WASHINGTON -- The Internal Revenue Service is removing a major administrative hassle and expense for employers that want to offer generous 401(k) plans that are exempt from non-discrimination tests.
Under IRS Notice 2000-3 released this month, employers can satisfy "safe harbors" under federal law simply by matching employees' salary deferrals on the basis of employees' compensation for a payroll period, such as every two weeks or every month. No additional calculations or contributions would be required.
Under a 1996 federal law that went into effect last year, employers offering plans with rich contribution formulas that meet or exceed one of two "safe harbors" are not required to go through the time and expense of running non-discrimination tests on the plans. Plans meeting those safe harbors are automatically considered non-discriminatory.
To meet the safe harbors, employers must either contribute to the 401(k) plan at least 3% of compensation for each eligible non-highly compensated employee; or match 100% of employees' deferrals, up to at least the first 3% of compensation, and 50% of employees' contributions up to the next 2% of compensation.
But a 1998 IRS notice providing guidance on the safe harbors added new cost and administrative complications.
Added complication
Under that notice, employers' matching contributions had to satisfy the safe harbor based on employees' compensation for the entire year. Problems could occur, though, when employees during a part of the year deferred more than was needed to get a full employer match and, at other times, deferred less than was needed for the full match.
In such situations, employers' matching contributions for the full year could fall short of the percentage needed to satisfy the safe harbor. The result: Employers would have to "true up," or kick in an additional contribution.
"It was a real mess and certainly discouraged some companies from offering the plans," said Dennis Coleman, a principal at PwC Kwasha in Teaneck, N.J.
The new notice eliminates that complication.
For example, if an employer agrees to match for every payroll period 100% of employees' salary deferrals, up to the first 4% of employees' compensation, an employer would not need to make additional contributions at the end of the year for employees, who, for instance, defer 6% of pay during the first half of the year and nothing during the second half.
"If you match on the basis of payroll periods, you don't have to true up. That was a real concern from a cost and administrative perspective," Mr. Coleman said.
When the plans were authorized in 1996, legislators reasoned the tradeoff they set for having a safe-harbor plan -- mandating generous employer contributions but exempting employers making those contributions from running non-discrimination tests -- would appeal to companies.
To date, though, only a small percentage of employers with 401(k) plans -- perhaps 5%, according to benefit consultants -- have upgraded their plans to meet the safe harbors.
That is because for most employers, the cost of qualifying for the safe harbors is too high. In addition to the rich contribution requirements, employer contributions must vest immediately.
Few 401(k) plans, however, are that generous. The most common matching feature, according to a Hewitt Associates LLC survey, is one in which employers match 50% of employees' deferrals, up to 6% of pay.
In addition, it is rare for matching contributions to vest immediately, with three- or five-year schedules more common.
Less expense, hassle
Still, for employers already providing generous 401(k) plans, offering a plan that met the safe harbors did not add to costs and removed the expense and hassles of running non-discrimination tests.
The requirements laid down by the 1998 notice, chiefly the potential need to true-up matching contributions, may have deterred some employers, however, from using the safe harbors.
"There was an additional financial and administrative cost" attached to true-ups, said Frank Roque, a Hewitt consultant in Lincolnshire, Ill.
Eliminating the true-up is just one of several changes in the 401(k) safe-harbor plan arena the IRS has made in the new notice. Other changes include:
* Giving employers more time to make final decisions during a plan year on whether they will offer safe-harbor plans.
* Allowing employers with safe-harbor plans to require employees' salary deferrals to be made in whole dollar amounts or whole percentages of pay.
* Permitting employers to provide 401(k) safe-harbor notices electronically to employees.
In addition, in an issue not related to safe-harbor plans, the IRS said it would like public comment on ways of simplifying non-discrimination testing in plans that have both pre-tax and after-tax contribution options.
"The IRS has gotten rid of some picky little traps. The general tone of the guidance is very helpful," said Michael Weddell, a consultant in the Southfield, Mich., office of Watson Wyatt Worldwide.
