are seeking comments on the proposed
regulations, particularly with regard to their impact on plan systems and practices.2 Written
comments on the proposed regulations must be submitted to the IRS by October 22, 2003. A
public hearing also has been scheduled for November 12, 2003.3
The proposed regulations are comprehensive in scope and address numerous topics
under Code sections 401(k) and 401(m), such as: (1) the general structural requirements of cash
or deferred arrangements (CODAs); (2) the nondiscrimination requirements for 401(k) plans,
including the actual deferral percentage (ADP) test and related correction methods; (3)
matching and employee contribution requirements, including the actual contribution
percentage (ACP) test and related correction methods; (4) the aggregation and disaggregation of
401(k) plans for nondiscrimination testing purposes; (5) applicable withdrawal restrictions; (6)
prior year testing requirements; (7) safe harbor 401(k) and (m) rules; and (8) the requirements
for SIMPLE 401(k) plans.
The preamble to the proposed regulations provides that Treasury and the IRS — in
reviewing and integrating the existing administrative guidance under sections 401(k) and
401(m) — have reconsidered certain rules and, consequently, proposed certain changes. The
1 The proposed regulations as published in the Federal Register on July 17 is available at:
http://a257.g.akamaitech.net/7/257/2422/14mar20010800/edocket.access.gpo.gov/2003/pdf/03-17755.pdf.
The proposed regulations also may be found on Treasury’s website at:
http://www.treasury.gov/press/releases/reports/401(k)(m)fullreg.doc.
2 Other specific topics for which Treasury and the IRS are interested in receiving comments are discussed below.
3 Requests to speak at the hearing must be submitted by the comment deadline.
2
proposed regulations, therefore, reflect a number of substantive changes and clarifications to
previously issued guidance. Such modifications and other notable aspects of the proposed
regulations highlighted in the preamble include the following.
CODAs Under Section 401(k). As under the existing regulations, the proposed
regulations generally define a CODA as an arrangement under which employees can make a
cash or deferred election with respect to contributions to, or accruals or benefits under, a plan
intended to satisfy the requirements of section 401(a).4 Under the proposed regulations,
however, CODAs would not include an arrangement under which dividends paid to an
employee stock ownership plan (ESOP) are either distributed to a participant or reinvested in
employer securities in the ESOP under a participant’s election under section 404(k)(2)(A)(iii), as
added by EGTRRA.
The proposed regulations also clarify that contributions in anticipation of future
performance of services generally would not be treated as elective contributions under section
401(k); thus, an employer would not be able to prefund elective contributions to accelerate the
deduction for elective contributions. Additionally, the proposed regulations incorporate prior
IRS guidance permitting automatic plan enrollment under a CODA.5
Aggregation and Disaggregation with ESOPs. The proposed regulations would change
the treatment of a CODA under a plan that includes an ESOP.6 Specifically, the proposed
regulations would eliminate the mandatory disaggregation rule with regard to the ESOP and
non-ESOP portions of a plan (under Code section 414(l)) for purposes of ADP testing. The same
approach would apply for ACP testing under section 401(m). For purposes of applying the
ADP or ACP tests, an employer may permissively aggregate two section 414(l) plans, one that is
an ESOP and one that is not.
The exception to the mandatory disaggregation of ESOPs and non-ESOPs, however,
would not apply for purposes of section 410(b) (i.e., minimum coverage requirements). Thus, a
group of eligible employees under both the ESOP and non-ESOP portions of a plan must still
separately satisfy the requirements of sections 401(a)(4) and 410(b). The proposed regulations
also would provide that a single testing method must apply to all CODAs under a plan.
Accordingly, an employer would be restricted from aggregating section 414(l) plans for
purposes of section 410(b), if those plans apply inconsistent testing methods.7
4 As under prior guidance, CODAs would not include contributions that are treated as after-tax employee
contributions at the time of contribution and one-time irrevocable elections.
5 See Institute Memorandum to Pension Members No. 9-00 and Pension Operations Advisory Committee No. 7-00
(11594), dated February 1, 2000 (Revenue Ruling 2000-8). The proposed regulations, however, provide that the
Department of Labor has taken the position that a participant will not be considered to have exercised control when
the participant is merely apprised of investments that will be made on his or her behalf in the absence of instructions
to the contrary.
6 The preamble notes that the use of an ESOP as an employer stock fund in a 401(k) plan has become more
widespread since the issuance of the existing regulations.
7 For example, for purposes of section 410(b), a plan that uses the ADP safe harbor under section 401(k)(12) may not
be aggregated with a plan that applies a non-safe harbor ADP test.
