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IRS Describes 3 Top-Heavy 401(k) Plans

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NU Online News Service, Feb. 25, 2004, 6:14 p.m. EST – Employers that take some 401(k) contributions back from employees who leave early could end up with top-heavy plans.[@@]

The Internal Revenue Service comes to that conclusion in Revenue Ruling 2004-13, a document that analyzes the effects of a 2-year-old part of the Internal Revenue Code, Section 416(g)(4)(H), on the rules governing certain types of contributions to 401(k) plans.

The ruling describes an employer that has the discretion, or freedom, to make “nonelective” contributions to employees’ 401(k) plan accounts whenever it chooses to do so. The term “nonelective contribution” refers, in this case, to employer contributions other than matching contributions.

The IRS discusses a case in which the plan sponsor actually makes nonelective plan contributions.

The IRS also discusses an otherwise identical case in which employees forfeit some or all of the nonelective contribution if they leave before a 5-year vesting period ends, and it discusses a third case in which employees can begin making 401(k) plan contributions as soon as they start working but cannot receive matching contributions until they have completed 1 year of service.

In all 3 cases, the plans “do not meet the requirements of Section 416(g)(4)(H) and are therefore subject to the top-heavy rules in Section 416,” according to Roger Kuehnle, the IRS employment plans official who is listed as the principal author of the ruling.

The new section of the Internal Revenue Code, Section 416(g)(4)(H), was included in the Economic Growth and Tax Relief Reconciliation Act of 2001. It began taking effect Jan. 1, 2002.

The section protects 401(k) plans that contain only safe harbor salary deferrals and safe harbor employer contributions from top-heavy plan rules.

The top-heavy plan rules are meant to protect rank-and-file employees from sponsors that discriminate in favor of high-paid executives. When the IRS finds that a plan is top heavy, the sponsor must make minimum contributions or provide minimum benefits for rank-and-file employees.

The safe harbor deferral and contribution rules mentioned in Section 416(g)(4)(H), which are given in Internal Revenue Code Section 401(k)(12) and Internal Revenue Code Section 401(m)(11), set out rules that sponsors and the IRS can use to determine whether deferral and contribution rules are fair.

Simply making discretionary, nonelective contributions to a 401(k) plan puts the plan outside the scope of Section 416(g)(4)(H), because that kind of contribution is not described in the safe harbor deferral and contribution rules set out in sections 401(k)(12) and 401(m)(11), Kuehnle writes.

Requiring employees to go through a 5-year vesting period before they can receive the full amount of the nonelective contributions is also something that is not described in sections 401(k)(12) and 401(m)(11), Kuehnle writes.

In the third case, in which employees can begin making contributions immediately but must work for a year to qualify for matching contributions, the employer probably ends up offering a higher rate of matching contributions for highly compensated employees than for nonhighly compensated employees, Kuehnle writes.

The IRS has published the ruling in the Feb. 17 issue of the Internal Revenue Bulletin, at //