The Department of Labor (DOL) has finally provided much anticipated guidance
for the timely deposit of elective deferrals in qualified 401(k) plans. The
proposed regulation keeps the same basic framework for determining if
contributions are timely deposited but adds a safe harbor rule that many plans
can utilize.
This newsletter will discuss the new rules, as well as the timing
requirements for other types of plan contributions.
401(k) Salary Deferrals
A large percentage of retirement plans today are funded by employees' own
contributions. In a 401(k) plan, participants can elect to defer a portion of
their salary which is withheld from each paycheck. Deferrals can also be made
from bonuses or other special compensation awards, if the plan allows.
The question arises as to how quickly the employer must transmit such
deferrals to the plan once they have been withheld.
Existing Deferral Deposit Rules
Until now, DOL regulations provided only that salary deferrals must be
deposited as soon as they become plan assets and that occurs as of the earliest
date such contributions can reasonably be segregated from the employer's general
assets. The DOL did not provide any more specific instructions on how this date
could be determined.
The regulations also state that in no event shall the segregation date be
later than the 15th business day of the month following the month the
contribution was withheld. But the DOL has stated emphatically that this was not
to be relied on as a safe harbor date and that most employers should be able to
segregate the funds much sooner than the outside limit.
Upon audit, many employers were penalized for late deposits based on the
enforcement of these regulations in a highly subjective manner. That's because
the rules did not adequately provide objective standards that could be fairly
applied to every situation. For many years there has been no definitive standard
for determining if deferrals were being deposited on a timely basis in the
opinion of the DOL.
When deferrals are not deposited on a timely basis, the employer is
considered to be commingling plan funds with its own funds. The employer becomes
liable for the payment of lost earnings to participants' accounts as well as
prohibited transaction penalties. Trustees may also be liable for fiduciary
breach penalties.
New Safe Harbor for Small Plans
On February 29, 2008 the DOL issued proposed regulations providing additional
guidance on this issue. The existing standard of making deposits as soon as the
money can be segregated from the employer's general assets remains in force. But
a clear safe harbor time frame is established for small plans with fewer than
100 participants at the beginning of the plan year. The safe harbor deadline is
the 7th business day after the day on which such amounts would have been payable
to the participant in cash (in other words, withheld from paychecks).
The 100 participant cut-off for small plan status under the safe harbor
deposit rule is not the same as small plan filing status of Form 5500. That is,
a plan with a participant count between 100 and 120 may be able to file Form
5500 as a small plan but cannot utilize the 7-day safe harbor deposit rule.
Plans with 100 or more participants at the beginning of the plan year are
subject to the existing deposit rules.
Loan Repayments
Loans to plan participants, secured by their vested benefits, are common in
401(k) plans. Repayments are often deducted from the employee's wages, similar
to salary deferrals. The same 7-day safe harbor deposit rules apply to loan
repayments.
Effective Date
The new safe harbor rule will become effective on the date of publication of
final regulations in the Federal Register. But the DOL has clearly stated that
employers can rely on the proposed safe harbor deadline until final regulations
are issued. This provides immediate relief for many employers who now have at
least 7 business days to make timely deposits without the uncertainty that
previously existed.
Small employers who feel that they can't reasonably segregate withheld
deferrals from their general assets within the 7-day period may want to rely on
the existing deposit rules and ignore the safe harbor. But that may be a risky
position to take now that a safe harbor has been established.
Matching Contributions
In order to encourage employees to participate in their 401(k) plans,
employers will often provide a matching contribution. It is usually based on the
employee's elective deferrals or a portion of such deferrals. Matching
contributions are often deposited throughout the year along with deferral
contributions.
The actual deadline for making matching contributions that are to be
allocated for a particular year and included in the nondiscrimination test is
the last day of the following plan year. But in order to be deducted on the
employer's tax return for the year allocated, the contribution must be deposited
by the tax return due date, including extensions. Different deduction rules
apply where the employer's fiscal year is different than the plan year.
Example: ABC Company's fiscal and 401(k) plan year are both the calendar
year. The company always deposits the entire matching contribution after the
plan year end. For 2007, ABC filed for an extension (to September 15, 2008) to
file its federal tax return. The matching contribution is made September 12,
2008. Since it was contributed before the federal tax return due date (including
extension), it is deductible on the 2007 return.
