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Part 4. Examining Process

Chapter 72. Employee Plans Technical Guidelines

Section 2. Cash or Deferred Arrangements

4.72.2  Cash or Deferred Arrangements

4.72.2.1  (03-01-2002)
Overview of Section 2

  1. The information contained in this section 2 is designed primarily to assist EP examiners in identifying relevant issues relating to cash or deferred arrangements (CODAs) for plan years beginning after December 31, 1996.

  2. This section 2 reflects statutory changes made by the Uniformed Services Employment and Reemployment Rights Act of 1994, Pub. L. 103-353 (USERRA), the Small Business Job Protection Act of 1996, Pub. L. 104-188 (SBJPA), the Taxpayer Relief Act of 1997, Pub. L. 105-34 (TRA), the Internal Revenue Service Restructuring and Reform Act of 1998, Pub. L. 105-206 (RRA) and all guidance issued by the Service prior to 2001. In addition this section also reflects several changes made by the Community Renewal Tax Relief Act of 2000, Pub. L. 106-554 (CRA), and the Economic Growth and Tax Relief Reconciliation Act of 2001, Pub. L. 107-16 (EGTRRA), that have retroactive effect.

4.72.2.2  (03-01-2002)
Overview of CODAs

  1. A CODA is an arrangement that allows participants to elect between cash (or some other taxable benefit) or an employer contribution to a deferred compensation plan on the participants’ behalf. The election must be made before the taxable benefit is "currently available" to the participant. A qualified CODA is a CODA that satisfies the requirements of IRC section 401(k), and a nonqualified CODA is one that does not satisfy the requirements of IRC section 401(k).

  2. Except where clearly specified, these guidelines assume a CODA is intended to be a qualified CODA (and will use the term "CODA" to mean a qualified CODA), since only qualified CODAs get the benefit of tax deferral. Under IRC section 402(e)(3), contributions made pursuant to a CODA election to a qualified CODA are not included in participants’ gross income until distributed, even though participants had the right to receive the contribution as taxable wages in the year contributed.

4.72.2.2.1  (03-01-2002)
Recent Changes to CODAs

  1. The statutes listed above in IRM 4.72.2.1 made the CODA-related changes listed in (2), (3), (4) and (5) below.

  2. Effective in 1997:

    1. IRC section 401(k)(4)(B) was amended by section 1426(a) of SBJPA to permit tax exempt organizations and Indian tribal governments to maintain CODAs.

    2. IRC section 401(k)(7) was amended by section 1443 of SBJPA to expand the definition of rural co-ops and permit (after August 20, 1996) certain distributions from section 401(k) plans of such entities.

    3. IRC sections 401(k)(11) and 401(m)(10) were added by section 1422 of SBJPA (as amended by section 1601(d) of TRA) to permit SIMPLE section 401(k) plans.

    4. IRC sections 401(k) and 401(m) were amended by section 1433(c), (d) and (e) of SBJPA to allow testing HCEs’ ADP and ACP against prior year’s NHCEs’ ADP and ACP and to change the method of correcting failed tests.

    5. IRC section 401(k)(3)(G) was added by section 1505(b) of TRA to provide that governmental plans are treated as satisfying the ADP test.

    6. IRC section 414(q) was amended by section 1431 of SBJPA to repeal the family aggregation rules and simplify the definition of HCE.

    7. Section 664 of EGTRRA directed the Secretary of the Treasury to amend the regulations under IRC section 410(b) to provide that employees who are eligible to make elective deferrals under a section 403(b) annuity maintained by a 501(c)(3) tax-exempt entity may be treated as excludable employees with respect to a 401(k) plan maintained by the same employer if certain conditions are satisfied.

  3. Effective in 1998:

    1. IRC section 401(k)(7) was amended by section 1525 of TRA to permit certain mutual irrigation and drainage companies to maintain CODAs.

    2. IRC section 402(g)(9) was added by section 1501 of TRA to provide that matching contributions for self-employed individuals are not to be treated as elective deferrals.

    3. IRC section 415(c)(3) was amended by section 1434 of SBJPA to provide that the definition of compensation includes elective deferrals and deferrals made under section 125 and section 457 plans.

    4. IRC section 415(c)(3) was further amended by section 314(e) of CRA to add IRC section 132(f)(4) elective amounts to the definition of compensation, effective for years beginning after 1997. See Notice 2001-37, 2001-25 l.R.B. 1340.

  4. Effective in 1999:

    1. IRC sections 401(k)(12) and 401(m)(11) were added by section 1433(a) and (b) of SBJPA to provide safe-harbor methods for satisfying the nondiscrimination tests of sections 401(k) and 401(m).

    2. IRC sections 401(k)(3)(F) and 401(m)(5)(C) were added by section 1459 of SBJPA to permit the ADP and ACP tests to be applied by excluding NHCEs who have not met the minimum age and service requirements of section 410 in certain cases.

    3. IRC section 402(c)(4) was amended by section 6005(c)(2)(A) of RRA to provide that a hardship distribution of elective deferrals is not eligible for rollover.

  5. In addition to the above, USERRA, codified at 38 U.S.C. sections 4301-4333, revised and restated the Federal law protecting the reemployment rights of an employee following an absence because of military service. Among the protected rights is the right to receive certain pension, profit-sharing and similar benefits that would have been received but for the employee's absence during military service, now codified at IRC section 414(u), which was added to the Code by section 1704(n) of SBJPA. IRC section 414(u) provides that employees are entitled to make catch-up elective deferrals and receive any matching contributions on those deferrals for an absence due to military service. IRC section 414(u) is effective as of December 12, 1994, but a plan has to the end of the SBJPA remedial amendment period to amend for IRC section 414(u). For a summary of the requirements of USERRA and IRC section 414(u), see Rev. Proc. 96-49, 1996-2 CB 369.

  6. In addition to the statutory changes, the Service released the following guidance on section 401(k) plans in the last few years:

    1. Notice 97-2, 1997-1 C.B. 348, dealing with the methodology of prior year testing and correction.

    2. Rev. Proc. 97-9, 1997-1 C.B. 624, relating to SIMPLE 401(k) plans and providing a model amendment.

    3. Notice 98-1, 1998-1 C.B. 327, providing guidance on prior year testing.

    4. Notice 98-52, 1998-2 C.B. 632, and Notice 2000-3, 2000-4 I.R.B. 413, providing guidance on safe harbor plans.

    5. Notice 99-5, 1999-3 I.R.B. 10, and Notice 2000-32, 2000-26 I.R.B. 1274, providing guidance on ineligible rollover distributions.

