Effective for plan years beginning on or after January 1, 2006, newly finalized 401(k) regulations affect the “aggressive” or “bottom-up” qualified non-elective contribution (QNEC). The QNEC is an employer contribution that has been used by numerous 401(k) plans to ensure the Average Deferral Percentage (ADP) and/or the Average Contribution Percentage (ACP) tests are satisfied without having to refund contributions to highly compensated employees (HCE’s). The new regulations do not eliminate the use of QNECs for ADP and ACP testing, however, they will cause a significant increase in the cost to the plan sponsor.
What has changed?
Prior to the effective date of the new regulations, when the ADP and/or the ACP test fails, a 401(k) plan sponsor can make a QNEC to the lowest paid participants and satisfy the testing requirements. The QNEC can be as high as 100% of the participant’s compensation for the plan year.
Under the new regulations the maximum QNEC that can be made to any non-highly compensated employee (NHCE) is either 5% of their compensation or no more than two times the plan’s “representative contribution rate”. The “representative contribution rate” is the lowest QNEC rate given to a group of NHCEs that includes half of all eligible NHCEs.
Regardless of which new method is used, the effect of this requirement is that several more non-highly compensated participants will have to receive a QNEC than under the prior regulations.
| For example: | |||
| In order to pass the ADP testing, ABC Company will need to increase the NHCE’s average deferral rate by 30%. There are 6 NHCEs and their compensation for the plan year is: | |||
| Tom $2,000.00 Ted $20,000.00 Jack $30,000.00 |
Jane $40,000.00 Janet $50,000.00 Jill $60,000.00 |
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| Under the old regulations ABC Company could make a $600.00 QNEC to Tom and the ADP test would be satisfied (30% of $2,000.00 compensation). Under the new regulations, ABC Company will have to make either a $10,100.00 QNEC – 5% of compensation to each NHCE or, using the more complicated “representative contribution rate” calculations, $4,050.00 (15% to Tom, 7.5% to Ted, and 7.5% to Jack). | |||
This example is a simplified case but the effect of the new regulations is clear. Regardless of the new QNEC method used, the cost to the plan sponsor will be significantly higher than under the old regulations.
What are the options for the Plan Sponsor?
If a plan has consistently failed the ADP and/or the ACP testing the plan sponsor can do one of three things:
1. Continue making QNECs. Although they will be much more expensive, they are still an option.
2. Make refunds to HCEs. The amounts of the refunds are dependent on the test results and could cause an unwanted and unexpected tax burden for the affected HCEs.
3. Adopt the Safe Harbor Provisions. The employer can adopt either a Safe Harbor Match or Safe Harbor Non-elective contribution.
The “aggressive” QNEC can still be used to satisfy the 2005 ADP testing but plan sponsors must prepare for 2006. Safe Harbor provisions can be adopted but must be done by January 1, 2006 to be effective for the 2006 Plan Year. We will gladly run a cost projection should you wish to explore the Safe Harbor provisions. Please contact your Uniglobal Plan Administrator for further details.
©2006 Uniglobal Pension Planning, Inc.