by Robert J. Lowe

Congress has provided some relief for employers who struggle with complex tests to prove that their 401(k) plans do not overly favor so-called "highly compensated employees." Effective this year, they can adopt "safe harbor" 401(k) plans which are exempt from the special testing that is required by other 401(k) plans.

As most employees know, a 401(k) plan allows them to elect to reduce their compensation by an amount that is then contributed to a tax-deferred retirement plan. These contributions are generally referred to as elective contributions. Many 401(k) plans also provide matching contributions in which the employer makes an additional contribution equal to all or a portion of the employee's elective contribution.

In a typical 401(k) plan, the employer must perform a complex mathematical test. First, all participants are divided into two groups: "highly compensated employees" (generally those earning more than $80,000) and "non-highly compensated employees" (everybody else). Second, a ratio of elective contributions to compensation is determined for each employee. Third, the average of these ratios for all highly compensated employees as a group and all non-highly compensated employees as a group is determined. If the average ratio for the highly compensated employees exceeds certain limits set forth in the Internal Revenue Code, the plan flunks its "nondiscrimination test." If the plan also provides matching contributions, the same test must be performed for the matching contributions.

When a plan flunks, the employer is faced with unpleasant choices: it must either make an additional contribution for the non-highly compensated employees or have the plan repay some of the contributions made by the highly compensated employees.

Safe harbor plan rules

This testing and the negative consequences of flunking may be avoided by a "safe-harbor" plan. There is a cost, however. The employer must contribute to the plan under one of the following formulas:

? All eligible employees must receive a contribution of at least three percent of compensation, regardless of whether they make elective contributions; OR

? Any employee who makes an elective contribution must have a matching contribution made on his or her behalf that is at least equal to: (1) 100 percent of the first three percent of compensation contributed by the employee and (2) 50 percent of the next two percent of compensation contributed by the employee.

Most employers who adopt safe harbor 401(k) plans so far appear to be choosing the matching contribution formula. Under this approach, if an employee makes a three percent of pay elective contribution, a matching contribution must be made on his behalf equal to three percent of pay. However, if the employee makes a five percent of pay elective contribution, a matching contribution of four percent of pay must be made on his behalf (100 percent of the first three percent plus 50 percent of the next two percent). The maximum matching contribution under this approach would be four percent of pay. Of course, the employer may contribute more if it wishes to do so.

One thorny issue is whether the matching contribution requirement has to be satisfied on an annual basis or a pay period basis if the employer makes matching contributions each pay period. If an annual basis is used, additional costs may result for some employers who otherwise contribute on a pay period basis. The IRS has recently taken the position that the matching contribution requirement has to be satisfied on an annual basis, although employers have asked the IRS to reconsider its position on this issue.

The Treasury Department has recently proposed amending the law so that employers who adopt the matching formula would also be required to contribute at least one percent of compensation for each eligible employee regardless of whether the employee makes an elective contribution. If enacted, this change would be effective in 2000.

Other requirements

There are three other important requirements for a safe harbor 401(k) plan:

? The employer contributions must be fully vested at all times.

? The employer contributions generally cannot be distributed or withdrawn until an employee attains age 59-1/2, terminates employment or becomes disabled. The IRS also takes the position that these employer contributions cannot be withdrawn in the event of hardship, even though the employee's elective contributions may be withdrawn.

? The employer must give eligible employees a written notice explaining their rights and obligations under the plan. The notice generally must be given prior to the beginning of each plan year.

If all of these requirements are satisfied, the plan is automatically considered to satisfy the nondiscrimination tests applicable to elective and matching contributions. No testing is required, the employer will not have to make additional contributions to the plan and the plan will not be required to repay contributions to highly compensated employees.

Should employers adopt safe harbor plans?

If a plan is easily passing its non-discrimination tests with a matching formula that is less generous than that required by a safe harbor plan, then there is probably little reason for an employer to change its plan. However, for plans which have difficulty satisfying the non-discrimination tests or for plans that already satisfy nearly all the safe harbor plan requirements, then the change may bring significant benefits with little additional cost.

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Robert Lowe is a special counsel in O'Melveny & Myers' tax department, located in the firm's Century City office. He specializes in all areas of employee benefits and executive compensation including qualified retirement plans, equity incentive and nonqualified deferred compensation plans, plan issues in mergers and acquisitions, group health plans and more.

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