    6. Rev. Rul. 2000-8, 2000-7 l.R.B. 617, dealing with automatic enrollment ( "negative elections" ) features.

    7. Rev. Rul. 2000-27, 2000-27 l.R.B. 1016, providing guidance on when a separation from service has occurred.

  7. Due to all these recent changes, the regulations under IRC section 401(k) do not reflect current law. However, they are still valid to the extent they are not inconsistent with the items listed in (2) through (6) above.

4.72.2.3  (03-01-2002)
Eligible Employer and Plan

  1. Any employer, other than a State or local government, can establish a CODA and a State or local government that had a CODA on May 6, 1986, can continue it and even establish new ones. (See the Field Directive on grandfathered CODAs, issued on March 12, 1992.) A tax-exempt organization, other than a rural co-op, could not establish a CODA during the period between May 6,1986, and January 1, 1997. (See section 1116 of the Tax Reform Act of 1986.) Indian tribal governments and related entities can also establish a CODA (see IRC section 401(k)(4)(B)(iii)). Thus, sole proprietors, partnerships, corporations and agencies of the Federal government are all eligible to establish CODAs.

  2. In addition to meeting the requirements in (1) above, an employer intending to establish a SIMPLE 401(k) plan as described in IRC section 401(k)(11) must satisfy the 100-employee rule stated in IRC section 408(p)(2)(C)(i).

  3. A CODA must be part of a profit-sharing plan, a stock bonus plan, a pre-ERISA money purchase plan or a rural cooperative plan. See IRC section 401(k)(1), (2) and (6). Since a CODA is part of a qualified plan, the failure of the CODA to satisfy IRC section 401(k) will not always result in the failure of the plan to satisfy IRC section 401(a). For example, a CODA in a profit-sharing plan does not automatically disqualify the plan merely because the CODA failed the ADP test, although, in such case, the plan will most likely have failed to follow its terms, providing alternative grounds for disqualification. On the other hand, a CODA that is part of a defined benefit plan would disqualify the entire plan because such plans are not permitted to contain CODAs.

  4. Sometimes the term "section 401(k) plan" is used to denote a plan that properly contains a CODA and that may or may not provide for one or more types of other contributions, such as employee (after-tax) contributions, and employer matching and nonelective contributions. However, under the regulations, a "section 401(k) plan" is the portion of a plan consisting only of elective contributions, and a "CODA" is the portion of a plan consisting of elective contributions plus QNECs and QMACs that are treated as elective contributions.

4.72.2.4  (03-01-2002)
Common Abbreviations

  1. For brevity, this text uses some common abbreviations for frequently used terms. Such terms are briefly defined in this IRM 4.72.2.4, but will be discussed in greater detail in the relevant parts of this section 2 and IRM 4.72.3 (Employee Contributions and Matching Contributions).

  2. "ECs," or "elective contributions," are the contributions made to a plan pursuant to an employee’s CODA election. These contributions are included in the definition of elective deferrals under IRC section 402(g) and are treated as employer contributions for most purposes under the Code, including IRC sections 401(a), 401(k), 402, 404, 409, 411, 412, 415, 416, and 417. However, ECs are counted as part of the employee’s wages for FICA withholding, FUTA, and Railroad Retirement tax, and are treated as plan assets for purposes of Title I of ERISA under the Department of Labor’s rules.

  3. "ADR," or "actual deferral ratio," is an employee’s ECs (and amounts treated as ECs) for a plan year divided by the employee’s compensation for the plan year.

  4. "ADP," or "actual deferral percentage," is the average of the ADRs for the relevant group of employees. It is used in discussions about the ADP test, an anti-discrimination test contained in IRC section 401(k)(3)(A)(ii).

  5. "ACR," or "actual contribution ratio," is the sum of an employee’s employee contributions and matching contributions (and amounts treated as matching contributions) for a plan year divided by the employee’s compensation for the plan year.

  6. "ACP," or "actual contribution percentage," is the average of the ACRs for the relevant group of employees. It is used in discussions about the ACP test, an anti-discrimination test contained in IRC section 401(m)(2)(A).

  7. "QNECs" (sometimes "QNCs" ), or "qualified nonelective contributions," are special employer contributions that are not subject to a CODA election. They are always fully vested and are subject to certain distribution restrictions. They may be treated as ECs or matching contributions in the ADP test or ACP test, respectively.

  8. "QMACs," or "qualified matching contributions," are employer matching contributions that are always fully vested and are subject to certain distribution restrictions. They are counted in the ACP test unless they are treated as ECs, in which case they are counted in the ADP test.

4.72.2.5  (03-01-2002)
CODA Defined

  1. A CODA is an arrangement under which an eligible employee may make a cash or deferred election with respect to benefits under a plan. It does not include an arrangement under which amounts contributed at an employee’s election are treated at the time of contribution as after-tax employee contributions

  2. Any plan which allows a participant an election between receiving cash (or some other taxable benefit) and having an amount contributed on his or her behalf to a plan has a CODA. As noted above, only certain plans may contain CODAs and only certain employers may maintain plans with CODAs. If the employee is not permitted to receive cash as one of the choices, then the CODA does not satisfy IRC section 401(k).

4.72.2.5.1  (03-01-2002)
Cash or Deferred Election

  1. A cash or deferred election is any election (or modification of a previous election) by an employee to have the employer either:

    1. provide an amount to the employee in the form of cash or some other taxable benefit that is not currently available to the employee at the time of the election, or

    2. contribute an amount to a trust, or provide an accrual or other benefit, under a plan deferring the receipt of compensation.

  2. An amount is not currently available if the employee does not yet have a right to receive that amount or if there is a significant restriction on the employee’s right to receive the amount. For example, an amount is not currently available if it has not yet been earned or if payday has yet to arrive. Also, an election can only be made with respect to amounts that would become currently available after the later of the date the cash or deferred arrangement is adopted or the date it first becomes effective.

  3. Usually the election is in the form of a salary reduction agreement, where an eligible employee agrees to reduce his or her cash compensation, or forgo an increase in cash compensation, in exchange for the employer making a plan contribution in an amount equal to the reduction. However, the election may also be a "negative election," whereby an eligible employee’s cash compensation is automatically reduced by a percentage specified in the plan and such amount is contributed to the plan unless the employee affirmatively elects otherwise. Under these so-called "automatic enrollment" plans, employees must be given a reasonable opportunity to elect to have a different amount or no amount at all contributed under the arrangement. (See Rev. Rul. 2000-8.)

