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Qualified CODA

  1. A qualified CODA must be part of a profit-sharing plan, stock bonus plan, a pre-ERISA money purchase plan (that has had a CODA provision since 1974), or a rural co-op plan. See IRC 401k (2) and (7).
  2. The plan may (but is not required to) provide nonelective employer contributions. In fact qualified nonelective contributions ( QNECs ) may help the plan pass the actual deferral percentage test ( ADP test ). See 2.4.
  3. A qualified CODA may not use the IRC 401(1) permitted disparity (but the plan of which it is a part may use permitted disparity with respect to other contributions).

Salary Reduction CODA

  1. The most common type of CODA is a CODA with a "salary reduction" arrangement. The participant may elect to have his/her wages reduced in return for having an employer contribution made to the plan.
  2. Another common arrangement allows the participant to choose between receiving a bonus in cash or having all or a part of that bonus paid into the plan as an employer contribution. Under the CODA rules, such contributions are generally treated as employer contributions (notably for IRC 415, 411, 404, and 402) but are treated as employee contributions for certain other purposes.
    • For example, the contributions are counted as part of the employee's wages for FICA withholding, FUTA, and Railroad Retirement tax.

401(k) Facts:
According to Southern California-based (401k) Enginuity (www.401kenginuity.com), twenty-year veteran in developing and running 401(k) administration and 401(k) software and recordkeeping systems, the Internet will be the primary delivery system for 401(k)s by 2007. Many web-based 401(k) plans will run on administration and recordkeeping platforms that plan providers will outsource to 401k specialists and 401k Application Service Providers (ASP).

The advantages of web-based online 401(k) plans are obvious to today's workers, and include use conveniences, real-time monitoring and reporting, and instant re-allocation of their retirement assets. The internet has also dramatically reduce the cost of 401(k) plan administration, saving plan sponsor 50% or more in ongoing fees and costs when compared to the older traditional labor-intensive plans. Outsourcing of 401(k) functions by plan providers will extend the trend towards lower cost, high-quality 401(k) products.

401(k) plan providers of all types, financial institutions including banks, insurance companies, brokerages, mutual fund companies, credit unions, and third-party administrators, are now actively outsourcing 401(k) administration and recordkeeping tasks to 401(k) ASPs --- vendors such as 401k Enginuity, whose sole function is to maintain, updated and supervise software-based 401(k) administration and recordkeeping systems on behalf of plan providers. 401(k) ASP vendors are responsible for all routine day-to-day 401(k) recordkeeping and administration functions, thus allowing the plan providers to reduce internal staff, eliminate the expense and complications of licensing, housing and running hardware and 401(k) administration software in-house. Plan providers can refocus and concentrate their efforts on to the needs of their plan sponsors and plan participants, and rely upon the outsourced ASP 401(k) vendor for the recordkeeping and technical "backbone" supporting providers' Internet-based plans. It is inevitable that some of this 401(k) outsourcing to ASPs will include secondary outsourcing of certain non-critical low-level routine day-to-day tasks to non-US locations, where labor costs are less yet the expertise is abundant.

Legislative History

  1. Congress intended that pre-tax contributions to a CODA should generally be used for retirement . As such, elective contributions (ECs) to a qualified CODA are subject to special distribution restrictions. Unlike most contributions to profit-sharing or stock bonus plans, these contributions may not be distributed except as allowed in IRC 401k (2)(B).
  2. For years beginning after 12/31/86, state or local governments and their instrumentalities and tax-exempt organizations (except for rural co-op plans) may not maintain qualified CODAs . Any government organization that had a CODA in effect before 5/6/86, or any tax-exempt organization with a CODA in effect before 7/2/86, is allowed to continue its CODA (and add new employees to the plan) under a grandfather rule contained in section 1116 of TRA'86.

A governmental organization with a grandfathered CODA can establish other CODAs , but a tax-exempt organization cannot. See Field Directive issued on 3/12/92.

Regulatory History

  1. On 8/8/88, the Service issued both final regulations and proposed regulations under IRC 401k. In 1991, the Service released final regulations under IRC 401k (which were amended in 1994 by T.D. 8581), replacing both the final and proposed regulations issued in 1988.

CODA Defined

  1. Any plan which allows a participant an election between receiving cash and having an amount contributed on his/her behalf to a qualified plan has aCODA . All CODAs , whether or not qualified, are governed by IRC 401k, and the regulations thereunder.
  2. A CODA includes ANY choice between cash (or a taxable benefit) and a deferral, even in a defined benefit plan. A CODA election is not limited to amounts deferred from the employee's regular compensation, so any time the employer gives any employee a choice between an amount in taxable benefits and a contribution into a plan there may be a CODA .

Irrevocable Election

  1. Although any choice between cash and a deferral is technically a CODA , the regulations provide an exception. See Reg. 1.401(k)-1(a)(3)(1)(iv).
    1. A one-time irrevocable election by the employee when first hired or first eligible for any plan of the employer, is deemed not to be a choice between cash and a deferral and is therefore not a CODA election. Once such an election is made, it cannot be changed.
    2. Thus, if an employer terminated a money purchase pension plan and replaced it with a different money purchase pension plan, an employee who elected to receive a 5% contribution under the old plan may only receive a 5% contribution from the new plan.
    3. In addition, a change in status, such as from associate to partner or union employee to supervisor does NOT give rise to another one-time irrevocable election. Once an employee has participated in ANY plan of the employer, the one-time election is unavailable.
  2. A plan giving this one-time irrevocable election must allow the election to a nondiscriminatory group, and the plan (because it is not a CODA ) must satisfy the regular nondiscrimination rules. Thus, each benefit level must satisfy the nondiscrimination requirements.

