Prior Year method, first only has HCEs

[John Feldt ERPA CPC QPA]

A new 401(k) plan is effective 1/1/2006. For the 2006 plan year, only the 2 HCEs had met the eligibility requirements (and they deferred the full 402(g) limit).

On January 1, 2007, one NHCE enters the plan. This plan is currently written to use the prior year testing method.

If this new entrant is the only NHCE for 2007 and they defer zero for the year, what is the maximum percent that the HCE's could defer for 2007?

[stephen]

Off the cuff answer, perhaps 5% as in the first year you can assume 3% deferrals for NHCEs. Maybe they should consider safe harbor plan design for 2008.

[John Feldt ERPA CPC QPA]

I'm not sure about the 5%.

In the client meeting last year, they indicated that their one employee would certainly not work over 1000 hours, and thus never become eligible. Our first reaction had been to suggest safe harbor, just to be sure, but they didn't buy it.

[Lori H]

I believe the default NHCE ADP is 3% where you do not have any NHCE's eligible, therefore, 5% would be the maximum HCE ADP to avoid excess deferrals.

[stephen]

I agree with Lori's analysis on the 5%.

Apparently they were wrong about the one employee never working 1,000 hours and not becoming eligible. Thus, maybe they should revisit the safe harbor suggestion for 2008.

[Archimage]

See Treas. Reg 1.401(k)-2(a)1(ii). If the plan use the prior year testing method and the only eligible employees that were eligible in the prior year are HCEs, the plan is deemed to pass ADP.

[Bird]

Mmmm. Did you use prior year testing in 2006? If so, I think 2006 should have been 5% for the HCEs and 2007 is the year of no testing limits for the HCEs. I disagree with 5% for 2007.

[stephen]

Nice work Bird and Archimage!

[John Feldt ERPA CPC QPA]

Thanks, Archimage, I like your answer (not just because I like the result of course)!

Here's that section of the regulation:

1.401(k)-2(a)(1)(ii):

"HCEs as sole eligible employees. If, for the applicable year for determining the ADP of the NHCEs for a plan year, there are no eligible NHCEs (i.e, all of the eligible employees under the cash or deferred arrangement for the applicable year are HCEs), the arrangement is deemed to satisfy the ADP test for the plan year."

[austin3515]

I think what some people are saying though is that you should have limited them to 5% in 2006 (first year ADP for NHC's is deemed to be 5%, no matter what). Which, if they contributed the maximum did not happen ($15,000/$220,000 = 6.82%. In 2007, I think we all agree you're okay though.

[John Feldt ERPA CPC QPA]

Thanks Austin, I'll verify what actually happened in 2006 wrt deferrals.

[Bird]

I think what some people are saying though is that you should have limited them to 5% in 2006 (first year ADP for NHC's is deemed to be 5%, no matter what). Which, if they contributed the maximum did not happen ($15,000/$220,000 = 6.82%. In 2007, I think we all agree you're okay though.

First year for NHCEs using prior year testing is deemed to be 3% so HCE max is 5%; I don't think they're ok in 2006 if they were over 5%.

[Belgarath]

I think they are fine for 2006. Since there were NO NHC, then that is the precise purpose of the regulation 1.401(k)-2(a)(1)(ii). They are deemed to pass ADP, and are not limited to 5%.

[WDIK]

I agree with Belgarath. What if the ADP testing was done on a current year basis rather than a prior year basis? The HCE's would not be limited to a 0% deferral to pass the test just because no NHCE was eligible.

[Bird]

OK, in the course of trying to prove my point I found a cite that proves I'm wrong; sorry for the distraction. Here's Belgarath's cite, which on its face is not on point because the applicable year is the prior year:

1.401(k)-2(a)(1)(ii) HCEs as sole eligible employees. If, for the applicable year for determining the ADP of the NHCEs for a plan year, there are no eligible NHCEs (i.e., all of the eligible employees under the cash or deferred arrangement for the applicable year are HCEs), the arrangement is deemed to satisfy the ADP test for the plan year.

And here's the important cite saying you can (effectively) use current year in the first year even if you're on a prior year basis:

1.401(k)-2©(2) Pension Calculation of ADP under the prior year testing method for the first plan year.

1.401(k)-2©(2)(i)(i) Pension Plans that are not successor plans. If, for the first plan year of any plan (other than a successor plan), the plan uses the prior year testing method, the plan is permitted to use either that first plan year as the applicable year for determining the ADP for eligible NHCEs, or use 3% as the ADP for eligible NHCEs, for applying the ADP test for that first plan year. A plan (other than a successor plan) that uses the prior year testing method but has elected for its first plan year to use that year as the applicable year is not treated as changing its testing method in the second plan year and is not subject to the limitations on double counting on QNECs under paragraph (a)(6)(vi) of this section for the second plan year.

My bad/sorry.

[austin3515]

I'm not yet convinced. Every document I've ever seen indicates that in the first year, the NHC average is deemed to be 3%. IF (and only IF) you elected in the document to use current year testing in the first year, then I agree with everything y'all are saying.

If you're plan document says your NHCE average is deemed to be 3% than it's 3%. I've never known them to read "deemed to be 3% unless there are no NHCE's."

The stipulation in the regulation that a plan with no NHCE's is "deemed to pass" is to clarify that HCE's are not limited zero simply because there are no NHCE's. In this "deemed to be 3%" scenario, the rule seems to become irrelevant.

[Bird]

If your plan document says your NHCE average is deemed to be 3% than it's 3%.

Good point. Thanks, I feel somewhat vindicated in bringing it up.

[Archimage]

I would agree that if your document says such, then you need to follow it. I have seen many, many documents that do not say as much. There are ones that give you the choice of what to use, one's that you designate whether you use 3% or the current year amount, or the designated 3%. It does depend on what the document says but if the document does not state that you must use 3% then I stick by my original post as well as some of the others.