Michael J. Karlan

Coda Article

CASH OR DEFERRED ARRANGEMENTS,

MATCHING CONTRIBUTIONS,

AND EMPLOYEE CONTRIBUTIONS

by

Mary Oppenheimer and Michael Karlan

Office of Chief Counsel

(Employee Benefits and Exempt Organizations)

Internal Revenue Service

 

 

  1. INTRODUCTION
    1. Cash or deferred arrangements, also known as "CODAs" or "401(k) plans", are one of a wide variety of plans permitting individuals to make before-tax contributions to retirement plans. In addition to the standard CODA, which is described in detail in this outline, other options available to some or all employers include:
      1. 401(k) SIMPLE (Savings Incentive Match Plans for Employees of Small Employers) can be established by employers with no more than 100 employees earning $5000 or more during the preceding year. See Section X(A) below.
      2. IRA SIMPLE arrangements can be established by employers with no more than 100 employees earning $5000 or more during the preceding year. See Section X(B) below.
      3. Section 403(b) salary reduction arrangements can be established by section 501(c)(3) organizations and certain educational institutions. See Section X(C) below.
      4. Section 457 nonqualified deferred compensation arrangements can be established by tax-exempt organizations and state and local governments. See Section X(D) below.
      5. Salary Reduction Simplified Employee Pensions (SARSEPs) could be established by small employers before January 1, 1997. Although new SARSEPs cannot be established, old ones can continue to operate. See Section X(E) below.
    2. Extraordinary growth of elective arrangements, especially 401(k) plans, has been accompanied by concern about complexity of nondiscrimination testing, resulting in a multiplicity of possible nondiscrimination tests.
      1. Growth of elective arrangements is fueled by a number of factors.
        1. Flexibility in who contributes what responds to demographic change.
        2. Disparity in contributions for highly compensated and other employees can be higher than under more traditional arrangements.
        3. Plan contributions can often be limited to salary reduction, requiring no true employer contribution.
        4. Ability to make pre-tax contributions coincides with the desire to reduce current taxation.
      2. Small Business Job Protection Act of 1996 (P.L. 104-188) ("SBJPA") supplemented basic 401(k) testing methods, described in Section III(B) below, with safe harbor methods described in Section III(C).
  2. CASH OR DEFERRED ARRANGEMENTS
    1. All cash or deferred arrangements involve an election under which an employee chooses between cash (or some other taxable form of compensation) or an employer contribution to a plan that is qualified or is intended to be qualified. Reg. § 1.401(k)-1(a)(3)(i).
      1. An irrevocable one-time election at the commencement of employment or plan participation is not a cash or deferred election. Reg. § 1.401(k)-1(a)(3)(iv).
        1. The one-time election rule was especially controversial as applied to partnership plans. Prior to TRA '86, these plans often provided one level of contributions for employees, but permitted partners to elect that level or any lower level of contributions on an annual basis. (This design, in turn, reflected pre-1984 requirements for plans benefitting self-employed individuals, if any of these had a more than ten percent interest in capital or profits.) Partnership representatives contended these elections should not be treated as cash or deferred elections, and should therefore not be limited to $7000. For partnership plans, see reg. § 1.401(k)-1(a)(6).
        2. See also Notice 88-127, 1988-2 C.B. 538, and reg. § 1.401(k)-1(a)(6)(ii)(C), which gave partnership plans until the later of March 31, 1989, or the first day of the first plan year beginning after December 31, 1988, either to be amended to become qualified CODAs or to require individuals to make one-time irrevocable elections. The 1994 regulations clarified perceived ambiguities in the 1988 language by requiring the election to be made on or before December 23, 1994.
      2. The election must be made with respect to compensation that is neither currently available nor treated as an after-tax employee contribution. Reg. §§ 1.401(k)-1(a)(2)(ii) and 1.401(k)-1(a)(3)(ii).
        1. Amounts are currently available if they have been paid to the employee or if the employee can currently receive the amount at his/her discretion. Reg. § 1.401(k)-1(a)(3)(iii).
        2. Thus, section 401(k) permits deferral of amounts already earned so long as they are not yet paid or payable.
      3. A cash or deferred election may be changed as often as the plan permits so long as it relates only to compensation that is not currently available.
    2. Maximum deferrals under qualified cash or deferred arrangements
      1. A qualified cash or deferred arrangement is the exclusive method for electively deferring compensation under a qualified plan on a pre-tax basis.
        1. Amounts deferred under a qualified CODA are excluded from the participant's income under section 402(g). Reg. § 1.401(k)-1(a)(4)(iii).
        2. The maximum amount that can be deferred is governed by section 402(g), which limits deferrals under a cash or deferred arrangement to $7000.
            1. This figure is adjusted annually. Section 402(g)(5). For 1989 it was $7313; for 1990 it is $7979; for 1991 it was $8475; for 1992 it was $8728; for 1993 it was $8994; for 1994 and 1995 it was $9240; for 1996 and 1997 it was $9500; for 1998 it is $10000.
            2. The $7000 limit was made a qualification requirement by TAMRA. See section 401(a)(30).
      2. Plans may provide for distribution of deferrals in excess of $7000, provided the distribution is made by April 15 of the subsequent year. Income attributable to the deferral must also be distributed. Section 402(g)(2)(A) and reg. § 1.402(g)-1(e)(2).
        1. Despite the language of the statutory caption, these distributions are not required to be made by plans. Distributions of excess deferrals cannot be made unless permitted by the plan. Reg.§ 1.402(g)-1(e)(4).
        2. However, if distributions are not made by April 15, the excess deferral is included in income both in the year in which contributed and the year in which distributed. See sections 402(a), 402(g)(1), 402(g)(2), and 402(g)(7), and reg. § 1.402(g)-1(a). Section 402(g)(7) provides the participant with no investment in the contract if the excess is not distributed. See also reg. § 1.402(g)-1(e).
        3. If the excess distribution is not timely distributed, it cannot be distributed until occurrence of a distributable event under section 401(k)(2)(B). See reg. § 1.402(g)-1(e)(8)(iii). But see permitted correction under the Standardized VCR Procedure. Rev. Proc. 98-22, 1998-12 I.R.B. 11, App. A.04.
