As the effects of the COVID-19 pandemic continue to ripple through the economy, financially stressed employers are scrambling to control costs and keep their businesses afloat. Many of these employers may be considering temporarily suspending 401(k) matching contributions as a cost-saving measure. While companies evaluating this option have to consider the impact on employee morale and retirement adequacy, they may overlook some less obvious compliance issues. This article identifies a number of technical compliance issues for employers to consider before reducing or suspending a 401(k) match, including ERISA’s anti-cutback protections, the actual deferral percentage (ADP) and actual contribution percentage (ACP) safe harbor requirements, and the Internal Revenue Code’s $285,000 cap on plan compensation.
An employer will need to amend its plan to suspend matching contributions if they are required by plan terms — as is usually the case. If the plan gives the employer discretion to make matching contributions, an amendment may be unnecessary. However, even if the contributions are entirely discretionary, employers still might want to review past employee communications for any statements that could be interpreted as promising a match, since the expectation of a match likely influenced some employees’ deferral elections.
ERISA’s anti-cutback rules generally require employers implementing a suspension to fund matching contributions based on deferrals and compensation through the amendment’s adoption date (or effective date, if later). However, an exception may apply to plans that condition the match on employees satisfying a service condition — for example, completing 1,000 hours or being employed on the last day of the year. Sponsors of these plans may be able to eliminate the match retroactively to the start of the plan year for employees who haven’t yet satisfied the service condition, which arguably means they haven’t accrued a right to receive a matching contributions. Employers taking this approach assume some legal risk and should consult with legal counsel. In addition, however unpopular a match suspension will be with many employees, employers may face the most backlash from employees for whom the change is retroactive to the start of the year, since they presumably made deferrals with the expectation of a match.
Employers with safe harbor plans must notify employees at least 30 days in advance of a match suspension (as discussed in the next section). The law doesn’t specify notice timing for nonsafe harbor plans, but employees should receive notice sufficiently in advance of the suspension’s effective date to have a reasonable amount of time to change their deferral elections.
The Section 401(k) regulations allow midyear suspension of safe harbor matching contributions if employers satisfy either of the following requirements:
An employer that suspends safe harbor contributions midyear effectively opts out of the safe harbor for the year. This will require the plan to pass the ADP and ACP nondiscrimination tests for the year. The plans could also become subject to top-heavy testing because exemptions for safe harbor plans will no longer apply.
To exit the safe harbor, an employer must take the following steps:
─ Since exiting the safe harbor subjects the plan to ADP/ACP testing, the amendment must state that the plan will satisfy ADP/ACP testing for the entire plan year, using the current-year testing method.
Employers considering suspending safe harbor nonelective contributions may be able to do so using the same procedures discussed above, but with one small wrinkle: For plan years starting after Dec. 31, 2019, the Setting Every Community Up for Retirement Enhancement (SECURE) Act (Pub. L. No. 116-94) has eliminated the safe harbor notice requirement for employers making safe harbor nonelective contributions. If a company not operating at an economic loss didn’t provide a safe harbor notice for the 2020 plan year, can the employer suspend safe harbor nonelective contributions?
This shouldn’t be an issue for employers with calendar-year plans, since these employers had to send safe harbor notices for the 2020 plan year several weeks before the SECURE Act became law (provided, of course, the notice contained the requisite language regarding a midyear suspension or reduction). However, if an employer with a noncalendar-year plan didn’t provide a safe harbor notice for the 2020 plan year and isn’t operating at an economic loss, it’s unclear whether the employer can exit the safe harbor. IRS clarification is needed.
Section 403(b) plans aren’t subject to ADP testing. However, nongovernmental and nonchurch 403(b) plans that offer matching and/or after-tax contributions are subject to ACP testing. Sponsors of these plans can provide safe harbor matching contributions to satisfy the ACP testing requirements. These sponsors can exit the ACP safe harbor midyear by following the same procedures outlined above. This will require the plan to pass ACP testing for the entire year, using the current-year testing method.
