IRS, Treasury Unveil "New" 401(k) Regs

July 16, 2003 ( - In a move likely to (at least initially) engender heartburn on the part of plan sponsors and providers alike, today the Treasury Department and Internal Revenue Service have issued a new set of proposed regulations dealing with 401(k) plans.

>On the other hand, while the printed regulations are voluminous, the new proposed regulations will replace the current regulations, incorporate the guidance issued since 1994 (the last time regulations on 401(k) plans were updated), and address open issues, according to regulators.

>Plan sponsors will (perhaps) be comforted to note an acknowledgement by Treasury and the IRS that while “certain of the substantive changes in these proposed regulations will require changes in plan design or plan operation…the proposed regulations are not otherwise intended to require significant changes in plan systems and practices that were developed under existing guidance and that conform to the requirements of sections 401(k) and 401(m),” according to the regulations.  

>In fact, in announcing the changes, the IRS noted that the most substantial changes to the section 401(k) and section 401(m) provisions were made to the methodology for testing the amount of elective contributions, matching contributions, and employee contributions for nondiscrimination.

Insightful Comments

“The proposed rules are the result of years of gathering useful and much appreciated insights from the retirement plan community,” Treasury Assistant Secretary for Tax Policy Pam Olson said in a statement. “Our goal with the proposed rules is to put all the rules in one place and resolve a number of open matters. Ending uncertainty will make it easier for employers to sponsor plans to help employees save for their retirement and will assist administrators who are charged with ensuring that their plans adhere to all the Internal Revenue Code requirements that apply to employer plans.”

>It was the second big announcement in the past week for federal regulators who, on July 10, unveiled final regulations for plans qualified under Section 457 (see  Final Regs Shed Light on 457 Programs ).

>Among the items addressed in the new 401(k) regulations:

  • incorporation of prior guidance on automatic enrollment, reflecting the fact that a cash or deferred arrangement (CODA) can specify that the default that applies in the absence of an affirmative election by an employee can be a contribution to a trust
  • clarify the definition of a CODA, noting that it excludes contributions that are treated as after-tax employee contributions at the time of the contribution and contributions made pursuant to certain one-time irrevocable elections, but would also specify that a CODA does not include an arrangement under which dividends paid to an ESOP are either distributed to a participant or reinvested in employer securities in the ESOP pursuant to an election by the participant or beneficiary under section 404(k)(2)(A)(iii) as added by EGTRRA.
  • clarify that amounts contributed in anticipation of future performance of services generally would not be treated as elective contributions under section 401(k).  
  • Note that, pursuant to section 401(k)(3)(G), a state or local governmental plan is deemed to satisfy the ADP test.

>The proposed regulations specify that "a plan will not be treated as satisfying the requirements of section 401(k) if there are repeated changes to plan testing procedures or plan provisions that have the effect of distorting the ADP so as to increase significantly the permitted ADP for HCEs, or otherwise manipulate the nondiscrimination rules of section 401(k), if a principal purpose of the changes was to achieve such a result."

>The proposed regulations would change the treatment of a CODA under a plan which includes an ESOP, noting that since the issuance of the existing regulations, the use of an ESOP as the employer stock fund in a section 401(k) plan "has become much more widespread."   Consequently, the proposed regulations would eliminate the disaggregation of the ESOP and non-ESOP portions of a single section 414(l) plan for purposes of ADP and ACP testing, as required under current law.

Distribution Directions

>The proposed regulations reflect EGTRRA's amendments to replace "separation from service" with "severance from employment", as a reason for distribution, as well as eliminating the "same desk rule" as a standard for distributions under section 401(k) plans.

>The proposed regulations also note that EGTRRA directed the Secretary of the Treasury to revise the regulations relating to distributions under section   401(k)(2)(B)(i)(IV) to provide that the period during which an employee is prohibited from making elective and employee contributions following a hardship distribution is now just six months (rather than the 12 months required under §1.401(k)-1(d)(2)(iv)(B)(4) of the existing regulations).