        4. If distributions are made in a timely fashion, the excess deferral is included in income in the year in which deferred. TAMRA altered the tax treatment of income on the excess deferral, which now is includible in income in the year in which distributed. Section 402(g)(2)(C) and reg.§ 1.402(g)-1(e)(8)(i).
  3. NONDISCRIMINATION TESTS FOR QUALIFIED CASH OR DEFERRED ARRANGEMENTS
    1. A qualified cash or deferred arrangement must comply with the coverage requirements of section 410(b)(1). Section 401(k)(3)(A)(i). However, a governmental plan is treated as meeting this requirement. Section 401(k)(3)(G).
      1. Any employee eligible to make a cash or deferred election is treated as an eligible employee for purposes of section 410(b) with respect to a cash or deferred arrangement. Section 410(b)(6)(E).
      2. Employees who are suspended due to a distribution, loan, or election not to participate are considered eligible employees. Reg. § 1.401(k)-1(g)(4)(i) and 1.401(m)-1(f)(4)(i).
      3. NOTE: Under reg. § 1.410(b)-9, a 401(k) plan includes only elective deferrals. It does not include amounts treated as elective deferrals. The consequence is that both the 401(k) plan and any related plan to which other contributions, such as qualified nonelective contributions, are made must separately satisfy section 410(b).
    2. A qualified cash or deferred arrangement must also comply with the special nondiscrimination test of section 401(k)(3). This test involves several steps, and a number of alternative approaches are available. In addition, for post-1998 plan years, safe harbor methods are available. See III.C. below.
        1. The first step is computing the "actual deferral ratio" for each participant. The actual deferral ratio is the amount deferred divided by the participant's plan year compensation. Thus, if a participant earns $40,000 and defers $4,000, the participant's actual deferral ratio is 10 percent. If the participant defers nothing, the participant's actual deferral ratio is zero.
          1. Any safe harbor or alternative definition of compensation contained in the 414(s) regulations may be used in computing the actual deferral ratio. See reg. § 1.401(a)(4)-12 for the definition of plan year compensation.
            1. Elective deferrals may be included or excluded, i.e., gross or net compensation may be used.
            2. If the individual participated in the plan for only part of the plan year, compensation for the partial year can be used. Reg.§ 1.401(k)-1(g)(2)(i).
          2. In the case of highly compensated employees who participate in two or more cash or deferred arrangements maintained by the same or related employers, all the arrangements are treated as a single arrangement. Thus for purposes of testing any of the arrangements, elective deferrals under all of the arrangements are taken into account. Reg.§ 1.401(k)-1(g)(1)(ii)(B)
        2. The next step is computing the average deferral percentage (ADP) for two groups -- highly compensated employees who are participants and nonhighly compensated employees who are participants.
          1. The ADP is the average of the actual deferral ratios of participants in the group.
          2. Example. Assume a plan has two nonhighly compensated participants who earn $10,000 and $40,000 respectively. The participant earning $10,000 defers nothing, while the participant earning $40,000 defers 10 percent. The ADP for the group is five percent.
          3. For plan years beginning after December 31, 1998, if the plan includes employees who do not meet the minimum age and service requirements of section 410(a)(1)(A), the average deferral percentage for nonhighly compensated employees can be calculated by excluding those employees. See Section 401(k)(3)(F) as amended by SBJPA.
        3. The ADP of highly compensated participants may not exceed:
          1. 125 percent of the ADP of nonhighly compensated participants; or
          2. 200 percent of the ADP of nonhighly compensated participants, provided that not more than two percentage points separate the two groups. Section 401(k)(3)(C).
        4. In testing for discrimination, the actual deferral ratios may include qualified matching contributions (QMACs) or qualified nonelective employer contributions (QNCs) to a qualified plan if the following conditions are met. Reg. §§ 1.401(k)-1(b)(5) and 1.401(k)-1(g)(13).
          1. The contributions are nonforfeitable when made. Thus, matching contributions or other employer contributions subject to a vesting schedule may not be treated as QMACs or QNCs.
          2. The contributions are subject to the same withdrawal restrictions as elective contributions. In addition, for post-1988 plan years, the contributions may not be withdrawn on account of hardship. Reg. § 1.401(k)-1(d)(2)(ii).
          3. The contributions are subject to other requirements contained in regulations. Thus, for example, QNCs can be used only if the nonelective contributions satisfy the general nondiscrimination rules of section 401(a)(4) both before and after the use of QNCs, and only if the plan under which they are contributed can be aggregated with the CODA under reg. § 1.410(b)-7(d).
          4. Special rules must be applied to define the plan that is subject to testing under section 401(k)(3).
            1. Amounts deferred, and amounts treated as elective deferrals, cannot be taken into account for determining whether another plan meets coverage, nondiscrimination, or other qualification rules, except as permitted under section 401(m). Section 401(k)(4)(C).
            2. Aggregation of ESOPS with cash or deferred arrangements that are not ESOPS is not permitted for discrimination testing. Reg.§§ 1.401(k)-1(b)(3), -1(g)(11)(i) and 1.410(b)-7.
            3. Final regulations require disaggregation of collectively bargained and noncollectively bargained employees. Further disaggregation, on the basis of each collective bargaining unit, is permitted but not required. Reg. § 1.401(k)-1(g)(11)(ii)(B).
        5. Effective for plan years beginning after December 31, 1996, the average deferral percentage for nonhighly compensated employees must be determined on the basis of the preceding plan year (three percent in the case of the first plan year) unless the employer elects, prior to the end of the year before the change is to take effect, to use the current plan year. Although the employer is not required to notify the IRS of the election, the plan document must reflect whether the plan uses the current year testing method or the prior year testing method for a testing year. The election may not be changed from the current year method to the prior year method without consent. Section 401(k)(3)(A) as amended by SBJPA.
          1. The prior year’s ADP for nonhighly compensated employees may be determined as soon as prior year data are available.

