The IRS has issued proposed regulations that will permit employers who maintain a safe harbor 401(k) plan to reduce or suspend (“exit") the safe harbor nonelective contribution during the plan year without disqualifying the 401(k) arrangement. The new rules will apply both to a traditional safe harbor plan leaving the deferral choice totally with each participant and to a qualified automatic contribution arrangement – a QACA – providing for specified levels of automatic contributions in absence of a participant’s affirmative deferral election. The proposed regulations respond to an omission in the final regulations perceived by many practitioners. This technical update summarizes the proposed regulations, and explains the current regulatory provisions that provide the context for the proposed regulations.

The proposed regulations. The proposed regulations permit an employer maintaining a safe harbor 401(k) plan using the nonelective contribution alternative that incurs a substantial business hardship to reduce or suspend the nonelective contribution during the plan year. The proposed regulations generally are the same as the safe harbor match exiting rules (explained below), and have 5 requirements: (1) eligible employees receive a supplemental notice of the suspension or reduction; (2) the amendment is effective no earlier than the later of 30 days after the supplemental notice to all eligible employees and the date of adoption of the amendment; (3) the employees have a reasonable opportunity after the notice and prior to the reduction or suspension to change their deferral elections; (4) the employer amends the plan to provide for current year ADP testing; and (5) the plan satisfies the safe harbor nonelective contribution requirement through the amendment’s effective date. A safe harbor 401(k) nonelective plan that also provides matching contributions satisfying the ACP safe harbor requirements may apply the same rules except the amendment also must indicate that the plan will apply the ACP test for the entire year using current year testing. The proposed regulations also require that the supplemental notice specifically explain: (1) the consequences of the exiting amendment; (2) the procedures for changing a deferral election; and (3) the effective date of the amendment. These supplemental notice requirements are identical to the rules that currently apply to the exiting rules for a safe harbor match.

Substantial business hardship. For purposes of identifying a substantial business hardship, the proposed regulations indicate the employer must apply criteria “comparable" to a substantial business hardship described under the statutory criteria for a pension plan funding deficiency waiver (Code §412(c)). Under this provision, the criteria for determining a substantial business hardship include (but are not limited to) whether or not: (1) the employer is operating at an economic loss; (2) there is substantial unemployment or underemployment in the employer’s trade or business; and (3) the sales and profits of the employer’s industry are depressed or declining.

Current reliance. Employers may rely on the proposed regulations now. However, because of the specific amendment timing rules that require amendment in advance of the amendment’s effective date discussed above, the employer may not wait until the end of the plan year to amend the plan to comply with the proposed nonelective exiting regulations, even though amendment by the last day of the plan year generally would be acceptable, under other existing IRS guidance, to make a discretionary amendment effective during the plan year.

Full plan year safe harbor requirements. The final 401(k) regulations (generally effective for 2006 plan years), as amended by the February 2009 final regulations for eligible automatic contribution arrangements (EACAs) and QACAs, generally require that a safe harbor 401(k) plan provide that the safe harbor provisions will be in effect for the entire 12-month plan year, and that the plan may not revert to ADP and/or ACP testing if the plan fails to satisfy the safe harbor requirements for the entire plan year.

Exiting the safe harbor match. A plan using the matching contribution alternative, rather than the safe harbor nonelective alternative, to satisfy the safe harbor rules, has had the ability under the existing regulations to exit the safe harbor match by reducing or eliminating the safe harbor match at any time during the plan year, provided the employer satisfies several regulatory requirements (essentially identical to those listed under the “proposed regulations" heading, but applied to safe harbor match). However, until now the regulations have not permitted an employer maintaining a safe harbor plan using the nonelective alternative to exit the nonelective contribution during the plan year under the same rules that apply to the safe harbor match. Under the proposed regulations, the only difference between exiting a safe harbor match and exiting a safe harbor nonelective is that an employer can exit the nonelective contribution only if there is a substantial business hardship. There is no such limitation for a safe harbor match.

