July 2000


By Mark I. Bogart

The IRS recently issued additional guidance on safe harbor requirements for 401(k) plans. Safe harbor contribution formulas became available for most 401(k) plans beginning with the 1999 plan year. By following the safe harbor rules, a plan sponsor does not have to perform the actual deferral percentage (ADP) test for pretax contributions for a plan year. Other safe harbor contribution rules enable a plan sponsor to avoid performing the actual contribution percentage (ACP) test for matching contributions for a plan year, although the ACP test still has to be performed for any after-tax employee contributions.

Many plan sponsors have considered adopting safe harbor plans because the ADP and ACP tests are complex and often limit contributions for highly compensated employees. However, the increased costs associated with safe harbor plans and the limited amount of flexibility initially provided by the IRS in 1998 deterred many plan sponsors. The revised guidance (IRS Notice 2000-3) provides plan sponsors with somewhat more flexibility. However, since the safe harbor contribution levels are a matter of law and not the IRS, they remain unchanged.

Overview of Safe Harbor Plans

Two alternative safe harbor contribution methods can be used to avoid the ADP test. For all eligible participants (or just all eligible non-highly compensated participants), a plan sponsor can either

1) make a contribution of 3% of compensation or
2) match pretax contributions at a rate of 100% of the first 3% of compensation and 50% of the next 2% of compensation. Within certain parameters, a plan sponsor can revise the matching formula, but matching contribution rates cannot be increased as the rate of pretax contributions increases. For example, a safe harbor matching contribution formula could be set at 100% of the first 4% of compensation or at 133
!d% of the first 3% of compensation. ADP safe harbor contributions must be fully vested.

If the plan sponsor uses safe harbor matching contributions for the ADP test and does not make any additional matching contributions, then the ACP test does not have to be performed for those matching contributions. Also, a higher level of matching contributions can be provided under the ACP safe harbor rules for matching contributions. The ACP safe harbor is available if

1) the plan sponsor uses one of the ADP safe harbor methods,
2) matching contributions do not exceed 6% of compensation,
3) the notice requirements for the ADP safe harbor rules (summarized below) are followed, and
4) the rate of matching contributions does not increase as the rate of pretax contributions increases. Although ACP safe harbor matching contributions do not have to be fully vested, plan sponsors could find that it does not make sense to subject them to a vesting schedule if they are used in connection with ADP safe harbor matching contributions.

For both the ADP and ACP safe harbor formulas, the 1998 IRS guidance required that

1) participants must be notified in writing of the contributions at least 30 days, and not more than 90 days, prior to the beginning of the plan year (but there was a transitional rule for the 1999 plan year),
2) participants must be provided with a reasonable period to make or change a pretax contribution election,
3) participants must be provided with flexibility in setting their pretax contribution rates to obtain the maximum match or less than the maximum match,
4) the plan's procedures for changing the rate of pretax contributions had to be explained in the notice, and
5) the plan sponsor could not discontinue the safe harbor contributions during the year. In addition, the plan document had to provide for the safe harbor contribution formula being used before the beginning of the plan year, although this rule applies only after the current remedial amendment period expires (the last day of the plan year beginning in 2000).

Recent IRS Changes to Safe Harbor Rules

The following are the highlights of the IRS's recent notice on safe harbor plans:

Extended date for certain plans adopting the 3% ADP safe harbor nonelective contribution method. Plan sponsors that want to utilize the flat 3% of compensation contribution for the ADP safe harbor now have up to 30 days before the end of the plan year to make their decision. To be able to take advantage of this new rule, the plan must

1) use the current year testing method (as opposed to the prior year method),
2) provide notices to participants prior to the beginning of the plan year indicating that the plan can be amended to provide for the 3% safe harbor contribution, and
3) provide another notice at least 30 days prior to the end of the plan year if the plan sponsor is going to make the 3% contribution. A plan sponsor that adopts such an amendment during a plan year is not required to continue making the 3% contribution for future plan years. Plan sponsors considering using this approach should also consider that some flexibility might be lost by forgoing the ability to use prior year testing. Although plan sponsors can always switch to the current year testing method, there are restrictions on switching back to the prior year testing method.

Transitional relief for plan sponsors first adopting safe harbor contributions in 2000. If the 2000 plan year is the first time that a plan sponsor utilizes safe harbor contributions, the sponsor had until May 1, 2000, to provide the required safe harbor notices to employees.

Method of providing notice. The new guidance permits plan sponsors to provide the required safe harbor notices through an electronic medium, such as an intranet. However, the electronic medium must be reasonably accessible to all employees and the employees must be informed that a written copy of the notice can be obtained upon request and at no charge. Certain aspects of the notice may now cross-reference the summary plan description.

Timing of making matching contributions. Safe harbor matching contributions can be made at year-end for contributions made during the entire plan year, or separately with respect to each payroll period, month, or quarter. If the payroll period, month, or quarter method is used, the matching contributions must be made by the last day of the following quarter. The 1998 IRS guidance also permitted the payroll approach to be used, but required a "true-up" contribution in some cases at the end of the year if the participant's year-end contribution and compensation figures resulted in additional contributions. The new guidance no longer requires this.

Eliminating matching contributions during the plan year. The new guidance permits a plan sponsor to amend its plan prospectively to eliminate safe harbor matching contributions during a plan year. However, if the sponsor does so, the plan must pass applicable ADP and ACP tests for that year under the current year testing method. In addition, employees must be given at least 30 days' advance notice of this change and the opportunity to change their pretax contribution rates. Since all other safe harbor contribution rules apply until the effective date of the amendment, the safe harbor contributions made before the amendment would continue to be subject to the safe harbor vesting rules.

Excluding certain employees from safe harbor contributions. 401(k) plans can test separately employees that have not yet attained age 21 or completed one year of service. The new guidance provides that a plan can exclude this group of employees from receiving safe harbor contributions, but the group must separately pass the ADP and ACP tests using the current year testing method. Beginning with the 1999 plan year, plans also can exclude these employees from testing entirely if they are not highly compensated. However, the new guidance does not address the availability of safe harbor contributions for these employees under a plan that excludes them from testing. Under a conservative approach, safe harbor contributions should be made available to them absent guidance to the contrary from the IRS. *

Mark I. Bogart is in the employee benefits group of Vedder Price Kaufman & Kammholz. He can be contacted at (312) 609-7878. Reprinted with permission from the Vedder, Price, Kaufman & Kammholz Employee Benefits Bulletin (April 2000).

Sheldon M. Geller, Esq.
Geller & Wind, Ltd.

Michael D. Schulman, CPA
Schulman & Company

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