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Welcome to the Retirement Learning Center’s (RLC’s) Case of the Week. Our ERISA consultants regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans, and other types of retirement savings and income plans, including nonqualified plans, stock options, Social Security, and Medicare. This is where we highlight the most relevant topics affecting your business. A recent call with a financial advisor in South Carolina is representative of a common question on compensation and 401(k) safe harbor plans.
“I have a client who operates a 401(k) safe harbor plan with a nonelective safe harbor contribution. Can the owner change the definition of compensation mid-year to remove bonuses from eligible compensation and have the plan remain a safe harbor plan if they provide a 30-day notice of the change and only apply the amended definition after the amendment goes into effect?”
Because 401(k) safe harbor plans, by design, allow plan sponsors to avoid nondiscrimination testing on contributions, they are more restrictive than non-safe harbor plans in the types of changes the plan sponsor can make during a 12-month plan-year. Nevertheless, it is possible to change the definition of compensation mid-year in limited circumstances.
In IRS Notice 2016-16, the IRS outlines which types of mid-year changes are impermissible in a safe harbor 401(k) plan. The notice defines “mid-year changes” as changes that are:
First effective during a plan year, but not effective as of the beginning of the plan year, or
Effective as of the beginning of the plan year, but adopted after the beginning of the plan year.
Also in the same notice, the IRS explicitly allows for a mid-year change to the definition of compensation for matching contributions if the change:
Increases the amount of matching contributions,
Applies at least three months before the end of the plan year,
Is communicated via an updated notice to participants 30 days before the effective date of the change,
Includes the opportunity for participants to change their deferral elections, and
Is made retroactive for the entire plan year (which may also require a change to plan year computation if matching contributions were made on a payroll-by-payroll basis before the change).
Although Notice 2016-16 provides a helpful checklist for changing the definition of compensation in a safe harbor plan mid-year for safe harbor matching contributions, there is no discussion in the notice regarding whether it is possible to change the definition of compensation mid-year for safe harbor nonelective contributions. Nonetheless, based on the rules for matching contributions, we can extrapolate that any mid-year change to the definition of plan compensation that affects nonelective contributions must increase safe harbor contributions, be effective for the entire plan year, and satisfy notice requirements.
In addition to the guidance for changing the definition of compensation found in Notice 2016-16 for matching contributions, one can find further support that the same definition of compensation must be applied for the full 12-month plan year in the consistency rules of Tres. Reg. §1.414(s)-1(b)(2), which typically requires the same safe harbor definition of compensation to apply for the entire determination period (i.e., the 12-month plan year). Furthermore, if the definition of compensation must be consistent for the full 12-month plan year, the anti-cutback rules of IRS Code 411(d)(6) would prohibit any retroactive amendment that reduced accrued benefits by retroactive amendment, so excluding any type of compensation mid-year would not be allowed, even if the exclusion would otherwise pass the IRC 414(s) nondiscrimination rules if it were in place for the full plan year.
Changing the definition of compensation in a safe harbor 401(k) plan with nonelective contributions mid-year appears possible if 1) the change is made retroactively to the start of the year, and 2) it increases nonelective safe harbor contributions for the plan year. Current IRS guidance under Notice 2016-16, IRC Code 411(d)(6), and Treas. Reg. §1.414(s)-1(b)(2) does not support changing the definition mid-year to reduce future benefits during a plan year.