On December 29, 2004, the IRS issued long awaited final regulations which provide guidance for certain cash or deferred arrangements under section 401(k) and matching contribution under section 401(m) of the Internal Revenue Code (IRC). Note, the IRC is the law and the regulations are the IRS’s interpretations of the law. The final regulations apply for plan years beginning on or after January 1, 2006.

History: The last comprehensive final regulations under section 401(k) & 401(m) of the IRC were published in August 1991 and subsequently amended in December 1994. Significant changes to these regulations were made by the Small Business Job Protection Act of 1996 (SBJPA), the Taxpayer Relief Act of 1997 (TRA 97) and the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA).

The recent final regulations are really just an opportunity for the IRS to consolidate and clarify the regulations under 401(k) and 401(m) due to tax changes from SBJPA, TRA 97 and EGTRRA. While these regulations are quite extensive, this article only covers items most commonly relevant to plan sponsors.

Qualified Nonelective Contributions: One of the most significant clarifications incorporated into the final regulations is the limited use of Pointed Qualified Nonelective Contributions (QNEC) and Qualified Matching Contribution (QMAC). Currently plan sponsors that have a plan document allowing Pointed QNEC/QMAC can contribute the necessary minimum contribution to the lowest paid employee(s) that allow the plan to pass the ADP or ACP tests. The final regulations clarify that a plan’s ability to use Pointed QNEC/QMAC is limited. A QNEC/QMAC may not be used in the Average Deferral Percentage (ADP) or Average Contribution Percentage (ACP) tests to the extent that it exceeds the product of the Nonhighly Compensated Employees’ (NHCE) compensation and the greater of 5 percent or two times the plan’s representative contribution rate. The plan’s representative contribution rate is the greater of the lowest contribution rate in a group consisting of half of all eligible NHCE or the lowest contribution rate of any eligible NHCE employed on the last day of the plan year.

Expanded Hardship Provisions: The final regulations add two new provisions to the standard four hardship provisions of: (1) payment of expenses for medical care, (2) purchase of a principal residence (excluding mortgage payments), (3) payment of tuition and related education fees, including room and board, for the next 12 months of post secondary education, and (4) payment for prevention of foreclosure on or eviction from a principal residence. The two new provisions are: (5) payment for burial or funeral expenses, and (6) payment of expenses for repair of damage to the employee’s principal residence that would qualify as deductible casualty expenses.

Advanced Contributions: 401(k) or Matching contributions can only be made after the employee's performance of service. Exceptions apply for bona fide administrative considerations.

Plan Testing Choices: A 401(k) plan must state which nondiscrimination testing alternative it will use (i.e., the nondiscrimination tests, the safe harbor provisions or the SIMPLE provisions). If there are optional testing choices (e.g., current year testing method, prior year testing method, or applying the "first plan year" rule), the plan must state those choices. A safe harbor plan must state whether it will satisfy the safe harbor provisions using the nonelective or match alternative.

Gap Period Income: One method of correcting a failed ADP or ACP test is to distribute excess contributions to Highly Compensated Employees (HCEs). Excess contributions distributed to an HCE must be credited with the gain or loss accrued in the period between the end of the plan year and the distribution date (gap period). Gap Period Income is removed by the Pension Protection Act of 2006, which will be effective for plan years beginning after January 1, 2008.

Other Clarifications: The final regulations include the following additional clarifications: (1) a partner may defer out of "draws" paid during the year; (2) an employee may make a one-time irrevocable election no later than when the employee first becomes eligible under any plan of the employer (rather than upon employment), (3) distributed excess contributions are includible in income in the year the first 401(k) contributions were made for the plan year.