Section 401(k) Plans - IRS Guidance on Nondiscrimination Testing Rules and on the Correction of Excess Contributions (Retirement Plans)

April 1, 1997 Advisory

IRS Notice 97-2 provides guidance for plan sponsors in implementing some of the §401(k) plan changes made by the Small Business job Protection Act of 1996.

Nondiscrimination Testing. For plan years beginning on or after January 1, 1997, employers are expected to run the Actual Contribution Percentage ("ACP") and Actual Deferral Percentage ("ADP") tests using the prior year's data for non- highly compensated employees ("NHCEs") and the current year's data for highly compensated employees ("HCEs"). (For this purpose, NHCE status is determined using the prior year's plan definition, regardless of any individual employee's status changes in the current year.) In theory, use of prior year data leads to better estimates of the maximum amounts that the HCEs can defer in a current year, thus avoiding excess contributions (that must be corrected).

The new law permits an employer to elect to continue using current year data for calculating the ADP and ACP of all of its employees. This election is effective for all future plan years and can only be changed in accordance with regulations to be provided by the IRS. However, Notice 97-2 sets out a transition rule that permits employers to use current year data in 1997 without amending their plans or making a formal election with the IRS. Under the transition rule, employers who elect to use current year data in 1997 will be permitted to use prior year data for the 1998 plan year without IRS approval of the change.

Correction of Excess Contributions. For plan years beginning on or after January 1, 1997, the correction of excess contributions for plans that fail the ACP or ADP tests must be made based on the dollar amount of the excess contributions made by each HCE, rather than on the percentage of compensation contributed. Under the prior law, HCEs with the highest contribution ratios had their deferrals reduced first, which had the unintended effect of penalizing the lower paid HCES. Notice 97-2 outlines the steps to be used in allocating excess contributions.