[Federal Register Volume 68, Number 137 (Thursday, July 17, 2003)]
[Proposed Rules]
[Pages 42476-42532]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 03-17755]



[[Page 42475]]

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Part II





Department of the Treasury





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Internal Revenue Service



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26 CFR Part 1



Retirement Plans; Cash or Deferred Arrangements Under Section 401(k) 
and Matching Contributions or Employee Contributions Under Section 
401(m); Proposed Rule

  Federal Register / Vol. 68, No. 137 / Thursday, July 17, 2003 / 
Proposed Rules  

[[Page 42476]]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-108639-99]
RINs 1545-AX26, 1545-AX43


Retirement Plans; Cash or Deferred Arrangements Under Section 
401(k) and Matching Contributions or Employee Contributions Under 
Section 401(m)

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: This document contains proposed regulations that would provide 
guidance for certain retirement plans containing cash or deferred 
arrangements under section 401(k) and providing for matching 
contributions or employee contributions under section 401(m). These 
regulations affect sponsors of plans that contain cash or deferred 
arrangements or provide for employee or matching contributions, and 
participants in these plans. This document also contains a notice of 
public hearing on these proposed regulations.

DATES: Written and electronic comments and requests to speak (with 
outlines of oral comments) at a public hearing scheduled for November 
12, 2003, must be received by October 22, 2003.

ADDRESSES: Send submissions to: CC:PA:RU (REG-108639-99), room 5226, 
Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, 
DC 20044. Submissions may be hand delivered Monday through Friday 
between the hours of 8 a.m. and 4 p.m. to: CC:PA:RU (REG-108639-99), 
Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue, 
NW., Washington, DC. Alternatively, taxpayers may submit comments 
electronically via the Internet directly to the IRS Internet site at: 
www.irs.gov/regs. The public hearing will be held in the IRS Auditorium 
(7th Floor), Internal Revenue Building, 1111 Constitution Avenue, NW., 
Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, R. Lisa 
Mojiri-Azad or John T. Ricotta at (202) 622-6060 (not a toll-free 
number); concerning submissions and the hearing, and/or to be placed on 
the building access list to attend the hearing, Lanita Van Dyke, (202) 
622-7180 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    The collections of information contained in this notice of proposed 
rulemaking have been submitted to the Office of Management and Budget 
for review in accordance with the Paperwork Reduction Act of 1995 (44 
U.S.C. 3507(d)). Comments on the collections of information should be 
sent to the Office of Management and Budget, Attn: Desk Officer for the 
Department of the Treasury, Office of Information and Regulatory 
Affairs, Washington, DC 20503, with copies to the Internal Revenue 
Service, Attn: IRS Reports Clearance Officer, W:CAR:MP:T:T:SP 
Washington, DC 20224. Comments on the collections of information should 
be received by September 15, 2003. Comments are specifically requested 
concerning:
    Whether the proposed collections of information are necessary for 
the proper performance of the functions of the IRS, including whether 
the information will have practical utility;
    The accuracy of the estimated burden associated with the proposed 
collection of information (see below);
    How the quality, utility, and clarity of the information to be 
collected may be enhanced;
    How the burden of complying with the proposed collection of 
information may be minimized, including through the application of 
automated collection techniques or other forms of information 
technology; and
    Estimates of capital or start-up costs and costs of operation, 
maintenance, and purchase of services to provide information.
    The collections of information in these proposed regulations are 
contained in Sec. Sec.  1.401(k)-1(d)(3)(iii)(C), 1.401(k)-2(b)(3), 
1.401(k)-3(d), 1.401(k)-3(f), 1.401(k)-3(g), 1.401(k)-4(d)(3), 
1.401(m)-3(e), 1.401(m)-3(g) and 1.401(m)-3(h). The information 
required by Sec. Sec.  1.401(k)-3(d), 1.401(k)-3(f), 1.401(k)-3(g), 
1.401(m)-3(e), 1.401(m)-3(g) and 1.401(m)-3(h) is required by the IRS 
to comply with the requirements of sections 401(k)(12)(D) and 
401(m)(11)(A)(ii) regarding notices that must be provided to eligible 
participants to apprize them of their rights and obligations under 
certain plans. This information will be used by participants to 
determine whether to participate in the plan, and by the IRS to confirm 
that the plan complies with applicable qualification requirements to 
avoid adverse tax consequences. The information required by Sec.  
1.401(k)-4(d)(3) is required by the IRS to comply with the requirements 
of section 401(k)(11)(B)(iii)(II) regarding notices that must be 
provided to eligible participants to apprize them of their rights and 
obligations under certain plans. This information will be used by 
participants to determine whether to participate in the plan, and by 
the IRS to confirm that the plan complies with applicable qualification 
requirements to avoid adverse tax consequences. The information 
required by Sec.  1.401(k)-2(b)(3) will be used by employees to file 
their income tax returns and by the IRS to assess the correct amount of 
tax. The information provided under Sec.  1.40(k)-1(d)(3)(iii)(C) will 
be used by employers in determining whether to make hardship 
distributions to participants. The collections of information are 
mandatory. The respondents are businesses or other for-profit 
institutions, and nonprofit institutions.
    Estimated total annual reporting burden: 26,500 hours.
    The estimated annual burden per respondent is 1 hour, 10 minutes.
    Estimated number of respondents: 22,500.
    The estimated annual frequency of responses: On occasion.
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless it displays a valid 
control number assigned by the Office of Management and Budget.
    Books or records relating to a collection of information must be 
retained as long as their contents may become material in the 
administration of any internal revenue law. Generally, tax returns and 
tax return information are confidential, as required by 26 U.S.C. 6103.