Qualified and Non-qualified CODAs

  1. A qualified CODA uses a special anti-discrimination test. Under this test, the ADP test , a CODA is permitted some difference between the rate of contributions made on behalf of the highly compensated employees (HCEs) and those made on behalf of the nonhighly compensated employees (NHCEs). See IRC 401(k)(3). Certain employer contributions other than ECs (called QNECs and QMACs ) may be used by the employer to help the plan pass the ADP test . See 2.4.
    1. To be qualified, a CODA must also satisfy the coverage and nondiscrimination; nonforfeitability; distribution; and contingent benefit and participation rules, etc., under Reg. 1.401(k)-1.
    2. The CODA must also be separately accounted for, using an acceptable accounting method. This does not mean the ECs must be held in separate accounts, but the employer MUST be able to separately account for the ECs , gains, losses, etc. See Reg. 1.401(k)-1(e)(3).
    3. Generally, if these requirements are not satisfied, the CODA is non-qualified. If a plan later distributes CODA assets in violation of the terms of the plan or the CODA restrictions on distributions, the plan is generally disqualified under IRC 401(a) for ignoring the terms of the plan.
  2. The existence of a non-qualified CODA in a profit-sharing plan, stock bonus plan, or certain pre-ERISA money purchase plans (plans allowed to have qualified CODAs ) will not by itself affect the qualified status of the rest of the plan. That is, even though the CODA is not qualified, the plan is not automatically disqualified. In a non-qualified CODA , the ECs are included in the individual's gross income in the year contributed. However, they are still treated as an employer contribution for IRC 401(a)(4), 401(k), 404, 409, 410, 411, 412, 415, 416, and 417.
    1. A non-qualified CODA is not permitted to use the special qualified 401(k) participation, coverage, or nondiscrimination rules set forth in the regulations under IRC 401(a)(26), 410(b) and 401(a)(4).
    2. Instead, the ECs , with any other employer contributions to the plan, must satisfy the general participation, coverage and nondiscrimination rules under IRC 401(a)(26), 410(b) and 401(a)(4). The regulations specifically state that the ECs are not subject to IRC 401(m). See Reg. 1.401(k)-1(a)(5)(ii).
    3. If the plan is not permitted to maintain a qualified CODA (e.g., a defined benefit plan), the entire plan is disqualified by the existence of a CODA .

Partnership Rules

  1. Under Reg. 1.401k -1(a)(6)(ii), a partnership plan under which the partners can vary the amount of their own plan contributions is a CODA , whether or not the plan is intended to be a CODA . This rule is effective for contributions made with respect to plan years beginning on or after 12/31/88.
    1. The same type of variation in the amount of contributions in a corporation does not AUTOMATICALLY make the corporate plan a CODA .
    2. The partnership rule is required by the unique nature of partnership taxation. A partner's contribution to the plan on his/her own behalf is allocated to that partner and deducted on his/her own return. Any amount not contributed to the plan is the partner's own income. Thus, there is an automatic election between cash and a deferral.
  2. Notice 88-127 and Reg. 1.401(k)-1(a)(6)(ii)(c) allowed partnerships to eliminate these unintentional CODAs by eliminating the right to vary their contributions; partners could choose to participate or not participate before the later of the first day of the first plan year beginning after 12/31/88, or 3/31/89.
  3. Rev. Proc. 91-47, provided limited relief for partnership plans that had variable partnership contributions but did not properly eliminate the right to vary contributions within the Notice 88-127 time period. The revenue procedure gave such plans until the end of the 1992 plan year to distribute the partner's variable contributions in excess of the 402(g) limit for the year. The plan had to be amended by the end of 1992 to become either a qualified CODA or a plan without variable contributions.
  4. The final regulations provide special rules on the timing of partner CODA elections under qualified CODAs . Elections must be made by the close of the partnership taxable year and relate to the plan year including the last day of the partnership tax year. See Reg. 1.401k -1(d)(6)(ii)(B).
  5. Another anomaly caused by the unique nature of partnership taxation is the treatment of matching contributions made on behalf of partners. Because these matching contributions will be allocated to the partner, they are also considered ECs and elective deferrals (subject to IRC 402(g)). Thus, in 1991, if a partner makes a $7,000 elective contribution and receives a 50% matching contribution, for purposes of the ADP test and IRC 402(g) the partner has actually made a $10,500 elective deferral. See Reg. 1.401k-1(a)(6)(iii) and the preamble to the 1991 regulations, part 2.

Examination Steps

  1. Determine whether the plan allows participants the right to elect contributions to the plan in lieu of cash or some other taxable benefit. Also determine whether there is a pattern of allowing employees to elect, on a regular basis, into and out of plan participation in return for changes in compensation. This is a cash or deferred election unless it fits the one-time irrevocable election exception.
  2. If a CODA exists, determine whether the plan could otherwise have a qualified CODA (i.e., a profit-sharing plan). If the plan may not otherwise have a qualified CODA , the existence of a cash or deferred arrangement disqualifies the plan.
  3. If the plan may have a qualified CODA , determine whether the CODA is qualified (see below) or non-qualified. If non-qualified,
    1. Check whether the ECs were reported as wages in the year withheld from compensation.
    2. Check whether the plan satisfied the regular coverage and nondiscrimination rules of IRC 401(a)(4) rather than the 401k coverage and ADP test , counting the ECs as employer contributions .
  4. If the arrangement involves a partnership, determine whether the partners elected into or out of the plan within the time period specified in Notice 88-127 or satisfied Rev. Proc. 91-47.


  1. To be qualified, a CODA must:
    1. Pass the coverage and participation tests under IRC 410(b) and IRC 401(a)(26);
    2. Limit elective deferrals as provided in IRC 401(a)(30) to the amount allowed by IRC 402(g);
    3. Satisfy the IRC 401(k)(2) distribution rules; and
    4. Satisfy the ADP test.

