Select-group qualified nonelective contributions.

• Author: Cvach, Gary Q.

Pensions

The sponsor of a Sec. 401(k) plan may be able to avoid making distributions to highly compensated employees (HCEs) under the actual deferral percentage (ADP) test or under the actual contributions percentage (ACP) test by making qualified nonelective contributions (QNECs) to a select group of very low-paid employees. The difference in cost between giving a QNEC to all nonhighly compensated employees (NHCEs) and giving the QNEC to just a select group can be significant, making the latter worthwhile. This technique can also be used in the IRS correction programs, significantly reducing the cost of correction.

Background

The Tax Reform Act of 1986 (TRA) significantly changed the rules for Sec. 401 (k) plans. Most obviously, the TRA added Sec. 402(g), limiting elective contributions made to Sec. 401 (k), Sec. 403(b) and other elective plans to $7,000. The TRA also tightened the ADP test, added the ACP test (for employee after-tax and matching contributions), and codified the right to correct failures of the ADP and ACP test with QNECs.

The ADP test permits a disparity between the elective contributions made by HCEs and NHCEs equal to the greater of

--1.25 X NHCE average deferral percentage, or --the lesser of 2 percentage points + NHCE average deferral percentage or 2 X NHCE average deferral percentage.

The ACP test is numerically the same as the ADP test but measures the disparity between the matching contributions and after-tax employee contributions for HCEs and NHCEs. For most plans, the maximum disparity between the HCEs and the NHCEs in either test is two percentage points above the NHCE average deferral percentage. In addition, if the employer must satisfy both the ADP and the ACP tests, the employer may also have to satisfy a third test--the multiple use test--which essentially allows the employer to use the more generous 2+/2x test only once, in either the ADP or the ACP test.

The ADP and ACP tests are run at the end of the plan year. If a plan does not satisfy the ADP or ACP test, the employer can either make distributions to HCEs (to reduce the HCE average to the level permitted under the test) or make QNECs to the NHCEs (to increase the NHCE average to the level needed to sustain the HCE average). QNECs and distributions may be made any time during the year following the year being tested. However, if the corrections are made by distribution, and the distribution is made more than 2 1/2 months after the end of the plan...