Sponsor may let employees flex their benefits under new IRS ruling  

September 24, 2024

A recent IRS private letter ruling (PLR) paves the way for a 401(k) plan sponsor to give employees flexibility to allocate an employer nonelective contribution among other tax-favored benefit options. These alternatives include employees’ health savings accounts (HSAs), retiree health reimbursement arrangements (HRAs) and educational assistance benefits. However, employees can’t receive the contribution in cash or as another taxable benefit. Only the recipient of a PLR can rely on it, so employers interested in exploring a similar design may want to seek their own IRS ruling to mitigate risk. That said, because PLRs provide insight into how IRS would analyze similar plan designs, some employers may decide to proceed without obtaining their own ruling.

Under the ruling, the employer has traditionally offered its 401(k) plan participants both a safe-harbor and discretionary nonelective contribution, each based on a percentage of annual eligible compensation. Employees become eligible for the discretionary contribution after completing a year of service but receive an allocation only if they remain employed through the end of the plan year, subject to certain exceptions. The discretionary contribution is subject to a six-year graded vesting schedule.

The sponsor proposes reducing the discretionary nonelective contribution and implementing a new employer contribution equal to a percentage of employees’ compensation. Eligible employees will be able to make an annual irrevocable election during the sponsor’s open enrollment period to allocate the following year’s new employer contribution — up to a particular dollar amount — among four different tax-favored benefit options. Employees become eligible for the new contribution after completing a year of service. The new employer contribution is immediately vested and is not subject to an end-of-plan-year employment condition.

Participants can choose to allocate the new contribution among the following benefits:

• 401(k) plan nonelective contribution. Employees will automatically receive the entire amount as a nonelective contribution to their 401(k) plan accounts unless they make a different election during open enrollment. For employees who elect to apply their contributions to a different benefit option, the sponsor will automatically contribute amounts exceeding the allocable portion to the 401(k) plan as a nonelective contribution.
• HSA contribution. HSA-eligible employees can allocate the employer contribution into their HSAs.
• Notional contribution to retiree HRAs. Employees who satisfy the sponsor’s retiree HRA eligibility criteria (i.e., are age 55 or older and have 10 years of service) at the time of their election can allocate the employer contribution to their retiree HRAs.
• Student loan repayment under educational assistance program. Employees can apply the contribution to pay down the principal or interest of a qualified education loan under the sponsor’s Internal Revenue Code (IRC) Section 127 educational assistance program. Employees may not elect to apply the contribution toward other benefits allowed under Section 127. (This election won’t be available after 2025 unless Congress again extends the Coronavirus Aid, Relief and Economic Security Act provision allowing employers to reimburse employees’ qualified education loan payments.) This element of the proposed design is not a matching contribution, and thus is different than the SECURE 2.0 Act’s provision allowing sponsors to make matching contributions to a defined contribution plan based on employees’ qualifying student loan payments.

The ruling doesn’t expressly indicate whether the sponsor will allow employees to allocate the employer contribution among more than one of these options. However, the ruling’s analysis doesn’t preclude this.

No ability to receive cash or a taxable benefit. A key element of the proposed design is that employees can’t receive the nonelective contribution as cash or another taxable benefit. As discussed later, this avoids characterization of the contribution as an employee deferral or contribution for purposes of several of the benefit options.

Timing of contribution. The sponsor will allocate the contribution to 401(k) accounts, HSAs or the educational assistance program by March 15 of the year after the employee’s election. For retiree HRAs, amounts will be credited as a notional contribution on Dec. 31 of the same year as the employee’s election (i.e., the sponsor’s annual crediting date for interest on notional retiree HRAs).

Restrictions on HSA contributions and educational assistance benefits. To comply with IRC contribution and benefits limits, restrictions will apply to employees who choose to allocate the employer contribution to their HSAs or the educational assistance program. These employees won’t be allowed to make salary-reduction HSA contributions or receive other educational assistance benefits until after March 15.