Coverage and Participation

  1. The CODA portion of the plan, by itself, must satisfy one of the coverage tests under IRC 410(b), either the ratio percentage test or the average benefits test.
    1. To satisfy the ratio percentage test, a CODA may be aggregated with another CODA (if it has the same plan year) but may not be aggregated with any non- CODA . See 2.5.
    2. In determining whether the coverage tests have been satisfied there is a special 401k coverage rule for qualified CODAs . Under this rule, the CODA counts each person who is eligible to make an EC (an eligible employee) as "benefiting," (i.e., covered), regardless of whether the employee elected a deferral. Because any eligible person is deemed to be benefiting, an eligible employee may not be excluded from the coverage test using the 500 Hours of Service exclusion set forth in Reg. 1.410(b)-6(f)(1).
  2. Reg. 1.401(a)(4)-11(g)(3) provides that 401k and (m) plans may retroactively extend eligibility to employees for coverage purposes within 10 ½ months after the plan year in which there is a coverage problem. This retroactive correction feature cannot be used to correct other defects, such as a failure to satisfy the ADP test.
    1. IRC 401(k)(3) provides the exclusive method for testing qualified CODAs for nondiscrimination with respect to amounts. See 2.3.
    2. Under -11(g)(3) a CODA that has failed coverage because not enough people were eligible to make ECs can correct the defect by contributing QNECs equal to the average deferral percentage for the group to all employees who should have been eligible but were not.
    3. For example, if the ADP for the nonhighly compensated group is 4%, an employee who must be added to the group to satisfy coverage will have a 4% contribution made on his/her behalf to the plan.
  3. A CODA must also satisfy the IRC 401(a)(26) participation test. Like coverage, IRC 401(a)(26) treats an eligible employee as "benefiting" whether or not the employee chooses to make ECs.
    1. A non-qualified CODA may not use the special "benefiting" rules to satisfy coverage or participation.
  4. Reg. 1.401(k)-1(e)(5) provides that for plan years beginning after
  5. 12/31/88, a qualified CODA may not have a minimum service requirement for ECs in excess of one year. The plan may hold employees out of eligibility for other employer contributions (including contributions used in the ADP test ) for up to 2 years.
Examination Steps
  1. Using employment records, verify that the group of employees eligible to participate in the CODA satisfies the IRC 410(b) coverage requirements. See IRC 410(b).
  2. Check to ensure the information on the Form 5500 regarding the number of employees eligible to participate and the number of employees actually participating agrees with the employee records maintained by the employer.
Contribution Limitations
  1. IRC 402(g) provides that elective deferrals in excess of $7,000 (indexed) are included in the employee's income for the year.
  2. Indexed Limit 1988 - $7,313 1989 - $7,627 1990 - $7,979 1991 - $8,475 1992 - $8,728 1993 - $8,994 1994 - $9,240 1995 - $9,240 1996 - $9,500 1997 - $9,500
  3. IRC 402(g) is applied to the participant (for the participant's tax year) rather than the plan. Thus, a participant covered by two unrelated plans cannot defer (using elective deferrals ) more than $8,994 overall in 1993. In addition, IRC 402(g) is applied to plans through IRC 401(a)(30), which provides that accepting contributions from a participant in excess of the 402(g) limit ( excess deferrals ) is a disqualifying event.
  4. Under IRC 401(a)(30), if the employer has more than one plan, the plans must state that the plans of the employer (taken together) will not accept elective deferrals on an employees' behalf in excess of the IRC 402(g) limit.
    1. For example, if an employee works for Company Y from January to June and then transfers to related Company Z for the next six months, his elective deferrals into Company Y's plan and into Company Z's plan for the calendar year are aggregated to determine whether the 402(g) limit has been exceeded.
    2. Under the statute, the plans will fail qualification if they accept excess deferrals.
    3. However, Reg. 1.402(g)-1 provides a correction mechanism for excess deferrals. A plan may distribute the excess deferrals by April 15 of the following year, if the plan permits such a distribution and an employee requests or is deemed by the plan to request a distribution of the excess.
  5. If excess deferrals are not distributed and are not disqualifying (i.e., made to two unrelated plans) they must remain in the plan until there is a permitted distribution event. Under IRC 402(g)(7), any excess deferral not distributed by April 15 of the following year will be taxed twice, once in the year contributed, and again when distributed.
    1. excess deferrals on behalf of the HCEs distributed before April 15 are included in the ADP test but not counted as annual additions under IRC 415.
    2. excess deferrals on behalf of the NHCEs prohibited by IRC 401(a)(30) are not included in the ADP test , and are also not counted as annual additions under IRC 415. See Reg. 1.402(g)-1(e)(1)(ii).
    3. If an excess deferral is distributed before April 15, the plan should count that distribution as an offset against any distribution of an excess contribution that must be made to that employee to correct the ADP test. See 2.4.
  6. The 402(g) limit only affects elective deferrals (including partner's matching contributions); it does not affect other contributions that may be included in the ADP test. The amount of the 402(g) limit may be incorporated by reference.

Examination Steps

  1. If the employer group has more than one plan, ask whether the other plan(s) allow elective deferrals and how the plans coordinate. Check to see if any employee in the plan also made elective deferrals to the other plans.
  2. Verify there were no excess deferrals to the plan(s), or if there were excess deferrals , they were corrected by April 15 of the following year. If corrections were made, check for plan language allowing such corrections.
  3. Verify the excess deferrals were included in the highly compensated ADP, and not in the nonhighly compensated ADP (either check the records or run the test).
  4. Verify that the plan properly reported distributions of excess deferrals on Form 1099-R.

IRC 401(k)(2) Requirements

  1. To satisfy IRC 401(k)(2), a CODA must have a proper CODA election (between a deferral and cash ), restricted distributions, and 100% immediate vesting of ECs and other contributions used in the ADP test.
  1. A cash or deferred election in a qualified CODA has the following characteristics:
    1. Effective after adoption
    2. Not currently available
    3. Cash election

Date Effective

  1. The election may not be made effective prior to the later of the date the cash or deferred arrangement and the plan are adopted or become effective. Until the cash or deferred arrangement (and the plan) are in operation, participants cannot make elective deferrals.

Not Currently Available

  1. The election must be with regard to amounts not yet currently available. An amount is "not currently available" if the participant does not yet have a right to receive that amount. See Reg. 1.401(k)-1(a)(3)(iii).
    1. For example, an amount is not currently available if it has not been earned or if payday has not come. Occasionally, a condition is placed on the amount that keeps it from being currently available.
    2. For example, a bonus might be payable only if the participant is still employed on the last day of the year.
  2. For a partner, income is not currently available until the end of the partnership tax year. Most partners take "draws" against that income during the year. These draws are not income for income tax purposes, they are more like advances against the partner's expected income. Thus, "draws" against income during the year do not cause an election at the end of the partnership tax year to be made after an amount is "currently available" .

Cash Election

  1. Reg. 1.401(k)-1(e)(2) provides that the election must be between a deferral and CASH, not just a taxable benefit. The employee must be allowed the option to have the amount paid as wages during the year.

Examination Steps

  1. Ensure the plan is adopted and in effect, AND the election was in effect before the employee has a right to the amount.
  2. Ensure the employee has a choice between the deferral and cash , not just some other taxable benefit.

Restricted Distributions

  1. IRC 401(k)(2)(B) provides the ECs may only be distributed on death, disability, separation from service, and as provided in IRC 401(k)(10). ECs to a profit-sharing or stock bonus plan may also be distributed after age 59 ½ or on account of hardship.
  2. Distribution of any contribution that could be used in the ADP test (i.e., QNECs or QMACs ) must be similarly restricted.

Plan Termination

  1. IRC 401(k)(10)(A) provides that the plan may distribute CODA assets to employees if the plan is being terminated and the employer does not maintain or establish another defined contribution plan (other than an ESOP).
    1. Thus, generally, if any employer who is in the employer group at the effective date of the termination has a defined contribution plan, the CODA assets must be transferred to that plan rather than distributed to the employees.
    2. However, distributions of CODA assets are permitted if less than 2% of the employees of the terminating plan have been eligible or will become eligible for the other plan in the 12 months before and the 12 months after termination. See Reg. 1.401(k)-1(d)(3).
  2. If the CODA is permitted to distribute assets, the distribution must be in the form of a lump sun. See Reg. 1.401(k)-1(d)(5). In plans subject to the joint and survivor distribution rules, this requirement may be satisfied by the distribution of an immediate annuity that satisfies the Qualified Joint and Survivor Annuity requirements set forth in IRC 401(a)(11) and IRC 417.

