Update: Final Regulations Issued
On Nov. 15, 2013, the IRS issued final regulations on mid-year reductions or suspensions of “safe harbor” contributions made to 401(k) plans, revising the proposed regulations issued in May 2009. Safe-harbor notices may need to be revised. See the SHRM Online article "Final Regulations on Suspending 401(k) Safe-Harbor Contributions."
The article below is based on compliance with the proposed regulations.
Employer-sponsored 401(k) plans often include employer contributions through a variety of funding mechanisms, including matching contributions on employee deferrals, nonelective contributions that aren't dependent on what employees contribute, and discretionary contributions that are optional and usually made at the end of the plan year as a form of profit-sharing.
It's estimated that more than 90 percent of 401(k) plans provide some form of employer contributions. The associated costs can be significant.
In tough economic times, many employers are seeking to cut compensation-related costs; employer contributions to 401(k) plans are an obvious target. While reducing employer contributions can hurt employee morale, it is sometimes a better option for reducing labor costs than furloughs and layoffs, for example. (See Suspend the 401(k) Match? Issues to Weigh, Pitfalls to Avoid.)
Here are the most practical options for employers to reduce or suspend contributions before the end of a plan year:
• Midyear modifications to a safe harbor and non-safe harbor 401(k) plan.
• The exercise of the employer’s discretion, where appropriate, to eliminate contributions.
• Plan termination.
A key issue for employers with respect to each option is the distribution of timely, clearly written notices to participants.
Safe Harbor 401(k) Plans
The Internal Revenue Code includes various rules designed to ensure that 401(k) plans do not discriminate in favor of highly compensated employees (HCEs), generally employees who earned in excess of $110,000 from their employer in 2009. Therefore, 401(k) plans generally must satisfy an actual deferral percentage (ADP) test with respect to employee pretax elective contributions and an actual contribution percentage (ACP) test with respect to employer matching and employee after-tax contributions.
The ADP and ACP tests are intended to preclude a plan that is nondiscriminatory on its face from providing disproportionately large benefits to HCEs. To alleviate the potential burdens associated with compliance (which can be quite complex to administer), the code provides “safe harbor” alternatives that eliminate the need for these tests.
The potential employer contributions associated with these safe harbors are:
1. A nonelective contribution equal to at least 3 percent of each non-highly compensated employee’s (NHCE) compensation or
2. A matching contribution at least equal to the sum of 100 percent of the participating NHCE’s elective contributions, up to 3 percent of compensation, plus 50 percent of the NHCE’s elective contributions between 3 percent and 5 percent of compensation.
The nonelective contribution safe harbor will result in a fixed employer contribution of 3 percent for each NHCE (independent of elective contributions), while the matching contribution safe harbor may result in a maximum employer contribution of 4 percent (depending on the amount of elective contributions by NHCEs).
The ADP and ACP safe harbors require that the employer provide written notice to all eligible employees. The notice generally must be provided at least 30 days (and no more than 90 days) before the beginning of each plan year and must be sufficiently accurate and comprehensive to inform employees of their rights and obligations. The notice must be written in a manner calculated to be understood by the typical eligible employee. This advance notice advises eligible employees of the 401(k) plan’s safe harbor provisions and allows them to decide whether to make elective contributions. In addition, all safe harbor contributions must be fully vested at all times (unlike other employer contributions, which might be subject to vesting schedules).
Reducing or Suspending Safe Harbor Matching Contributions
Employers using the matching contribution safe harbor are permitted to reduce or suspend such matching contributions during a plan year, provided that:
1. All eligible employees are provided with a supplemental notice, which explains the consequences of the plan amendment that reduces or suspends matching contributions on future employee elective contributions, the procedures for changing their elective contribution elections and the effective date of the amendment.
2. The reduction or suspension of safe harbor matching contributions is effective no earlier than the later of 30 days after eligible employees are provided the supplemental notice and the amendment is adopted.
3. Eligible employees are given a reasonable opportunity prior to the reduction or suspension of safe harbor matching contributions to change their elective contributions to the 401(k) plan.
4. The plan is amended to provide that the ADP/ACP tests will be satisfied for the entire plan year in which the reduction or suspension occurs using the plan’s current year testing method.
5. The requirements for the safe harbor have been satisfied for the period through the effective date of the amendment.
Providing timely, clearly written notices to employees is a key component to the reduction or suspension in safe harbor matching contributions.
Reducing or Suspending Nonelective Contributions
In general, the nonelective contribution may not be eliminated during a plan year. However, effective May 18, 2009, Treasury regulations provide that an employer that incurs a substantial business hardship may reduce or suspend safe harbor nonelective contributions during a plan year. The regulations were designed to provide an employer with an alternative to the option of terminating the safe harbor plan because of the substantial business hardship. The substantial business hardship requirement is defined under tax code section 412(c), which applies a facts-and-circumstances analysis. Relevant facts include whether the employer is operating at an economic loss and whether there is substantial unemployment in the employer’s industry.
Besides the substantial business hardship requirement and the May 18, 2009, effective date, the reduction or suspension of safe harbor nonelective contributions is subject to the same basic rules as those applying to safe harbor matching contributions: the reduction or suspension of safe harbor matching and nonelective contributions can be effective no earlier than the later of 30 days after the notice is provided to all eligible employees and the date the amendment is adopted. Consequently, employers wishing to reduce or suspend safe harbor contributions during a plan year should act quickly and not wait until the end of the plan year. A year-end amendment will not achieve the desired reduction or suspension for the current plan year, and such an amendment, if applied retroactively, could jeopardize the tax-qualified status of the plan.