             

            1. The nonhighly compensated employees for the preceding year are determined using the definition of nonhighly compensated employees in effect for that year. Notice 97-2, 1997-2 I.R.B. 22. Thus the changes in the definition of highly compensated employee made by the SBJPA can be disregarded in determining the actual deferral ratio for use in the 1997 plan year.
            2. In addition, the nonhighly compensated employees taken into account in determining the prior year’s ADP are those who were nonhighly compensated employees during the preceding year, without regard to status in the current year. Thus, an individual is treated as nonhighly compensated for the prior year if that individual is no longer nonhighly compensated due to termination of employment or new status as highly compensated during the current year. Notice 97-2.
            3. A special weighting rule applies under the prior year method when there is a significant change in plan coverage during the testing year. In that case, the ADP and ACP for nonhighly compensated employees for the prior year under the plan is the weighted average of the ADPs and ACPs, respectively, for the prior year subgroups. Notice 98-1, 1998-3 I.R.B. 42.
            1. However, if at least 90% of the total number of nonhighly compensated employees from all prior year subgroups are from a single prior year subgroup, then in determining the ADP or ACP for nonhighly compensated employees for the prior year under the plan, the employer may elect to use the ADP and ACP for nonhighly compensated employees for the prior year of the plan under which that single prior year subgroup was eligible. Notice 98-1.
            2. Notice 98-1 provides that an employer using the prior year method may take into account QNCs and QMACs in calculating ADP, and QNCs in calculating ACP, under the same standards as used in current year testing even though the QNCs allocated to the highly compensated employees and nonhighly compensated employees in a single plan year are taken into account in different testing years for ADP and ACP testing.
          2. If prior year testing is used, the ADP for nonhighly compensated employees for the first plan year is 3%, unless the employer elects to use the actual ADP for that plan year. A similar rule applies for ACP testing. Notice 98-1.
            1. For ADP purposes, the "first plan year" is the first year in which the plan provides for elective deferrals. However, a plan does not have a first plan year if it is aggregated with any other plan that was or that included a 401(k) plan in the prior year.

              For ACP purposes, the "first plan year" is the first plan year in which a plan provides for employee contributions or matching contributions, or both. However, a plan does not have a first plan year if it is aggregated with any other plan that was or included a 401(m) plan in the prior year.