Sale of Subsidiary/Assets

  1. IRC 401(k)(10)(A)(iii) allows distributions from a CODA to employees of a subsidiary sold to an unrelated company. Similarly, distributions are permitted to employees of a trade or business if the corporation sells at least 85% of the assets used in the trade or business to an unrelated corporation .
    1. For example, if the corporation has a CODA for all of its employees, including those in a subsidiary, and the subsidiary is sold, any employee who stays with the subsidiary after sale may receive a lump sum distribution from the CODA . This distribution is only permitted if the purchasing company has not accepted a merger or transfer under IRC 414(l) of some the plan's assets or liabilities, or otherwise taken over maintenance of part of the plan. See Reg. 1.401(k)-1(d)(4).

Hardship Distribution

  1. A profit sharing or stock bonus plan may provide that ECs are available for distribution on account of hardship. However, as a general rule, QNECs, QMACs, and accrued gains may not be distributed on account of hardship.
    1. The regulations permit a plan to provide a grandfather rule for interest, QNECs, and QMACs accrued prior to 12/31/88, (or if later, the end of the last plan year ending before 7/1/89). See Reg. 1.401(k)-1(d)(2)(ii). This is done by determining the ECs, QNECs, and QMACs on the applicable date and using this as a frozen amount. Losses in the account after that date do not reduce this amount.
      Other employer contributions, outside of the CODA , are not subject to these more restrictive hardship rules. Thus, a profit-sharing plan could have one set of rules for hardship distributions from the CODA and another, less restrictive, set of rules for other non- CODA contributions.
  2. To make a hardship distribution the plan must determine:
    1. There is an immediate and heavy financial need, and
    2. A distribution from the plan, of the specified amount, is necessary to satisfy the financial need.

Immediate And Heavy Financial Need

  1. The plan must determine whether the participant has a financial need. Therefore, participants must specify what they need and why . As stated in the regulations, there is generally no financial need for a TV or boat, nor, presumably, for any other luxury item. There are four instances in which the plan need not determine whether the participant needs the money. Basically, the need is presumed in these "deemed hardship" situations (if the plan adopts the deemed hardship rules):
    1. Medical expenses (as the term is defined in IRC 213, without regard to the AGI limit specified) incurred, to the extent not reimbursed by insurance. A distribution necessary to pay for procedures that have not yet occurred is permitted.
    2. Purchase of a primary residence for the participant. (This does not include making mortgage payments.)
    3. Post-secondary school tuition and tuition-like fees (e.g., lab fees) for the next 12 months.
    4. Prevent eviction/foreclosure from the participant's primary residence.

Necessary to Satisfy Hardship

  1. In determining whether a distribution is necessary, the plan generally looks at the other resources available to the employee. That is, the plan must determine what other assets the employee has (vacation homes, insurance policies, availability of loans from the plan or a bank (at reasonable rates), etc.). Remember the basic retirement plan principle is that money should be kept in a retirement plan. Thus, a loan is preferable to a distribution because the plan will be repaid.
    A loan from a commercial source or a loan from the plan (if otherwise available) can be ruled out unless the full amount can be reasonably obtained from either. However, a plan may permit a combination of a plan loan up to the limits of IRC 72(p) and a hardship distribution which together are sufficient to satisfy the financial need.
  2. The plan may state it will deem a distribution to be necessary (having already determined there is an immediate and heavy financial need) if it meets the four safe harbor requirements set forth in Reg. 1.401(k)-1(d)(2):
    1. The distribution is not in excess of the amount needed,
    2. The employee has obtained all distributions and nontaxable loans currently available under all plans maintained by the employer,
    3. All plans of the employer limit the employee's ECs to the 402(g) limit minus the employee's ECs for the year of the distribution, and,
    4. The employee is prohibited from making ECs and employee contributions to any plan of the employer for at least 12 months after receiving the distribution.
  3. This "deemed necessary" safe harbor is a method by which the employer can avoid examining the employee's "other resources" . It is not required. However, if it is not used, the plan administrator must have some method of determining whether the participant has other resources available.
  4. The participant will have to state the amount that will satisfy the hardship. No more than that amount can be distributed. The participant may include in the "amount necessary" the taxes due on the distribution, assuming the increase due to taxes is reasonable given the applicable tax rates.
  5. To the extent the plan does not use the deemed hardship rule and the deemed necessary rule, the plan must state, in objective nondiscriminatory terms, what it considers an immediate and heavy financial need and what criteria will be used to determine whether the distribution is necessary.
    1. Thus, the plan could state that it allows a distribution for a specified circumstance, like paying funeral expenses, that would generally be a hardship. The plan or administrative procedures would have to provide the criteria used to determine whether the participant has an immediate and heavy financial need for a distribution to satisfy these expenses.
  6. Under Reg. 1.411(d)-4, a plan may not have a "catch-all" hardship category (i.e., "and other events which the plan administrator deems to be hardships" ), because it would be impermissible employer discretion. The plan may be amended to add or eliminate a hardship category, if the employer feels the need. Hardship categories (deemed or otherwise) must be both currently and effectively available to a group of participants that satisfies Reg. 1.401(a)(4)-4.
  7. The employer is permitted to rely on the employee's statement that there are no assets, and that he/she could not obtain a loan at a reasonable rate for an amount sufficient to satisfy the financial need, unless the employer has actual knowledge to the contrary. If the employer has actual knowledge of other assets, etc., the plan administrator is charged with that knowledge.

Examination Steps

  1. Make sure amounts that can be used in the ADP test ( ECs, QNECs, and QMACs ) can only be distributed on death, disability, separation from service, hardship (if allowed), and as provided in IRC 401(k)(10).
  2. If the CODA has been terminated, determine whether the employer had another defined contribution plan in existence at the time of termination or established one in the 12 months following termination.
    1. If so, the CODA is non-qualified unless the assets are transferred to the existing DC plan or the 2% overlap rule is satisfied.
    2. If not, the CODA assets could be distributed but only in the form of lump sum distributions.
  3. If the plan allows hardship distributions, make sure only ECs and grandfathered amounts can be distributed. Also make sure such hardship distributions are governed by safe harbors, or by objective criteria, clearly stated in the plan.


  1. Under IRC 401(k)(2)(C) and IRC 401(k)(3)(D)(ii), an employee's interest in ECs, QNECs, and QMACs must be nonforfeitable when made. Thus, an employer may not redesignate a particular contribution as a nonforfeitable contribution and call it a QNEC as needed to satisfy the ADP test for the year.

