Changes to the Tax Laws Affecting Qualified Retirement Plans Effective in 1999

From Employee Benefits Alert

December 1998

The Small Business Jobs Protection Act of 1996 ('96 Act) added a safe harbor as an alternative method for a 401(k) plan to satisfy the actual deferral percentage (ADP) and actual contribution percentage (ACP) tests. The ADP and ACP tests generally require that deferrals and contributions for highly compensated employees do not exceed deferrals and contributions for other employees by more than a minimum degree. Under the new safe harbor, an employer may satisfy the ADP and ACP tests by satisfying a contribution requirement and a notice requirement.

The contribution requirement for the ADP safe harbor may be satisfied in two ways. Under either method, the employee must be immediately vested in the amount of the contribution. The first option is for the employer to make nonelective contributions equal to 3% of salary for eligible nonhighly compensated employees. Alternatively, the employer may make a matching contribution on behalf of each nonhighly compensated employee equal to 100 percent of the employee's elective contribution up to 3% of compensation and 50% of the employee's elective contribution from 3% to 5% of compensation (i.e., a matching contribution of 4% of compensation for employees contributing 5% of compensation). The contribution requirement also may be satisfied by making matching contributions at different rates, so long as the rate of matching does not increase as the employee's rate of contribution increases and the total amount of matching contributions at the same rate of elective contributions is at least as great as it would have been under the safe harbor percentage requirements discussed above.

Matching contributions must be subject to the limitations on distribution generally applying to 401(k) contributions. Thus, they cannot be withdrawn until the employee's separation from service, death, disability, or, if the plan is a profit sharing or stock bonus plan, attainment of age 59_. The matching contributions do not qualify for hardship withdrawals.

The ACP test safe harbor will be satisfied if the employer meets the requirements for the ADP safe harbor and limits matching contributions to the first 6% of compensation.

Although the safe harbor will simplify nondiscrimination testing for employers who adopt it, many employers may choose not to use the safe harbor. With the implementation of look-back nondiscrimination testing (which permits the prior year non-highly compensated employee deferral percentage to be tested against the current year highly compensated employee deferral percentage), nondiscrimination testing has become somewhat less difficult to monitor. The requirement to provide a generous matching contribution or a 3% nonelective contribution is likely to make the safe harbor alternative more costly than continuing to conduct nondiscrimination testing. For employers that already have a generous match, however, the safe harbor may be worthwhile.

Employers who choose to adopt the safe harbor must notify employees within a reasonable period before the beginning of the plan year. Under a safe harbor, notice is deemed to be given within a reasonable period if given within 30 days before the beginning of the plan year. In addition, for plan years beginning on or before April 1, 1999, notice is deemed timely if given not later than March 1, 1999.

Since the new safe harbor is "design-based," employers who wish to adopt it must amend their 401(k) plans to provide for the contributions that will satisfy the safe harbor. Plan amendments must be adopted by the date that other amendments required by the '96 Act are required (i.e., December 31, 1999 for calendar year plans).

Under the Internal Revenue Service Restructuring and Reform Act of 1998, hardship distributions from pre-tax contribution accounts will not be eligible rollover distributions beginning on January 1, 1999. The law was changed to prevent employees from avoiding 20% income tax withholding and the 10% early withdrawal penalty by rolling the hardship distribution into their IRA and then withdrawing it from the IRA. IRA distributions are not subject to 20% withholding and are not subject to the 10% penalty if they are use to fund certain higher education expenses or to purchase a first home, while hardship distributions would have been subject to withholding and the penalty if not rolled over. This change will have a number of consequences.

As distributions that are not eligible for a rollover, hardship distributions from a pre-tax account (i.e., attributable to 401(k) contributions) will no longer be subject to the 20% mandatory income tax withholding. Such distributions will be subject to the 10% penalty tax, however, if the participant is not at least age 59_. The 10% tax must be withheld from the distribution unless the participant elects out of withholding.

Hardship distributions from other accounts (i.e., employer matching and after-tax contributions) will continue to be eligible rollover distributions. As such, these distributions will be subject to 20% withholding and 10% penalty tax if not rolled to an IRA.

As a result, hardship distributions may now be subject to two different sets of rules, depending from which account they are made. The possibility that a hardship distribution may come from both a pre-tax account and other accounts means that employers must alter their election forms and withholding procedures to permit appropriate treatment of the hardship distribution.

One way to simplify these rules would be to permit hardship distributions only from pre-tax accounts. Amounts contributed to other accounts can be distributable without the need for hardship. For example, an employer could permit distribution of after-tax contributions, and permit hardship distributions from the pre-tax account only and subject to the requirement that all amounts available in other accounts have already been distributed.

The '96 Act added an alternative nondiscrimination testing method for 401(k) plans that permit employees to participate before completing a year of service and reaching age 21. Under current law, an employer may test these employees separately from those who have reached age 21 and completed a year of service. Although performing two separate tests is more difficult, testing separately may help the employer to pass the ADP and ACP tests because the younger and newer employees may not be contributing at the same rate as more senior employees. For plan years beginning after December 31, 1998, an employer who satisfies the minimum coverage test separately with regard to employees who have less than a year of service or are under age 21 may apply the ADP and ACP tests by excluding these employees (other than highly compensated employees) from the testing group. Thus, the employer can now perform a single ADP and ACP test.

To learn more about these new rules or for additional information about employee benefits, please contact Paul J. Powers, Jr. or Kirk H. O'Ferrall at our New York office.