Current developments: this two-part article provides an overview of current developments in employee benefits, including executive compensation, welfare benefits and retirement plan requirements. Part II focuses on qualified plans and welfare benefits.

• Author: Walker, Deborah
• Position: Part 2

EXECUTIVE SUMMARY

* The IRS issued regulations effective in 2006 on Sec. 401(k) cash-or-deferred arrangements, including rules on ADP tests, QNECs and designated Roth contributions.

* The DOL issued guidance on missing participants, abandoned defined-contribution plans and the simplified VFC Program.

* The Service offered additional clarification on HSAs, HRAs and MRAs provided through profit-sharing plans.

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This two-part article covers the most significant developments in employee benefits and pensions in the past year. Part I, in the November 2005 issue, focused on executive compensation and certain fringe benefits. As noted therein, the American Jobs Creation Act of 2004 made far-reaching changes to the rules on executive compensation and certain welfare benefits. Part II, below, focuses on updates and changes in the rules on qualified retirement plans and the taxation of welfare benefits.

Qualified Plans

Sec. 401(k) Cash-or-Deferred Regs.

On Dec. 29, 2004, the IRS published final Sec. 401 (k) regulations, effective for plan years beginning after 2005. (33) Plan sponsors may, however, apply them to plan years ending after Dec. 29, 2004, as long as they apply such rules for that plan year and all subsequent plan years.

The new regulations confirm that plan sponsors can make elective deferrals a default option for employees who fail to make an affirmative election to receive cash. The default compensation reduction percentage can be set at any level permitted by the plan's terms, does not have to be tied to the plan's matching contributions and can have scheduled increases as long as the schedule is properly disclosed.

Under the final regulations, a contribution is made pursuant to a cash-or-deferred election only if it is made after (1) the relevant election and (2) the employee's performance of services relating to the compensation that otherwise (but for the election) would have been paid to the employee. Thus, employers may not pre-fund elective contributions to accelerate their deductions (consistent with the IRS's position in Rev. Rul. 2002-46, (34) but overturning the guidance in Notice 2002-4835). An exception applies when contributions for a pay period are occasionally made before services are performed, (1) to accommodate bona fide administrative considerations and (2) without a principal purpose of accelerating deductions. For these rules, partners (or other self-employed individuals) are not precluded from making elective contributions during the year.

ADP tests: The regulations require Sec. 401(k) plans to satisfy either the actual deferral percentage (ADP) test or the alternative safe-harbor method. Plans :nay incorporate the ADP test by reference, but must specify whether they are using a current- or prior-year testing method. Plans must specify whether the safe-harbor contribution will be the nonelective or the matching safe-harbor contribution. Additionally, plans using the safe-harbor method as of the beginning of a plan year cannot use ADP testing if the safe-harbor requirements are not met and, generally, plans cannot be amended in the middle of the plan year to revert to ADP testing for that year. Similar rules apply to the actual contribution percentage (ACP) test and safe harbor, if relevant.

QNECs: The regulations are also designed to curb the use of qualified nonelective contributions (QNECs) for non-highly-compensated employees (NHCEs) with the lowest compensation, to pass the ADP or ACP test. This technique made it possible for employers to correct a testing failure by contributing small amounts to NHCEs with very low compensation for the plan year. Under the new regulations, targeted QNECs may not be counted for ADP or ACP testing purposes to the extent they are more than double the QNECs that at least 50% of the other NHCEs are receiving, when expressed as a percentage of compensation.

Hardship distributions include distributions used for certain postsecondary education expenses for an employee or his or her spouse or dependents, and burial or funeral expenses for the employee's deceased parent, spouse or dependents. The new regulations clarify that, for purpose of the hardship distribution rules for education and funeral expenses, the term "dependent" is to be applied without reference to the otherwise applicable Sec. 152 gross income limit for "qualifying relatives."

Designated Roth Contributions

Beginning in 2006, employers will be permitted to give their employees the option of making designated Roth contributions to their Sec. 401(k) plans. A designated Roth contribution will be treated like a contribution to a Roth IRA. Thus, it will be subject to income and employment taxes at the point of contribution, but subsequent distributions of these contributions--and any related earnings--will not be taxed if certain requirements are met. Designated Roth contributions will be subject to the Sec. 402(g) limit on elective deferrals ($15,000 in 2006), instead of the Sec. 219(b) limit on contributions to Roth IRAs ($4,000 in 2006). All participants, regardless of income, will be eligible to make designated Roth contributions.

Prop. Regs.: On March 2, 2005, the IRS issued proposed guidance for Roth Sec. 401(k) features. (36) These rules would require employees to irrevocably designate elective deferrals as Roth contributions at the time of the cash-or-deferred election. Employees could change or revoke the designation only for future deferrals.

Plans will have to specify the extent to which participants can designate elective deferrals as Roth contributions and keep designated Roth contributions-including earnings attributable thereon--in separate accounts. The proposed regulations also would clarify that this separate accounting requirement begins when the contribution is made to the plan and continues until all assets in the designated Roth account have been distributed. The rules would require plans to maintain a record of each employee's investment in the contract (i.e., designated Roth contributions that have not been distributed), and to allocate gains, losses and other credits or charges to each employee's designated Roth account and other accounts under the plan, on "a reasonable and consistent basis." The proposed regulations would prohibit forfeitures from being allocated to designated Roth accounts.

Designated Roth contributions will be subject to the same requirements as other elective deferrals to Sec. 401(k) plans. The proposed regulations specify that designated Roth contributions will be immediately nonforfeitable and subject to the Sec. 401(k)(2)(B) restrictions on distributions and Sec. 40 l(a)(9) minimum required distribution rules. Direct rollovers of designated Roth contributions will be possible, but only to another designated Roth account or a Roth IRA.

The proposed regulations would also provide that designated Roth contributions are elective contributions for ADP test purposes. For a plan that uses corrective distributions of excess contributions to cure a failed ADP test, the proposed regulations would permit highly compensated employees (H C E s) to elect whether excess contributions are attributable to designated Roth contributions or to pre-tax elective deferrals. Any corrective distributions of excess contributions attributable to designated Roth...