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IRS Rules Curb Some 401(k) Plan Contributions

January 28, 2005
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Related Topics: Retirement/Pensions, Featured Article, Compensation
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Final Internal Revenue Service 401(k) rules curb a low-cost approach that some employers have used to allow higher-paid employees to contribute more to 401(k) plans and still enable the plans to pass nondiscrimination tests.

    The rules also broaden the list of situations in which employees can make so-called hardship withdrawals from the plans. The rules now bar normal distributions, though, when an employee terminates employment but then immediately resumes work for his or her former employer through an employee leasing arrangement.

    In addition, the final rules make clear that employers cannot advance or prefund 401(k) contributions, which is a position that the IRS had already been taking in audits of 401(k) plans, experts say.

    The final regulations, published late December 2004, mark the first time in more than a decade that the IRS has issued comprehensive regulations on 401(k) plans, which are, by far, the most widespread type of defined contribution plan. As of the end of 2003, nearly 50 million people were enrolled in about 435,000 401(k) plans, according to the Employee Benefit Research Institute in Washington.

    Since the IRS issued its last set of comprehensive regulations in 1994, Congress has passed numerous measures affecting the plans, including changing nondiscrimination testing methodology, permitting older employees to make additional contributions to 401(k) plans and allowing tax-exempt organizations to offer 401(k) plans.

    As Congress has enacted 401(k)-related measures, the IRS has issued an array of notices and rulings to provide guidance on the laws. It also has issued many notices dealing with other 401(k) issues.

    By issuing comprehensive regulations, which total 237 pages, the IRS has centralized those numerous rulings and guidance.

    "They have meshed out a lot of things and put it in one place," said Fred Rumack, director of tax and legal services in New York for Mellon's Human Resources & Investor Solutions.

    The final rules retain an earlier IRS proposal to curb a technique that a small percentage of employers have used in recent years to enable higher-compensated employees to make the maximum salary deferral to their plans allowed under law with the plans still passing nondiscrimination tests even though average salary deferrals by rank-and-file employees are low.

    The technique, known as "bottoming up," involves employers making voluntary contributions to their 401(k) plans on behalf of only their lowest-paid employees. By making such contributions, which can be as much as 100 percent of an employee's compensation, the average deferral rate of all rank-and-file employees can rise dramatically.

    Achieving that result, in turn, aids highly compensated employees, because their ability to make the maximum annual contribution--currently $14,000--to 401(k) plans depend on the deferral rates of rank-and-file employees.

    Under law, the difference in average salary deferrals of higher-paid employees-measured as a percentage of pay-generally can exceed the average deferrals of rank-and-file employees by no more than two percentage points. The purpose of this rule is to ensure that participation in the plan is not unduly skewed in favor of higher-paid employees.

    In a bottom-up approach, because the employees selected to receive employer contributions are very low paid, even a small employer contribution can significantly boost their contribution rate--measured as a percentage of pay--along with that of the entire group of lower-paid employees.

    "It was a relatively low-cost way to pass the nondiscrimination test," Mr. Rumack said.

    Still, while the cost may have been low, relatively few employers used it, 401(k) experts say.

    "For a lot of employers, it just didn't feel right," said Michael Weddell, a consultant in the Southfield, Mich., office of Watson Wyatt Worldwide. "Providing a windfall to a handful of the lowest-paid employees didn't seem like a very strategic way to allocate dollars," Mr. Weddell added.

    According to the IRS, the bottom-up approach, which it describes as "targeting," "undermines the integrity" of nondiscrimination testing and flies in the face of congressional intent.

    The final rules do permit employers to provide voluntary contributions for nondiscrimination testing purposes to whatever number of very low-paid employees they choose, but only if those contributions do not exceed 5 percent of any employee's compensation.

    Contributions exceeding 5 percent of pay still could be counted in running the nondiscrimination test, but only if a two-prong test is satisfied: the contributions must be provided to at least half of lower-paid employees, and the highest contribution, as a percentage of pay, to any low-paid employee can be no greater than twice as much as the lowest contribution.

    While the new restrictions might not kill bottoming up, they will reduce the appeal of the approach.

    "It makes it a lot more costly," said Dan Schwallie, a consultant in the Cleveland office of Hewitt Associates Inc.

    Other provisions in the final regulations include:

  • The list of situations in which 401(k) plan participants can make hardship withdrawals from the plans has been broadened to include funeral expenses and damage repairs to an employee's principal residence.

  • Employers generally cannot prefund matching contributions. "An employer is not able to prefund elective contributions in order to accelerate the deductions," the IRS said.

  • Employees who terminate employment and immediately become leased employees working for the same employer are not eligible to receive their 401(k) account balances. In that situation, the IRS said, there has been no severance of employment.

From the January 24 issue ofBusiness Insurance. Written by Jerry Geisel.

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