4.72.2.5.2  (03-01-2002)
Certain One-Time Elections

  1. A cash or deferred election does not include a one-time irrevocable election upon an employee’s commencement of employment with the employer, or upon the employee’s first becoming eligible under any plan of the employer, to have or not to have a specified amount contributed to the plan and to any other plan of the employer (including plans not yet established) for the duration of the employee’s employment with the employer. Thus, if these were the only elections available under a plan, such plan would not be considered to contain a CODA, and contributions made to a plan pursuant to such an election would not be considered to be elective contributions.

  2. Once an employee has participated in any plan of the employer, he or she cannot make this one-time election. In addition, a change in status, such as from associate to partner, or union employee to manager, does not give rise to a new one-time election.

  3. A plan giving this one-time irrevocable election is subject to the regular, non-CODA nondiscrimination rules. Thus, such one-time election must be offered to a nondiscriminatory group, and the plan as a whole must satisfy the regular nondiscrimination rules.

4.72.2.5.3  (03-01-2002)
Partnership Rules

  1. Under the partnership taxation rules, a contribution made on behalf of a partner to a plan of a partnership is allocated to that partner and deducted on his or her income tax return. The remaining portion of the partner’s distributive share of partnership income is payable directly to the partner. Thus, if a partner can individually choose to vary the plan contribution made on his or her behalf, this is a cash or deferred election. Rev. Proc. 91-47 provided limited relief for partnership plans that allowed partners to individually vary their plan contributions. The plan had to be amended by the end of 1992 to become either a qualified CODA or a plan without variable contributions.

  2. Also due to the nature of the partnership taxation rules, and the definition of elective contributions, in a partnership CODA, matching contributions made to partners fall within the definition of elective contributions, because, by varying a partner’s elective contributions, any match on such elective contributions would reduce the partner’s compensation. (It is a cash or deferred election because a partner can choose, indirectly, to have an amount contributed to the plan — in this case matching contributions — or receive the amount in cash simply by varying the amount of his or her elective contributions.) This was changed for plan years beginning after December 31, 1997, when section 1501 of TRA added IRC section 402(g)(9) to provide that matching contributions of self-employed individuals, including partners, are not elective contributions.

  3. The regulations under IRC section 401(k) provide that for purposes of a cash or deferred election a partner’s compensation is deemed currently available on the last day of the partnership taxable year. Thus, a partner can make a cash or deferred election with respect to a year’s compensation any time before (but not after) the last day of the year, even though the partner takes "draws" against his or her expected share of partnership income throughout the year.

4.72.2.5.4  (03-01-2002)
Qualified CODAs

  1. As already mentioned, this section of the IRM assumes a qualified CODA is intended. To be a qualified CODA, the arrangement must satisfy the requirements specified in IRC section 401(k). These are:

    1. The CODA must be part of an eligible plan maintained by an eligible employer.

    2. The employee’s election must be between cash (rather than some other taxable benefit) and deferral.

    3. Elective contributions are not distributable prior to certain events.

    4. Elective contributions are nonforfeitable at all times.

    5. The CODA satisfies the participation requirements of IRC section 410(b)(1).

    6. The CODA satisfies the special nondiscrimination test (the ADP test).

    7. Benefits, other than matching contributions, must not be contingent on an employee’s choosing or not choosing to have elective contributions made to the plan.

4.72.2.5.5  (03-01-2002)
Nonqualified CODAs

  1. A nonqualified CODA is one that fails to meet one or more of the requirements listed immediately above in IRM 4.72.2.5.4. The elective contributions in a nonqualified CODA are included in an employee’s gross income at the time the amount would have been (but for the cash or deferred election) included in the employee’s gross income.

  2. If the CODA is nonqualified because it is part of an ineligible plan (e.g., a defined benefit plan), then the entire plan is not qualified. However, if the nonqualified CODA is part of a plan that is permitted to include a CODA (e.g., a profit-sharing plan), then it’s possible, although unlikely, the entire plan may still satisfy IRC section 401(a). In such case, the elective contributions are treated and tested as employer nonelective contributions.

  3. A CODA that is intended to satisfy IRC section 401(k) but for some reason fails and becomes a nonqualified CODA will invariably violate the terms of the plan document and so cause the entire plan to be nonqualified.

4.72.2.5.6  (03-01-2002)
Examination Steps

  1. Review corporate documents or other enabling instruments to verify that the CODA was adopted and effective prior to any election taking effect.

  2. Determine whether the plan allows participants the right to elect to have contributions made to the plan in lieu of cash or some other taxable benefit. Also determine whether there is a pattern of allowing employees (including partners in a partnership plan) to elect, on a regular basis, into and out of plan participation in return for changes in compensation. This is a cash or deferred election unless it fits the one-time irrevocable election exception.

  3. Review W-2s and payroll records to verify that contributions are not designated or treated as after-tax employee contributions.

  4. If a CODA exists, determine whether the plan is eligible to include a CODA (e.g., a profit-sharing plan). If the plan is not eligible to include a CODA, the entire plan is not qualified.

  5. If the plan may have a CODA, determine whether the CODA is qualified or non-qualified. If non-qualified:

    1. Check whether the ECs were reported as wages in the year withheld from compensation. Use IDRS search if necessary.

    2. Check whether the plan satisfied the regular coverage and nondiscrimination rules of IRC sections 410(b) and 401(a)(4), rather than the special IRC section 401(k) coverage nondiscrimination rules, counting the ECs as employer contributions.

4.72.2.6  (03-01-2002)
Coverage and Participation

  1. The CODA portion of the plan, by itself, must satisfy one of the coverage tests under IRC section 410(b), either the ratio percentage test or the average benefits test. To satisfy the ratio percentage test, a CODA may be aggregated with another CODA if it has the same plan year, uses the same testing method (prior year or current year) and may be permissively aggregated under the IRC section 410(b) regulations, but may not be aggregated with any non-CODA.

  2. In a CODA, each employee who is eligible to make an EC (an "eligible employee" ) is treated as "benefiting," (i.e., covered), regardless of whether the employee elects to have deferrals made to the plan. The term "eligible employee" also includes certain employees who are temporarily prohibited under the plan from making deferrals, such as a suspension following a hardship distribution. See the discussion later under "ADP Test."