Background

    This document contains proposed new comprehensive regulations 
setting forth the requirements (including the nondiscrimination 
requirements) for cash or deferred arrangements under section 401(k) 
and for matching contributions and employee contributions under section 
401(m) of the Internal Revenue Code (Code).
    Comprehensive final regulations under sections 401(k) and 401(m) of 
the Code were last published in the Federal Register in TD 8357 
(published August 9, 1991) and TD 8376 (published December 2, 1991) and 
amended by TD 8581 published on December 22, 1994. Since 1994, many 
significant changes have been made to sections 401(k) and 401(m) by the 
Small Business Job Protection Act of 1996, Public Law 104-188 (110 
Stat. 1755) (SBJPA), the Taxpayer Relief Act of 1997, Public Law 105-34 
(111 Stat. 788) (TRA '97), and the Economic Growth and Tax Relief

[[Page 42477]]

Reconciliation Act of 2001, Public Law 107-16 (115 Stat. 38) (EGTRRA).
    The most substantial changes to the section 401(k) and section 
401(m) provisions were made to the methodology for testing the amount 
of elective contributions, matching contributions, and employee 
contributions for nondiscrimination. Section 401(a)(4) prohibits 
discrimination in contribution or benefits in favor of highly 
compensated employees (within the meaning of section 414(q)) (HCEs). 
Section 401(k) provides a special nondiscrimination test for elective 
contributions under a cash or deferred arrangement that is part of a 
profit-sharing plan, stock bonus plan, pre-ERISA money purchase plan, 
or rural cooperative plan, called the actual deferral percentage (ADP) 
test. Section 401(m) provides a parallel test for matching 
contributions and employee contributions under a defined contribution 
plan, called the actual contribution percentage (ACP) test. These 
special nondiscrimination standards are provided in recognition of the 
fact that the amount of elective contributions and employee 
contributions (and corresponding matching contributions) is determined 
by the employee's utilization of the contribution opportunity offered 
under the plan. This is in contrast to the situation in other defined 
contribution plans where the amount of contributions is determined by 
the amount the employer decides to contribute.
    Sections 401(k) and 401(m) provide alternative methods for 
satisfying the applicable nondiscrimination rules: a mathematical 
comparison and a number of design-based methods. The inherent variation 
in the amount of contributions among employees noted above, and the 
fact that the economic situation of HCEs may make them more likely to 
make elective or employee contributions, means that the usual 
nondiscrimination test under section 401(a)(4)--under which for each 
HCE with a contribution level there must be a specified number of 
nonhighly compensated employees (NHCEs) with equal or greater 
contributions--is not appropriate. Instead, average rates of 
contribution are used in the ADP and ACP tests (with a built-in 
differential permitted for HCEs) and minimum standards for nonelective 
or matching contributions are provided in the design-based 
alternatives.
    Prior to the enactment of SBJPA, sections 401(k) and 401(m) 
provided only for mathematical comparison. Specifically, the ADP and 
ACP tests compare the average of the rates of contributions of the HCEs 
to the average of the rates of contributions of the NHCEs. For this 
purpose, the rate of contributions for an employee is the amount of 
contributions for an employee divided by the employee's compensation 
for the plan year. These tests are satisfied if the average rate of HCE 
contributions does not exceed 1.25 times the average rate of 
contributions of the NHCEs. Alternatively, these tests are satisfied if 
the average rate of HCE contributions does not exceed the average rate 
of contributions of the NHCEs by more than 2 percentage points and is 
no more than 2 times the average rate of contributions of the NHCEs. To 
the extent that these tests are not satisfied, the statute provides for 
correction through distribution to HCEs (or forfeiture of nonvested 
matching contributions) or, to the extent provided in regulations, 