              1. A successor plan is not eligible for the first plan year rule. A plan is a "successor plan" if the employer maintained another section 401(k) plan (or section 401(m) plan, as applicable) in the prior year and 50% or more of the eligible employees for the first plan year were eligible employees under that plan.
              2. If a plan uses this first plan year rule, then the use of the prior year testing method for the next testing year is not treated as a change in testing method. Such a plan would not be subject to the limitations on double counting of contributions for the next testing year.
          3. Notice 98-1 provides that if an employer elects to use the current year testing method for purposes of the ADP test, the employer may switch to prior year testing only in the following circumstances:
            1. The plan (or all plans, if the plan is the result of the aggregation of two or more plans) used the current year testing method for each of the five preceding plan years or, if less, the number of years the plan has been in existence;
              1. A transaction occurs that is described in section 410(b)(6)(C)(i) and reg. § 1.410(b)-2(f), that transaction results in the employer maintaining both a plan using the prior year testing method and a plan using the current year testing method, and the change occurs by the end of the plan year after this transaction; or
              2. The change occurs during the plan's remedial amendment period for the SBJPA changes.
    3. New safe harbor testing rules can be used for plan years beginning after December 31, 1998.
        1. One alternative is matching 100 percent of elective contributions, up to three percent of compensation, and 50 percent of the elective contributions between three and five percent of compensation. Variants which result in contributions equal to the aggregate under the specified formula are possible. Section 401(k)(12)(B).
        2. A second alternative is making three percent nonelective contributions to all nonhighly compensated participants. Section 401(k)(12)(C).
    4. Prohibited discrimination with respect to contributions or benefits is not limited to the amount of the contributions or benefits, but includes, for example, the conditions under which the contributions or benefits are provided or the privileges attached to them under the plan. Reg. § 1.401(k)-1(a)(4)(iv).
        1. The right to make each rate of elective contributions is specifically listed as a "right or feature" in reg. § 1.401(a)(4)-4(e)(3)(iii)(D). Each level of elective contributions must therefore be currently available and effectively available to a group of employees that satisfies section 410(b). Reg. § 1.401(a)(4)-4(a).
        2. The rate of elective contributions is determined using the plan's definition of compensation out of which elective contributions are made even if that definition of compensation does not satisfy section 414(s). However, if the same rate is provided to different groups of employees using different definitions of compensation (or different formulas or other requirements) there will be multiple rates for purposes of testing other rights and features. Reg.§ 1.401(a)(4)-4(b)(1).
  4. METHODS FOR CORRECTING DISCRIMINATION
    1. For post-1986 plan years, discrimination under a cash or deferred arrangement may be corrected using one or more of the following three methods.
      1. The plan may correct discrimination by distributing the aggregate amount of excess contributions and income thereon to highly compensated employees. Section 401(k)(8)(A).
          1. Excess contributions are amounts deferred in excess of maximum permitted. The excess contribution for each highly compensated participant is determined through a levelling process under which the highest deferral ratio is reduced to the next highest level, etc., until the permitted level for highly compensated employees is reached. Reg. § 1.401(k)-1(f)(2).
            1. For plan years beginning before January 1, 1997, the amount of each highly compensated employee’s excess contributions, and income thereon, was distributed to that highly compensated employee in order to correct discrimination. This resulted in less highly compensated highly compensated employees receiving larger distributions than more highly compensated highly compensated employees. (This is because a given elective contribution, e.g. $8000, is a higher percentage of the compensation of an individual earning $80,000 than of an individual earning a greater amount.)
            2. The SBJPA amended section 401(k)(8)(C) to provide that distributions of excess contributions for any plan year are made to highly compensated employees on the basis of the amount of contributions by or on their behalf. This does not affect the total amount of excess contributions to be distributed, but merely reallocates the distributions among the highly compensated employees.
            3. As a result of the SBJPA amendment, determining the amount to be distributed to each highly compensated employee requires using a four step process described in Notice 97-2.
              1.  
                1. Calculate the excess contribution for each highly compensated employee as described in reg. § 1.401(k)-1(f)(2).
                2. Determine the sum of the excess contributions.
                3. Reduce the elective contributions of the highly compensated employee with the highest dollar amount by the amount required to bring that employee’s elective contributions down to those of the highly compensated employee with the next highest dollar amount. Distribute this amount. However, if a smaller reduction, when added to prior distributions, would equal the total excess contributions, distribute the smaller amount.
                4. If the total amount distributed is less than the total excess contributions, repeat the step above until the required amount has been distributed.
            4. Note that under the new method, it is not necessary that the ADP test be satisfied after excess contributions have been distributed using the above method. For details, see example in Notice 97-2.
          2. Excess contributions are deemed to be the first contributions made during the plan year. Conference Report on TRA '86, p. II-388.
          3. The amount distributed must be reduced by excess deferrals previously distributed with respect to the taxable year of the employee ending with or within the plan year. Reg. § 1.401(k)-1(f)(5)(i)(B).
          4. Time of inclusion of amounts distributed within two and one-half months after the close of the plan year depends on the aggregate amount of excess and excess aggregate contributions (excluding income) distributed to the individual under a plan. Section 4979(f)(2).
            1. If the amount is less than $100, the excess contributions and earnings are includible in income in the year distributed.
            2. If the amount is $100 or more, the excess contributions and earnings are includible in income in the year in which the excess contributions were made. Thus, an amended Form 1099R must be provided by the employer and an amended income tax return may be needed.
        1. Amounts distributed more than two and one-half months after the close of the plan year are includible in income in the taxable year in which distributed. However, the employer is liable for a ten percent excise tax on the amount of these excess contributions. Section 4979(a).
        2. Distribution must include income allocable to excess contributions.
            1. Plan can use its normal method for allocating income to accounts if that method satisfies section 401(a)(4), and is used for all participants and all corrective distributions for the plan year.
            2. As an alternative, income allocable to excess contributions is that portion of the income on the participant's account balance for the year that bears the same ratio to total income as the excess contributions bear to the opening account balance. Reg. § 1.401(k)-1(f)(4)(ii)(C).
            3. If plan so provides, income that must be distributed includes income for the "gap period" between the end of the plan year and the date of distribution. Reg. § 1.401(k)-1(f)(4)(ii). A safe harbor method for calculating gap period income is contained in reg.§ 1.401(k)-1(f)(4)(ii)(D).
          1. Any distribution of less than the entire amount of excess contributions plus income attributable to the contributions is treated as a pro-rata distribution of excess contributions and income. Reg. § 1.401(k)-1(f)(1)(iv). Thus, assume that an excess contribution of $1,000 is distributed, but not the related income of $100. $909 would be treated as a distribution of excess contributions, and $91 as a distribution of income.
          2. For examples and transition rules, see Notice 88-33, 1988-1 C.B. 513.
      2. In accordance with regulations, the plan may recharacterize excess contributions as employee contributions. Section 401(k)(8)(A)(ii).
          1. Regulations permit recharacterization for all years plan has been in existence. However, the plan must permit employee contributions. Reg.§ 1.401(k)-1(f)(3)(iii)(B). In addition, recharacterization must be completed within 75 days after the close of the plan year. For this purpose, recharacterization occurs on the day on which notice is provided to the last affected highly compensated employee. Reg. § 1.401(k)-1(f)(3)(iii)(A).
          2. Recharacterized amounts are treated as employer contributions for all purposes except sections 72, 401(a)(4), and the discrimination rules of section 401(k). Reg. § 1.401(k)-1(f)(3)(ii). Employee contributions resulting from recharacterization are, of course, tested for discrimination under section 401(m).
      3. The employer may make additional QNCs or QMACs to increase ADP of nonhighly compensated employees.
          1. Prior to TRA '86, this was the sole method of correction permitted under IRS regulations.