The ruling provides IRS’s conclusions only on these legal issues raised by the proposed design:

• Amending the 401(k) plan to incorporate the proposed design won’t cause the plan to offer an additional cash or deferred arrangement, and the employer nonelective contribution won’t be treated as an employee contribution subject to the IRC Section 402(g) annual contribution limit.
• Amounts contributed to an HSA are excludable from the employee’s taxable income as long as the employee is HSA-eligible and the contribution doesn’t exceed the annual HSA contribution limit for the employee’s coverage level.
• Amounts credited to a retiree HRA aren’t treated as salary reductions and won’t affect the tax-free treatment of future reimbursements for eligible medical expenses under IRC Section 213(d) incurred by covered retirees, their spouses and dependents.
• Employees’ ability to allocate the contribution to pay down qualified education loans (or to the other permissible tax-favored programs) won’t jeopardize the educational assistance program’s tax-preferred status, and the loan repayments will be excludable from employees’ income.

Implementing similar program features may involve additional compliance and plan administration considerations not discussed in the ruling.

Nondiscrimination testing. The ruling expressly declines to address the employer’s compliance with the different nondiscrimination regimes applicable to the proposed design’s benefit programs. Sponsors considering a similar arrangement should carefully consider the potential nondiscrimination testing implications, including the following:

• The new contribution presumably will be subject to nondiscrimination testing under IRC Section 401(a)(4). Contributions equal to a uniform percentage of compensation for all employees generally are deemed to be nondiscriminatory. However, under this design, the portion of the new contribution allocated to the 401(k) plan will not be a uniform percentage of compensation for all employees.
• Under the proposed design, the employer contribution won’t satisfy the HSA comparability rules, which require employer contributions to be either the same dollar amount or the same percentage of the deductible for all HSA-eligible individuals who have the same tier of high-deductible health plan coverage and the same employment status (full-time, part-time or former employees/retirees). However, sponsors can avoid these rigid and unworkable rules by making employer HSA contributions through an IRC Section 125 cafeteria plan. If the cafeteria plan’s written terms allow employees to make pretax HSA contributions through salary reduction, any employer contributions (e.g., match, seed, allocable employer contribution) are treated as made through a cafeteria plan (and thus subject to the cafeteria plan nondiscrimination rules), even if the employee doesn’t elect to make HSA contributions via salary reduction.

HSA considerations. Sponsors may need to monitor changes to employees’ HSA eligibility between open enrollment and the allocation date, specifically confirming whether employees who chose to allocate the employer contribution to their HSAs have HSA-disqualifying coverage under the sponsor’s plan. If the sponsor knows an employee is no longer HSA-eligible on the allocation date, might the program provide for voiding the employee’s election and making a nonelective contribution to the employee’s 401(k) plan account instead?

Vendor coordination. Sponsors likely won’t have the same vendor administering the different benefit options under this kind of arrangement. Ensuring coordination between multiple vendors administering these benefit programs is essential for ensuring compliance and an optimal employee experience.

The ruling is limited to the proposed plan design, but sponsors might consider designs incorporating other benefit alternatives.

• Integrated, excepted-benefit and individual-coverage HRAs. Some sponsors offer employees various types of HRAs. These sponsors could explore allowing employees to apply the nonelective contribution to these HRAs, subject to annual contribution limits for excepted-benefit HRAs.
• Flexible spending arrangements (FSAs). Health and dependent care FSAs are typically funded by employee pretax contributions. However, employers may also contribute to these accounts, subject to annual contribution limits — i.e., for a dependent care FSA, $5,000 per year ($2,500 for married individuals filing separately). In addition, employers’ nonmatching contributions to a health FSA must be capped at $500 annually to maintain the health FSA’s excepted-benefit status. Loss of excepted-benefit status would subject the health FSA to additional ERISA and Affordable Care Act compliance requirements. Sponsors might consider allowing employees to apply an employer contribution to a health or dependent care FSA, but since most unused amounts are generally subject to annual forfeiture, these accounts may be a less attractive option.

• PLR 202434006 (IRS, Aug. 23, 2024)

• IRS schools sponsors on SECURE 2.0’s new student loan match (Sept. 19, 2024)
• SECURE 2.0’s student loan match 101 (June 13, 2023)
• Virus aid bill offers help for retirement plans, student loans (Jan. 6, 2021)
• Final rules ease restrictions on health reimbursement arrangements (June 14, 2019)