recharacterization of elective contributions as after-tax 
contributions. In addition, to the extent provided in regulations, 
nonelective contributions can be made to NHCEs and elective 
contributions and certain matching contributions can be moved between 
the ADP and ACP tests, in order to reduce the discrepancy between the 
average rates of contribution for the HCEs and the NHCEs.
    SBJPA added design-based alternative methods of satisfying the ADP 
and ACP tests. Under these methods, if a plan meets certain 
contribution and notice requirements, the plan is deemed to satisfy the 
nondiscrimination rules without regard to actual utilization of the 
contribution opportunity offered under the plan. These regulations 
reflect this change and the other changes that were made to sections 
401(k) and 401(m) under SBJPA, TRA '97 and EGTRRA since the issuance of 
final regulations under those sections.
    SBJPA made the following significant changes affecting section 
401(k) and section 401(m) plans:
    [sbull] The ADP test and ACP test were amended to allow the use of 
prior year data for NHCEs.
    [sbull] The method of distributing to correct failures of the ADP 
test or ACP test was changed to require distribution to the HCEs with 
the highest contributions.
    [sbull] Tax-exempt organizations and Indian tribal governments are 
permitted to maintain section 401(k) plans.
    [sbull] A safe harbor alternative to the ADP test and ACP test was 
introduced in order to provide a design-based method to satisfy the 
nondiscrimination tests.
    [sbull] The SIMPLE 401(k) plan (an alternative design-based method 
to satisfy the nondiscrimination tests for small employers that 
corresponds to the provisions of section 408(p) for SIMPLE IRA plans by 
providing for smaller contributions) was added.
    [sbull] A special testing option was provided for plans that permit 
participation before employees meet the minimum age and service 
requirements, in order to encourage employers to permit employees to 
start participating sooner.
    TRA '97 made the following significant changes affecting section 
401(k) and section 401(m) plans:
    [sbull] State and local governmental plans are treated as 
automatically satisfying the ADP and ACP tests.
    [sbull] Matching contributions for self-employed individuals are no 
longer treated as elective contributions.
    EGTRRA made the following significant changes affecting section 
401(k) and section 401(m) plans:
    [sbull] Catch-up contributions were added to provide for additional 
elective contributions for participants age 50 or older.
    [sbull] The Secretary was directed to change the section 401(k) 
regulations to shorten the period of time that an employee is stopped 
from making elective contributions under the safe harbor rules for 
hardship distributions.
    [sbull] Beginning in 2006, section 401(k) plans will be permitted 
to allow employees to designate their elective contributions as ``Roth 
contributions'' that will be subject to taxation under the rules 
applicable to Roth IRAs under section 408A.
    [sbull] Section 401(k) plans using the design-based safe harbor and 
providing no additional contributions in a year are exempted from the 
top-heavy rules of section 416.
    [sbull] Distributions from section 401(k) plans are permitted upon 
``severance from employment'' rather than ``separation from service.''
    [sbull] The multiple use test specified in section 401(m)(9) is 
repealed.
    [sbull] Faster vesting is required for matching contributions.
    [sbull] Matching contributions are taken into account in satisfying 
the top-heavy requirements of section 416.
    In addition, since publication of the final regulations, a number 
of items of guidance affecting section 401(k) and section 401(m) plans 
addressing these statutory changes and other items have been issued by 
the IRS, including:
    [sbull] Notice 97-2 (1997-1 C.B. 348) provided initial guidance on 
prior year ADP and ACP testing and guidance on correction of excess 
contributions and excess aggregate contributions, including 
distribution to the HCEs with the highest contributions.
    [sbull] Rev. Proc. 97-9 (1997-1 C.B. 624) provided model amendments 
for SIMPLE 401(k) plans.