          2. This method avoids excise tax under section 4979, even if contributions are made more than 2 1/2 months after the close of the plan year.
      4. If correction does not occur within 12 months after the close of the plan year, administrative correction is available. For example, the Standardized VCR Procedure (SVP) contains the following method. Rev. Proc. 98-22, 1998-12 I.R.B. 11.
          1. Corrective contributions must be made on behalf of all eligible NHCEs and these contributions must be either the same flat dollar amount or the same percentage of compensation. QNCs contributed to satisfy the ADP test do not have to be matched.
          2. The plan must satisfy the ACP test, and it must count as eligible employees for the ACP test any employees who would have been eligible for a matching contribution had they made elective deferrals.
        1. A plan may not be treated as two separate plans, one covering employees that would otherwise be excludable and the other covering all remaining employees in order to reduce the number of employees eligible to receive QNCs. Similarly, the plan may not be restructured into component plans in order to reduce the number of employees eligible to receive QNCs.
    2. For reporting rules applicable to corrective distributions, see Notice 87-77, 1987-2 C.B. 385, Notice 88-33, 1988-1 C.B. 513, and Notice 89-32, 1989-1 C.B. 671.
  5. DISTRIBUTION REQUIREMENTS FOR QUALIFIED CASH OR DEFERRED ARRANGEMENTS
    1. Amounts deferred may generally not be distributed prior to death, disability, separation from service, hardship, or attainment of age 59 1/2. Section 401(k)(2)(B). In general, the distribution rules also apply to qualified nonelective and qualified matching contributions, and to earnings attributable to elective deferrals, qualified nonelective, and qualified matching contributions.
      1. One of the most controversial issues concerning cash or deferred arrangements has been the definition of "hardship".
        1. Final regulations define a hardship distribution as one that meets two tests.
          1. It is made on account of an immediate and heavy financial need of the employee. Reg. § 1.401(k)-1(d)(2)(i).
          2. It is necessary to satisfy the need and cannot be satisfied from other resources that are reasonably available to the employee. Reg. § 1.401(k)-1(d)(2)(iii).
        2. In general, what constitutes an immediate and heavy financial need is to be determined on the basis of facts and circumstances. The fact that an expenditure is voluntary or foreseeable does not, however, mean it is not a hardship. Reg. § 1.401(k)-1(d)(2)(iii)(A).
        3. The following may be deemed to be immediate and heavy financial needs under a plan. Reg. § 1.401(k)-1(d)(2)(iv)(A). Of course, other items may also be immediate and heavy financial needs, but that must be determined by the plan administrator or other fiduciary.
            1. Medical expenses previously incurred or necessary for obtaining medical care deductible under section 213(d) for the participant, spouse, or dependents.
            2. Purchase of principal residence (excluding mortgage payments) for participant.
            3. Payment of post-secondary tuition, related educational fees, and room and board for next 12 months for participant, spouse, children, or dependents.
            4. Prevent eviction/foreclosure on participant's principal residence.
        4. A distribution may be deemed necessary to satisfy an immediate and heavy financial need if the following requirements are met. Reg. § 1.401(k)-1(d)(2)(iv)(B). This too is a safe harbor: the plan may instead make determinations based on facts and circumstances.
            1. The distribution does not exceed the amount of the immediate and heavy financial need. The distribution may be "grossed up" to take into account taxes that will be incurred as a result of the distribution.
            2. The employee has obtained all other non-hardship distributions and nontaxable loans currently available under all plans maintained by the employer.
            3. The plan, and all other plans maintained by the employer, provide for a twelve month suspension of elective and employee contributions.
            4. The plan, and all other plans maintained by the employer, limit the participant's elective contributions for the succeeding taxable year to the difference between the section 402(g) limit for the year and the amount deferred in the previous taxable year. Thus, if an employee deferred $2000 in 1988, and took a hardship distribution during that year, the maximum deferral in 1989 would be $5313 ($7313 - $2000).
        5. The Code provides that only elective deferrals can be distributed on account of hardship. Section 401(k)(2)(B)(i)(IV). See also Conference Report at II-389.
            1. Because of administrative problems faced by plan administrators that had not maintained sufficient records to distinguish elective deferrals, other elective contributions, and income thereon, reg. § 1.401(k)-1(d)(2)(ii) permits distribution of amounts treated as elective contribution and of income allocable to elective deferrals and other amounts treated as elective contributions. These amounts must have been credited to participants' accounts on or before December 31, 1988, or -- if later -- the end of the last plan year ending before July 1, 1989.
            2. In a general information letter, the Service has indicated that, in the event of subsequent loss, the dollar amount determined as of December 31, 1988, less subsequent hardship distributions, may be distributed in the event of hardship.
      2. Special rules permit distributions upon plan termination without establishment of a successor plan. Section 401(k)(10) and reg.§ 1.401(k)-1(d)(3).
        1. A successor plan is a defined contribution plan, other than an ESOP, that is maintained by the same employer at the time of plan termination or within twelve months thereafter. An exception is provided if less than 2 percent of the participants in the terminated plan are or were eligible under the other defined contribution plan within 12 months before or after the plan termination date. Reg. § 1.401(k)-1(d)(3).
        2. The amount distributed must be a lump sum distribution within the meaning of section 402(e)(4), except that it may be made on account of termination, does not require a minimum period of service, and is not subject to the one-time election rule of section 402(e)(4)(B). Section 401(k)(10)(B) and reg. 1.401(k)-1(d)(5).
      3. In addition, distributions may be made in the event of certain sales of subsidiaries and assets. Section 401(k)(10).
        1. A sale of 85 percent of the assets used in a trade or business is deemed to be a sale of substantially all the assets used in the trade or business. Reg. §1.401(k)-1(d)(4)(iv).
        2. These distributions are permitted only with respect to employees who continue employment with the subsidiary or with the purchaser of the assets. Section 401(k)(10)(A)(ii) and (iii) and reg.§ 1.401(k)-1(d)(4)(ii).
        3. These distributions are permitted only if the transferor corporation continues to maintain the plan. Section 401(k)(10)(C). A similar concern is reflected in the requirement that the plan from which distributions are made cannot be maintained by the transferee employer. See, e.g., reg. § 1.401(k)-1(d)(4).
        4. The distribution must be a lump sum distribution, subject to the same exceptions as upon plan termination. Section 401(k)(10)(B) and reg. § 1.401(k)-1(d)(5).
      4. A loan is not treated as a distribution, even if it is secured by the employee's accrued benefit attributable to elective contributions or is includible in the employee's income under section 72(p). However, if a default on a loan causes a reduction of an employee's accrued benefit derived from elective contributions, the reduction is treated as a distribution. Reg. § 1.401(k)-1(d)(6)(ii). Hence, if the reduction occurs prior to an event permitting distribution, the CODA will cease to be qualified.
          1. Final DOL regulations indicate that a loan is considered adequately secured despite such a delay so long as it is reasonably anticipated that there will be no loss to the plan of principal or interest. DOL reg. §2550.408b-1, 54 FR 30526 (July 20, 1989). Earmarked loans should meet this requirement.
          2. Note also that DOL regulations permit up to 50 percent of the present value of a participant's vested account balance to be used as security for a loan. DOL reg. §2550.408b-1(f)(2).
  6. OTHER REQUIREMENTS FOR QUALIFIED CASH OR DEFERRED ARRANGEMENTS
    1. The cash or deferred arrangement must be part of a profit-sharing or stock bonus plan, a pre-ERISA money purchase pension plan that contained a deferral feature, or a rural cooperative plan. Section 401(k)(1).
        1. For plan years beginning before January 1, 1997, section 401(k)(4)(B) barred tax-exempt organizations (other than rural cooperatives) and state and local governments from establishing 401(k) plans. (Plans established by tax-exempt organizations before July 2, 1986, and by state or local governments before May 6, 1986, were grandfathered.)
          1. This led to serious problems for tax-exempt organizations other than 501(c)(3) and certain educational organizations, inasmuch as there was no vehicle permitting deferrals by employees who were not in a "select group of highly compensated and management employees".
          2. In addition, the status of plans established by Indian tribes was unclear.
        2. For plan years beginning after December 31, 1996, tax-exempt organizations and Indian tribes may establish 401(k) plans.
    2. For post-1998 plan years, no more than one year of service and attainment of age 21 can be required as a condition of plan participation. Section 401(k)(3)(F).
    3. Amounts deferred must be nonforfeitable when contributed. Section 401(k)(2)(C).