3
ADP Test. The proposed regulations, which generally retain the structure for ADP
testing under the existing regulations, incorporate the rule in Treas. Reg. 1.402(g)-1 providing
that excess deferrals that are distributed are still taken into account under the ADP test, with the
exception of deferrals made by NHCEs that were in violation of section 401(a)(30). The
proposed regulations also reflect the recently-finalized catch-up contribution regulations under
section 414(v).8 In the context of catch-up contributions under safe harbor 401(k) plans,
Treasury and the IRS request comments on the circumstances under which elective
contributions by non-highly compensated employees (NHCEs) would be less than the amount
required to be matched, and the extent to which a safe harbor plan should be required to match
catch-up contributions under such circumstances.
Targeted QNECs Under ADP Test. The proposed regulations add a new requirement
that restricts the use of the “bottom-up leveling” correction approach to satisfy the ADP test.
The preamble explains that under such a method, an employer can pass the ADP test by
contributing small amounts of qualified nonelective contributions (QNECs) to NHCEs with low
compensation for the plan year.
Specifically, the proposed regulations would provide that a QNEC that exceeds 5
percent of compensation may be taken into account for an ADP test only to the extent the
contribution, when expressed as a percentage of compensation, does not exceed two times the
plan’s representative contribution rate (i.e., the lowest contribution rate among a group of
NHCEs that is half of all the eligible NHCEs under the arrangement (or the lowest contribution
rate among all eligible NHCEs under the arrangement who are employed on the last day of the
year, if greater)). In determining a NHCE’s contribution rate, an employee’s QNECs and
qualified matching contributions (QMACs) taken into account under the ADP test for the plan
year are added together and the sum is divided by the employee’s compensation for the same
period.9 Finally, the proposed regulations would prohibit the double counting of QNECs in a
manner generally consistent with Notice 98-1.10
Distribution Restrictions. In addition to incorporating EGTRRA’s statutory changes to
certain distribution rules (e.g., the elimination of the “same desk rule,” and the reduction from
12 to 6 months the period for which an employee is prohibited from making contributions
following a hardship distribution), the proposed regulations would clarify the application of the
safe harbor standards for hardship distributions by requiring an employee’s “hardship”
representation to provide that the need cannot be reasonably relieved by any available
distribution or nontaxable plan loan.11 The proposed regulations also clarify the application of
the existing safe harbors to the hardship standards.
8 See Institute Memorandum to Pension Members No. 32-03 and Pension Operations Advisory Committee No. 41-03
(16290), dated July 11, 2003.
9 As discussed below, the proposed regulations under section 401(m) would provide parallel restrictions on QNECs
taken into account in ACP testing.
10 See Institute Memorandum to Pension Members No. 5-98 (9623), dated January 27, 1998.
11 An employee’s representation, however, need not provide that a loan from a commercial source will be taken if no
such loan in an amount sufficient to satisfy the need is available on reasonable commercial terms.
4
The proposed regulations would modify the existing regulations on the types of plans
that an employer may maintain after the termination of a CODA, as well as clarify the effect on
withdrawal restrictions for elective deferrals, QNECs and QMACs where a plan-to-plan transfer
takes place.
Section 401(m) Matching Contributions and Employee Contributions. Consistent with
the current regulatory structure, the proposed regulations include separate, parallel regulations
under Code section 401(m). As under the existing regulations, whether an employer
contribution is on account of an elective deferral or employee contribution — and therefore a
matching contribution — is determined based on all relevant facts and circumstances.
Furthermore, the section 401(m) rules, similar to those under section 401(k), prohibit employers
from prefunding matching contributions to accelerate the deduction for those contributions.
Accordingly, where a contribution is made before an employee’s elective deferral or his or her
performance of services with respect to which an elective deferral is made, the employer
contribution would not be treated as a matching contribution.
The proposed regulations on ACP testing under section 401(m) are generally parallel to
the rules for ADP testing. This includes the determination of the actual contribution ratio
(ACR) for employees and the contributions taken into account in determining the ACR. The
proposed regulations under section 401(m) also provide rules on plan aggregation and
disaggregation similar to those under section 401(k). For instance, matching contributions
made under the portion of the plan that is an ESOP and the portion of the same plan that is not
an ESOP would not be subject to mandatory disaggregation under the proposed regulations.
Targeted QNECs and QMACs Under Section 401(m). The proposed regulations would
continue to allow QNECs to be taken into account for ACP testing, but the same restrictions
under the section 401(k) proposed regulations on targeting QNECs to a small number of
NHCEs would apply. The difference between the 401(m) versus the 401(k) rules would be that
the contribution percentages used to determine the lowest contribution percentage would be
based on the sum of the QNECs and those matching contributions taken into account in the
ACP test, rather than the sum of the QNECs and the QMACs taken into account under the ADP
test. Because QNECs that do not exceed 5 percent are not subject to the limits on targeted
QNECs under either the ADP or ACP tests, an employer may take into account up to 10 percent
in QNECs for an eligible NHCE — 5 percent in ADP testing and 5 percent in ACP testing —
without regard to how many NHCEs receive QNECs.