Employers providing an “enhanced” safe harbor match may consider switching to a “basic” match midyear instead of suspending the match entirely. This could reduce costs while still providing employees an incentive to save for retirement. However, the plan would lose its safe harbor status, since a safe harbor formula must be adopted before the start of the plan year and remain in effect for all 12 months of the plan year. So sponsors should also use the steps outlined above when reducing safe harbor matches.
Example. An employer currently offers a safe harbor match of 100% on contributions up to 5% of pay. Effective July 1, the employer wants to substitute a basic safe harbor match — 100% on contributions up to 3% of pay, plus 50% on contributions that exceed 3% of pay but do not exceed 5% of pay. Because the reduction will occur midyear, the employer should follow the steps outlined above for suspending a match.
A plan may not base allocations on compensation exceeding the Section 401(a)(17) compensation limit — $285,000 for 2020. Under the 401(a)(17) regulations, the limit must be prorated if “compensation for a period of less than 12 months is used for a plan year” (subject to certain exceptions). When an employer suspends its match midyear, the match earned prior to the suspension is based on less than a full year’s compensation. In the preambles to the 2009 proposed and 2013 final regulations on midyear suspensions of safe harbor contributions, IRS took the position that the limit must be prorated in this circumstance. The same rule presumably applies to suspensions of nonsafe harbor contributions.
Prorating the compensation limit can result in a forfeiture of excess matching contributions (plus earnings) allocated during the portion of the year before the suspension. Consider the following example:
Example. A calendar-year plan matches 100% of deferrals up to 6% of base pay. Jane earns $360,000 in annual base pay ($30,000 a month) and elects to defer 6% of base pay ($1,800 per month). During the first half of 2020, Jane earns $180,000, defers $10,800 and is credited with $10,800 in matching contributions. The plan sponsor suspends matching contributions effective July 1, 2020. The 401(a)(17) pay cap must be reduced from $285,000 to $142,500. As a result, Jane’s maximum match is only $8,550 (6% x $142,500). Jane must forfeit the excess match of $2,250 ($10,800 – $8,550).
Reducing matching contributions will directly affect the ACP test and may also indirectly affect the ADP test for pretax deferrals. Here are some factors to consider in evaluating the testing consequences:
What if the plan fails ADP/ACP testing? Plans failing the ADP/ACP tests must refund or recharacterize excess contributions to highly compensated employees (HCEs) if the employer is too cash-strapped to make qualified nonelective employee contributions (QNECs). To avoid a 10% excise tax, corrective distributions and/or recharacterization must occur within 2-1/2 months after the end of the plan year (or six months after plan year-end for certain auto-enrollment plans).
Some plans provide a year-end true-up match to ensure employees don’t lose out merely because the match formula applies each pay period, rather than on an annualized basis. Employers suspending their match must consider how they want to determine the true-up and carefully draft a plan amendment suspending the match to avoid unintended true-ups.
Employers maintaining nonqualified mirror plans for HCEs should consider how suspending the match would affect accruals under the nonqualified plan. In particular, employers should assess whether any shift between the plans raises concerns under Section 409A.
To treat all employees equally, employers might want to suspend the mirror plan’s match when the qualified plan’s match is suspended. While this generally should be permissible under 409A, some employees may be contributing to the mirror plan only to earn the match. Allowing these employees to suspend their contributions to the mirror plan when the match is suspended would violate 409A and give rise to substantial tax penalties. This outcome may frustrate employees.
Plan sponsor groups, including the ERISA Industry Committee, are asking policymakers for help navigating many of these issues. These groups are urging Congress and the Treasury Department to waive the requirement that employers seeking to suspend safe harbor matching contributions have to meet the “economic loss” test or had to provide a safe harbor notice with the requisite language in late 2019. Expanded relief could also let employers prospectively suspend safe harbor matching contributions without prorating the Section 401(a)(17) limit for the presuspension period. In addition, the groups are asking for a two-year extension of the period for making corrective QNECs after a failed ADP test triggered by a suspension of nonsafe harbor matching contributions.
The outlook for relief is not clear, but these provisions are in the mix as Congress considers “Phase 4” economic rescue legislation in the weeks ahead.