>Regulators specifically requested feedback on whether a change in status from employee to leased employee described in section 414(n) should be treated as a severance from employment that would permit a distribution to be made.    Additionally, the proposed regulations do not include reference to "retirement" (included in the existing regulation) as an event allowing distribution because retirement is not listed in the statute, and is subsumed by severance from employment, according to the announcement.  

Hardship Course

>Regulators noted that, in addition to the statutory changes, the rules relating to hardship distributions have been reorganized in order to clarify certain ambiguities - including the relationship between the generally applicable rules, employee representations, and the safe harbors provided under the existing regulations.  

>While the existing regulations set forth two basic requirements (an immediate and heavy financial need, and that the distribution is necessary to satisfy that need) followed by safe harbor provisions.   The proposed regulations would retain those basic requirements, but would clarify that each safe harbor is separately applicable to each basic requirement.   The proposed regulations would also provide that an employee representation used for purposes of determining that a distribution is necessary must provide that the need cannot reasonably be relieved by any available distribution or nontaxable plan loan (even if the distribution or loan would not be sufficient to satisfy the financial need).   However, the representation does not need to provide that a loan from a commercial source will be taken if no such loan "in an amount sufficient to satisfy the need is available on reasonable commercial terms."

The proposed regulations would also modify the existing regulations to add other types of defined contribution plans to the list of plans that an employer may maintain after the termination of the plan that contains the qualified CODA while still providing for distribution of elective contributions upon plan termination, to include not only an ESOP and a SEP, but also a SIMPLE IRA plan, a plan or contract that satisfies section 403(b) and a section 457 plan.

>Noting that the IRS and Treasury have been concerned that employers have been making high percentage qualified non-elective contributions (QNECs) to a small number of employees with low compensation rather than providing contributions to a broader group of NHCEs in order to pass the ADP test, the proposed regulations would add a new requirement that is designed to limit the use of targeted QNECs.  

>The new requirement would generally treat a plan as providing impermissibly targeted QNECs if less than half of all NHCEs are receiving QNECs and would also treat a QNEC as impermissibly targeted if the contribution is more than double the QNECs other non-highly compensated employees are receiving, when expressed as a percentage of compensation, according to the regulations.   However, QNECs that do not exceed 5% of compensation are never treated as targeted and would always satisfy the new requirement.   The regulations also provide guidance on the implementation of this new restriction.

>Additionally, under the existing regulations, a plan that receives a plan-to-plan transfer that includes elective contributions, QNECs, or QMACs, must provide that the restrictions on withdrawals continue after the transfer.    The proposed regulations make explicit a requirement that the transferor plan will fail to comply with the restrictions on withdrawals if it transfers elective contributions, QNECs, or QMACs to a plan that does not provide for these restrictions.    However, a transferor plan will not fail to comply with this requirement if it reasonably concludes that the transferee plan provides for restrictions on withdrawals.  

Nondiscrimination Notice

>The proposed regulations say that a plan must provide for satisfaction of one of the specific nondiscrimination alternatives described in section 401(k), either by incorporating by reference the ADP test of section 401(k)(3) and the regulations under proposed §1.401(k)-2, if that is the nondiscrimination alternative being used (i.e. the current year testing method or prior year testing method, which type of safe harbor).   If, with respect to the nondiscrimination alternative being used there are optional choices, the plan must provide which of the optional choices will apply, according to the regulations.

>As per the Small Business Job Protection Act, the proposed regulations eliminate the provision prohibiting a tax-exempt employer from adopting a section 401(k) plan.   Additionally, the proposed regulations clarify that a partnership is permitted to maintain a CODA, and individual partners are permitted to make cash or deferred elections with respect to compensation attributable to services rendered to the entity, under the same rules that apply to common-law employees - a rule that the new proposal extends to sole proprietors.

>The regulations are proposed to apply for plan years beginning no sooner than 12 months after publication of final regulations in the Federal Register.    However, it is anticipated that the preamble for the final regulations will permit plan sponsors to implement the final regulations for the first plan year beginning after publication of final regulations in the Federal Register.  

>You can read the regulations in their entirety at .