The IRS, on December 29, 2004, issued final regulations under Code Sections 401(k) and 401(m). The regulations finalize the proposed regulations issued in July 2003. The final regulations substantially follow the proposed regulations. The regulations incorporate statutory changes and other IRS guidance issued since the 1994 regulations.

Effective Date. The final regulations apply for plan years beginning on or after January 1, 2006 (i.e., beginning with the 2006 plan year). An employer may apply the final regulations to any plan year that ends after December 29, 2004 (e.g., the 2004 calendar year just ended), provided the plan applies ALL of the final regulations, to the extent applicable, for that plan year and all subsequent plan years. This means a plan may elect to apply the final regulations in the middle of the 2005 plan year only if the plan has been operated in accordance with the final regulations for the entire plan year.

Expanded Safe Harbor Hardship Criteria. The final regulations add two new “deemed” immediate and heavy financial needs to the list of safe events permitting a hardship distribution. The two new events are: (1) burial or funeral expenses for the employee’s deceased parent, spouse, children or dependents; and (2) expenses for repair of damage to the employee’s principal residence that would qualify as deductible casualty expenses (without regard to the 10% “floor” for deductibility). Under the prior regulations, funeral expenses was used as an example of an immediate and heavy financial need permitting a hardship distribution, but was not on the more narrow list of “deemed hardship” events. As a result of this change, the regulations now state six “deemed hardship” events. The final regulations also clarify that the plan applies the deductible medical expense hardship event without regard to the 7.5% “floor” for deductibility.

Targeted QNECs. One of the most significant additions included in the proposed regulations was the restriction on an employer’s ability to use “bottom-up” QNECs to pass the ADP or ACP test. The final regulations essentially adopt the targeted QNEC rules without change. Under the final regulations, a plan can count a QNEC greater than 5% of compensation only if the QNEC does not exceed two times the plan’s “representative contribution rate.” The representative contribution rate measures the rate of QNECs (and QMACs used in the ADP test) received by all members of a testing group (which consists of either half of all eligible NHCEs or all eligible NHCEs employed on the last day of the plan year). A similar 5% limitation applies to QNECs taken into account in the ACP test. A special rule added to the final regulations increases the 5% threshold to 10% for QNECs made in connection with an employer’s contribution under a prevailing wage (e.g., Davis Bacon) plan.

Targeted Matching Contributions. As in the proposed regulations, the final regulations also restrict an employer’s ability to use “targeted” matching contributions to pass the ACP test. The targeted match restrictions apply if the matching contributions exceed the greatest of: (1) 5% of compensation; (2) 100% of an employee’s deferrals; or (3) two times the plan’s “representative matching rate.” The plan determines the representative matching rate in a manner similar to the representative contribution rate that limits targeted QNECs, except that the matching rate is an employee’s matching contributions divided by deferrals. The final regulations add a rule that if the matching rate is not the same for all levels of deferrals, the plan determines an employee’s matching rate assuming the employee’s deferrals equal 6% of compensation.

Prefunded Deferrals. The final regulations, like the proposed regulations, adopt the rule that a plan contribution is an elective deferral or a matching contribution only if the employer makes the contribution after the employee performs the services. The employer therefore generally may not prefund contributions to accelerate the deductions as permitted under Notice 2002-48. The final regulations adopt the exception contained in the proposed regulations to permit a deduction where the compensation would have been paid (but for the deferral election) before the performance of services. The final regulations also add an exception under which the employer will not violate the prefunding prohibition merely because the employer makes contributions for an occasional pay period before the services with respect to that pay period are performed, provided the early contributions are made for bona fide administrative considerations and are not made early with the principal purpose of accelerating deductions (e.g., temporary absence of the bookkeeper responsible for transmitting funds to the plan).