      1. The amounts cannot be nonforfeitable solely because of age and service. See reg. § 1.401(k)-1(c)(1)(i).

        1. Thus an amount that is nonforfeitable by reason of a vesting schedule may not be taken into account under section 401(k).
    4. Other employer benefits, other than matching contributions, cannot be contingent upon the employee's election to make or not make elective contributions. Section 401(k)(4).
        1. Thus, neither welfare benefits (such as health benefits) nor participation in another plan of deferred compensation (including 457 plans or 403(b) annuities) can be limited to employees who defer a specified amount. For an extensive list of contingent benefits, see reg. § 1.401(k)-1(e)(6)(ii).
        2. In addition, a plan that permits only employees who defer a specified amount to make after-tax employee contributions, or which permits after-tax employee contributions only in the case of recharacterization, will violate section 401(k)(4).
        3. The following items will not violate the contingent benefit rule. Reg. § 1.401(k)-1(e)(6).
          1. Any benefit provided under a cafeteria plan.
          2. Participation in a nonqualified deferred compensation plan, unless the participant's failure to make elective contributions under the cash or deferred arrangement increases deferrals under the nonqualified arrangement.
          3. Benefits under defined benefit or excess benefit plans that are dependent upon the participant making, or not making, elective contributions under a cash or deferred arrangement.