“Maybe" notice. The regulations have provided that an employer that maintains a 401(k) plan using the current year testing method, and provides a required notice to participants (essentially the equivalent of the safe harbor notice, but indicating the employer may amend the plan during the year to provide the safe harbor nonelective contribution – commonly referred to as the “maybe" notice) may decide during the plan year that the plan will be a safe harbor plan for the entire plan year using the nonelective contribution alternative, provided the employer timely amends the plan to add the nonelective contribution requirement and provides a supplemental notice at least 30 days before the last day of the plan year. While the maybe notice accommodates an employer that anticipates a plan contribution shortfall before the beginning of the plan year, an employer that encounters unexpected adverse financial consequences during the plan year after having promised under the plan to provide the safe harbor nonelective contribution has not had the ability to exit the nonelective contribution requirement during the plan year, leaving plan termination as the only option to end the employer's contribution obligation.

The termination option. While the exiting option has not been available to a safe harbor nonelective plan, an employer with a safe harbor plan using either the match or the nonelective contribution option has been and is able to terminate the plan, subject to regulatory conditions that include funding the plan to the termination date. The regulations have provided that while the employer terminating a safe harbor plan midyear generally must test the plan under the ADP and ACP tests for the year of termination using the current year testing method and follow the other exiting rules (except the requirement to give participants the opportunity to change their deferral elections), if the employer terminates the plan either because of a substantial business hardship (applying the pension plan funding waiver criteria under Code §412) or in connection with an acquisition or disposition transaction (described under Code §410(b)(6)(C)), the plan may terminate but maintain its safe harbor status for the plan year of termination.

Other effects of exiting. The preamble to the proposed regulations also notes that a plan that is amended to suspend or reduce either the safe harbor nonelective or the safe harbor matching contributions must prorate the otherwise applicable compensation limit for the plan year, and that the plan will not be exempt from the top-heavy rules under the “safe-harbor-only" provisions of the Code, and will be subject to the top-heavy rules.

Example. Corporation X maintains a safe harbor 401(k) nonelective plan with a 3% contribution. During 2009, X experiences significant financial difficulties (constituting a substantial business hardship) and needs to reduce its expenses. X does not want to terminate its plan because it wants to permit employees to continue deferring and it expects to return to profitability when the economy turns around. X determines that it has incurred a substantial business hardship. On June 1, 2009, X amends its plan to provide that, effective July 1, 2009, it will suspend its nonelective contribution. The amendment also provides that the plan will apply the ADP test for the year using current year testing. On the same date, X provides a notice to employees explaining the reduction. The plan imposes no limitation on employees changing their deferral elections. X will fund the nonelective contribution through July 1, 2009. The amendment complies with the changes in the proposed regulations, and therefore X may continue to maintain the plan.

Comment: While the proposed regulations provide a new opportunity to eliminate a safe harbor nonelective contribution requirement during the year, practitioners should note that the proposed nonelective contribution exiting rules are narrower than the safe harbor match exiting rules. The match exiting rules do not require the employer to have any particular business reason to exit the safe harbor match. In contrast, the nonelective exiting rules are available only on account of a substantial business hardship. Therefore, if the employer wishes to have total discretion regarding the use of the safe harbor nonelective during the plan year, the employer must use the maybe notice, which permits the employer total discretion whether to commit to the safe harbor nonelective during the plan year. The new proposed exiting rules thus complement and work in tandem with, but do not replace, the maybe notice option. The IRS has requested comments on the proposed regulations, and is considering imposing an additional requirement as to the minimum notice content requirements, that would include a specific requirement to describe the possibility of exiting the safe harbor contributions (which, under the proposed regulations, now would apply both to the safe harbor match and the safe harbor nonelective).

Upcoming SunGard seminars and conferences. SunGard will discuss in detail the safe harbor 401(k) plan rules, including the new proposed regulations and the final EACA and QACA regulations (issued February 2009), in the Fundamentals of 401(k) and Other Qualified Plans seminar. Fundamentals is a 3-day seminar covering the basics of qualified defined contribution plans, with emphasis on 401(k) plans. The seminar provides a comprehensive explanation of the qualified plan and special 401(k) plan rules for new 401(k) practitioners and is an excellent review for experienced practitioners. For more information on Fundamentals, seminar locations and registration information, please visit our Web site.