December 28, 2004
BB 04—130

In this issue:

  • Treasury and IRS Release Final 401(k) Regulations

Treasury and IRS Release Final 401(k) Regulations

On December 28, the U.S. Treasury Department and the Internal Revenue Service (IRS) released final regulations affecting the administration of retirement plans under section 401(k) and in particular the nondiscrimination testing of contributions made to these plans under sections 401(k) and 401(m) of the Internal Revenue Code. The final regulations are expected to be published in the Federal Register on Wednesday, 2004. The final regulations apply for plan years beginning on or after January 1, 2006, but plan sponsors are permitted to apply the final regulations to any plan year that ends after the regulations' publication in the Federal Register.

The final regulations generally mirror the regulations proposed on July 16, 2003, with some modifications reflecting comments received on the proposed regulations (some of the more significant modifications or additions are listed below).  The American Benefits Council filed a comment letter on October 22, 2003 and testified in a hearing on the matter on November 12, 2003.

The final regulations:

  • Clarified that the exclusion of after-tax contributions from the definition of a cash or deferred arrangement does not include designated Roth 401(k) contributions (elective contributions that are included in income) and indicated the IRS and Treasury will issue guidance on Roth 401(k) contributions in the near future.
  • Clarified that plans that use automatic enrollment are not limited to a 3 percent contribution amount and indicated that the percentage of compensation used in Revenue Ruling 2000-8 was merely illustrative.
  • Rejected most comments concerning prefunding of elective contributions and matching contributions, generally requiring that they be made after the employee's performance of services relating to the compensation that would have been paid to the employee. However, the regulations provide limited exceptions for (1) early contributions made for an occasional pay period for bona fide administrative considerations (and not made early with the principal purpose of accelerating deductions), (2) forfeitures, and (3) contributions that result in a matching allocation of employer securities released upon loan payments for a leveraged ESOP, provided the payment is due under the loan terms and not made early with a principal purpose of accelerating deductions.
  • Eliminated the disaggregation requirement of the Employee Stock Ownership Plan (ESOP) and non-ESOP portions of the plan for nondiscrimination testing purposes (ADP and ACP testing) and allows the disaggregation to be applied to plan years that end after the date the regulations are published provided the plan applies all the rules of the final regulations for that year (could be used for 2004 testing for calendar year plans).
  • Makes clear that plans that allow early entry into the plan for employee deferrals but delay matching contributions may use the safe harbor design in lieu of nondiscrimination testing for employees who have satisfied minimum age and service requirements and only apply nondiscrimination testing to the remaining employees (by treating them as separate plans for testing purposes).
  • Made several clarifications to hardship distribution rules. First, the regulations added funeral expenses and repair of damage to the employee's principal residence to the “safe harborâ€� events that can result in a hardship distribution. In addition, the regulations clarified that an employee requesting a hardship distribution must elect distribution of an ESOP dividend. The regulations also stated changes made to the definition of dependent under the Working Families Tax Relief Act of 2004 (such as income limitations) would not apply for purposes of determining whether a participant is eligible for a hardship distribution for medical expenses and college tuition for a dependent.
  • Added a rule that additional elective contributions made because of the eligible employee's military service will not be counted in nondiscrimination testing.
  • Maintained the rule outlined in the proposed rule that restricts the use of targeted qualified non-elective contributions (QNECs) but allowed an exception of up to 10 percent of compensation for QNECs made in connection with an employer's obligation under prevailing wage laws. The general rule does not allow the QNECs to be taken into account for nondiscrimination testing purposes if it exceeds 5 percent of compensation unless the contributions meet certain additional requirements designed to ensure that the contributions are not targeted to participants with lower compensation.
  • Generally followed the proposed regulations regarding calculation of gap period income (i.e., income for the period after the plan year) but allowed a distribution of excess contributions to not include income for a period that is no more than 7 days before the distribution.

A Benefits Briefing conference call on this issue will be scheduled early in the new year. For more information on the regulations, please contact Jan Jacobson, Council director, retirement policy, at (202) 289-6700.


The American Benefits Council is the national trade association for companies concerned about federal legislation and regulations affecting all aspects of the employee benefits system. The Council's members represent the entire spectrum of the private employee benefits community and either sponsor directly or administer retirement and health plans covering more than 100 million Americans.