[[Page 42478]]

    [sbull] Notice 98-1 (1998-1 C.B. 327) provided additional guidance 
on prior year testing issues.
    [sbull] Notice 98-52 (1998-2 C.B. 632) and Notice 2000-3 (2000-1 
C.B. 413) provided guidance on safe harbor section 401(k) plans.
    [sbull] Rev. Rul. 2000-8 (2000-1 C.B. 617) addressed the use of 
automatic enrollment features in section 401(k) plans.
    [sbull] Notice 2001-56 (2001-2 C.B. 277) and Notice 2002-4 (2002-2 
I.R.B. 298) provided initial guidance related to the changes made by 
EGTRRA.

These items of guidance are incorporated into these proposed 
regulations with some modifications and the proposed regulations have 
been reorganized as indicated in the tables of contents at proposed 
Sec. Sec.  1.401(k)-0 and 1.401(m)-0. Treasury and the IRS believe that 
a single restatement of the section 401(k) and section 401(m) rules 
serves the interests of plan sponsors, third-party administrators, plan 
participants, and plan beneficiaries.
    The process of reviewing and integrating all existing 
administrative guidance under sections 401(k) and 401(m) has led 
Treasury and the IRS to reconsider certain rules and to propose certain 
changes in those rules. To the extent practicable, this preamble 
identifies the substantive changes and explains the underlying 
analysis. In many cases, the changes will clarify or simplify existing 
guidance and will reduce plan administrative burdens.
    Treasury and the IRS appreciate the fact that plan sponsors and 
third-party administrators have developed systems and practices in the 
application of existing administrative guidance to the design and 
operation of section 401(k) and section 401(m) plans. In many cases, 
the details of these systems and practices have been determined through 
a plan sponsor's or administrator's interpretation of specific terms in 
existing guidance or, where no guidance has been provided, through a 
plan sponsor's or administrator's best legal and practical judgment. As 
a result, these systems and practices may differ from administrator to 
administrator, from sponsor to sponsor, or from plan to plan.
    Treasury and the IRS also recognize that certain of the substantive 
changes in these proposed regulations will require changes in plan 
design or plan operation. However, the proposed regulations are not 
otherwise intended to require significant changes in plan systems and 
practices that were developed under existing guidance and that conform 
to the requirements of sections 401(k) and 401(m). Therefore, Treasury 
and the IRS specifically request that plan sponsors and third-party 
administrators comment on points where the proposed regulations might 
have the unintended effect of requiring a change to plan systems or 
practices so that Treasury and the IRS can further evaluate whether 
such a change is in fact appropriate or whether Treasury and the IRS 
should instead make an adjustment in the final regulations.

