New Regulations Issued Regarding 401(k) Plans

The regulations address significant statutory changes that have occurred since the last update in 1994. Proposed regulations to comply with these changes were published on July 17, 2003.

The final regulations reflect a concerted and lengthy effort to address the concerns submitted by retirement plan participants, sponsors and service providers in response to the proposed regulations. As such, the U.S. Department of Treasury and IRS have attempted to design the final regulations to make it easier for employers to sponsor plans to encourage employees to save for their retirement and to assist administrators in keeping the plans qualified.

Notably, the final regulations make substantial changes to the methodology for nondiscrimination testing to ensure benefits for rank and file employees. Other key areas of the new final regulations include:

  • Elimination of the mandatory requirement to disaggregate ESOP and non-ESOP portions of a plan for purposes of nondiscrimination testing related to employee elective deferrals and matching contributions
  • Anti-abuse provisions to ensure that certain employer contributions that are made to pass nondiscrimination tests are spread over a large group of rank-and-file employees before they can raise the ability of high-paid employees to defer income under the plan
  • Clarification that plans using an automatic enrollment feature are not limited to a 3% contribution amount as the default option
  • Requirement that plans must allow employees who enter military service to contribute to their 401(k) plans the amount that they were unable to pay while in military service
  • Modification of the rules regarding hardship withdrawals, including the addition of funeral expenses and certain expenses related to repairing damage to the employee's principal residence to the list of events deemed immediate and heavy financial needs that do not incur a penalty for withdrawing money
  • Exclusion of nonprescription drugs or medicine (other than insulin) from the medical expense safe harbor under hardship withdrawal
  • Clarification of the circumstances under which a safe harbor 401(k) plan can have a short, i.e., less than 12-month, plan year
  • Revising the definition of dependent to reflect the definition of dependent used before the Working Families Tax Relief Act of 2004 for purposes of hardship distribution

    These final regulations apply for plan years beginning on or after January 1, 2006. However, plan sponsors are permitted to apply these final regulations to any plan year that ends after Dec. 28, 2004. If a plan sponsor applies these final regulations before 2006, that plan sponsor must use all of the new regulations for the entire plan year and for all subsequent years. Sponsors of 401(k) plans should carefully determine the year in which they will adopt these new regulations to ensure that they administer the plan in compliance with the final regulations for the entire year.

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