EGTRRA and ACP/ADP testing

[Guest sampat]

We have a small S_corp with three employees each earning 55K/Year. Two of the employee (me and my wife) would be considered key employee because of my ownership. We want to establish a 401K plan starting 2002 Jan because employee deferrals are not counted against the 25% profit Sharing contributions.

Me and my wife want to do the maximum tax savings. The other employee does not want to defer any.

Starting 2002, if S_corp contributes 100% vested 3% of salary contribution for the employee can it make 25% contributions for the key employees and in addition would the key employees be able to defer 11k/year?

[Blinky the 3-eyed Fish]

The answer to your question is maybe, but probably not. The plan would not be a safe harbor and would have to pass 401(a)(4).

A TPA should be able to run numbers to see what allocations would pass nondiscrimination or if you give the ages of you three, I bet someone here would run a quick calculation.

Also, keep in mind the 25% of comp annual addition limitation is the way of the dodo in 2002.

[Guest sampat]

I did not understand why 25% of compensation as annual additions limit would not work in 2002.

[Medusa]

Sampat:

As stated by Blinky, the arrangement you describe would have to pass the 401(a)(4) general test because it does not meet the safe harbor design requirements.

Blinky points out that in 2002, the deduction limit, currently 15%, goes up to 25%, whereas the annual addition limit, currently 25%/35,000, goes up to 100%/40,000 (assuming your plan year is the calendar year). 401(k) deferrals still count as annual additions. To get $11,000 deferral plus a full 25% of pay, your compensation before the deferral would have to be no more than $116,000 ((40,000 - 11,000)/.25). If it is more than that, you will bump into the $40,000 limit and will not be able to get the full 25%.

If that does not present a problem, AND if you can pass the general test, you should be able to do what you describe.

[Guest sampat]

Thank you Medusa, Blinky.

The salary this year is 55K per year for both the two Owner employee and the third non HCE. The current ages for the two owners are 43 years and 40 Years and the non-HCE is 29 years old. The two owners will defer 11k/year and non-HCE will not defer any.

I am looking to set up a 401K plan for 2002 to utilize the 11k deferral option.

[Guest TAG]

Just for kicks consider the following situation. 3% non-elective contribution 100% vested. A discretionary match limited to 4 percent of comp of 7 times deferrals. No 1000 hour rule,standard prototype, employee elects zero deferral. HCe elects $11,000 year.

2002 deductibility states total comp includes elective deferrals, contributions no longer subject to the limit. The limit is aggregate, not personal.

Probably have a hard time explaining why nhce elected zero deferral when match is so generous if audited..thoughts?

[Medusa]

LCAT, although this satisfies the ADP safe harbor, I don't see how it satisfies the ACP safe harbor.

[Medusa]

By the way, Sampat, one problem you will run into with your 25%/3% scenario is that it doesn't comply with the cross-testing regulations, so at minimum you would probably have to bump that 3% up to 5%.

[Guest TAG]

Medusa,

Formula for discretionary match not applied to employee deferrals in excess of 4%, no last day rule, no post tax contributions, no fixed match to aggregate with.

[Medusa]

What about Notice 98-52 Section VI B,4,b?

"A plan fails to satisfy the ACP test safe harbor for a plan year if the plan provides for matching contributions made at the employer's discretion on behalf of any employee that, in the aggregate, could exceed a dollar amount equal to 4 percent of the employee's compensation."

[Guest sampat]

Tcat,

Are you sure about this high match ratio on discretionary match. If allowed, I think a vesting schedule could be added for Discretionary Match to answer an audit that the vesting schedule may have deterred the employee.

Medusa,

Is your 5% based on Cross-tested plan gateway or age-weighted plan?

Thanks

[Medusa]

Sampat,

The 5% gateway is for "new comparability" (aka "cross-tested") plans - which is what you would have.

[Blinky the 3-eyed Fish]

Sampat, I ran a quick calc using 8.5% interest and 83 IAF without considering permitted disparity and not considering TCAT's info, and got the following results:

Nonelective contribution for 2002

You - 9% of comp

Wife - 7.3% of comp (roughly)

NHCE - 3% of comp

The problem is there is not much age disparity, so cross-testing doesn't have that great an impact.

[Guest sampat]

Medusa,

May be we can use Safe Harbor Enhanced Matching Formula for up to 6% of compensation based on Elective Defererals with a 3.5 for 1 company match.

NHCE will get nothing other than 3% safe harbor because he does not defer. Key employees will get

11K+21% match+3% safe Harbor.

Any holes?

[Medusa]

Sampat, in my opinion, the biggest hole is that it still does not comply with Notice 98-52. By making a 3.5/1 match on 6% of compensation, the total match is 21% of compensation, which clearly does not comply.

My suggestion at this point is that you have a professional work up some numbers for you, instead of trying to do it yourself. This area is a minefield for the inexperienced. My personal opinion, especially now that the Three Eyed Fish has run numbers, is that you can't get anywhere close to doing what you want to do.

[Guest sampat]

All,

Thanks for the great input!

[Richard Anderson]

I believe that a 3.5/1 safe-harbor match on the first 6% deferred does satisfy the ADP and ACP safe-harbors. Only discretionary match is limited to 4% of comp. There is no such limit on an enhanced match.

But given the required notice, the employee would most likely want to defer with a 350% match that is 100% vested.

[Guest sampat]

Richard,

Does 3.5 to 1 enhanced match would satisfy ACP safe harbor? I am getting some conflicting info on this ACP Safe Harbor. Some places I hear that max Emplyer Match contribution have to be no more than 6% of compensation for avoiding ACP test under Safe Harbor. Some other place I see that Match contributions should be BASED on employee deferral election no more than 6% of employee contributions.

Also, I presume the Enhanced Match would have to 100% vested for Safe Harbor.

[Richard Anderson]

For ACP safe harbor, the match must not relate to deferrals in excess of six percent. The matching rate must be at least as great as the basic safe harbor match, but can be more, such as 350% in your example. It must be 100% vested and the notice requirements must be followed.

[Guest sampat]

Medusa,

I read the quote you provide as being referring to "Discretionary Match". The Enhanced Match formula is for the required Safe Harbor Match. If Employee elects 6% deferrals, employer has to match 21% of compensation (which will be 100% vested). Employer does not have any discretion about it. He can not wait till End of Year and see how the company is doing profit-wise before providing this match.

[Medusa]

Yes, I was caught up in LCAT's issue and did not properly read your question. Richard is correct in his analysis.