Sec. 401(k) nondiscrimination safe harbors.

• Author: Lavenberg, Robert A.
• Position: Taxation

New design-based safe harbor methods for meeting the nondiscrimination rules for cash or deferred arrangements (CODAs) became effective Jan. 1, 1999 for calendar-year plans. These new methods, enacted by the Small Business Job Protection Act of 1996 (SBJPA), allow many organizations to adopt or expand their use of CODAs.

Prior to the SBJPA, employers maintaining a Sec. 401(k) plan had to calculate the average deferral percentage (ADP) of the highly compensated employees (HCEs) and the non-highly compensated employees (non-HCEs) for the plan year. Tests were then performed to determine whether the HCEs' deferrals were nondiscriminatory. If they were, corrections were required (e.g., return of excess amounts to the HCEs or additional employer contributions to non-HCEs' accounts). Similar testing (average contribution percentage (ACP) test) and corrections were required for employer matching contributions and employee nondeductible (after-tax) contributions.

Other SBJPA changes simplified the definition of HCEs and provided for the use of the prior plan year's nonHCE ADP and ACP test results to determine the current plan year's nondiscriminatory percentages for HCEs.

If met, the new safe harbors, Sec. 401(k)(12) and (m)(11) (added by SBJPA Section 1433), generally allow an employer to avoid the ADP and ACP tests. In October 1998, the IRS released Notice 98-52, providing additional guidance.

New Sec. 401(k)(12) provides that, if an employer makes either (1) a nonelective contribution of 3% of compensation for all eligible non-HCEs (regardless of whether they make elective contributions) or (2) non-discretionary matching contributions of 100% of the first 3% of employee elective contributions and 50% of the next 2%, the safe harbor is met for the cash or deferred portion of the plan. These contributions must be non-forfeitable, contributed within 12 months after the close of the plan year and subject to the same withdrawal rules that apply to employee elective contributions. In addition, the plan may not use the permitted disparity rules (i.e., providing additional contributions above the Social Security wage base) for safe harbor contributions.

If an employer elects the matching contribution safe harbor, the rate of any HCE matching contribution cannot exceed the rate used for any non-HCE. However, an employer may use an alternative plan design for matching contributions, as long as the matching percentage does not increase for higher deferral...