  3. Reg. 1.401 (a)(4)–11(g)(3) provides that section 401(k) and section 401(m) plans may be retroactively amended to extend eligibility to employees for coverage purposes within 101/2 months after the plan year in which there is a coverage problem. Under this regulation, if a CODA needs to add some nonhighly compensated employees to satisfy IRC section 410(b), the employer must make a QNEC contribution to each of the added employees equal to the average of the ADRs of the nonhighly compensated employees who were eligible. This retroactive correction feature cannot be used to correct other defects, such as a failure to satisfy the ADP test.

  4. IRC section 401(k)(2)(D) provides that a CODA may not have a minimum service requirement for participation that is greater than 1 year. The general rules under IRC section 410(b) (up to 2 years if immediate vesting) apply for other contributions, such as matching contributions or QNECs.

  5. Employees covered by a collective bargaining agreement must be disaggregated from employees not covered by a collective bargaining agreement for purposes of the ADP test. Separate collective bargaining units within the same plan may be disaggregated, but are not required to be, for purposes of the ADP test. The combination of bargaining units used for testing must be reasonable and reasonably consistent from year to year. Equivalent rules apply to multi-employer plans.

  6. An ESOP must be disaggregated from a CODA in the same plan. Even if an employer maintains CODAs in both an ESOP and another plan and an HCE participates in both, the CODAs are not aggregated.

4.72.2.6.1  (03-01-2002)
Examples

  1. The plan document contains language stating that only employees of division A are eligible for participation in the section 401(k) plan. The only other division of the employer is division B. The employees of these two divisions make up the total number of employees of the employer’s workforce. Division A employs a total of 80 employees, 5 are highly compensated employees and 75 are nonhighly compensated employees. All employees of division A have satisfied the participation requirements for the section 401(k) plan. Division B employs 25 employees and all are nonhighly compensated employees. The plan benefits at least 70% of employees who are not highly compensated employees (75/75+25 or 75/100=75%) therefore, the plan passes coverage without having to use the average benefits test.

  2. Employer A maintains a plan which allows for elective contributions, matching contributions and employer discretionary profit-sharing contributions. Under the terms of the plan, all employees are eligible to make elective contributions and to receive matching contributions. The employer makes a matching contribution on behalf of all employees making elective contributions. In addition, the employer made a discretionary profit-sharing contribution equal to 5% of each employee’s compensation. Under the disaggregation rules, each portion of the plan must be separately tested for coverage. In this case, the 401(k) portion satisfies coverage as 100% of all employees are benefiting. The 401(m) portion satisfies coverage as 100% of all employees are benefiting. The profit sharing portion satisfies the coverage rule as 100% of all employees are benefiting. All portions of the plan must satisfy coverage separately.

4.72.2.6.2  (03-01-2002)
Examination Steps

  1. Inspect the plan document and review the sections concerning eligibility. An employer can have separate eligibility requirements for ECs, matching contributions and discretionary contributions. Thus, review plan sections that define eligible employees and that specify age and service requirements and entry dates. A CODA cannot require that an employee complete more than 1 year of service in order to be eligible to make ECs.

  2. When testing the plan for coverage, the following records should be reviewed to determine proper inclusion or exclusion of employees. The records for any related entities should be included in the review if the entity is a member of a controlled group or part of an affiliated service group.

    1. Inspect the Form 5500 series return and extract the total number of employees of the employer, employees excluded and employees benefiting. Compare these numbers with the numbers from the employer’s payroll records to determine if all employees have been accounted for on the return.

    2. Inspect employer payroll records to extract the total employees, birth dates, hire dates, hours worked, union status and other pertinent information.

    3. Inspect Form(s) W-2 and State Unemployment Tax Returns (compare the employees on these records with the employer’s payroll records) to ensure all employees of the employer are counted for the coverage test.

    4. Inspect participant election forms to verify the names of eligible employees who have elected not to have ECs made to the plan. These employees are considered as eligible employees with a zero percentage in the ADP calculations (and in the ACP calculations if no after-tax employee contributions are made). These employees also must be included for purposes of receiving an allocation of other, non-EC, employer contributions if they are otherwise eligible.

    5. Inspect payroll records and extract the names of those employees who terminated employment during the year. Many plans will require an employee to be employed on the last day of the plan year in order to receive an allocation of an employer discretionary contribution. Any terminated employee with 500 or more hours of service must be included in the coverage test. Many small plans have a last-day requirement in their plans and can easily fail coverage because of it.

    6. Inspect Schedule E, Compensation of Officers, of Form 1120 to gather names of officers and ownership percentages to help identify related entities.

    7. Inspect any Form 851, Affiliation Schedule, attached to the Corporate Income Tax return to determine if there are any related entities.

    8. Inspect a self-employed individual’s Form 1040 Income tax return to determine whether there are any other entities operated and owned by the self-employed individual. Separate Schedule Cs, Profit or Loss from Business, should be filed for each business.

    9. Inspect the plan document to determine whether the plan covers leased employees. If the employer has leased employees the plan may state that these employees are excluded, however, certain rules apply under IRC section 414(n) that may require the employer to include these leased employees for purposes of certain code sections, such as coverage and discrimination. Obtain contracts of the employer with any leasing organization and information/records for pension benefits received by the leased employee under the leasing organization’s retirement plans.

  3. Ensure the plan passes either the ratio percentage test or the average benefits test under IRC section 410(b). For purposes of the coverage test all employees of the employer must be considered, including all employees of entities that are part of a controlled group of corporations or affiliated service group that includes the employer. (See IRC section 1563(a) and the regulations thereunder for rules on aggregation of stock ownership for controlled group rules. See IRC section 414(m) and the regulations thereunder for rules pertaining to affiliated service groups.) There are three common forms of controlled groups: parent-subsidiary, brother-sister and combined groups.

  4. Ensure the plan includes leased employees if defined as eligible under the terms of the plan. Ensure that the plan passes coverage when leased employees are required to be included in the coverage test. Generally, the employer will have to include a leased employee in the test when the leased employee is performing services on a substantially full-time basis and when the total number of leased employees constitute more than 20% of the nonhighly compensated employee workforce of the employer. In these instances, these employees must be considered for the code sections noted under IRC section 414(n). However, an employer may include the benefits that the leased employee received from the leasing organization as being provided by the employer when testing for coverage.