Explanation of Provisions

1. Rules Applicable to All Cash or Deferred Arrangements

    Section 401(k)(1) provides that a profit-sharing, stock bonus, pre-
ERISA money purchase or rural cooperative plan will not fail to qualify 
under section 401(a) merely because it contains a qualified cash or 
deferred arrangement. Section 1.401(k)-1 would set forth the general 
definition of a cash or deferred arrangement (CODA), the additional 
requirements that a CODA must satisfy in order to be a qualified CODA, 
and the treatment of contributions made under a qualified or 
nonqualified CODA.
    As under the existing final regulations, a CODA is defined as an 
arrangement under which employees can make a cash or deferred election 
with respect to contributions to, or accruals or benefits under, a plan 
intended to satisfy the requirements of section 401(a). A cash or 
deferred election is any direct or indirect election by an employee (or 
modification of an earlier election) to have the employer either: (1) 
Provide an amount to the employee in the form of cash or some other 
taxable benefit that is not currently available; or (2) contribute an 
amount to a trust, or provide an accrual or other benefit, under a plan 
deferring the receipt of compensation. A cash or deferred election can 
include a salary reduction agreement, but the specific reference to a 
salary reduction agreement has been eliminated as unnecessary. In 
addition, the proposed regulations would incorporate prior guidance on 
automatic enrollment, and thus would reflect the fact that a CODA can 
specify that the default that applies in the absence of an affirmative 
election by an employee can be a contribution to a trust, as described 
in Rev. Rul. 2000-8.\1\
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    \1\ The Department of Labor has advised Treasury and the IRS 
that, under Title I of the Employee Retirement Income Security Act 
of 1974 (ERISA), fiduciaries of a plan must ensure that the plan is 
administered prudently and solely in the interest of plan 
participants and beneficiaries. While ERISA section 404(c) may serve 
to relieve certain fiduciaries from liability when participants or 
beneficiaries exercise control over the assets in their individual 
accounts, the Department of Labor has taken the position that a 
participant or beneficiary will not be considered to have exercised 
control when the participant or beneficiary is merely apprised of 
investments that will be made on his or her behalf in the absence of 
instructions to the contrary. See 29 CFR 2550.404c-1 and 57 FR 
46924.
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    The proposed regulations would continue to provide that the 
definition of a CODA excludes contributions that are treated as after-
tax employee contributions at the time of the contribution and 
contributions made pursuant to certain one-time irrevocable elections, 
but would also specify that a CODA does not include an arrangement 
under which dividends paid to an ESOP are either distributed to a 
participant or reinvested in employer securities in the ESOP pursuant 
to an election by the participant or beneficiary under section 
404(k)(2)(A)(iii) as added by EGTRRA.
    The proposed regulations would also specify that a contribution is 
made pursuant to a cash or deferred election only if the contribution 
is made after the election is made. Thus, a contribution made in 
anticipation of an employee's election is not treated as an elective 
contribution. Similarly, the regulations would provide that a 
contribution is made pursuant to a cash or deferred election only if 
the contribution is made after the employee's performance of services 
which relate to the compensation that, but for the election, would be 
paid to the employee. (If the payment of compensation would have 
preceded the performance of services, a contribution made no earlier 
than the date the compensation would have been paid, but for the 
election, is also treated as made pursuant to a cash or deferred 
election). Accordingly, amounts contributed in anticipation of future 
performance of services generally would not be treated as elective 
contributions under section 401(k). These restrictions on the timing of 
contributions are consistent with the fundamental premise of elective 
contributions, that these are contributions that are paid to the plan 
as a result of an employee election not to receive those amounts in 
cash. Moreover, ensuring that contributions are made after the 
employee's election furthers plan administrability.
    The deductibility of these prefunded elective contributions (as 
well as prefunded matching contributions) for the taxable year in which 
the contribution was made was addressed in Notice 2002-48 (2002-29 
I.R.B.139). In that notice, the IRS indicated that it was reviewing 
issues other than the deductibility of prefunded contributions but, 
pending additional guidance,