Permitted Forfeiture of Matching Contributions

  1. Under IRC 401(k)(8)(E) and IRC 411(a)(3)(G), a plan is allowed to forfeit a vested or non-vested matching contribution made on account of an EC or employee contribution that has been distributed to satisfy the ADP test (or the ACP test or as excess deferrals ).
  2. Under Reg. 1.401(a)(4)-4, a matching contribution still in the plan but was matched to an excess contribution (or an excess aggregate contribution ) that is now distributed is matched at a higher rate than is otherwise available, and is likely to be discriminatory. If this matching contribution is not required to be distributed as an excess aggregate contribution under the ACP test , it should be forfeited. It cannot be distributed, because there is no mechanism for distributing amounts that fail the Reg. 1.401(a)(4)-4 availability test.
    1. Of course, an amount may only be forfeited under this section if the plan has a provision allowing such a forfeiture.

Examination Step

  1. Verify that any amounts used to satisfy the ADP test ( ECs, QNECs, and QMACs ) are 100% immediately vested at all times.

ADP test

  1. IRC 401(k)(3) provides a discrimination test for qualifiedCODAs that is in lieu of the amounts test under IRC 401(a)(4). Under the ADP test , the average deferral percentage ( ADP ) of the HCEs cannot exceed the greater of--
    1. 1.25 ADP of NHCEs, or
    2. lesser of --2 + ADP of NHCEs or 2 X ADP of NHCEs.
  2. The employer is required to maintain the records necessary to prove IRC 401k has been satisfied. If the employer fails to provide the required documentation, the CODA may be non-qualified. See Reg. 1.401(k)-1(e)(8).
  3. ADR and ADP

    1. Before running the test, the employer must determine the actual deferral ratio ( ADR ) for each employee.
      1. The ADR = the employee's (ECs + QNECs + QMACs) ÷ compensation
    2. The employer must next separately determine the ADP for the NHCE group and the HCE group. The ADP is the average of the ADR s for the group.
    3. Each individual's ADR and the ADP for each group must be calculated to the nearest one-hundredth of 1% of the employee's compensation. See Reg. 1.401(k)-1(g)(1).

    Highly Compensated Family ADR and ADP

    1. The compensation and contributions of employees who are family members of:
      1. 5% owners, or
      2. one of the 10 most HCEs, must be aggregated as though all the family members are one employee.
    2. IRC 414(q) defines "family member" as the employee's spouse, lineal ascendants and descendants and their spouses.
      1. For example, a 5% owner and his daughter, both of whom work for the same employer, are treated as a single employee for most purposes under a CODA . Thus, the plan must determine the ADR for the family group in order to run the ADP test .
    3. To find the ADR of the family group, the plan adds together the contributions ( ECs, QNECs, and QMACs ) made on behalf of all family members who are eligible to make ECs , and divides the aggregate contribution amount by the aggregate compensation of these family members. A family member who is eligible to make contributions but has not done so is counted. This calculation determines the ADR for the family group.
    NOTE: This test is NOT the same as the test shown in the proposed regulations. The prior test was eliminated in favor of a simpler test.

Excess Contribution Determination

  1. A plan must use the leveling method to determine how much of the excess contribution is to be allocated to each HCE for recharacterization or distribution. See Reg. 1.401(k)-1(f)(2).

Leveling Method

  1. Under this method, the HCE with the highest ADR will have the greatest excess contribution. The highest ADR is reduced to the next highest level, and so on until the ADP reaches the maximum acceptable ADP under the ADP test .
  2. The "Short Cut Leveling Method" is calculated as follows:
    1. (4 (A's ADR ) + 2X) ÷ 3 (# of HCEs) = 5 (Target ADP ). Solve for X, X = 5.50

Leveling Method for HCE Family Group

  1. When an employer has employees who are related to a HCE, or a former HCE, extra steps are needed to determine the ADP for the aggregated family group.

Examination Steps

  1. Verify that the ADP for each group (HCE and NHCE) has been properly determined.
  2. Compare the ADPs of the HCE and NHCE groups with the employer's records to see if the ADP test has been satisfied.
  3. Test check whether the highly compensated group has been properly determined, using payroll and organizational data. Ensure that the eligible family members, as defined in IRC 414(q), have been aggregated.
  4. Verify that the leveling method was used to determine the amount of excess contributions and to allocate the excess to HCEs.


  1. There are three methods for correcting excess contributions :
    1. Distribution,
    2. Recharacterization, and
    3. Contribution of QNECs and QMACs.
  2. To use any method of correction, the method must be stated in the plan. A plan may provide for more than one correction method or may provide for a combination of methods.
  3. The plan has 12 months after the end of the plan year being tested to correct excess contributions . The plan may distribute excess contributions any time during the 12 month period, but the employer will be subject to a 10% excise tax under IRC 4979 (see below) for distributions made more than 2 ½ months following the end of the plan year.
    1. The plan may recharacterize excess contributions only during the first 2 ½ months following the end of the plan year being tested.
    2. The plan may contribute QNECs or QMACs , or both, to correct the ADP test any time during the 12 months following the plan year being tested, without incurring the IRC 4979 tax.
  4. If the corrections are not made within the 12 month period, the CODA is non-qualified and the plan may be disqualified.
    1. Failure to correct excess contributions will result in the CODA being non-qualified not only for the plan year for which the excess contributions were made but also all subsequent plan years during which the excess contributions remain in the trust. See 2.1.4, for the treatment of non-qualified CODAs .
    2. Once the excess contributions (and applicable gains or losses) have been distributed, the CODA will be requalified for the following plan year. See Reg. 1.401(k)-1(f)(6)(ii).
  5. Relief is given to employers for the 1987, 1988, and 1989 plan years if QNECs are added to satisfy the ADP tests for those years and the additional tax under IRC 4979 is paid on the amounts that would have been due were QNECs not added. These corrections may be made any time during the 401(b) period (now extended through 1994). This relief has not been extended to any subsequent years. See Field Memorandum issued on 10/12/90.

Correction by Distribution

  1. For plan years beginning on or after 1/1/87, Reg. 1.401(k)-1(f)(4) allows a plan to correct excess contributions by making taxable distributions of the excess contributions (and the attributable income) to the HCEs on whose behalf the excess contributions were made. Each HCE's portion of the excess is calculated using the leveling method. See
  2. The plan may offset the excess contributions to be distributed by any excess deferrals that have already been distributed to that participant.

Timing and Treatment

  1. Distributions of both the excess contributions and the attributable income must be reported on Form 1099-R and designated as "excess contributions" to distinguish them from other distributions.
    1. Such distributions are taxable distributions under IRC 72, but are not subject to the spousal consent rules or the early withdrawal tax under IRC 72(t).
    2. The distributions must be immediately subject to income tax, so a "distribution" of the excess contributions into a non-qualified deferred compensation arrangement is not a permissible method of correction.
  2. If the distributions are made within the first 2 ½ months of the following plan year, the distributed amounts are treated (for income tax purposes) as if they were received by the employee as of the earliest date the employee could have received the amount in cash. Thus, the distributions are generally taxable or partly taxable (see example below) in the prior year, and in an even earlier year. See Reg. 1.401(k)-1(f)(4)(v).
    1. If the distributions are made after the first 2 ½ months, the distributions are taxable in the year distributed (and the employer is subject to the IRC 4979 tax).
    2. However, if the total excess contributions and any excess aggregate contributions are less than $100 (without regard to the attributable income), the amount is included in gross income in the year distributed even if the amounts are distributed in the first 2 ½ months.

