Setting up a 401(k) plan has become a little more complex since the enactment of the Small Business Job Protection Act of 1996, Pub. L. 104-188 (SBJPA).

Currently, employers can establish either a traditional 401(k) plan or a 401(k) plan which uses a SIMPLE or Safe Harbor formula. A traditional 401(k) plan must pass a nondiscrimination test, does not require employer contributions and is subject to top heavy rules. 

     SIMPLE and Safe Harbor Plans were created to encourage small businesses to adopt 
     retirement plans for their employees.

     SIMPLE and Safe Harbor 401(k) plans require either an employer non-elective or matching 
     contribution, which eliminates the need for nondiscrimination testing. 

The employers’ contributions are 100 percent vested immediately. Top heavy rules do not apply to SIMPLE plans. Safe Harbor plans are subject to top heavy rules unless they contribute a non-elective three percent contribution.

Within this issue, we will review each type of plan. Administrative Retirement Services, Inc. (ARS) recommends that you have a trained professional review your company census and obtain an understanding of your retirement plan objectives and to assist you in designing a retirement plan which meets your needs.

401(k) Plans  -- 401(k) plans have been in existence since the enactment of Internal Revenue Code (IRC) sections 401(k) and 401(a)(8) in the Revenue Act of 1978. They allow employees to elect to defer a portion of their salary and contribute those funds into a profit sharing plan. For 2000, employees can elect to defer up to $10,500 subject to nondis-crimination testing. 

A 401(k) plan qualifies under the tax code and employee deferrals are not currently taxed if a retirement plan satisfies a nondiscrimination test, which compares eligible employee contri-butions of highly compensated employees (HCE) to eligible non-highly compensated employees (NHCE). An employee is considered HCE if in the prior year they earned more than $80,000, or owns five percent or more of the business in the current or preceding year. Employers can apply the $80,000 threshold to the top 20 percent of employees meeting the plan eligibility requirements.

The nondiscrimination test, which applies to employee deferrals, is the Actual Deferral Percentage (ADP) test and for the employer matching contri-bution the Actual Contribution Percentage (ACP) test. The ADP test is satisfied if the ADP for HCEs does not exceed the ADP for NHCEs multiplied by 1.25 or, if the ADP for the HCEs does not exceed the ADP for the NHCEs by more than 2 percentage points. The ACP test must also pass. Its rules are similar to the ADP test with the addition of the multiple use limitation which does not allow either the ADP or  ACP test to pass using the plus 2  percentage points component. 

The SBJPA allows employers the option to elect to use the prior year’s NHCE ADP in performing the current year’s non-discrimination test. This alleviates unwanted refunds to HCEs by providing an exact percent, which HCEs may contribute.

The process of performing the ADP test is as follows:
     > Determine the HCEs & NHCEs
     > Calculate a deferral ratio for each employee by dividing their deferrals by their compensation. 
        Eligible participants not contri-buting to a plan have a deferral ratio of zero, which is averaged 
        with other eligible participants.
     > Calculate the averages for the HCEs and NHCEs by totaling the deferral percentage and dividing 
        this by the number of employees in each group.
     > Compare the averages for the HCE and NHCE. In order for the test to pass, the difference cannot 
        be greater than 2 percent or than the NHCE average multiplied by 1.25 percent.

Another important test for a 401(k) plan is the top heavy test. Under IRC 416, if the “key employee” account balances plus distributions for the past four years are greater than 60 percent of plan assets at the beginning of the plan year, the plan is considered top heavy. 

In order for the key employees to contribute to a 401(k) plan, a top-heavy minimum contribution must be contri-buted by the employer, equal to the key employees deferral percentage, up to 3 percent. Key employees are defined in the following section.

Definition of a Key Employee:
     > An officer having annual com-pensation in excess of 50 percent of the annual dollar limitation for 
        defined benefit plans in effect for such plan year.
     > One of the ten largest owners of the employer having annual com-pensation in excess of the annual 
        addition limitation in effect for such plan year.
     > A five percent owner.
     > A one percent owner whose annual compensation exceeds $150,000.

