Employment & Benefits Law Update

June 2006

401(k) Plans -- New Features And Compliance Rules Effective For 2006

The IRS issued new 401(k) regulations that became effective for most plans on January 1, 2006. Now is a good time to review your 401(k) plan for compliance with the new rules and to consider adding new features. Here is a brief list of important new features and rules:

1.    Roth 401(k) Contributions

  Beginning in 2006, 401(k) plans may permit participants to designate all or a portion of their 401(k) salary deferrals as Roth contributions. Roth contributions are taxable up front, but there is no tax when the contributions and accumulated earnings are distributed (assuming that all rules are followed). For 2006, participants may contribute up to $15,000, which may be designated as "regular" 401(k) salary deferrals, Roth contributions, or both (total cannot exceed $15,000). 401(k) plans must be amended to add this feature and Roth contributions must be accounted for separately. The IRS has issued model plan amendments for Roth contributions.

Issues for employers to consider include:

  • The cost and complexity of additional recordkeeping for Roth contributions;
  • Whether participants will actually use the Roth feature; and
  • Challenges in explaining the tax treatment of Roth contributions and when participants should make Roth vs. "regular" 401(k) contributions.

2.    Automatic Enrollment – California Employers Beware

Automatic enrollment is being touted as a solution to increase individual retirement savings and participation in 401(k) plans. Automatic enrollment may help employees to save for their own retirement and may also improve ADP testing results for employers with low participation.

Automatic enrollment means that employees are initially enrolled in an employer's 401(k) plan and are automatically signed up to contribute a fixed percentage of their pay to the plan each pay period. Employees may avoid or cancel these "automatic" contributions by formally electing not to participate. The IRS has explicitly approved these arrangements and many retirement plan providers now offer automatic enrollment as an option.

California employers considering automatic enrollment features should be aware that these arrangements may violate state Labor Code provisions which require specific written consent before any amounts can be withheld from employees' wages. Pending legislation may preempt California law on this subject, but until the law is actually enacted, California employers should beware.

3.    Expanded Distributions For Hardship

Prior regulations permitted hardship distributions from 401(k) plans for --

  • Medical expenses for the employee, or the employee's spouse or dependents;
  • Costs directly related to the purchase of a principal residence for the employee (not including mortgage payments);
  • Payments for tuition, related educational fees, and room and board expenses, for the next 12 months of post-secondary education for the employee or the employee's spouse, children or dependents; and
  • Payments necessary to prevent eviction from the employee's principal residence, or to prevent foreclosure on a mortgage on the employee's principal residence.
  • Beginning in 2006, new regulations expand the definition of hardship. 401(k) plans can now permit hardship distributions for --
    • Payment of burial expenses for the employee's deceased parent, spouse, children or dependents;
    • Expenses for repair of damage to the employee's principal residence that would qualify for deduction as a casualty under Internal Revenue Code section 165 (determined without regard to whether the loss exceeds 10% of adjusted gross income); and
    • The new regulations also clarify that hardship distributions may be made for medical expenses that would be deductible under Code section 213(d), regardless of whether the expenses exceed 7.5% of adjusted gross income.

Plan amendments may be required before permitting hardship distributions under the new regulations.

4.    New 401(k) Regulations Change Rules For Correcting Excess Deferrals

All 401(k) plans should be reviewed before the end of the year to determine if amendments are needed to address issues raised by new 401(k) regulations effective for plan years beginning in 2006. Other changes in the regulations may affect the operation of 401(k) plans in 2006.

A.   New regulations restrict the use of employer contributions to non-highly compensated employees to correct testing failures. Some plans use a "bottom-up" allocation method where additional employer contributions are allocated to the lowest paid employees first to correct testing failures. Beginning in 2006, this method will no longer be effective. 401(k) plans that specify the use of "bottom-up" allocation methods to correct ADP testing failures should be amended as soon as possible to remove these provisions. If plans are not timely amended, the correction of testing failures may be more expensive than necessary.

B.   Beginning in 2006, for 401(k) plans with "daily valuation," distributions of excess contributions to highly compensated employees to correct ADP testing failures will be required to include income for the "gap period" from the date contributions are made to the date the excess amount is distributed.

5.    Cashout/Automatic Rollover Rules

Many qualified retirement plans provide for the immediate distribution of account balances of less than $5,000, without the participant's consent following termination of employment. Effective for distributions made on or after March 28, 2005, any "mandatory" distribution of more than $1,000 must be deposited in an individual retirement plan for the participant's benefit, unless the participant affirmatively elects to receive the distribution in cash or have it rolled over to another plan.

Plan sponsors may choose to comply with the new IRA rollover rules or may choose to eliminate mandatory distributions for account balances greater than $1,000. Plans must comply with the new rules in operation for distributions made on or after March 28, 2005. For lost plans, amendments to comply with these new rules had to be adopted by December 31, 2005. If your plan was not timely amended, it may not be in compliance with the qualification rules and you should consider immediate corrective action under one of the IRS voluntary correction programs.

Deferring Severance Pay

Please note that the information contained in this newsletter is not intended to provide specific legal advice. You should consult with an attorney and not rely on any information contained herein regarding your specific situation.