Using compensation only while participant for 3% safe harbor QNEC?

[Guest GMedley]

We have a client who has commited to using the 3% QNEC safe harbor method to avoid ADP/ACP & Top Heavy testing. But he is loathe to give this 3% to employees who leave before 3 months. the plan entry dates are quarterly after 3 months. Is it possible for him to exclude employees who never become eligible for the plan from getting the 3% minimum?

I belive this relates to definition of compensation. Per Treas Reg 1.401(a)(4)-12, plan comp can be limited to that which is earned while a participant, but only if nondiscriminatory. (Would I have to test it each year?) Also, he's willing to give the 3% on full year compensation, but only to those who stay on more than 3 months. Is this legal? thanks.

[Guest MEGary]

I guess I am confused - does the plan have a service requirement of 3 months, then the employees enter the first of the quarter following? If this is the case, the employees who are not elgibile for the plan (people who worked less than 3 months) cannot receive a 3% QNEC because they are not participants of the plan, so in a sense, you do "exclude" them from the 3% because they are not part of the plan. The only way to receive the 3% QNEC is to meet the entry requirements and become a participant of the plan.

As far as the definition of compensation - I was always under the impression that this information was defined in the plan document. Therefore, if the plan used period of participation pay, then is should be stated in the document.

Am I missing something?

[KJohnson]

You basically have to give the 3% to each person who is eligible to defer into the Plan. The 3% can be based on a full year of compensation or only the portion of the year while the employee is a participant.

IRS notice 98-52 (which was the initial guidance on safe-harbor plans) provides that "an employer may limit the period used to determine compensation for a plan year to that portion of the plan year in which the employee is an eligible employee, provided that this limit is applied unformly to all eligible employees under the plan for the plan year."

[Guest MEGary]

OK - so there's the answer to the compensation issue. What about the eligible/not-eligible issue?

[Guest SeanT]

If your question is whether or not your client may "exclude" from the safe harbor contribution any EEs who have not met the plan's age and service requirements - the answer is Yes. The first paragraph of Notice 98-52 states that ERs wanting to meet the safe harbor standards need only fund the contribution for ELIGIBLE EEs.

Additionally, if your client wants to avoid funding a contribution for ANYONE hired in the past year, he/she may do so as well. IRS Notice 2000-3 (Q-10) allows plan sponsors the freedom to "exclude" EEs who have not completed one year of service or attained age 21 regardless of whether they are eligible to make salary reduction contributions. However, in order to treat these otherwise excludable employees as non-eligible for 401(k) safe harbors, the plan must continue to pass coverage pursuant to IRC section 410(B).

[Guest GMedley]

Thanks - you've answered my question. Seems obvious in retrospect, but I sure had become confused. I'll tell my client that he should just not contribute that 3% to anyone until they become eligible.

[Guest]

all of this should be on the announcement you provide to the clients.

I think there is standard one available - at least we ended up with one, and the usual check box is

3% safe harbor non elective : if you are eligible to make salary deferrals but have not yet attained age 21 or completed 1 yr of service you will not be eligible for this contribution.

[R. Butler]

You mention the plan is top heavy. I just researched this issue; for mid-year entrants a 3% subject to vesting contribution would have to be provided on the portion of their wages earned prior to their entry date. Notice 98-52 states that the 3% contribution can be counted toward top heavy requirements, it does not say it satisifies top heavy by itself.