Non-Safe Harbor 401(k) Plans
Greater flexibility is generally available to employers wishing to reduce or suspend the stated employer contributions under a non-safe harbor 401(k) plan because the potentially burdensome safe harbor notice requirements are not applicable. A non-safe harbor 401(k) plan generally may be amended to suspend or reduce employer contributions (nonelective or matching) at any time on a prospective basis. For example, a 401(k) plan could be amended on Sept. 15, 2009, to provide that employer matching contributions will no longer be made effective Oct. 1, 2009.
An important concept for employers to consider is the individual 401(k) plan’s provisions regarding eligibility for the employer contributions. If an employee has already satisfied the requirements to receive an employer contribution, that right cannot be eliminated retroactively.
If an employee has already satisfied requirements
to receive an employer contribution, that right
cannot be eliminated retroactively.
For example, many 401(k) plans include a requirement that the participant work at least 1,000 hours of service during the plan year and that the participant be employed on the last day of the plan year in order to be eligible for the employer contribution. Generally, such plans may be amended before the last day of the plan year to remove the employer contributions. However, if the 401(k) plan contains a requirement for 1,000 hours of service but does not contain a “last day of the plan year” requirement, then the plan may still be amended to remove the employer contributions, but those employees who have already qualified for the contribution (i.e., exceeded 1,000 hours of service) will still be entitled to the employer contribution. In other words, the employer may not remove contributions from participants who have already qualified for the contribution.
In addition, it is not uncommon for 401(k) plans to include exceptions to the “last day of the plan year” requirement for participants that became disabled or retired (e.g., after the attainment of age 55) during the plan year. In this case, the 401(k) plan may not be amended to eliminate the employer contribution for a participant who satisfied this requirement by becoming disabled or retiring before the amendment is adopted.
While notice to employees about reducing or suspending employer contributions to the plan may not be specifically required by the tax code, such notice should be provided as soon as possible in order to maintain good will between employees and the employer and to comply with fiduciary responsibility rules under the Employee Retirement Income Security Act (ERISA). While employees are still likely to be upset, a timely, clearly written notice provided as far in advance as possible might be helpful in alleviating employees’ disappointment.
Discretionary Employer Contributions
Reducing or suspending discretionary employer contributions is far simpler than reducing or suspending nonelective or matching employer contributions because such contributions are by their nature optional. Therefore, the employer is free to exercise its discretion to make or not make such contributions.
Participants in a 401(k) plan with discretionary employer contributions should know such contributions are discretionary and may not be made for each plan year. This should be laid out clearly to participants in the plan’s summary plan description.
Remind participants in a 401(k) plan with discretionary
employer contributions that these may not be made
for every plan year.
Especially for organizations that traditionally have made discretionary employer contributions, it is a good practice to notify participants if such contributions will not be made for the current plan year. While providing such notice is not required under the tax code, participants will likely be appreciative (or at least less disappointed) if they are informed prior to the close of the plan year.
401(k) Plan Termination
The termination of a 401(k) plan will serve to remove the employer’s contribution requirements (whether nonelective or matching) as of the termination date (subject to the caveats noted above for employees who have already met all of the requirements to receive a contribution). The termination of a 401(k) plan is relatively simple compared to the termination of a defined benefit pension plan because it is not governed by Title IV of ERISA.
Terminating 401(k) plans is typically done through the adoption of board resolutions or following other plan termination procedures in the individual plan document. Following the effective date of plan termination, no employer or employee contributions may be made with respect to compensation earned after that date.
An important restriction on distributions from a 401(k) plan following its termination is the tax code’s prohibition on the distribution of employee 401(k) contributions on a plan’s termination if the employer maintains an “alternative defined contribution plan.” A plan is an “alternative defined contribution plan” if it exists at any time during the period beginning on the date of plan termination and ending 12 months after distribution of all assets from the terminated plan. This distribution restriction does not apply to employer contributions.
Because of this rule, which in effect precludes any “successor” plan for at least 12 months, employers typically are reluctant to terminate plans except in unusual circumstances (e.g., in connection with a sale of the employer to a third party).
While the notice of intent to terminate that is associated with defined benefit pension plans is not required with respect to a 401(k) plan, it is advisable to notify employees of an imminent 401(k) plan termination as soon as possible.
There are several options available for an employer looking to reduce or suspend its contributions to a 401(k) plan. Specifically, the plan (whether safe harbor or non-safe harbor) may be amended to reduce or suspend the employer contributions, the employer may exercise its discretion with respect to employer contributions (where appropriate) and the plan may be terminated. In all events, the specific terms of the plan at issue must be reviewed carefully before any action is taken.
No matter which option is chosen, the distribution of timely, clearly written communications with employees is essential to ensure that they are aware of the pending reduction or suspension in employer contributions and the associated time frame. While such reductions or suspensions might be temporary, providing strong employee communications can help maintain employee participation during this period.
Timothy B. Collins and W. Michael Gradisek are attorneys based in Philadelphia with the law firm Duane Morris LLP. Mr. Gradisek chairs the firm's Employee Benefits and Executive Compensation practice.
© 2009 Duane Morris LLP. All Rights Reserved.
This article should not be construed as legal advice.
IRS Proposes Allowing Safe Harbor 401(k)s to Suspend Nonelective Contributions, SHRM Online Benefits, May 2009
Suspend the 401(k) Match? Issues to Weigh, Pitfalls to Avoid, SHRM Online Benefits, April 2009
Most Workers Underestimate Employer's Health Benefit Costs, but Value 401(k) Matches, SHRM Online Benefits, March 2009
SHRM Online Benefits Discipline