Income/Loss Calculation

  1. A plan must distribute both the excess contribution and the income/loss (earned or lost by the close of the plan year) attributable to that contribution.
    1. Under the final regulations, any reasonable method of determining income/loss otherwise used by the plan may be used to determine income/loss attributable to excess contributions .
    2. The final regulations do not require the plan to determine or pay out the "gap period" income (i.e., the income earned between the end of the plan year and the distribution date). However, if a plan does provide for payment of gap period income, the method used must be consistent for all participants and must otherwise be used in the plan.

Correction by Recharacterization

  1. IRC 401(k)(8)(A)(ii) allows plans to correct an excess contribution by "recharacterizing" an employee's excess contributions as an employee after-tax contribution. This is a fiction in which the plan "distributes" the excess contribution but then allows the employee to "contribute" this distribution as an after-tax employee contribution.
    1. Plans may only recharacterize excess contributions within the first 2 ½ months after the plan year during which the excess arose.
    2. The "distribution" is included in gross income and must be reported on Form 1099-R.
      However, the income or loss attributable to the excess contribution is not treated as distributed. Like amounts actually distributed, recharacterized amounts are includible in the participant's gross income as of the date they would have been received had the participant elected to take them in cash. This is because the amount is treated as if it was received by the employee during the plan year and contributed to the plan on an after-tax basis.
  2. Once an amount has been recharacterized, it will be considered an employee contribution subject to the ACP test . However, for all other qualification purposes, such as IRC 404 deductibility, the recharacterized amount continues to be considered an employer contribution.
    1. The use of recharacterization in a plan that does not otherwise allow employee after-tax contributions would be discriminatory because only HCEs with recharacterized excess contributions could make employee contributions. Therefore, Reg. 1.401(k)-1(f)(3)(iii)(B) precludes recharacterization as a correction method in such a plan.
  3. The employer or plan administrator must promptly notify the employees to whom the excess contributions are attributable that the excess contributions are being recharacterized and must inform them of the tax consequences of the recharacterization. The date of the recharacterization (used to determine whether the 2 ½ month rule has been satisfied) is the date on which the last affected employee receives notification. See Notice 89-32, 1989-1 C.B. 671.
    1. The plan may require recharacterization or may allow the HCEs to choose between recharacterization and distribution.
Correction by Use of QNECs and QMACs
  1. If the plan allows, an employer may correct excess contributions by contributing qualified nonelective contributions ( QNECs ) or qualified matching contributions ( QMACs ), or both. These employer contributions are treated as ECs for purposes of the ADP test if they satisfy certain conditions.


  1. IRC 401(a)(4) must be satisfied, both including and excluding QNECs .
    1. The plan must first test the total QNECs with other nonelective contributions to see if these allocations favor the HCEs.
    2. Next, the QNECs not used in the ADP test are tested with other nonelective contributions to see if the net QNECs favor the HCEs.
  2. QMACs not used in the ADP test are tested in the ACP test under IRC 401(m). See Reg. 1.401(k)-1(b)(5).
  3. QNECs and QMACs , when contributed, must be 100% vested and must be subject to the same distribution restrictions imposed on ECs , whether or not they are actually used in the ADP test , or ACP test for the year. See Reg. 1.401(k)-1(g)(13)(iii). Thus, a QNEC cannot be an unrestricted profit-sharing contribution that is "recharacterized" as a QNEC just because it is needed in the ADP test or the ACP test .
  4. If QNECs or QMACs are given only to NHCEs, they are nondiscriminatory unless needed to help other non-elective contributions satisfy IRC 401(a)(4), or to help other employee or matching contributions satisfy IRC 401(m). An employer may give QNECs or QMACs to some NHCEs and not to others, if permitted by the plan document.


  1. Contributions of QNECs or QMACs may be made as late as 12 months after the year for which they are allocated. If they are added, even after the Form 5500 filing date, they "cure" the ADP test and therefore the employer is not liable for the 10% additional tax under IRC 4979.
    NOTE: Contributions made after the filing date are not deductible for the prior plan year. These contributions are counted, with other employer contributions, against the IRC 404 deduction limits in the year made.

IRC 4979 Tax

  1. IRC 4979 applies a 10% tax (the 4979 tax) on any excess contributions not corrected within 2 ½ months after the end of the plan year being tested. However, the tax is not applied if QNECs or QMACs were added within 12 months after the end of the plan year being tested. If the QNECs or QMACs added were insufficient to fully satisfy the ADP test , the tax will apply to the remaining excess contributions .
  2. The 4979 tax is applied to the employer, and is due 15 months after the end of the plan year being tested. See Reg. 1.4979-1. The extension of the time to pay the tax is not an extension of the time to correct the plan. The tax is reported on Form 5330.
  3. The 4979 tax is a one-time tax. Thus, if the ADP test is not satisfied and the excess contributions are not timely corrected, the tax applies only for that year.

Examination Steps

  1. Verify that any methods used to correct excess contributions are specified in the plan document and that the document is followed (otherwise the employer has failed to follow the plan's terms and the plan is therefore disqualified under Reg. 1.401-1(a)(2)).
  2. Establish whether the corrections were made in a timely manner, and, if necessary, included gains or losses.
    1. If excesses were distributed, determine whether the distributions were made within 2 ½ months of the end of the plan year in which the excess arose. If not, determine whether the 4979 tax was paid.
    2. Determine whether the employer properly reported the distribution of excess contributions as taxable income to the participants on Form 1099-R.
    3. If the correction is by recharacterization, determine whether that recharacterization occurred within 2 ½ months following the end of the plan year in which the excess arose. Ensure all of the recharacterization notices were sent out before the end of the 2 ½ month period, and that Forms 1099-R were issued.
    4. If the correction is by additional contributions, determine whether the contributions were made within one year following the end of the plan year in which the excess occurred. Check to see whether the timing of the contributions matches the timing of the deductions.
  3. If corrections were not made within the next plan year, treat the CODA as a non-qualified CODA and determine whether the IRC 401(a)(4) nondiscrimination requirements are satisfied, counting the ECs as employer contributions.


