Making the Grade
Understanding the EACA exception for nondiscrimination tests
Reported by Quana C. Jew
By way of background, employers who maintain Section 401(k) plans (other than SIMPLE 401(k) plans, safe harbor 401(k) plans, and qualified automatic contribution arrangements—also known as QACAs) are required to perform certain nondiscrimination tests to ensure that the contributions made under such plans do not unduly favor highly compensated employees (HCEs).
If the nondiscrimination tests pass, then all continue on their merry way. However, if the tests fail, then the excess contributions under the ADP Test (and/or the excess aggregate contributions under the ACP Test) and the gains/losses associated with those contributions through the end of the plan year to which the excess contributions (and/or the excess aggregate contributions) relate must be distributed. Any such distribution must be made after the close of the plan year to which the testing relates and by no later than 12 months after. For example, excess contributions and excess aggregate contributions plus gains/losses associated with such contributions that were made during the 2009 calendar year plan must be distributed by no later than December 31, 2010.
What is the tax treatment to the participant with respect to excess contributions? Under the Pension Protection Act and for plan years beginning on and after January 1, 2008, excess contributions (not including Roth contributions), as well as excess aggregate contributions (not including after-tax contributions), and any related gains/losses are includable in the participant’s gross income in the year in which the excess contributions and/or excess aggregate contributions are distributed (rather than the year of deferral, as was the case before 2008). What about the tax treatment to the employer? The distribution of excess contributions (and/or excess aggregate contributions) will be subject to a 10% excise tax unless the excess amounts and associated gains/losses are distributed within 2½ months after the plan year in which the relevant contributions were made.EACA Exception
Significantly, there is an exception for EACAs that meet certain requirements on coverage and this is where the confusion begins. The 2½-month deadline described above is extended to six months for certain EACAs. More specifically, in February 2009, the Internal Revenue Service (IRS) issued final regulations on EACAs. To the surprise of many, the IRS clarified in the final regulations that an EACA need not cover all employees eligible to make deferrals under a plan (e.g., a plan sponsor maintaining an EACA could design the plan so that the automatic-enrollment feature only applies to new hires). However, as with all news that sounds too good to be true, there’s a twist: If the EACA covers less than all eligible employees (e.g., the EACA only automatically enrolls new hires who have not otherwise affirmatively elected to participate), then the 2½-month deadline to avoid the 10% excise tax will continue to apply. By contrast, if, in fact, the EACA covers all eligible employees for the entire plan year (or the portion of the year during which such employees were eligible) such as when the plan is designed to automatically enroll both new hires and existing employees who have not otherwise made an affirmative election to participate under the terms of the plan, then the six-month extended deadline will apply.
The EACA final rules are effective for plan years beginning on and after January 1, 2010. Given the various deadlines for the nondiscrimination tests and to avoid the unnecessary costs associated with the 10% excise tax, it is essential that employers, with timely guidance from their advisers, understand which testing deadline applies to them.
Quana C. Jew is a Partner at the law firm of Arent Fox LLP, focusing on ERISA, employee benefits, and executive compensation. Quana frequently serves as a guest lecturer in these areas for various law schools, bar seminars, and employee benefits-related organizations. Washingtonian magazine has repeatedly named Quana as one of Washington’s best tax lawyers.