4.72.2.7  (03-01-2002)
Contribution Limitation

  1. IRC section 402(g) provides that elective deferrals in excess of $7,000 (indexed for cost-of-living increases) for a year are included in the employee’s gross income for the year and are included in gross income again when distributed from the plan. IRC section 402(g)(7). Deferrals in excess of the 402(g) limit are called "excess deferrals." To avoid double income inclusion of excess deferrals, an employee may inform an employer of the amount of excess deferrals in that employer’s plan and request the return of them together with attributable earnings. (See Reg. 1.402(g)-1.) If returned by April 15 following the year of the excess, such deferrals will not be included in gross income when distributed. However, the employer is not required to honor such a request, although most plans do provide for such distributions. Indeed, if the employee is young, it may be cost effective to leave the excess deferrals in the plan: double income inclusion being outweighed by maybe 30 years of tax-free earnings. However, if the excess deferrals arose under plans of one employer, the employee cannot refuse a distribution. (See (3) and (4) below.) If excess deferrals are not distributed and are not disqualifying (i.e., they are made to plans of unrelated employers) they must remain in the plan until there is a permitted distributable event.

  2. IRC section 402(g) is applied to each employee, rather than to a plan, and for the employee’s taxable year, which is nearly always the calendar year. Thus, it’s possible that an employee can have deferrals to a plan equal to two times the 402(g) limit if the plan year is not the calendar year, although most are.

  3. IRC section 401(a)(30) provides that an employer’s plan cannot accept elective contributions ( "elective deferrals" ) from an employee in excess of the 402(g) limit, counting only plans of that employer. Thus, if an employee defers more than the 402(g) limit, in the aggregate, spread among one or more plans maintained by the employer group, such plans are not qualified. For example, if an employee works for Company Y from January to June and then transfers to related Company Z for the next 6 months, his deferrals into Company Y’s plan and into Company Z’s plan for the calendar year are aggregated to determine whether the 402(g) limit has been exceeded. The plans will fail qualification if they accept excess deferrals. This limit must be stated in the plan.

  4. To avoid failing IRC section 401(a)(30), a plan must distribute excess deferrals and related earnings by April 15 following the year of the excess. In such case, affected employees are deemed to have requested a distribution.

  5. Excess deferrals that are timely distributed are still treated as employer contributions for most purposes of the Code, including the ADP test, but not IRC section 415. However, excess deferrals of nonhighly compensated employees that are timely distributed are not counted in the ADP test if they are prohibited by IRC section 401(a)(30). See Reg. 1.402(g)-1(e)(1)(ii).

  6. If an excess deferral is distributed before April 15, the distributing plan counts that distribution as an offset against any distribution of excess contributions that must be made to that employee to correct the ADP test.

  7. The 402(g) limit only applies to elective deferrals (i.e., elective contributions, in a section 401(k) plan); it does not affect other contributions that may be included in the ADP test. The amount of the 402(g) limit may be incorporated by reference.

4.72.2.7.1  (03-01-2002)
Example

  1. Employer A maintains a section 401(k) plan that allows participants to elect to defer up to a maximum of 15% of the their compensation for the plan year, which is a calendar year. During calendar year 1998, Participant B elects to defer 15% of her compensation for the year. Participant B, a highly compensated employee, received compensation during the year of $100,000. The total elective contributions made on behalf of Participant B for calendar year 1998 was $15,000. The IRC section 402(g) limit in effect for 1998 was $10,000, therefore, Participant B has an excess deferral in the amount of $5,000. Accordingly, the employer must distribute the excess, plus attributable earnings, by April 15, 1999, in order for the plan to remain qualified.

4.72.2.7.2  (03-01-2002)
Examination Steps

  1. Inspect the plan document to determine the maximum elective contributions that an employee can defer under the terms of the plan.

  2. When testing for compliance with the IRC section 402(g) limit in effect for the year, the following actions and inspection of records should be taken to ensure compliance.

    1. Inspect Form W-2’s for purposes of testing the plan for compliance with the IRC section 402(g) limit. The 402(g) limit is measured on the individual’s tax year (calendar year) rather than the plan year.

    2. Compare Form W-2 (Box #13 — coded "D," which indicates the amount that the individual deferred under the plan) with payroll records and account statements for reconciliation and accuracy of the deferred amounts reported.

    3. Inspect all Form W-2s of each entity of a controlled group in order to ensure the limit has not been exceeded if an employee participates in more than one section 401(k) plan of the controlled group during the year. The IRC section 402(g) follows the individual and all deferrals must be aggregated to ensure compliance with this Code section and section 401(a)(30). It is not unusual for an employee in a mid-size or a large company to split time between the different companies that comprise a controlled group of corporations and that may have separate 401(k) plans. In these instances, the individual cannot defer more than the 402(g) limit to the employer’s plans, therefore, the deferrals must be aggregated to determine whether the limit has been exceeded. Conduct an interview with your contact person to determine whether employees work for more than one company in the controlled group.

    4. If a larger employer gives you payroll data on electronic media you may need to solicit the help of a Computer Audit Specialist (CAS). Usually the CAS can assist you in downloading the data to an Excel spreadsheet or Access Database. The CAS can also help in conducting the testing or queries for different limitations such as IRC section 402(g).

    5. After testing the section 401(k) plan for IRC sections 402(g) and 401(a)(30), it is important to ensure that any excesses were properly and timely corrected by April 15th of the following year. Inspect Form 1099-Rs for distributions made to correct, and inspect cancelled checks to determine when the distribution was actually made.

4.72.2.8  (03-01-2002)
Restricted Distributions

  1. IRC section 401(k)(2)(B) provides the elective contributions may only be distributed on death, disability, separation from service, or an event described in IRC section 401(k)(10). Contributions made to a CODA that is part of a profit-sharing or stock bonus plan may be distributed upon attainment of age 591/2. Distribution of any contribution that could be used in the ADP test (i.e., QNECs or QMACs) must be similarly restricted. Elective contributions (and grandfathered earnings, QNECs, QMACs and earnings on such QNECs and QMACs) to a profit-sharing or stock bonus plan may also be distributed on account of hardship.

  2. The events in IRC section 401(k)(10) are termination of the plan, disposition of corporate assets and sale of a subsidiary by the corporation maintaining the plan. To be distributable upon one of these events, the elective contributions must be distributed in a lump sum and, except for plan termination, the transferor corporation must continue to maintain the plan.

  3. Revenue Ruling 2000-27 provides that a separation from service can occur when an employer disposes of less than substantially all the assets of a trade or business. The notice describes circumstances involving sales and transfers of employees where a section 401(k) plan distribution may be made to such employees even though their working conditions have not changed.

