Michael J. Karlan
CASH OR DEFERRED ARRANGEMENTS,
AND EMPLOYEE CONTRIBUTIONS
Mary Oppenheimer and Michael Karlan
Office of Chief Counsel
(Employee Benefits and Exempt Organizations)
Internal Revenue Service
OTHER ELECTIVE ARRANGEMENTS
- 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
- 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
- IRA SIMPLE arrangements can be established by
employers with no more than 100 employees earning
$5000 or more during the preceding year. See Section
- Section 403(b) salary reduction arrangements can
be established by section 501(c)(3) organizations
and certain educational institutions. See Section
- Section 457 nonqualified deferred compensation
arrangements can be established by tax-exempt
organizations and state and local governments. See
Section X(D) below.
- 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.
- 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.
- Growth of elective arrangements is fueled by a
number of factors.
- Flexibility in who contributes what responds
to demographic change.
- Disparity in contributions for highly
compensated and other employees can be higher
than under more traditional arrangements.
- Plan contributions can often be limited to
salary reduction, requiring no true employer
- Ability to make pre-tax contributions
coincides with the desire to reduce current
- 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
- CASH OR DEFERRED ARRANGEMENTS
- 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).
- An irrevocable one-time election at the
commencement of employment or plan participation is
not a cash or deferred election. Reg. §
- 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).
- 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.
- 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).
- 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).
- Thus, section 401(k) permits deferral of
amounts already earned so long as they are not
yet paid or payable.
- 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.
- Maximum deferrals under qualified cash or deferred
- A qualified cash or deferred arrangement is the
exclusive method for electively deferring
compensation under a qualified plan on a pre-tax
- 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).
- The maximum amount that can be deferred is
governed by section 402(g), which limits
deferrals under a cash or deferred arrangement
- 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
- The $7000 limit was made a
qualification requirement by TAMRA.
See section 401(a)(30).
- 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. §
- 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.
- 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).
- 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.
- 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.§
- NONDISCRIMINATION TESTS FOR QUALIFIED CASH OR DEFERRED
- 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
- 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).
- 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
- 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).
- 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.
- 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.
- 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
- Elective deferrals may be included or
excluded, i.e., gross or net compensation
may be used.
- 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).
- 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.§
- 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
- The ADP is the average of the actual
deferral ratios of participants in the group.
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
- 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.
- The ADP of highly compensated participants may
- 125 percent of the ADP of nonhighly
compensated participants; or
- 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).
- 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).
- 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.
- 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. §
- 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).
- Special rules must be applied to define the
plan that is subject to testing under section
- 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
- 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.
- 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. §
- 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.
- The prior year’s ADP for nonhighly
compensated employees may be determined as
soon as prior year data are available.
- 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
- 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.
- 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.
- 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.
- 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
- 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
- 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.
- 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.
- 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
- 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
- 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;
- 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
- The change occurs during the
plan's remedial amendment period for
the SBJPA changes.
- New safe harbor testing rules can be used for plan
years beginning after December 31, 1998.
- 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
- A second alternative is making three percent
nonelective contributions to all nonhighly
compensated participants. Section 401(k)(12)(C).
- 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).
- 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. §
- 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.§
- METHODS FOR CORRECTING DISCRIMINATION
- For post-1986 plan years, discrimination under a cash
or deferred arrangement may be corrected using one or
more of the following three methods.
- 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).
- 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. §
- 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.)
- 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.
- 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.
- Calculate the excess
contribution for each highly
compensated employee as
described in reg. §
- Determine the sum of the
- Reduce the elective
contributions of the highly
compensated employee with the
highest dollar amount by the
amount required to bring that
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.
- If the total amount
distributed is less than the
total excess contributions,
repeat the step above until
the required amount has been
- 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
- Excess contributions are deemed to be
the first contributions made during the
plan year. Conference Report on TRA '86,
- 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).
- 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).
- If the amount is less than $100, the
excess contributions and earnings are
includible in income in the year
- 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
- 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
- Distribution must include income allocable to
- 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.
- 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. §
- 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.§
- 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.
- For examples and transition rules, see
Notice 88-33, 1988-1 C.B. 513.
- In accordance with regulations, the plan may
recharacterize excess contributions as employee
contributions. Section 401(k)(8)(A)(ii).
- 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.
- 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).
- The employer may make additional QNCs or QMACs to
increase ADP of nonhighly compensated employees.
- Prior to TRA '86, this was the sole
method of correction permitted under IRS
- 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.
- 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.
- 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.
- 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.
- 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.
- 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.
- DISTRIBUTION REQUIREMENTS FOR QUALIFIED CASH OR DEFERRED
- 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
- One of the most controversial issues concerning
cash or deferred arrangements has been the
definition of "hardship".
- Final regulations define a hardship
distribution as one that meets two tests.
- It is made on account of an immediate and
heavy financial need of the employee. Reg.
- 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).
- 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. §
- 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.
- Medical expenses previously incurred
or necessary for obtaining medical
care deductible under section 213(d)
for the participant, spouse, or
- Purchase of principal residence
(excluding mortgage payments) for
- Payment of post-secondary tuition,
related educational fees, and room and
board for next 12 months for
participant, spouse, children, or
- Prevent eviction/foreclosure on
participant's principal residence.
- 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.
- 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.
- The employee has obtained all other
non-hardship distributions and
nontaxable loans currently available
under all plans maintained by the
- The plan, and all other plans
maintained by the employer, provide for
a twelve month suspension of elective
and employee contributions.
- 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).
- 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.
- 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.
- 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.
- Special rules permit distributions upon plan
termination without establishment of a successor
plan. Section 401(k)(10) and reg.§
- 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. §
- 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).
