Employee Benefits-IRS Allows Employers To Stop Making Safe Harbor Nonelective Contributions

In these hard times, many employers would like to stop or reduce the contributions they are making to their retirement plans. However, the tax rules often limit an employer’s ability to do so. The rules pertaining to safe harbor 401(k) plans are a prominent example. Employers utilize these safe harbor plans to avoid discrimination testing on elective deferrals and matching contributions. Under a safe harbor 401(k) plan, an employer may either:

–provide a matching contribution for each nonhighly compensated employee of 100% of the employee’s elective deferrals up to 3% of pay, plus 50% of the employee’s elective deferrals over 3% but less than 5% of pay (alternatively, an enhanced matching formula may be used) ; or

–provide a nonelective contribution for each participating nonhighly compensated employee of 3% of the employee’s pay.

Also, 401(k) plans which provide for automatic enrollment under sections 401(k)(13) and 401(m)(12) of the Internal Revenue Code are a type of safe harbor 401(k) plan. In these plans, the employer can provide either matching contributions, in a lower amount than the matching contributions described above, or nonelective contributions in the above amount.

One problem has been that the tax regulations generally require that a safe harbor 401(k) plan be adopted prior to the start of a year, and then must remain in effect for the entire year.This means that an employer generally may not choose to take any action to stop or reduce the matching or nonelective contributions to the plan at any time after the year has started. The regulations do provide an exception under which, subject to certain conditions, an employer who has chosen to meet the the rules pertaining to safe harbor 401(k) plans by making matching contributions could take action to stop or reduce those contributions during the year. Also, the regulations let the employer terminate the plan during the year. But what about an employer who has chosen to meet these rules by making nonelective contributions, and who does not want to terminate the plan?

The IRS has now proposed to revise the tax regulations, so that, subject to generally the same conditions which apply in the case of matching contributions, an employer who had chosen to make nonelective contributions to its safe harbor 401(k) plan could take action to stop or reduce those contributions during the year (without terminating the plan). The proposal allows an employer to rely on the proposed rules immediately, and to take action to stop or reduce the nonelective contributions at any time after May 18, 2009. Note that, as one of the conditions for reducing or stopping the nonelective contributions under the proposed rules, the employer must be facing a substantial business hardship, of the type described in section 412(c) of the Internal Revenue Code.

The proposed rules are here. Also, the IRS comments on the proposed rules in its Spring 2009 edition of Retirement News for Employers. See it here.