While some experts are seeing optimistic signs of a national financial recovery, many employers still face very real economic hardships. These employers are scrambling to find ways to reduce costs and are trying to avoid dramatic reductions in employee benefits or in the size of their workforce. The Internal Revenue Service recently issued proposed regulations that might provide some relief to certain employers that sponsor so-called "safe harbor" 401(k) plans.
Many employers have adopted "safe harbor" 401(k) plans in which they commit to provide a contribution to each eligible employee's 401(k) account of at least three percent of the employee's compensation. In good economic times, a safe harbor 401(k) plan provides many advantages to employers. First, it provides an attractive benefit to employees. Second, in exchange for making the "safe harbor" contributions, these employers are not required to perform certain nondiscrimination tests on their 401(k) plans. This results in fewer administrative burdens to the plan. Third, in a safe harbor 401(k) plan, all employees (including the executives) are allowed to contribute their own money to the 401(k) plan up to applicable legal limits. In non-safe harbor plans, executives are often limited in the amount of their own salary that they may contribute.
However, if an employer chooses to treat its 401(k) plan as a safe harbor plan by making the three percent "nonelective" employer contributions, it must inform employees of its intent to do so before a plan year begins, and the employer is "locked in" to making those contributions for that particular plan year. This "lock-in" has caused severe hardships to employers who committed to make these contributions in 2009, but now find themselves in dire economic circumstances. Their only alternative has been to completely terminate their 401(k) plans to avoid the contributions. This "all-or-nothing" option is obviously not attractive to most employers who want to continue to provide some kind of retirement benefit to employees. Many of these employers simply need some temporary relief during the current economic downturn.
On May 18, 2009, the Internal Revenue Service published proposed regulations to permit employers that incur a substantial business hardship to suspend or reduce these safe harbor nonelective contributions in the middle of a plan year. The proposed regulations affect safe harbor 401(k) plans that satisfy the safe harbor rules by making a three percent safe harbor nonelective contribution. Employers that maintain safe harbor plans by making so-called "safe harbor matching contributions" may already suspend or reduce safe harbor matching contributions under certain circumstances under pre-existing regulations.
Substantial Business Hardship. Under the proposed regulations, employers are permitted to suspend or reduce safe harbor nonelective contributions mid-year if they incur a substantial business hardship. Factors taken into account in determining whether an employer has incurred a substantial business hardship include, but are not limited to:
whether the employer is operating at an economic loss;
whether there is substantial unemployment or underemployment in the trade or business and in the industry concerned;
whether the sales and profits of the industry concerned are depressed or declining; and
whether it is reasonable to expect that the plan will be continued only if the safe harbor nonelective contribution can be suspended or reduced.
Other Requirements. In addition to incurring a substantial business hardship, employers who want to suspend or terminate their nonelective safe harbor employer contributions must also satisfy the following requirements:
Supplemental Notice. Eligible employees must be provided with a supplemental notice that explains the consequences of the amendment that reduces or suspends future safe harbor nonelective contributions, the procedures for changing employee contribution elections, and the effective date of the amendment.
Effective Date. The reduction or suspension of the safe harbor nonelective contribution can occur no earlier than 30 days after the supplemental notice is provided to employees, or the date the amendment is adopted, if later.
Opportunity to Change Contribution Elections. Eligible employees must be given a reasonable opportunity to change their contribution elections prior to the reduction or suspension of the safe harbor nonelective contribution.
Satisfy Nondiscrimination Tests. The 401(k) plan must be amended to provide that the actual deferral percentage test and actual contribution percentage test (the nondiscrimination tests that apply to employee deferrals and employer matching contributions, respectively) will be satisfied for the entire plan year.
Pay Nonelective Contribution Through Effective Date. The safe harbor nonelective contribution requirement must be satisfied with respect to compensation paid through the effective date of the amendment.
While the regulations are still in proposed form, employers may rely on them for guidance pending the issuance of final regulations. If the final regulations are more restrictive than the proposed regulations, provisions of the final regulations that are more restrictive will be applied without retroactive effect.
These proposed regulations provide an opportunity for employers who are suffering a substantial financial hardship to reduce or eliminate their 401(k) safe harbor nonelective contributions. This provides a viable alternative to complete plan termination for these employers to provide them with temporary relief to get through current financial difficulties.
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