- In addition, distributions may be made in the
event of certain sales of subsidiaries and assets.
- 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).
- 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
- 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).
- 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).
- 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.
- 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.
- 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).
- OTHER REQUIREMENTS FOR QUALIFIED CASH OR DEFERRED
- 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).
- 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
- 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
- In addition, the status of plans established
by Indian tribes was unclear.
- For plan years beginning after December 31,
1996, tax-exempt organizations and Indian tribes
may establish 401(k) plans.
- 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).
- 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. §
- Thus an amount that is nonforfeitable by reason
of a vesting schedule may not be taken into
account under section 401(k).
- Other employer benefits, other than matching
contributions, cannot be contingent upon the employee's
election to make or not make elective contributions.
- 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. §
- 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
- The following items will not violate the
contingent benefit rule. Reg. § 1.401(k)-1(e)(6).
- Any benefit provided under a cafeteria plan.
- 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.
- 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
- SPECIAL DISCRIMINATION RULES FOR PLANS WITH EMPLOYEE OR
- 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
- Section 401(m) does not apply to employee
contributions to a defined benefit plan. See reg. §
- 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
- 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).
- 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(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.
- The regulations are effective for
post-1988 plan years. See reg. §
- There is no multiple use unless at
least one plan exceeds the 125 percent
limit. Reg. § 1.401(m)-2(b)(1)(i)(C)
- 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).
- 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).
- 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.
- Income and excise tax consequences are identical
to those described with respect to section 401(k).
- Note that recharacterized elective deferrals may
be required to be distributed in order to correct
excess aggregate contributions.
- 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).
- 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
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
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
Note. Neither the Code nor regulations permit
matching contributions to be distributed to correct
the discriminatory rate.
- RELATIONSHIP BETWEEN PLAN QUALIFICATION AND SATISFACTION
OF SECTIONS 401(K) AND (M)
- 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).
- 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.
- 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. §
- 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
- RELATIONSHIP BETWEEN SECTIONS 401(K) AND 415
- 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.
- 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
- 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.
- Elective deferrals distributed under this
provision are includible in income when distributed.
Rev. Proc. 92-93, 1992-2 C.B. 505.
- Reporting requirements for these distributions are
also contained in Rev. Proc. 92-93.
- 401(k) SIMPLE arrangements
- 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
- 401(k) SIMPLEs are restricted to employers
with no more than 100 employees earning $5000
or more during the preceding year. See section
- 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
- Salary reduction contributions are limited
to $6000, indexed for cost-of-living
adjustments. Section 401(k)(11)(B)(i)(I).
- Special nondiscrimination rules must be
- 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).
- 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).
- This arrangement, however, will
remain subject to the other rules
governing qualified plans.
- This top-heavy exception applies to
401(k) SIMPLE plans only, and not to
- The plan year for the 401(k) SIMPLE must be
the calendar year.
- All other qualification requirements apply.
- 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.
- As with 401(k) SIMPLE arrangements, SIMPLE plans are
intended to increase retirement savings by providing a
simple vehicle for use by small employers.
- Basic structure involves employer establishment of
plan, which is funded by contributions to special IRAs
(SIMPLE IRAs) established for all eligible employees.
- 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).
- Eligible employers are those with no more than 100
employees earning $5000 or more during preceding year.
- Two year grace period in which plan of growing
employer may continue to be maintained. Section
- 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).
- 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:
- 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).
- 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).
- 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.
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
In lieu of match, employer may make two percent contribution
to all eligible employees . Section 408(p)(2)(B)(i).
Match on behalf of a self-employed individual is not treated as
an elective employer contribution. Section 408(p)(9).
- Can limit recipients to those with at least $5000 in
compensation, even if larger group is eligible to make
salary reduction contributions.
- Compensation limited to section 401(a)(17) amount. Section
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.)
Notification requirements and election periods
- 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).
- 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).
- 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.
- 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
- Employees must be able to terminate election at any time.
- 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
- Administrative aspects
- Reporting and fiduciary requirements under Title
I of ERISA.
- Participant is treated as exercising control
over assets upon affirmative investment
decision, rollover to another plan, or one
year after account is established.
- Form 5500 reporting requirements do not
- Distributions reported on Form 1099-R.
- Financial institution provides Form 5498.
- Annual statement of account activity must be provided
to participant within 31 days after calendar year.
- Tax treatment of SIMPLE IRAs.
- 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).
- 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).
- 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.
- 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.
- Section 403(b) annuities
- Available to 501(c)(3) organizations, schools, and
home health service agencies.
- 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
- 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).
- Section 457 plans
- 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
- 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
- No nondiscrimination rules apply.
- 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).
- However, if a plan is in existence on August 20,
1996, the trust does not have to be established
before January 1, 1999.
- This requirement does not affect section 457 plans
of tax-exempt organizations. Section 457(b)(6).
- Simplified Employee Pensions (SEPS)
- SEPS are in essence "superIRAs" designed to
appeal to small employers. See section 408(k).
- In general, SEPS are subject to the tightest
nondiscrimination rules of any plans. See section
408(k)(2) and (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.
- Elective deferrals under SEPS are limited to $7000
(adjusted), and are coordinated with those under 401(k)
plans and 403(b) annuities.
- Historical Background of Cash or Deferred Arrangements
- 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.
- 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.
- 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.
- 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.
- In 1978, Congress enacted section 401(k), effective
for tax years beginning after 1979. Shortly thereafter,
the 1972 proposed regulations were withdrawn.
- 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.
- Proposed regulations issued in November 1981
permitted both loans and salary reduction, and the
avalanche of plan adoptions and plan conversions
- 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
- 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