     

  7. SPECIAL DISCRIMINATION RULES FOR PLANS WITH EMPLOYEE OR MATCHING CONTRIBUTIONS
    1. For post-1986 plan years, the amount of before-tax employee contributions and employer contributions that match either employee contributions or elective deferrals must meet the nondiscrimination tests of section 401(m). Elective deferrals recharacterized as employee contributions must be included in this calculation.
      1. Section 401(m) does not apply to employee contributions to a defined benefit plan. See reg. § 1.401(m)-1(f)(6).
      2. For plan years beginning after 1988, section 401(m) applies to employee and matching contributions under a section 403(b) plan, except in the case of an annuity purchased by a church within the meaning of section 3121(w)(3)(B). Section 403(b)(12)(A)(i).
    2. Section 401(m) parallels section 401(k). Thus, it first requires computing, for each participant, a contribution ratio equal to the sum of the employee's employee and matching contributions divided by the employee's compensation. The average contribution percentages (ACPs) for the groups of highly compensated and nonhighly compensated employees are then calculated and compared, using the 125 percent and 200 percent/two percentage point tests. As with the average deferral percentage, effective for plan years beginning after December 31, 1996, the average contribution percentage for nonhighly compensated employees must be determined on the basis of the preceding plan year (three percent in the case of the first plan year) unless the employer elects to use the current plan year. The election may not be changed without consent. See Section 401(m)(2)(A) and Notice 97-2, 1997-2 I.R.B. 22. Safe harbor methods are available for plan years beginning after December 31, 1998. Section 401(m)(11)(A).
      1. Elective deferrals and QNCs may be taken into account in computing contribution ratios under certain conditions, which generally parallel those under which QNCs and QMACs may be used in 401(k) testing. Reg. § 1.401(m)-1(b)(5). These amounts may not also be used in testing for discrimination under section 401(k).
      2. Section 401(m)(9)(A) provides that regulations may prevent the multiple use of the 200 percent/two percentage point limitation with respect to any highly compensated employee.
          1. The regulations are effective for post-1988 plan years. See reg. § 1.401(m)-2(d)(1).
            1. There is no multiple use unless at least one plan exceeds the 125 percent limit. Reg. § 1.401(m)-2(b)(1)(i)(C) and (D).
            2. In addition, there are also special rules to eliminate inappropriate results for plans with extremely low deferral rates. Reg. §1.401(m)-2(b)(3).
          2. Cash or deferred arrangements with matching contributions may run afoul of the multiple use restriction. For example, assume that elective deferrals are six percent of highly compensated employees and four percent of nonhighly compensated employees. If there is a fifty percent match, the contribution percentages will be three and two percent respectively. Regulations require reduction of either elective deferrals or matching contributions or both in this case. See reg. § 1.401(m)-2(c).
    3. Excess aggregate contributions (those exceeding permitted amount) may be corrected by distributing or (if forfeitable) forfeiting the amounts by the close of the following plan year. Section 401(m)(6)(A). The SBJPA changed the method of calculating how these amounts are distributed. See Section IV(A)(1) above.
        1. Income and excise tax consequences are identical to those described with respect to section 401(k).
        2. Note that recharacterized elective deferrals may be required to be distributed in order to correct excess aggregate contributions.
        3. The correction mechanism cannot discriminate in favor of highly compensated employees. Thus, for example, employee contributions may not be distributed while matching contributions remain in the plan. A pro rata distribution of matching and employee contributions will be considered nondiscriminatory. Reg. § 1.401(m)-1(e)(4).
    4. A plan subject to section 401(m) must also meet the nondiscriminatory availability requirements of section 401(a)(4). Note that the right to each rate of employee contributions, the right to an allocation of each rate of matching contributions, and the formulas and requirements for matching contributions are all rights and features listed in reg. § 1.401(a)(4)-4(e)(3)(iii)(E) and (F) and 1.401(m)-1(a)(2). Thus a plan may fail to meet the nondiscrimination requirements of section 401(a)(4) if, for example, the rate of matching contributions favors highly compensated employees, either expressly under the plan formula or because highly compensated employees receive matches on excess deferrals, excess contributions, or excess aggregate contributions.
        1. Example. A highly compensated employee has elective contributions of two percent and matching contributions of two percent. Half of the elective contributions must be distributed to satisfy section 401(k)(3). The highly compensated employee thus has a two hundred percent match. This is a discriminatory rate.
      1. Solution. Section 411(a)(3)(G) and reg. § 1.401(k)-1(f)(5)(iii) permit forfeiture of matching contributions that relate to excess contributions, excess deferrals, and excess aggregate contributions. This is true even if the matching contribution is vested.
      2. Note. Neither the Code nor regulations permit matching contributions to be distributed to correct the discriminatory rate.
  8. RELATIONSHIP BETWEEN PLAN QUALIFICATION AND SATISFACTION OF SECTIONS 401(K) AND (M)
    1. A defined benefit plan or post-ERISA money purchase pension plan that includes a cash or deferred arrangement cannot be qualified. Reg. §1.401(k)-1(a)(1).
    2. A plan (other than a defined benefit plan or post-ERISA money purchase pension plan) that includes a qualified CODA satisfies section 401(a)(4) with respect to the amount of contributions or benefits under the qualified CODA. Reg. § 1.401(a)(4)-1(b)(2)(ii)(B). Of course, a plan is a qualified CODA only if it satisfies the special nondiscrimination rule of section 401(k)(3) described at III above.
    3. A plan (other than a defined benefit plan or post-ERISA money purchase pension plan) that includes a nonqualified CODA, including a CODA that is nonqualified only because it fails to meet the special nondiscrimination test of section 401(k)(3) satisfies section 401(a)(4) with respect to the amount of contributions or benefits only if the contributions satisfy the general nondiscrimination test of reg § 1. 401(a)(4)-1(b)(2)(ii)(A) or (B). Cross-testing is permitted, as is imputing disparity. See reg. § 1.401(a)(4)-1(b)(2)(ii)(B).
    4. A plan that consists of contributions subject to section 401(m) satisfies section 401(a)(4) only if the plan satisfies the nondiscrimination rules described in VII above.
  9. RELATIONSHIP BETWEEN SECTIONS 401(K) AND 415
    1. For purposes of section 415, in plan years beginning after December 31, 1997, compensation includes elective deferrals and similar amounts under cafeteria plans and eligible section 457 plans.
    2. For plan years beginning before January 1, 1998, section 415 compensation does not include elective deferrals. Reg. § 1.415-2(d)(3). Plan administrators often forgot this when processing deferral elections. Thus, for example, an employee earning $28,000 may have been incorrectly permitted to defer $7000. The participant's section 415 compensation was then $21,000, and the participant had deferred 33 1/3 percent of compensation.
    3. Reg. § 1.415-6(b)(6)(iv) was amended in 1991 to permit correction of excess annual additions by distributing elective deferrals to the extent that this would reduce the excess annual additions.
      1. Elective deferrals distributed under this provision are includible in income when distributed. Rev. Proc. 92-93, 1992-2 C.B. 505.
      2. Reporting requirements for these distributions are also contained in Rev. Proc. 92-93.
OTHER ELECTIVE ARRANGEMENTS
  1. 401(k) SIMPLE arrangements
    1. 401(k) SIMPLE arrangements, like the SIMPLE IRA described below, are intended to increase retirement savings by providing a simple vehicle for use by small employers. The new vehicle is effective for plan years beginning after December 31, 1996. Note that section 401(k)(11)(D) cross-references section 408(p) for most definitions
        1. 401(k) SIMPLEs are restricted to employers with no more than 100 employees earning $5000 or more during the preceding year. See section 408(p)(2)(C)(i)(I).
        2. The 401(k) SIMPLE is intended to be the exclusive plan benefitting its participants. Section 401(k)(11)(C) provides that it must be the only plan to which contributions were made or benefits were accrued for services during the year on behalf of employees eligible to participate.
        3. Salary reduction contributions are limited to $6000, indexed for cost-of-living adjustments. Section 401(k)(11)(B)(i)(I).
        4. Special nondiscrimination rules must be used.
          1. The employer must make either 3 percent matching contributions or a 2 percent nonelective contribution to each eligible participant who has at least $5000 in compensation for the year. Sections 401(k)(11)(B)(i)(II) and 401(k)(11)(B)(ii).
          2. The plan is treated as meeting top-heavy requirements if it allows only contributions required under paragraph 401(k)(11). Section 401(k)(11)(D)(ii).
            1. This arrangement, however, will remain subject to the other rules governing qualified plans.
            2. This top-heavy exception applies to 401(k) SIMPLE plans only, and not to other CODAs.
        5. The plan year for the 401(k) SIMPLE must be the calendar year.
        6. All other qualification requirements apply.
        7. A model amendment for employers that wish to adopt a 401(k) SIMPLE arrangement is contained in Rev. Proc. 97-9, 1997-2 I.R.B. 55. Use of the model is not, of course, required.
SIMPLE IRAs
  1. As with 401(k) SIMPLE arrangements, SIMPLE plans are intended to increase retirement savings by providing a simple vehicle for use by small employers.
    1. Basic structure involves employer establishment of plan, which is funded by contributions to special IRAs (SIMPLE IRAs) established for all eligible employees.
    2. If employer does not wish to make contributions to SIMPLE IRAs established by employees at multiple financial institutions, employer can establish SIMPLE IRAs for all employees with designated financial institutions. Section 408(p)(7).
  2. Eligible employers are those with no more than 100 employees earning $5000 or more during preceding year. Section 408(p)(2)(C)(i)(I).
      1. Two year grace period in which plan of growing employer may continue to be maintained. Section 408(p)(2)(C)(i)(II).
      2. If there is failure to meet requirement result of acquisition, disposition, or similar transaction, rules similar to those of section 410(b)(6)(C)(i) apply. Section 408(p)(2)(C)(i)(II).
      3. Employer cannot maintain any other plan under which employees receive contributions or accrue benefits for the year. Section 408(p)(2)(D). There are two exceptions:
        1. An employer may maintain a collectively bargained plan covering only collectively bargained employees who are excluded from the SIMPLE plan. Section 408(p)(2)(D)(i).
        2. An employer may maintain another plan if the failure to meet the one-plan requirement is the result of an acquisition, disposition, or a similar transaction, and the employer complies with rules similar to those of section 410(b)(6)(C). Section 408(p)(2)(D)(iii).
  3. Eligible employees are those who received at least $5000 in compensation during two preceding years and are reasonably expected to earn that amount in current year. Section 408(p)(4). Model documents (see below) permit inclusion of employees with less compensation.
Plan Contributions