  1. If a plan contains more than one CODA , the CODAs must be aggregated for purposes of the ADP test .
    1. If the employer has different plans, each with a CODA , the CODAs may be aggregated. If so, the plans must also be aggregated for coverage and discrimination testing.
    2. If an employer is required to aggregate two or more plans in order to satisfy the coverage and discrimination requirements, the CODAs included in such plans must be treated as a single CODA . CODAs may not be aggregated unless they use the same plan year. See Reg. 1.401(k)-1(b)(3).
  2. Generally, if a HCE is eligible to participate in more than one plan containing a CODA , the HCE's ECs under all of the employer's CODAs must be combined to determine the ADR. This combination ADR is then used in each different plan.


  1. For the 1989, 1990, and 1991 plan years ONLY, a plan is permitted to be "restructured" into component plans, each of which is considered a separate plan for purposes of the ADP test . Each component plan must satisfy coverage. The component plans must be restructured using employee groups that have some "commonality" , i.e., some common business feature that links the employees together.
    1. For example, the method of salary or wage payment could be a common feature. Thus, a plan could be separated into a component plan covering only the hourly employees and a component plan covering only the salaried employees.
  2. A plan cannot be restructured based upon whether an employee contribution is made to the CODA . Likewise, a plan cannot be restructured based upon a compensation range (e.g., employees with compensation above $30,000 are in Group 1, employees with compensation below $30,000 are in Group 2).
  3. If one component plan satisfies the ADP test (and the coverage requirements) but the other does not, the employer is permitted to make corrections just to the component plan that failed the ADP test .


  1. If a plan is disaggregated into separate plans for purposes of IRC 410(b), the CODA must also be disaggregated.
    1. For example, if a plan covers all employees, but, for testing purposes the plan is disaggregated into two plans, one covering employees with less than 1 year of service and less than age 21, and one covering all other employees, the employer would run two ADP tests , one for the employees with less than 1 year of service and less than age 21, and the other for all other employees.
  2. For plan years beginning after 12/31/89, an ESOP must be disaggregated from a CODA in the same plan. See Regs. 1.401(k)-1(b)(3)(ii)(B) and 1.401(k)-1(g)(11)(iii)(B). Even if an employer maintains CODAs in both an ESOP and another plan, and a HCE participates in both, the CODAs are not aggregated.
  3. Under Reg. 1.401(k)-1(g)(11)(iii)(A), employees covered by a collective bargaining agreement must be disaggregated from employees not covered by a collective bargaining agreement for purposes of the ADP test .
      Under a reproposed regulation 1.401(k)-1(g)(11)(iii), issued on 1/4/93, separate collective bargaining units within the same plan may be disaggregated but are not required to be disaggregated for purposes of the ADP test . Under the reproposed regulations, the combination of bargaining units used for testing must be reasonable and reasonably consistent from year to year. Equivalent rules apply to multi-employer plans.

Examination Steps

  1. Make sure if the CODAs are aggregated (either permissively or mandatorily), the underlying plans are also treated as one plan.
  2. Ensure only plans with the same plan year are aggregated.
  3. If a plan is disaggregated under IRC 410(b), make sure the ADP test is also run separately on each disaggregated plan.
  4. If there is an ESOP, make sure it is not aggregated with a non-ESOP to meet the ADP test .


  1. Under Reg. 1.401(k)-1(e)(6), the employer may not directly or indirectly condition another employer benefit upon the employee's election to make or not make ECs .
    1. For example, benefits under a DB plan, nonelective employer contributions to a DC plan, benefits under a non-qualified plan, the right to make employee contributions, the right to health and life insurance, and the right to employment may not be conditioned upon participation in the CODA . However, matching contributions made to a qualified plan based on ECs are not considered conditioned upon another employer benefit. If the employer has made an employer benefit conditioned upon ECs , the CODA is non-qualified. NOTE:
      This rule is in the statute to prevent employers from encouraging employees to make or not make ECs by linking valuable benefits to the contribution or lack of a contribution.

Examination Steps

  1. Determine whether the employer ties any benefits other than matching contributions to making contributions. In certain circumstances it may be appropriate to ask employees whether employees who make or fail to make ECs get any special treatment from the employer.
  2. Determine whether there is a non-qualified plan linked with the CODA . If there is, ensure there are no conditions in the form or in the operation of the non-qualified plan made with respect to participation, lack of participation, or reduced participation in the CODA .


  1. IRC 125 permits an employer to maintain a "cafeteria plan" . A cafeteria plan allows an employee to select among various types of employer benefits by specifying where an employer contribution should be spent.
  2. Cafeteria plans are permitted to offer a contribution into a qualifiedCODA as one of the options. If so, another option in the cafeteria plan must be direct payment of cash to the employee of the amount contributed to the cafeteria plan. See also 2.12, concerning IRC 415 compensation where there is a cafeteria plan.

Examination Step

  1. Ask whether the employer has a cafeteria plan that allows a contribution to the CODA . Review the options available to the cafeteria plan participants to ensure that receiving cash is one of the listed options.


  1. For purposes of satisfying the IRC 410(b) coverage test and the ADP test , an "eligible employee" is one who is eligible under the plan to make an EC . The term includes an employee who--
    1. chooses not to make a mandatory after-tax employee contribution in a plan requiring after-tax contributions as a prerequisite to CODA participation,
    2. has been suspended from the plan (e.g., for having taken a hardship distribution), and
    3. may not receive contributions because of the limits imposed by IRC 415(c) and (e).
  2. Reg. 1.401(k)-1(g)(4) provides that if an employee is required to do any "purely ministerial or mechanical act" in order to make an EC , that person is counted as an eligible employee even though the stated act has not occurred. Thus, if an employee must fill out an application in order to be able to make ECs , that employee is counted as eligible even if no application was completed.
  3. The deferral percentage of every eligible employee must be considered when running the ADP test . This is so whether or not an employee actually chooses to defer.
    1. For example, if an eligible employee chooses not to make an EC for a particular year (and no QNECs are made on his/her behalf), that employee's deferral percentage, 0%, must be included in the ADP for the employee's group for that year.
  4. If the only eligible employees are HCEs, the plan automatically passes the ADP test . See Reg. 1.401(k)-1(b)(2)(i). However, the IRC 410(b)(1) coverage test and the IRC 401(a)(26) participation test must also be satisfied.

Examination Steps

  1. Establish that the group of employees counted in the ADP test contains all those who are eligible under the plan to make ECs , even if those employees do not make ECs .
  2. Determine whether employees who are eligible to make a deferral but cannot because they have been suspended from making deferrals (e.g., because of receiving a hardship distribution) have been included as "eligible" with a deferral percentage of "0" when running the ADP test .
  3. Check the overall group of eligible employees to determine whether those who have, for instance, at least one year of service are allowed to make deferrals. Also ask if any other benefits are contingent on a contribution into the CODA .
  4. Compare the total number of eligible employees (including those who would be eligible but for a plan provision requiring a ministerial or mechanical act) with the number of employees used to run the ADP test . They should be the same.
  5. Test check the computer printout or ledger to see if individual employees who have not made a deferral have a deferral percentage of 0. Remember, for plan years beginning after 12/31/86, employers are obligated to keep sufficient records to show the ADP test is satisfied. If they do not, the CODA may be non-qualified. See Reg.
  6. 1.401(k)-1(e)(8).