To prevent an employer from using targeted matching contributions to circumvent the
limitation on targeted QNECs, the proposed regulations would provide that matching
contributions are not considered in ACP testing to the extent the matching rate for the
contribution exceeds the greater of 100 percent and 2 times the representative matching rate (i.e.,
the lowest matching rate for any eligible employee in a group of NHCEs that consists of half of
all eligible NHCEs in the plan for the plan year (or the lowest matching rate for all eligible
NHCEs in the plan who are employed by the employer on the last day of the plan year, if
greater)). For this purpose, the matching rate is the ratio of the matching contributions to the
contributions being matched, and only NHCEs who make elective deferrals or employee
contributions for the plan year would be considered.
5
The proposed regulations also set forth a new rule providing that elective contributions
under a plan that is not subject to the ADP test (e.g., a plan that uses the safe harbor method of
section 401(k)(12) or a contract or arrangement under section 403(b)(12)(A)(ii)) may not be taken
into account for the ACP test. Section 401(m) rules on the correction of excess contributions and
calculation of allocable income would be generally consistent with the 401(k) proposed
regulations. Existing rules on correction through distribution of vested matching contributions
and forfeiture of unvested matching contributions would continue to apply.
Safe Harbor 401(k) and (m) Requirements. While the proposed regulations generally
follow the safe harbor rules set forth in Notice 98-52 and Notice 2000-3,12 they provide a number
of clarifications and modifications to the existing rules. For example, the proposed regulations
clarify that under a safe harbor 401(k) plan, elective or matching contributions on behalf of a
highly compensated employee (HCE) who is eligible to participate in more than one plan of the
same employer need not be aggregated for purposes of the ADP safe harbor.13
With regard to section 401(m) requirements, the proposed regulations would clarify that
for purposes of determining whether an HCE has a higher rate of matching contributions than
any NHCE, any NHCE who is an eligible employee under the safe harbor plan must be taken
into account, even if the NHCE is not eligible for a matching contribution. As a result, a plan
that limits matching contributions to employees who are employed on the last day of the plan
year will not be able to satisfy the ACP safe harbor, given that a NHCE who is not eligible to
receive a matching contribution because of this requirement will nonetheless be considered
under the safe harbor 401(m) requirements. The proposed regulations also would require that
matching contributions made at the employer’s discretion for any employee not exceed a dollar
amount equal to 4 percent of the employee’s compensation and that a safe harbor plan must
permit all eligible NHCEs to make sufficient elective contributions to receive the maximum
matching contribution offered under the plan.
In addition, the preamble highlights the fact that the section 401(m) safe harbor does not
apply to employee contributions. Thus, a plan that provides for employee contributions and
matching contributions must satisfy the ACP test, even though the matching contributions
satisfy the section 401(m) safe harbor requirements. The proposed regulations would adopt the
rules set forth in Notice 98-52 permitting plans to disregard all matching contributions with
respect to all eligible employees for purposes of the ACP safe harbor.
Finally, the preamble states that the IRS and Treasury are considering the extent to
which the notice to eligible employees under section 401(k)(12)(D) — as well as other notices
under various plan-related Code requirements — can be provided electronically, taking into
account the Electronic Signatures in Global and National Commerce Act (E-SIGN).14 The
12 See Institute Memorandum to Pension Members No. 3-00 and Pension Operations Advisory Committee No. 2-00
(11530), dated January 7, 2000 (Notice 2000-3); Institute Memorandum to Pension Members No. 66-98 (10438), dated
October 30, 1998 (Notice 98-52).
13 Thus, the rate of match for purposes of determining whether an HCE has a higher matching rate is based only on
matching contributions with respect to elective contributions under the safe harbor plan.
14 See Institute Memorandum to Pension Members No. 39-00, Pension Operations Advisory Committee No. 56-00,
Electronic Commerce Advisory Committee No. 5-00, SEC Rules Members No. 54-00 and Tax Members No. 22-00
(12402), dated July 28, 2000.
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preamble further notes that Treasury and the IRS anticipate issuing proposed regulations on
these issues and invite comments on them. Until such regulations are issued, employers may
continue to rely on the interim guidance provided in Notice 2000-3.
Proposed Effective Date. The regulations are proposed to apply for plan years
beginning no sooner than 12 months after the regulations are finalized.
Thomas T. Kim
Associate Counsel