SunGard Relius

Recently, we have received a number of questions regarding whether a safe harbor 401(k) plan that provides for immediate or early eligibility must provide a safe harbor 401(k) contribution to an employee that has not completed one year of service and who has not attained one year of service (standard eligibility conditions). Similarly, we have received questions as to whether a 401(k) cross-tested plan must provide the minimum gateway contribution to employees who have not met the standard eligibility conditions.

In recent years, 401(k) plans have become a popular and expected employee benefit. To accommodate the interest in 401(k) plans, many employers have amended their plans to provide for immediate eligibility or eligibility after a few months of service. Although reduced eligibility requirements make the 401(k) plan benefit more available, the early eligibility provisions make the ADP test more difficult to pass because part-time and short-term employees, who often do not defer, become eligible. In order to avoid penalizing an employer for liberalizing its 401(k) plan benefits, the Code provides two alternative rules that eliminate any negative impact of early eligibility provisions:

Under the otherwise excludible employee rule, an employer may divide operationally the plan into two plans for ADP and ACP testing purposes – one plan covering the employees who could have satisfied standard eligibility conditions (upper group) if the plan had imposed such a condition, and the other plan covering the employees who would not have satisfied the standard eligibility conditions (lower group). To use the otherwise excludible employee rule, each of the “deemed” plans separately must satisfy coverage. Furthermore, in applying the coverage test, the employer could exclude the employees of the other plan (group).

The early participation rule is similar but not identical to the otherwise excludible employee rule. Under the early participation rule, the employer may disregard any nonhighly compensated employee (NHCE) from the ADP test (or ACP test) if the employee could not have satisfied standard conditions if the plan had imposed such conditions.

Safe harbor 401(k) plan. In designing a safe harbor 401(k) plan, an employer may provide for immediate eligibility for the elective deferrals but impose standard eligibility conditions for employer contributions, including safe harbor employer contributions. For purposes of applying the safe harbor 401(k) requirements, the plan would take advantage of the otherwise excludible employee rule and divide the plan into two plans: the plan for the upper group would be a safe harbor 401(k) plan because those employees would be receiving the safe harbor 401(k) contribution. The plan for the lower group would not be a safe harbor 401(k) plan because those employees do not receive the safe harbor 401(k) contributions. Accordingly, that plan would be subject to the ADP test. However, satisfying the ADP test with respect to the lower group typically is not at issue because the lower group usually consists solely of NHCEs. A "plan" that consists solely of NHCEs automatically satisfies the ADP test (and if applicable, the ACP test). Therefore, the employer only would need to make the safe harbor employer contribution to the upper group employees. IRS guidance does not permit the employer to apply the early participation rule to a safe harbor 401(k) plan.

401(k) cross-tested plan. Beginning with the 2002 plan year, an employer sponsoring a cross-tested plan generally must provide each NHCE who is benefiting under the plan a minimum gateway contribution (i.e., the lesser of 5% or 1/3 of the highest allocation provided to an HCE). However, a 401(k) cross-tested plan that provides for immediate or early eligibility may avoid the necessity of providing the minimum gateway contribution to those employees who do not satisfy the standard eligibility conditions by applying the otherwise excludible employee rule. Under the otherwise excludible employee rule, the employer would divide the plan into two plans: one for the upper group and one for the lower group. Although the lower group employees are benefiting (because they are eligible to defer) under the plan, the lower group plan does not need to apply cross testing principles to satisfy the nondiscrimination requirements. Consequently, the employer would not need to make the minimum gateway contribution to the lower group employees. The employer, however, would have to make the minimum gateway contribution to the upper group employees. If the plan is using the early participation rule, all employees would need to receive the minimum gateway contribution.

Top heavy rules. The otherwise excludible employee and early participation rules only apply for purposes of coverage and nondiscrimination testing. Therefore, the application of these rules does not excuse the employer from making the top heavy minimum contribution. If a non-key employee is eligible to defer (including an employee who did not meet standard eligibility conditions), the plan must make a top heavy minimum contribution for the employee regardless of whether he/she defers.

Although the otherwise excludible employee does not relieve the employer from making the top heavy minimum contribution with respect to employees who have not satisfied the standard eligibility conditions, the employer can design its plan in such a way that it does not need to provide the safe harbor 401(k) contribution or the minimum gateway contribution to employees who cannot satisfy the standard eligibility conditions.

In our upcoming 401(k) Update program, we will discuss the otherwise excludible employee and early participation rules in more detail. We will describe which entry dates a practitioner may use to divide the employees into the two groups.