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Midyear changes to 401(k) safe harbor plans sometimes are permitted when the changes are beneficial to plan participants, the Internal Revenue Service (IRS) clarified in a recent notice.
However, the notice “does not open the floodgate for changes to a 401(k) safe harbor plan,” cautioned Nicole Bogard, an attorney with Seyfarth Shaw in Atlanta. “The permitted changes are very specific with restrictions.”
For example, she noted, if the employer increases a matching contribution during the plan year, several conditions must be met. “The change would need to be adopted, the updated safe harbor notice would need to be distributed and the election period would need to be made available to the employees at least three months before the end of the plan year,” she said. “In addition, the change would need to be made retroactively for the entire plan year.”
IRS Notice 2016-16, issued Jan. 29, is “welcome relief from unnecessary angst regarding midyear amendments,” said Ann Caresani, an attorney with Tucker Ellis in Cleveland. “It allows employers to make amendments that are frequently made to nonsafe harbor plans, most of which are beneficial to employees, without worrying about whether the IRS might challenge those amendments.”
For example, an employer could make a midyear plan amendment to increase safe harbor matching contributions from 4 percent to 5 percent, retroactive to Jan. 1, and amend the plan to change from a payroll-period match calculation to an entire-plan-year match calculation, the notice stated. The employer would have to provide an updated safe harbor notice that describes the increased contribution percentage and additional election opportunity as soon as practicable.
Caresani added, “I don’t think the IRS ever had legal authority for a blanket prohibition on midyear amendments; this led to unnecessary drama.”
Yet, prior to the notice, employers “were reluctant or would not make any changes to their safe harbor 401(k) plan due to the risk of losing the plan’s safe harbor status,” Bogard noted. “Employers may now make changes to their safe harbor 401(k) plans with more certainty.”
Safe Harbor Plans
Safe harbor plans are most common in industries where employees are not highly paid and do not typically elect to contribute to their 401(k) plans or where employers have transitional workforces, Bogard said.
“In these situations, the 401(k) plan tends to fail certain nondiscrimination tests, called the average deferral percentage test—ADP test—and/or the average contribution percentage test—ACP test,” she explained.
The ADP test compares the average elective deferrals made by nonhighly paid employees and highly paid employees. The ACP test compares the matching contributions of nonhighly paid and highly paid employees.
The 401(k) plan can fail these tests if the highly paid employees are deferring too much more than the nonhighly paid employees, or if the highly paid employees have too much more of a matching contribution.
“A safe harbor 401(k) plan allows an employer to skip the ADP and ACP tests by making minimum employer contributions (e.g., 3 percent of the employee’s compensation) and minimum matching contributions to the plan,” Bogard noted. “There are additional strings attached. The participant would need to be 100 percent vested in these contributions for certain safe harbor 401(k) plan designs. And the plan would not be able to impose contribution allocation restrictions, like the employee being employed on the last day of the plan year or having 1,000 hours of service during the plan year.”
A significant hurdle to employers implementing safe harbor 401(k) plans, though, is the expensive nature of this plan design, she noted.
Safe harbor plans are usually unattractive to larger employers due to the 100 percent vesting requirement, Frank Palmieri and Lawrence Eisenberg, attorneys with Palmieri & Eisenberg in Princeton, N.J., noted in an e-mail.
That said, safe harbor plans often are attractive to smaller employers since the plans avoid the need to undertake ADP or ACP testing. “A small employer with low turnover is not concerned with 100 percent vesting since it is rewarding long-term employees with contributions. A safe harbor plan also simplifies the administration of a retirement plan, since years of service for vesting need not be tracked, no forfeitures exist and incorrect distributions should not occur,” they said.
Allen Smith, J.D., is the manager of workplace law content for SHRM. Follow him @SHRMlegaleditor.
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