Safe Harbor Plans: Allocation Conditions and Matching Catch-ups. The final regulations retain the rule of the proposed regulations against allocation conditions with respect to any matching contributions the employer uses to satisfy the ACP test safe harbor. Therefore, the plan will not be able to apply a “last day” or “1,000 hours of service” condition to an “additional” match not used to satisfy the ADP test safe harbor. With regard to catch-up contributions, the IRS solicited comments regarding circumstances under which elective deferrals by an NHCE to a safe harbor plan would be treated as catch-up contributions but would be less than the amount required to be matched by the safe harbor plan (e.g., less than 5% of safe harbor compensation). The final regulations do not include any special rules for the treatment of catch-up contributions in a safe harbor plan. Therefore, a plan making safe harbor matching contributions may not exclude catch-up contributions in applying the match.

Safe Harbor Plan Termination/Short Plan Year. The final regulations adopt the rules of the proposed regulations that permit a safe harbor 401(k) plan to terminate during the plan year and to maintain its safe harbor status for the plan year of termination, provided the termination is on account of a substantial business hardship (as defined in the regulations) or a merger or acquisition. The plan may terminate for other reasons, provided the employer funds the required contributions to the date of termination and gives an employee notice of the termination, and the plan satisfies the ADP test. The final regulations also retain the proposed regulations’ exception to the twelve-month plan year requirement for a short plan year (for which the plan will remain a safe harbor plan) that is preceded and followed by a twelve-month plan year (or followed by a short plan year if the plan satisfies the safe harbor requirements for the immediately following twelve months). The “following” plan year may be less than twelve months if the following short plan result year results from plan termination (regardless of the reason for the termination).

Plan Testing Choices. A 401(k) plan must state which nondiscrimination testing alternative it will use (i.e., the ADP and ACP tests, the safe harbor provisions or the SIMPLE provisions). If there are optional testing choices (e.g., current year testing method, prior year testing method, or applying the “first plan year” rule), the plan must state those choices. A safe harbor plan must state whether it will satisfy the safe harbor provisions using the nonelective or match alternative. The final regulations specifically state that a safe harbor plan may not provide that the plan will use the ADP test if the plan does not satisfy the safe harbor requirements. Unless a safe harbor plan satisfies the “exiting” rules to reduce or eliminate a safe harbor match, the plan will not satisfy the nondiscrimination requirements if the employer amends the safe harbor contribution requirements for the plan year.

Gap Period Income. As in the proposed regulations, the final regulations provide that in determining income on corrective distributions to satisfy the ADP and ACP tests, the distribution must include “gap period” income if a plan would credit a participant’s account with income between the last day of the plan year and the distribution date (e.g., a daily valuation plan) if the plan distributed the entire account. The final regulations also permit the plan to disregard income allocable to excess contributions for a period not more than seven days before the distribution.

USERRA Contributions. The final regulations clarify that the plan does not take into account, for the year of the contribution or for any other year, additional elective contributions an employer makes to satisfy the USERRA requirements for a reemployed veteran.

Other Clarifications. The final regulations include the following additional clarifications: (1) clarify that a partner may defer out of “draws” paid during the year; (2) with respect to a permitted one-time irrevocable election, clarify that an employee may make the election no later than when the employee first becomes eligible under any plan of the employer (rather than upon employment or initial eligibility), and include 403(b) and governmental 457(b) plans in the definition of a plan of the employer; (3) clarify that the nonforfeitability requirement requires that deferrals are disregarded only for purposes of applying the plan’s vesting schedule, rather than for purposes of applying the vesting rules in general, so that, for example, deferrals count in determining whether a participant is “nonvested” under the parity rule; and (4) clarify that distributed excess contributions are includible in income treating the excess contributions as attributable to the first elective deferrals for the plan year.

Issues Not Addressed. Like the proposed regulations, the final regulations do not provide guidance regarding the entry date the plan must use, or the compensation the plan must take into account, in applying the early participation rule and the otherwise excludible employee rule. Likewise, the final regulations do not address the timing of amendments to change plan testing choices (e.g., current or prior year testing).

Our 401(k) Plan Workshop offered in April and May 2005 will cover, in detail, the final 401(k) regulations as well as other 401(k) issues of current interest to practitioners. Further information and seminar registration for this timely program will be available in early February.