[[Page 42479]]

would not challenge the deductibility of the contributions provided 
actual payment is made during the taxable year for which the deduction 
is claimed and the amount deducted does not exceed the applicable limit 
under section 404(a)(3)(A)(i). After considering this issue, the IRS 
and Treasury have concluded that the prefunding of elective 
contributions and matching contributions is inconsistent with sections 
401(k) and 401(m). Thus, under these proposed regulations, an employer 
would not be able to prefund elective contributions to accelerate the 
deduction for elective contributions. Once these regulations are 
finalized, employer contributions made under the facts in Notice 2002-
48 would no longer be permitted to be taken into account under the ADP 
test or the ACP test and would not satisfy any plan requirement to 
provide elective contributions or matching contributions.

2. Qualified CODAs

A. General Rules Relating to Qualified CODAs
    Elective contributions under a qualified CODA are treated as 
employer contributions and generally are not included in the employee's 
gross income at the time the cash would have been received (but for the 
cash or deferred election), or at the time contributed to the plan. 
Elective contributions under a qualified CODA are included in the 
employee's gross income however, if the contributions are in excess of 
the section 402(g) limit for a year, are designated Roth contributions 
(under section 402A, effective for tax years beginning after December 
31, 2005) or are recharacterized as after-tax contributions as part of 
a correction of an ADP test failure.
    A CODA is not qualified unless it is part of a profit sharing plan, 
stock bonus plan, pre-ERISA money purchase plan, or rural cooperative 
plan and provides for an election between contributions to the plan or 
payments directly in cash. In addition, a CODA is not qualified unless 
it meets the following requirements: (1) The elective contributions 
under the CODA satisfy either the ADP test set forth in section 
401(k)(3) or one of the design-based alternatives in section 401(k)(11) 
or (12); (2) elective contributions under the CODA are nonforfeitable 
at all times; (3) elective contributions are distributable only on the 
occurrence of certain events, including attainment of age 59\1/2\, 
hardship, death, disability, severance from employment, or termination 
of the plan; (4) the group of employees eligible to participate in the 
CODA satisfies the coverage requirements of section 410(b)(1); (5) no 
other benefit (other than matching contributions or another specified 
benefit) is conditioned, directly or indirectly, upon the employee's 
making or not making elective contributions under the CODA; and (6) no 
more than 1 year of service is required for eligibility to elect to 
make a cash or deferred election.
    Subject to certain exceptions, State and local governmental plans 
are not allowed to include a qualified CODA. Plans sponsored by Indian 
tribal governments and rural cooperatives are allowed to include a 
qualified CODA.
B. Nondiscrimination Rules Applicable to CODAs
    As under the existing regulations, the proposed regulations would 
provide that the special nondiscrimination standards set forth in 
section 401(k) are the exclusive means by which a qualified CODA can 
satisfy the nondiscrimination in amount of contribution requirement of 
section 401(a)(4). These special nondiscrimination standards now 
include: the ADP test, the ADP safe harbor and the SIMPLE 401(k) plan. 
Pursuant to section 401(k)(3)(G), a State or local governmental plan is 
deemed to satisfy the ADP test.
    In addition, as under existing regulations, the plan must satisfy 
the requirements of Sec.  1.401(a)(4)-4 with respect to the 
nondiscriminatory availability of benefits, rights and features, 
including the availability of each level of elective contributions, 
matching contributions, and after-tax employee contributions. The 
provisions of the existing regulations related to compliance with 
sections 410(b) and 401(a)(4) would be revised to clarify the 
relationship of the rules under sections 410(b) and 401(a)(4) to the 
requirements for a qualified CODA and to remove redundant provisions. 
Except as provided below, however, these rules are substantively 
unchanged.
    These proposed regulations are designed to provide simple, 
practical rules that accommodate legitimate plan changes. At the same 
time, the rules are intended to be applied by employers in a manner 
that does not make use of changes in plan testing procedures or other 
plan provisions to inflate inappropriately the ADP for NHCEs (which is 
used as a benchmark for testing the ADP for HCEs) or to otherwise 
manipulate the nondiscrimination testing requirements of section 
401(k). Further, these nondiscrimination requirements are part of the 
overall requirement that benefits or contributions not discriminate in 
favor of HCEs. Therefore, a plan will not be treated as satisfying the 
requirements of section 401(k) if there are repeated changes to plan 
testing procedures or plan provisions that have the effect of 
distorting the ADP so as to increase significantly the permitted ADP 
for HCEs, or otherwise manipulate the nondiscrimination rules of 
section 401(k), if a principal purpose of the changes was to achieve 
such a result.
C. Aggregation and Disaggregation of Plans
    The proposed regulations would consolidate the rules in the 
existing regulations regarding identification of CODAs and plans for 
purposes of demonstrating compliance with the requirements of section 
401(k). As under the existing regulations, all CODAs included in a plan 
are treated as a single CODA for purposes of applying the 
nondiscrimination tests. For this purpose, a plan is generally defined 
by reference to Sec.  1.410(b)-7(a) and (b) after application of the 
mandatory disaggregation rules of Sec.  1.410(b)-7(c) (other than the 
mandatory disaggregation of section 401(k) and section 401(m) plans) 
and permissive aggregation rules of Sec.  1.410(b)-7(d), as modified 
under these regulations. For example, if a plan covers collectively 
bargained employees and noncollectively bargained employees, the 
elective contributions for the separate groups of employees must be 
subject to separate nondiscrimination tests under section 401(k). The 
proposed regulations would also retain the special rules in the 
existing regulations that permit the aggregation of certain employees 
in different collective bargaining units and the prohibition on 
restructuring under Sec.  1.401(a)(4)-9(c).
    The proposed regulations would change the treatment of a CODA under 
a plan which includes an ESOP. Section 1.410(b)-7(c)(2) provides that 
the portion of a plan that is an ESOP and the portion that is not an 
ESOP are treated as separate plans for purposes of section 410(b) 
(except as provided in Sec.  54.4975-11(e)). Accordingly, under the 
existing regulations, such a plan must apply two separate 
nondiscrimination tests: one for elective contributions going into the 
ESOP portion (and invested in employer stock) and one for elective 
contributions going in the non-ESOP portion of the plan. The additional 
testing results in increased expense and administrative difficulty for 
the plan and creates the possibility that the ESOP portion or the non-
ESOP portion may fail the ADP test or ACP test because HCEs may be more