4.72.2.8.1  (03-01-2002)
Plan Termination

  1. IRC section 401(k)(10)(A)(i) provides that a section 401(k) plan can make a distribution to employees if the plan is being terminated and the employer does not maintain or establish another defined contribution plan (other than an ESOP) within 12 months after all the assets are distributed from the terminated plan. A termination distribution can be made even if the employer maintains or establishes a SEP or SIMPLE IRA plan.

  2. Thus, generally, if any employer who is in the employer group at the effective date of the termination has a defined contribution plan (other than one listed above), the 401(k) plan assets must be transferred to that plan rather than distributed to the employees. However, distributions can be made if less than 2% of the employees of the terminating plan have been eligible or will become eligible for the other plan in the 12 months before and the 12 months after termination.

  3. In plans subject to the joint and survivor annuity rules, the lump-sum distribution requirement can be satisfied by the distribution of an immediate annuity that satisfies the qualified joint and survivor annuity requirements set forth in IRC section 401(a)(11) and IRC section 417.

4.72.2.8.2  (03-01-2002)
Sale of Subsidiary/Assets

  1. IRC section 401(k)(10)(A)(ii) allows distributions from a section 401(k) plan maintained by a corporation if the corporation sells at least 85% of the assets used in a trade or business to an unrelated corporation. Similarly, IRC section 401(k)(10)(A)(iii) allows distributions from a section 401(k) plan maintained by a corporation if the corporation disposes of its interest in a subsidiary. In either situation, a distribution may be made only to employees who continue employment with the employer that acquires the assets or subsidiary.

  2. For example, if a corporation maintains a section 401(k) plan for all of its employees, including those in a subsidiary, and the subsidiary is sold, any employee who stays with the subsidiary after the sale may receive a lump sum distribution from the plan. This distribution is only permitted if the purchasing company has not accepted a merger or transfer under IRC section 414(I) of any of the plan’s assets or liabilities, or otherwise has taken over maintenance of part of the plan.

4.72.2.8.3  (03-01-2002)
Hardship Distribution

  1. A profit-sharing or stock bonus plan may provide that elective contributions are available for distribution on account of hardship. However, as a general rule, QNECs, QMACs and earnings on QNECs, QMACs and elective contributions may not be distributed on account of hardship. The regulations permit a plan to provide a grandfather rule for earnings, QNECs and QMACs accrued prior to 12/31/88, (or, if later, the end of the last plan year ending before 7/1/89). This is done by determining an employee's elective contributions, QNECs and QMACs on the applicable date and using this as a frozen amount. Losses after that date do not reduce this amount.

  2. Note that other employer contributions, outside the CODA, are not subject to these restrictive hardship rules. Thus, a profit-sharing plan could have one set of rules for hardship distributions from the CODA and another, less restrictive, set of rules for other non-CODA contributions. Although most do, a CODA is not required to provide for hardship distributions at all.

  3. To make a hardship distribution the plan must determine if an employee:

    1. has an immediate and heavy financial need, and

    2. a distribution from the plan, of the specified amount, is necessary to satisfy the financial need.

  4. The determinations in a. and b. above can be made using either general hardship distribution standards or deemed hardship distribution standards, both as described in the 401(k) regulations. The majority of section 401(k) plans, including all M & P section 401(k) plans use the deemed standards. The determinations must be made in accordance with nondiscriminatory and objective standards set forth in the plan.

  5. The amount necessary to satisfy an immediate and heavy financial need of the employee can be grossed up to cover any taxes or penalties that may result from the distribution

  6. Under Reg. 1.411(d)-4, a section 401(k) plan may not have a "catch-all" hardship category (for example, "and other events which the plan administrator deems to be hardships" ) because this would be impermissible employer discretion. The plan may be amended to add or eliminate a hardship category or to change the conditions for receiving a hardship distribution and this will not violate IRC section 411(d)(6). Hardship categories (general or deemed) must be both currently and effectively available to a group of participants that satisfies Reg. 1.401(a)(4)-4.

4.72.2.8.3.1  (03-01-2002)
General Hardship Distribution Standards

  1. Under the general hardship distribution standards, the determination of whether an employee has an immediate and heavy financial need is based on all the relevant facts and circumstances. Generally, for example, funeral expenses of a family member would qualify, whereas the need for a television would not.

  2. Under the general hardship distribution standards, a distribution is not treated as necessary to satisfy an immediate and heavy financial need of the employee to the extent the need can be satisfied from other resources that are reasonably available to the employee. The plan must determine what other assets the employee has, such as, vacation homes, insurance policies, availability of loans from the plan or a bank (at reasonable rates), etc.

  3. The employer is permitted to rely on an employee’s written statement that an amount is necessary (and cannot be satisfied by other means that are reasonably available to the employee), unless the employer has actual knowledge to the contrary.

  4. A loan from a commercial source or a loan from the plan (if otherwise available) can be ruled out unless the full amount can be reasonably obtained from either. However, a plan may permit a combination of a plan loan up to the limits of IRC section 72(p) and a hardship distribution which together are sufficient to satisfy the financial need.

4.72.2.8.3.2  (03-01-2002)
Deemed Hardship Distribution Standards

  1. Under the deemed hardship distribution standards, a distribution is deemed to be on account of an immediate and heavy financial need of the employee if it is for any of the following:

    1. Medical expenses (as the term is defined in IRC section 213 but without regard to the AGI limit) incurred by the employee, spouse or dependant, to the extent not reimbursed by insurance. A distribution necessary to pay for procedures that have not yet occurred is permitted.

    2. The purchase of a primary residence for the employee. (This does not include making mortgage payments.)

    3. Post-secondary school tuition and tuition-like fees (e.g., lab fees) for the next 12 months.

    4. The prevention of eviction or foreclosure from the employee’s principal residence.

  2. Under the deemed hardship distribution standards, a distribution is deemed necessary to satisfy an immediate and heavy financial need of the employee if all of the following occur:

    1. The distribution is not in excess of the amount needed.

    2. The employee has obtained all distributions and nontaxable loans currently available under all plans maintained by the employer.

    3. All plans of the employer limit the employee’s elective contributions for the next year to the 402(g) limit for that year minus the employee’s elective contributions for the year of the hardship distribution.

    4. The employee is prohibited from making elective contributions and employee contributions to any plan of the employer for at least 12 months after receiving the distribution.