QNECs and QMACs
Each year a separate nondiscrimination test must be performed for salary
deferrals (ADP test) and matching and/or voluntary after-tax contributions (ACP
test) under a 401(k) plan. One method of passing an otherwise failed test is for
the employer to make a qualified nonelective contribution (QNEC) or a qualified
matching contribution (QMAC) to some or all of the non-highly compensated
employees.
In order to be utilized in the test for a particular plan year, these
contributions must be made by the last day of the following plan year. The
timing issues that apply to the deduction of matching contributions also apply
to QNEC and QMAC contributions.
Safe Harbor 401(k) Contributions
A 401(k) plan will be treated as automatically passing the ADP test for any
year that it satisfies the safe harbor contribution requirement and the notice
requirement. The contribution requirement can be met by either a specified
matching contribution rate or an employer nonelective contribution of 3% of
eligible employees' compensation.
Generally, the safe harbor contribution must be made by the last day of the
following plan year. The timing issues that apply to the deduction of matching
contributions also apply to safe harbor contributions.
Where the safe harbor matching contribution is being made on a per payroll
basis instead of an annual compensation basis, the match must be deposited by
the last day of the following plan quarter.
Profit Sharing Plans
Employer nonelective contributions to a profit sharing plan are generally
credited in the year they are deposited. However, contributions made after the
end of the employer's fiscal year but before the due date for filing its federal
tax return (including extensions) may be considered to have been paid as of the
last day of the fiscal year. If the employer's fiscal year is different than the
plan year, other factors may have to be considered.
Example: The XYZ Corporation's fiscal year is the calendar year. XYZ's profit
sharing plan also has a calendar plan year. For 2007, the due date of XYZ's
federal tax return was extended to September 15, 2008. Any employer nonelective
contributions deposited by that date can be considered deposited on December 31,
2007 and allocated under the plan as of that date. They would be deductible to
the corporation for 2007.
Money Purchase Pension Plans
Unlike profit sharing plans, in which employer contributions are often
discretionary, money purchase pension plans require a specific contribution
formula. Failure to deposit the required contribution is a violation of the
minimum funding standards. The contribution deadline for minimum funding
purposes is 8½ months after the end of the plan year. If the deadline is not
met, the employer is subject to a late funding penalty.
Where the employer's fiscal year is the same as the plan year, this date
matches the day a corporation could extend the due date of its tax return. This
allows the employer to deduct the payments necessary to fully fund the plan
within the allowable funding period. However, the 8½-month funding period exists
regardless of whether or not the corporation files for an extension.
Non-corporate entities such as partnerships and sole proprietors have
different tax filing due dates which must be taken into consideration for
deduction purposes.
Top Heavy Contributions
If a plan is considered to be top heavy (i.e., at least 60% of the benefits
belong to key employees), it must provide minimum contributions, usually 3% of
compensation, to non-key employees. Though there is no clear deadline for top
heavy contributions, it is advisable to make such contributions by the
employer's deduction deadline.
Defined Benefit Pension Plans
The funding requirements for defined benefit pension plans are based on
actuarial calculations which spread out payments over the years to provide for
specific benefits as they become due.
As with money purchase plans, defined benefit plans are also subject to the
minimum funding rules which allow required contributions to be made up to 8½
months after the end of the plan year. Plans that do not contribute enough money
to fully fund the current benefit liabilities must make deposits on a quarterly
basis or else notify employees that quarterly deposits will not be made.
The timing issues that apply to the deduction of money purchase plan
contributions also apply to defined benefit plan contributions.
Conclusion
Earlier this year the DOL provided long-awaited relief from the vague and
confusing salary deferral deposit rules for small employers. The new 7-day safe
harbor is a reasonable deadline that most small companies should be able to
meet. If not, the existing guidelines are still available. Failure to make
timely deposits could subject the plan to lost interest payments and penalties.
It is important that both employee and employer contributions be deposited by
the required due dates to keep the plan properly funded and in compliance with
qualification requirements.
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