Ownership is also attributable to lineal ascendants and descendants (i.e., parents and children).

SIMPLE & Safe Harbor 401(k) Plans:

In an effort to encourage small employers to adopt retirement plans for their employees, the SBJPA introduced the savings incentive match plan for employees (SIMPLE) and the Safe Harbor 401(k) Plan. Both plans allow employers to avoid nondiscrimination and top-heavy testing, but require the employer to contribute either a matching or non-elective amount which is 100 percent vested. A notice de-scribing employee rights and obligations under the plan must be provided.

SIMPLE plans have been allowed for plan years after 1996 and Safe Harbor plans became effective January 1, 1999.  Plan sponsors can amend their existing plan or establish a new one which utilizes either a SIMPLE or Safe Harbor formula.

SIMPLE 401(k) Plans

SIMPLE retirement plans are designed to allow small employers to provide retirement benefits for their employees without the complexities and costs associated with employer-sponsored, tax-qualified plans.

An employer can establish a SIMPLE retirement plan if the following two requirements are met:
     1. The employer has 100 or fewer employees who received at least $5,000 of compensation 
         from the employer for the preceding year,
     2. The employer does not maintain another employer-sponsored retire-ment plan.

A 401(k) plan which adopts a SIMPLE formula and provides the proper notice requirement, is deemed to satisfy the special nondiscrimination tests and top-heavy rules for any year for which a SIMPLE formula is adopted. The plan still must satisfy certain participation, vesting, contribution and administrative requirements in order to qualify as a SIMPLE retirement plan.

By adopting a SIMPLE plan, the employer agrees to limit employees’ elective deferrals to no more than $6,000.

Under a SIMPLE formula, an employer may either contribute:
     100 percent of the amount of the employees elective contribution up to three percent of their compensation, 
     OR
     two percent of compensation for each eligible employee who has at least $5,000 of compensation 
     for the calendar year.

Employers making such an election for any calendar year must notify employees within at least 60 days prior to the beginning of the year.

Contributions under the SIMPLE plan must be 100 percent vested, and the employer cannot reduce the matching percentage below three percent of compensation. Employer contributions generally are deductible by the employer in the tax year in which the calendar year ends for which the contributions were made. Contributions to a SIMPLE retirement plan are qualified under the tax code and employee deferrals are  currently not taxed.

Safe Harbor 401(k) Plans

Safe Harbor 401(k) Plans differ from SIMPLE 401(k) Plans in that the deferral limit under section 402(g)(1) is $10,500 in the year 2000 and employer contributions are more generous.

Under a Safe Harbor formula, an employer may either contribute:
     100 percent of the amount of the employee’s elective contribution up to three percent of their 
     compensation and 50 percent of the amount of the employee’s elective contribution that are 
     between three and five percent of the employee’s compensation.
     OR
     Non-elective contributions on behalf of each NHCE who is an eligible employee equal to 
     at least three percent of the employee’s compensation.

The employer may contribute the three percent non-elective contribution to a separate defined contribution plan. 

These Safe Harbor matching or non-elective contributions are 100 percent vested.  Highly compensated em-ployees (HCE) cannot receive a higher matching contribution than NHCEs.

The Safe Harbor matching contribution automatically satisfies the actual contribution percentage (ACP) test. A special rule allows Section 403(b) plans to take advantage of the ACP test safe harbor.

The annual compensation limit under section 401(a)(17) applies for purposes of the Safe Harbor methods. For the year 2000 this limit is $170,000.

Safe Harbor non-elective contri-butions may be counted toward the minimum contribution requirement for top heavy plans. Safe Harbor matching contributions may not be counted toward the minimum contribution requirement for top heavy plans.

These new rules provide many planning opportunities. For assistance in determining which plan best meets your company’s needs, contact Administrative Retirement Services, Inc.

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