Salary reduction contributions by eligible employees, expressed as percent of compensation, with maximum of $6000 for year. Section 408(p)(2)(A). Cost-of-living adjustments apply to $6000 limit. Section 408(p)(2)(E).

Dollar-for-dollar match by employer, up to three percent of compensation. Section 408(p)(2)(A)(iii).

Percentage match, can be reduced, but not below one percent of compensation, for two out of every five years. Section 408(p)(2)(C)(ii).

In lieu of match, employer may make two percent contribution to all eligible employees . Section 408(p)(2)(B)(i).

  1. Can limit recipients to those with at least $5000 in compensation, even if larger group is eligible to make salary reduction contributions.
  2. Compensation limited to section 401(a)(17) amount. Section 408(p)(2)(B)(ii).
Match on behalf of a self-employed individual is not treated as an elective employer contribution. Section 408(p)(9).

Time of contributions

Section 408(p)(5)(A)(i) requires salary reduction contributions to be made by 30 days after last day of month with respect to which contributions are made. To comply with Department of Labor plan asset regulations, contributions must be made as soon as reasonably segregable, but in no event later than the end of the 30-day period. The 15-day rule in 29 CFR 2510.3-102(b) does not apply. (See model form and instructions.)

  1. Other contributions must be made by the due date of the employer’s tax return for the year in which the calendar year ends. Section 408(p)(5)(A)(ii).
Notification requirements and election periods
    1. Employees must have 60-day election period before beginning of year and at beginning of participation in which to elect salary reduction. Section 408(p)(5)(C).
      1. Announcement 96-112, 1996-45 I.R.B. 7, provides special rule for 1997 year, under which 60-day election period before beginning of year was not required to begin before January 1, 1997, for plans effective on that date.
      2. Model forms (I-96-46) permit election period upon eligibility for participation to begin at any time from 60 days before eligibility for participation up to the date on which eligibility occurs.
  1. Employees must be able to terminate election at any time. Section 408(p)(5)(B).
  2. Notification of right to make contributions, and of employer contribution formula (other than dollar-for-dollar match up to three percent) must be provided immediately before the election period. Section 408(l)(2)(C). Employees must receive summary plan description as part of notification.
  1. Administrative aspects
      1. Reporting and fiduciary requirements under Title I of ERISA.
        1. Participant is treated as exercising control over assets upon affirmative investment decision, rollover to another plan, or one year after account is established.
        2. Form 5500 reporting requirements do not apply.
      2. Distributions reported on Form 1099-R.
      3. Financial institution provides Form 5498.
    1. Annual statement of account activity must be provided to participant within 31 days after calendar year. Section 408(i).
  2. Tax treatment of SIMPLE IRAs.
      1. Rules applicable to IRAs generally apply with respect to rollovers, treatments, and distributions. However, if rolled over or transferred to a regular IRA within first two years of participation, distribution is includible in gross income. Section 408(d)(3)(G).
      2. If distributions are made from SIMPLE IRA within first two years of participation, section 72(t) tax is increased to 25 percent. Section 72(t)(6).
  3. IRS has provided two model documents (Form 5305-SIMPLE) for establishing SIMPLE IRA plans, one of which is designed for use with a "designated financial institution". Two model SIMPLE IRAs (Forms 5305-S and 5305-SA) are available for use with trust or custodial accounts.
  4. For a detailed discussion of rules applicable to SIMPLE IRAs, see Notice 98-4, 1998-2 I.R.B. 25. For procedures for obtaining opinion letters on SIMPLE IRAs and a model amendment to be used in establishing prototype SIMPLE IRAs, see Rev. Proc. 97-29, 1997-24 I.R.B. 9.
  1. Section 403(b) annuities
    1. Available to 501(c)(3) organizations, schools, and home health service agencies.
    2. Amount that can be deferred is $9500 (unindexed), with higher catch-up amounts under certain circumstances. This is coordinated with 401(k) deferrals by section 402(g).
    3. No discrimination tests apply to deferrals. However, for post-1988 years, sections 401(a)(4) (and thus section 401(m)), 401(a)(5), 401(a)(17), 401(a)(26), and 410(b) will apply to contributions other than elective deferrals. Section 403(b)(12).
  2. Section 457 plans
    1. These are plans maintained by state and local governments and tax-exempt organizations. Note that due to section 457(b)(6) funding restrictions and Title I funding rules, a tax-exempt organization can only maintain this type of plan if it is a "top hat" plan.
    2. Deferrals are limited to $7500 (or one-third of taxable compensation, if less) with a catch up. The amount is coordinated with section 402(g) deferrals by section 457(c)(2). For tax years beginning after 1996, the $7500 figure is adjusted annually for inflation. Section 457(e)(15). For 1997, it was $7500. For 1998, it is $8000.
    3. No nondiscrimination rules apply.
    4. Beginning August 20, 1996, all amounts of compensation deferred under a section 457(b) plan maintained by a state or local government (or its agency or instrumentality), and all the plan's assets and income, must be held in trust for the exclusive benefit of participants and their beneficiaries. Section 457(g)(1).
      1. However, if a plan is in existence on August 20, 1996, the trust does not have to be established before January 1, 1999.
      2. This requirement does not affect section 457 plans of tax-exempt organizations. Section 457(b)(6).
  3. Simplified Employee Pensions (SEPS)
    1. SEPS are in essence "superIRAs" designed to appeal to small employers. See section 408(k).
    2. In general, SEPS are subject to the tightest nondiscrimination rules of any plans. See section 408(k)(2) and (3).
    3. TRA '86 introduced elective SEPS which are subject to looser nondiscrimination rules patterned after section 401(k). Section 408(k)(6). New SARSEPs cannot be established after December 31, 1996.
    4. Elective deferrals under SEPS are limited to $7000 (adjusted), and are coordinated with those under 401(k) plans and 403(b) annuities.
  1. Historical Background of Cash or Deferred Arrangements
    1. Progenitors were plans that allowed employees to defer a portion of their year-end bonus. The size of this universe was limited because relatively few employers provide bonuses to rank and file employees.
      1. These plans raised issues of constructive receipt. However, Rev. Ruls. 63-180 and 68-89 resolved this issue by saying that there was no constructive receipt if an irrevocable election to defer was made by the end of the year before the bonus was paid. Note that this is a year later than would be required under the IRS nonqualified deferred compensation ruling position.
      2. Questions of discrimination in coverage and contributions were resolved in Rev. Rul. 56-497, which approved a plan in which over 50% of the participants were in the bottom 2/3 of participants and disapproved a plan in which less than 50% were in that group.
    2. Regulations proposed in 1972 would have barred cash or deferred arrangements that involved salary reduction. This position was highly controversial. In Section 2006 of ERISA, Congress barred issuance of final regulations before a specified date and provided that, in the interim, plans existing on June 27, 1974, were to be dealt with in accordance with the cited rulings.
    3. In 1978, Congress enacted section 401(k), effective for tax years beginning after 1979. Shortly thereafter, the 1972 proposed regulations were withdrawn.
      1. Although some plans were established in 1980 and 1981, the pace of change was slowed by uncertainty about whether loans and salary reduction contributions would be allowed.
      2. Proposed regulations issued in November 1981 permitted both loans and salary reduction, and the avalanche of plan adoptions and plan conversions began.
    4. Section 401(k) has been modified by subsequent legislation, most notably by the Tax Reform Act of 1986 (TRA '86), which lowered the maximum dollar amount that could be deferred and also tightened nondiscrimination rules.
    5. The 1981 proposed regulations were finalized on August 8, 1988. Additional regulations under sections 401(k) and (m) reflecting the changes made by TRA '86 were proposed on the same date. These regulations were further modified in additional regulations proposed May 14, 1990 (55 FR 19947), Notice 88-127, 1988-2 C.B. 538, Rev. Proc. 89-65, 1989-2 C.B. 786, and regulations published on September 14, 1990 (55 FR 37888). A new set of final regulations, incorporating both the various proposals and notices and the previous final regulations, was published on August 15, 1991 (56 FR 40507). Proposed regulations modifying requirements to disaggregate on the basis of collective bargaining units were published on January 4, 1993 (58 FR 43). Final regulations published on December 23, 1994 (59 FR 66165) adopted the 1993 proposed regulations, added cross-references to final regulations under sections 401(a)(4) and 410(b), and clarified several other issues. (These 1995 regulations are often referred to as "the concordance".)