Has anyone seen a Paired / wrap arrangement that allows deferral of amounts returned due to failed discrimination test?

[Guest FAQ]

All of the private letter rulings that I have seen that address paired 401(k) and nonqualified plans state that the elected amount is contributed to the nonqualified plan, then, soon after the end of the year after testing is done, the amount that will "fit" into the qualified plan is "poured into" the qualified plan from the nonqualified plan. The IRS has sanctioned this approach. (PLR's 200116046, 200012083, 9924067, 9807027)

Would the reverse approach work? An employee who is eligible for the nonqualified plan would make separate 401(k) and nonqualified plan elections. He could also make an election to defer into the nonqualified plan any amount that is required to be returned to him from the 401(k) plan due to a discrimination testing failure. The election would be made in the year prior to the year that the funds would otherwise be returned.

It seems that the amounts returned due to the testing failure could have been contributed to the nonqualified plan if the 401(k) plan did not exist, and therefore the participant should not be precluded from contributing the amounts to the nonqulified plan simply because nondiscrimination rules prevent the 401(k) plan from accepting the contributions (assuming a timely election). Has anyone seen a ruling based on this approach?

If this is allowed, I imagine that complying with reporting requirements could be interesting, since the 401(k) is distributing amounts but they are not received by the participant.

Thanks in advance for any thoughts on these issues.

[Mark Whitelaw]

I understand your logic, but my understanding is no. You cannot bypass the 401(k) monies being returned to the participant. Tied plans, paired plans were popular concepts several years ago, but most companies chose to not introduce the administrative hassles and administrative fire drills of end of year 401(k) contributions. They just run their plans independently.

[Guest FAQ]

After reading the regs at 1.401(k)-1(f)(4), which require that the excess be "distributed to the appropriate highly compensated employees," I agree that deferral directly into the nonqualified plan would not be allowed.

However, it seems that the employee could elect in the prior year to defer into the nonqualified plan an amount equal to the taxable distribution to him from the qualified plan, once testing is done (using different dollars). There would be a mismatch in that he would be taxed on the distribution from the qualified plan in the prior year. The same amount ends up being "saved," although the contributions are in different years and there is some acceleration of tax.

[TCWalker]

If I understand your hypo, this allows an HCE - on quarterly deferral elections for example - to electively increase (k) deferrals and indirectly make a current year service period deferral of income into the NQ Plan by intentionally blasting through a projected testing limitation in the (k) plan. Hence, current service-comp period NQ deferral.