  1. To be taken into account when running the ADP test for a particular plan year, ECs must be allocated to the employee within that plan year and paid to the trust no later than 12 months after the end of the plan year to which the contributions relate. Further, the contributions must relate to compensation that, but for the employee's election to defer, the employee would have received in the plan year or would have received within 2 ½ months after the plan year for service performed during that plan year. See Reg. 1.401(k)-1(b)(4)(B)(2).
    The Department of Labor (DOL) has more stringent rules on the timing of payments of elective deferrals into the trust.
  2. If a bonus is paid AFTER the 2 ½ month period but is attributable to and allocated to the prior year, it cannot be counted in the ADP test for either year. It must be tested as a regular employer contribution to the profit sharing plan and pass the regular nondiscrimination rules.
Examination Steps
  1. Use payroll records to verify ECs are based on compensation that would have been paid during the plan year (or within 2 ½ months after the plan year) for services performed during the plan year.
  2. Make sure ECs are allocated within the plan year and that they were actually paid to the trust within 12 months of the end of the plan year.


  1. For plan years beginning after 12/31/88, an employer may not take into account more than the IRC 401(a)(17) compensation for the year in determining allocations to the plan. In 1989, this limit was $200,000. The indexed limit was: $209,200 (1990); $222,220 (1991); $228,860 (1992); and $235,840 (1993).
  2. In 1994, the compensation limit was reduced to $150,000. In a CODA , the compensation used to determine the ADR for an individual is limited to the IRC 401(a)(17) amount. Thus, in 1994, if an employee has total compensation of $300,000, and an allocation of $9,240, the ADR is ($9,240 ÷ $150,000), or 6%.

Family Aggregation

  1. Under IRC 401(a)(17), spouses and their children under age 19 are counted together as a family group.
    This is much narrower than the HCE family grouping.
  2. Regulations have not been issued providing guidance on how the family aggregation rules apply. In the absence of further guidance, a reasonable interpretation of the statute is the standard to which qualified plans will be held. The steps below illustrate the method used in the National Office Master and Prototype Program.
    1. Add together the compensation of all employees in the IRC 401(a)(17) group, and cap the total at the IRC 401(a)(17) limit (as indexed);
    2. Identify the remainder of the IRC 414(q) family group, if any, and cap each member at the IRC 401(a)(17) limit (as indexed),
    3. Add the capped compensation of the IRC 401(a)(17) group to the compensation of the other members of IRC 414(q) family group, but do not cap the total.


  1. Every employer maintaining a qualified plan must satisfy the top heavy requirements of IRC 416. If an employer maintains only a plan containing a CODA , the required top heavy minimum contributions must be satisfied in that plan for any year the plan is top heavy. If there are other plans, the employer may (but not must) satisfy the minimum contribution requirements in another plan instead of the CODA .
  2. ECs on behalf of key employees must be taken into account as employer contributions. See Reg. 1.416-1, M-20.
    1. If any key employee has an overall allocation of at least 3% of compensation, all eligible non-key employees must receive an employer contribution of at least 3% of compensation.
    2. If the highest contribution on behalf of any key employee is less than 3% of compensation, the non-key employees should receive a percentage of compensation equalling the percentage of compensation paid to the key employee receiving the highest percentage of compensation under the plan for the year.
    3. For example, if one key employee gets 2.3% of compensation and all other key employees receive 2% of compensation, the non-key employees should receive a minimum contribution of at least 2.3% of compensation. The existence of another plan, such as a DB plan, may change these rules.
  3. For plan years beginning after 12/31/88, ECs and QMACs (if used in the ADP test or ACP test ) made on behalf of non-key employees may not be used to satisfy the IRC 416 minimum contribution requirements . See Reg. 1.416-1, M-19 and 20.
    1. Thus, the employer will be required to make additional contributions on behalf of the non-key employees.
    2. Similarly, any amount used to satisfy the minimum contribution requirements may not be counted as a matching contribution.
    3. QNECs , however, whether or not used to satisfy the ADP test , can be used to also satisfy the required IRC 416 minimum contribution. See Reg. 1.416-1, M-18.

Examination Steps

  1. Determine whether the 416 top heavy minimum contributions are being provided in some plan of the employer. If the CODA is the only plan and the plan is top heavy, determine whether the non-key employees are receiving the required minimum employer contribution.
  2. Ensure that ECs on behalf of key employees are counted in determining the percentage of compensation contributed on behalf of key employees. Also make sure ECs (and QMACs ) on behalf of non-key employees are not counted.


  1. A plan can use any definition of compensation for determining allocations (but only to the extent the definition is stated in the plan). However, Regs. 1.415-2(d)(2) and (3) define compensation for purposes of determining whether a plan meets the IRC 415 limits.
    1. Under this definition, neither elective deferrals nor deferrals under a cafeteria plan may be counted as compensation for IRC 415 purposes.
    2. In contrast, IRC 414(s) permits inclusion of elective deferrals and cafeteria plan deferrals. Thus, if an employer uses another definition of compensation to determine allocations (even one that satisfies IRC 414(s)) the employer may run into a IRC 415 problem in certain instances. This has been a recurring problem in the VCR cases.


  1. Reg. 1.415-6(b)(6) (amended with the 401k regulations) may permit a plan to correct this problem.
    1. Assuming the plan made a "reasonable error in determining the amount of elective deferrals that may be made with respect to an individual under IRC 415" (which may or may not be the case in Example 15), the plan could put such amounts into a suspense account (Regs. 1.415-6(b)(6)(i)--(iii)) or distribute either elective deferrals or employee contributions to correct the problem (Reg. 1.415-6(b)(6)(iv)).
    2. The correction may be made even a few years after the error occurs. Of course, the plan must have such correction language in the plan document. See Rev. Proc. 92-93, 1993-2 C.B. 505, for information on the correction method.
  2. If the plan elects to distribute the elective deferrals to correct a IRC 415 problem, the ADP test may have to be run again for each year involved, since the amounts distributed under Reg. 1.415-6(b)(6)(iv) cannot be used in the ADP test .
    1. In addition, if the elective deferral distributed is tied to a matching contribution, the remaining matching contribution may be discriminatory if the employee receiving the distribution is a HCE.
    2. There is no mechanism for either forfeiting or distributing this discriminatory matching contribution, but Reg.
    3. 1.401(a)(4)-11(g)(3)(vii)(B) provides a method of correcting discriminatory matching contributions (if the problem is discovered and can be corrected within 10 ½ months after the end of the plan year).


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