As a late development, the Treasury and IRS have issued final rules that permit mid-year suspension or reduction of employer contributions under safe harbor 401(k) plans. The final rules liberalize and expand 2009 proposed rules for plans with non-elective contribution designs, and add a new requirement for plans with matching contribution designs. Employers with safe harbor 401(k) plans will need to modify their participant safe harbor notices to preserve maximum flexibility to change contributions mid-year. The new rules also appear to signal that the IRS will be developing guidance in the future on the effect of other types of mid-year changes to a safe harbor 401(k) plan design.
Safe Harbor Designs and Conditions
Section 401(k) plans are generally required to perform annual tests designed to ensure that contributions do not discriminate in favor of highly compensated employees. The “average deferral percentage” (ADP) test applies to employee pre-tax salary deferral contributions and the “average contribution percentage” (ACP) test applies to employee after-tax and employer matching contributions. Plans are exempt from these tests to the extent they meet the conditions of certain “safe harbor” plan designs.
There are two safe harbor designs that exempt a plan from ADP testing. Under the first, all eligible employees must annually receive an employer non-elective contribution of 3 percent of each eligible employee’s compensation, whether or not the employee makes any elective deferrals (the non-elective contribution design). Under the second alternative, eligible employees must receive a prescribed level of employer matching contributions (the matching contribution design).
A plan that is structured to meet the non-elective contribution design or the matching contribution design will also generally be exempt from ACP testing if certain additional conditions are met, including limiting matching contributions to no more than 6 percent of a participant’s compensation.
Each safe harbor contribution design is subject to a number of other conditions, including minimum eligibility requirements, immediate vesting and annually providing notices to all eligible employees that explain the plan design.
As a general matter, a safe harbor contribution formula must be adopted before the beginning of a plan year and must remain in effect through the full 12 months of that plan year. Before the issuance of the 2009 proposed rules, plans that relied on the non-elective contribution design could not be amended after the start of the plan year to suspend or reduce that contribution and instead revert to ADP or ACP. However, plans that used the matching contribution design could be amended during the year to suspend or reduce the matching contribution formula for the remainder of the plan year and revert to ADP or ACP testing provided that employees received advance notice of the change and were provided with an opportunity to change their deferral elections before the suspension or reduction of matching contributions took effect.
The 2009 Proposed Changes
In the wake of the 2008 financial crisis, the Treasury and IRS proposed rules in 2009 that would allow for mid-year suspension or reduction of employer non-elective contributions if the employer could show that the suspension or reduction was caused by the employer having experienced a “substantial business hardship.” This condition required consideration not only of the employer’s financial condition but also of whether there was substantial unemployment or declining sales and profits in the employer’s industry. Commentators noted that this standard would prevent many employers that were otherwise experiencing financial difficulties from making changes to their plans if other employers in their industry were relatively healthy.
Employers have been permitted to rely on the proposed rules pending the issuance of final rules, with the typical caveat that if, and to the extent, the final rules were more restrictive than the proposed rules, the final rules would not be applied retroactively.
The Final Rules
The final rules change the standards for suspending or reducing non-elective contributions and matching contributions under a safe harbor plan design. The final rules also include guidance in additional areas.
Non-Elective Contribution Designs
The final rules replace the substantial business hardship requirement originally proposed for non-elective contribution changes with a less strict “operating at an economic loss” standard that considers only the employer’s economic circumstances, and not conditions of its industry. Significantly, the final rules also allow for mid-year suspensions or reductions in non-elective contributions without regard to whether the employer is operating at an economic loss, provided that:
- the annual safe harbor notice distributed to participants before the start of the year includes a statement advising participants that the employer could suspend or reduce those contributions during the year;
- the suspension or reduction will not take effect until the participants receive notice of the change at least 30 days in advance; and
- certain other requirements are met, such as providing participants with a reasonable opportunity after notice is provided to change their salary deferral elections and having the plan meet the ADP and ACP test, as applicable, for the entire plan year using the current-year testing approach (i.e., based on current-year contribution data).
Matching Contribution Plan Designs
As under current law, employers may continue to suspend or reduce contributions mid-year under a matching contribution design. However, effective for plan years beginning on or after January 1, 2015, the employer must have included a statement in the annual safe harbor notice regarding its ability to implement such a change (as described above) or else meet the “operating at an economic loss” standard described above. The other conditions described above as to suspension of non-elective contributions also must be met.
Plan Termination Rules Clarified
The final rules also clarify the circumstances under which safe harbor plans may be terminated mid-year. First, the plan may be terminated and contributions may cease even if the annual notice does not contain information about the employer’s ability to terminate and even if the employer is not operating at an economic loss, provided that other conditions noted are met (other than the requirement to allow employees to change their deferral elections). Second, as under prior law, a safe harbor 401(k) plan may be terminated in connection with a merger, sale or similar transaction or if the employer is experiencing substantial economic hardship.
Compensation Limit Must Be Prorated
The final rules confirm the position taken in the 2009 proposed rules that if contributions are suspended mid-year under either a non-elective contribution design or a matching contribution design, the annual dollar limit on the amount of compensation that may be taken into account for a participant must be prorated. The final rules do not provide procedures for performing such a proration.
Additional Flexibility May Be Forthcoming
The final rules provide the IRS with the ability to develop rules for other circumstances in which mid-year changes under a safe harbor plan design would be permissible, such as in the case of a mid-year merger or sale involving the employer. This may be a platform for the IRS to address questions that have arisen in recent years concerning other types of mid-year changes to safe harbor plans and their potential impact on the plan’s ability to maintain its safe harbor status.
The final rules generally apply to plan amendments adopted after May 18, 2009, the effective date specified in the proposed rules. However, the changes to the existing rules on mid-year reductions or suspensions of matching contributions apply for plan years beginning on or after January 1, 2015.
Key Take-Aways for Employers
Employers sponsoring safe harbor plans — whether based on non-elective or matching contribution design — should begin including language in their annual safe harbor notices regarding the ability to suspend or reduce contributions mid-year. Including such language will provide the employer with maximum flexibility to make mid-year contribution changes.
Employers should carefully consider all the consequences of suspending or reducing contributions before doing so. In addition to the compensation limit proration noted above, the plan will be subject to top-heavy testing and ADP and/or ACP testing, as applicable. As a result, amounts already allocated to highly compensated employees’ accounts may need to be reduced. Such a change could also have ancillary effects on other plans that should be carefully considered, such as non-qualified deferred compensation plans maintained by the employer.