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IRS Permits Mid-Year Suspension of Safe-Harbor Nonelective Contributions

Since 1999, employers sponsoring Section 401(k) plans have been able to avoid ADP/ACP nondiscrimination testing (and the possibility of refunds to highly compensated employees in the event of a testing failure) by providing an annual notice to employees and making fully vested “safe-harbor” employer contributions. These “safe-harbor” contributions — which must be made on behalf of all eligible non-highly compensated employees — may be structured as either (i) matching contributions (which generally must total at least 4% of pay for those who defer at least 5% of pay) or (ii) non- matching contributions (referred to by the IRS as “nonelective” contributions) of at least 3% of pay.

Under current IRS regulations, employers generally may not reduce or suspend the safe-harbor contributions in the middle of the plan year unless the entire plan is being terminated. There is a special rule for plans using the safe-harbor matching formula that allows the employer to reduce or eliminate the safe-harbor match in mid-year (and treat the plan as if it were not a safe-harbor plan for that year) if the employer provides a timely notice to employees and takes certain other steps set forth in the regulations. However, there is currently no similar rule for plans that make nonelective safe-harbor contributions.

On May 18, 2009, the IRS issued proposed amendments to the 401(k) regulations that would permit a mid-year suspension or reduction of safe-harbor nonelective contributions under rules similar to the current exception for safe-harbor matching plans, but only in the event the employer is incurring a “substantial business hardship.” These regulations now provide employers that are sponsoring nonelective safe-harbor plans (and experiencing significant financial issues) an alternative to terminating their plans.

In order to suspend or reduce safe-harbor nonelective contributions in the middle of the plan year, the plan sponsor must:

  • Be incurring a “substantial business hardship” comparable to a hardship described in the minimum funding rules under Code Section 412(c) (e.g., the employer is operating at an economic loss, or there is substantial unemployment in the employer’s industry, or sales and profits in the employer’s industry are depressed or declining);

  • Adopt a plan amendment to prospectively reduce or eliminate the nonelective contribution, and to provide that the plan will be required to satisfy the ADP/ACP nondiscrimination tests for the entire plan year;

  • Make the amendment effective no earlier than 30 days after eligible employees are provided a notice that includes (i) the consequences of the amendment reducing the nonelective contribution, (ii) the procedure to change deferrals under the plan, and (iii) the effective date of the amendment;

  • Provide employees a reasonable opportunity, prior to the effective date of the reduction or suspension of the nonelective contributions, to change their elective deferrals (this requirement is presumably met if employees are given at least 30 days to freely change their elections);

  • Perform ADP/ACP tests on deferrals and matching contributions (and/or employee after-tax contributions, if any) for the entire plan year, and make refunds to highly compensated employees (or other corrective contributions) as necessary;

  • Make any required “top-heavy” contributions for the plan year; and

  • Make the required nonelective contribution with respect to compensation earned prior to the effective date of the amendment (for this purpose, the $245,000 limit on compensation that may be taken into account under the plan must be pro-rated for the portion of the plan year for which the employer is making the nonelective contribution).

Although these are only “proposed” changes to the 401(k) regulations, the IRS has specifically indicated that they may be relied on pending issuance of final regulations. Thus, employers that are currently incurring a substantial business hardship need not wait until January 1, 2010 (or resort to complete termination of the plan) to reduce or suspend nonelective contributions under their safe-harbor 401(k) plans.

If you have any questions about the legality of making mid-year changes to your qualified retirement plan, please feel free to contact any member of Spencer Fane’s Employee Benefits Group.