4.72.2.8.4  (03-01-2002)
Example

  1. Employer A maintains a section 401(k) plan that provides for hardship distributions under the deemed standards. The plan document contains language permitting participant loans. In 1999, Participant B submits an application requesting a hardship distribution of $2,000 in order to make a downpayment on a principal residence. At the time of the hardship distribution request, Participant B had an account balance of $50,000 and he did not have any outstanding loans from the plan. The plan administrator approved the hardship distribution request and made a distribution of $2,000.

  2. The hardship distribution should not have been approved because Participant B should have received a nontaxable loan from the plan before any hardship distributions were made.

4.72.2.8.5  (03-01-2002)
Examination Steps

  1. Inspect the language in the plan document to determine when and under what circumstances distributions can be made.

  2. Inspect the language in the plan document to determine if hardship distributions are allowed and under what circumstances (general or deemed standards).

  3. Examine the plan document provisions pertaining to allowable distributions. If the plan provides for QNECs and QMACs, then these contributions are subject to the same restrictions as elective contributions, except that they generally cannot be distributed on account of hardship.

  4. When hardship distributions are made from the plan, compare the amount distributed with the total elective contributions made by the participant to the plan to ensure the distribution was not in excess of total elective contributions. Participant account statements should provide a separate breakdown of the elective contributions from other types of contributions.

  5. Request from the Plan Administrator copies of hardship application files. Inspect these files to determine the reason the distribution was made.

  6. If the plan uses the deemed hardship distribution standards, inspect the employee’s individual account statement for the 12 months following the receipt of the hardship distribution. The employee must be prohibited from making elective contributions (and after-tax employee contributions) for at least 12 months following receipt of the hardship distribution.

  7. Inspect the plan document to determine whether loans are available. If the plan provides for loans, then all nontaxable loans should be made prior to making any hardship distributions.

  8. A distribution generally may be treated as necessary to satisfy a financial need if the employer relies upon the employee’s written representation, unless the employer has actual knowledge that the need can be reasonable relieved through reimbursement from insurance, by liquidation of the employee’s assets, by cessation of elective contributions, or by other distributions or nontaxable loans from plans maintained by the employer. Interviewing the plan administrator may be necessary to determine the facts and circumstances surrounding questionable distributions.

  9. Request copies of Form 1099-Rs for all distributions including hardship distributions. The hardship distribution amount may be increased for federal, state and local taxes.

  10. If the CODA has been terminated, determine whether the employer had another defined contribution plan in existence at the time of termination or established one in the 12 months following distribution of all the assets from the terminating plan. If so, the CODA is not qualified unless the assets are transferred to the other defined contribution plan or the 2% overlap rule is satisfied.

4.72.2.9  (03-01-2002)
Nonforfeitability

  1. Under IRC sections 401(k)(2)(C) and 401(k)(3)(D)(ii), an employee’s interest in elective contributions, QNECs, and QMACs must be nonforfeitable when made. Thus, an employer may not redesignate a particular contribution as a nonforfeitable contribution and call it a QNEC as needed to satisfy the ADP test for a year.

  2. However, an exception to this nonforfeitability rule is provided in IRC sections 401(k)(8)(E) and 411(a)(3)(G), which allows a plan to forfeit a vested or non-vested matching contribution made on account of an elective contribution or employee contribution that is treated as an excess deferral, an excess contribution (amounts in excess of what is permitted under the ADP test) or an excess aggregate contribution (amounts in excess of what is permitted under the ACP test).

  3. Under Reg. 1.401(a)(4)-4, a matching contribution that is still in the plan and that was matched to an excess contribution (or an excess aggregate contribution) that has been distributed (sometimes called "orphan matches" ) causes the plan to have a higher rate of match, when compared to the matched contributions remaining in the plan. This is most likely to be discriminatory because only highly compensated employees get the higher rate of match, since only highly compensated employees can have excess contributions. If this matching contribution is not required to be distributed as an excess aggregate contribution under the ACP test, it should be forfeited. It cannot be distributed, because there is no mechanism for distributing amounts that fail the Reg. 1.401(a)(4)-4 availability test, Of course, an amount may only be forfeited if the plan has a provision allowing such a forfeiture.

4.72.2.9.1  (03-01-2002)
Examination Steps

  1. Verify that any amounts used to satisfy the ADP test (ECs, QNECs, and QMACs) are 100% vested at all times.

  2. Check that matching contributions that relate to corrective distributions of elective or employee contributions to satisfy the ADP or ACP test are forfeited (or distributed, if necessary to satisfy the ACP test).

4.72.2.10  (03-01-2002)
CODA Nondiscrimination

  1. Under IRC section 401(k)(3), an employer maintaining a section 401(k) plan must annually compare the elective contributions of eligible highly compensated employees ( "HCEs" ) with those made by eligible nonhighly compensated employees ( "NHCEs" ) and, if certain limits are exceeded by the HCEs, must take corrective action to bring the plan within the limits. This testing for nondiscrimination (the ADP test) is the exclusive nondiscrimination test for amounts contributed to a CODA, that is, this test is used instead of any amounts test under IRC section 401(a)(4). QNECs and QMACs that are treated as elective contributions are also counted in the ADP test.

  2. The ADP test and its correction mechanisms can be costly for employers, so Congress enacted two alternatives to the ADP test:

    1. For plan years beginning after December 31, 1996, employers could adopt SIMPLE 401(k) plans, modeled after SIMPLE IRA plans described in IRC section 408(p). See IRC sections 401(k)(11) and 401(m)(10).

    2. For plan years beginning after December 31, 1998, employers could adopt safe harbor 401(k) plans described in IRC sections 401(k)(12) and 401(m)(11).

  3. Although a CODA must satisfy the ADP test (or be deemed to satisfy the ADP test because the CODA is part of a SIMPLE 401(k) plan or a safe harbor 401(k) plan) with respect to the amount of elective contributions, the right to make each level of elective contributions under a CODA is a benefit, right or feature that must satisfy the nondiscriminatory availability requirement of Regs. 1.401(a)(4)-4(e)(3).

  4. In addition to the ADP test, if an employer has one or more HCEs who are eligible under both a CODA of the employer that is subject to the ADP test and a plan of the employer that is subject to the ACP test, then the employer must perform an additional nondiscrimination test designed to limit the multiple use of the "2 plus or 2 times" prong of the ADP and ACP tests. This test is often referred to as the "multiple use test" and the "2 plus or 2 times" prong is referred to as the "alternative limitation." Of course, if the alternative limitation is not used twice (or more), then the multiple use test need not be performed.

  5. The employer is required to maintain records necessary to demonstrate compliance with the CODA nondiscrimination requirements, including the extent to which QNECs and QMACs are taken into account.

4.72.2.10.1  (03-01-2002)
ADP Test

  1. Under the ADP test, set forth at IRC section 401(k)(3)(A)(ii), the ADP of the eligible HCEs cannot exceed the greater of:

    1. 1.25 x the ADP of the eligible NHCEs, or

    2. the lesser of 2 + the ADP of the eligible NHCEs or 2 X the ADP of the eligible NHCEs.

  2. The ADP for a group (either HCE or NHCE) is the average of the individual ADRs of the particular group. An eligible employee’s ADR is the sum of the elective contributions and QNECs and QMACs that are treated as elective contributions allocated to the employee’s account in the plan divided by the employee’s compensation. ADRs and ADPs, expressed as a percentage, must be rounded to the nearest one-hundredth of a percent. If the only eligible employees under the CODA are HCEs, the plan automatically passes the ADP test.

  3. Only "eligible employees" are included in the ADP test. ( "Eligible employees" are also counted as “benefiting” for purposes of satisfying the IRC section 410(b) coverage requirements.) An "eligible employee" is one who is eligible under the plan to make an elective contribution, whether or not the employee actually makes any deferrals. If an eligible employee chooses not to make elective contributions, and no QNECs or QMACs are made under the CODA, the employee must be included in the ADP test with an ADR of zero. The term also includes an employee who:

    1. must perform purely ministerial or mechanical acts in order to make an elective contribution,

    2. chooses not to make a mandatory after-tax employee contribution in a plan requiring after-tax contributions as a prerequisite to CODA participation,

    3. has been suspended from making elective contributions under the plan (e.g., for having taken a hardship distribution), or

    4. may not receive additional contributions because of the limits imposed by IRC section 415(c) (and IRC section 415(e) for limitation years before 2000).

  4. An employee who cannot make elective contributions because he or she was given a one-time election when the employee commenced employment with the employer or upon first becoming eligible under any CODA of the employer and elected not to be eligible to make elective contributions for the duration of employment with the employer is not an eligible employee.

  5. The ADP test is performed on the plan level, so identification of the "plan" is the first step to be performed. See the discussion under "Coverage and Participation" above. If a plan contains more than one CODA, the CODAs must be aggregated for purposes of the ADP test.

  6. If a plan is disaggregated into separate plans for purposes of IRC section 410(b), the CODA must also be disaggregated. For example, if a plan covers all employees, but, for testing purposes the plan is disaggregated into two plans, one covering employees who have less than 1 year of service or are less than age 21, and one covering all other employees, the employer would run two ADP tests, one for the employees with less than 1 year of service or less than age 21, and the other for all other employees.

  7. Section 1459 of SBJPA added section 401(k)(3)(F) and section 401(m)(5)(C) to the Code to provide a special rule for early participation. Congress believed that some employers were reluctant to incIude younger or new employees in a section 401(k) plan because these employees tended to have lower deferral percentages and therefore could cause the plan to fail the ADP (and ACP) test. To encourage coverage of these employees, effective for plan years beginning after December 31, 1998, an employer may elect to disregard employees (other than HCEs) eligible to participate in the plan before they have completed 1 year of service and reached age 21, provided the plan separately satisfies the minimum coverage rules of IRC section 410(b) taking into account only those employees who have not completed 1 year of service or are under age 21. A single ADP test is applied that compares the ADP for all eligible HCEs with the ADP for eligible NHCEs who have completed one year of service and reached age 21. A similar rule applies for purposes of the ACP test.

  8. If an HCE is eligible to participate in more than one CODA maintained by the same employer, the HCE’s elective contributions under all of the employer’s CODAs must be combined to determine the HCE’s ADR. This combination ADR is then used in the ADP test under each CODA.

  9. The compensation used to calculate ADRs is limited to the IRC section 401(a)(17) amount and must also satisfy IRC section 414(s). The definition of compensation used by the CODA must be nondiscriminatory, and elective deferrals may be included or excluded from the definition.

  10. Contributions on behalf of HCEs that exceed the limits imposed by the ADP test are called excess contributions, that is, they are the amount of contributions used to calculate the HCE ADP that exceeds the amount of such contributions permitted if the ADP test were passed. A plan must dispose of excess contributions by distributing them to certain HCEs or recharacterizing them as employee after-tax contributions. QNECs and QMACs contributed on behalf of NHCEs can be used to raise the NHCE ADP, thereby reducing or eliminating HCE contributions that might otherwise become excess contributions.

  11. Prior to 1997, the HCE ADP was compared to the NHCE ADP for the same plan year (the "testing year" ). For plan years beginning after December 31, 1996, a plan can choose, by specifying in the plan document, whether it will perform the ADP test by comparing the HCE ADP with the same year’s NHCE ADP ( "current year testing" ) or by comparing the HCE ADP for a testing year with the prior plan year’s NHCE ADP ( "prior year testing" ).

4.72.2.10.1.1  (03-01-2002)
Current Year Testing

  1. In current year testing, the employer may not know for certain how much HCEs can defer for a particular plan year until the plan year is over, and by then it may be too late to have prevented excess contributions from arising. In calendar-year section 401(k) plans, the ADP test is usually performed around the end of January when the plan administrator receives all the necessary demographic and financial information.

  2. Elective contributions of an employee are taken into account for a plan year in current year ADP testing only if they are allocated to the employee’s account as of a date within that plan year and are paid to the trust no later than 12 months after the end of the plan year to which the contributions relate. (Note that under Department of Labor regulations, elective contributions must be paid into the trust by the earliest date such contributions can reasonably be segregated from the employer’s general assets. See DOL Regs. 2510.3-102.) Further, the contributions must relate to compensation that, but for the employee’s election to defer, would have been received by the employee in the plan year, or would have been received within 21/2 months after the plan year if the compensation is attributable to services performed in the plan year.

  3. Under IRC section 401(k)(3)(D), an employer may take into account QNECs and QMACs in calculating the ADP, but, in order to do so, the regulations provide that such contributions must satisfy the nonforfeitability requirement, the distribution limitations and the 12-month contribution-to-the-trust rule that apply to elective contributions. In addition, QNECs, both before and after some or all are used in the ADP test, must satisfy IRC section 401(a)(4).

  4. Note that QNECs and QMACs made after the tax return filing date are not deductible for the prior taxable year. These contributions are counted, with other employer contributions, against the IRC section 404 deduction limits for the year made.

  5. QNECs or QMACs that are used in the ACP test cannot be used in the ADP test.


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