[[Page 42480]]

or less likely to invest in employer securities than NHCEs.
    Since the issuance of the existing regulations, the use of an ESOP 
as the employer stock fund in a section 401(k) plan has become much 
more widespread. In light of this development, the proposed regulations 
would eliminate disaggregation of the ESOP and non-ESOP portions of a 
single section 414(l) plan for purposes of ADP testing. The same rule 
would apply for ACP testing under section 401(m). In addition, the 
proposed regulations would provide that, for purposes of applying the 
ADP test or the ACP test, an employer could permissively aggregate two 
section 414(l) plans, one that is an ESOP and one that is not.
    However, the exception to mandatory disaggregation of ESOPs from 
non-ESOPs set forth in these proposed regulations would not apply for 
purposes of satisfying section 410(b). Accordingly, the group of 
eligible employees under the ESOP and non-ESOP portions of the plan 
must still separately satisfy the requirements of sections 401(a)(4) 
and 410(b).
    The proposed regulations would also provide that a single testing 
method must apply to all CODAs under a plan. This has the effect of 
restricting an employer's ability to aggregate section 414(l) plans for 
purposes of section 410(b), if those plans apply inconsistent testing 
methods. For example, a plan that applies the ADP test of section 
401(k)(3) may not be aggregated with a plan that uses the ADP safe 
harbor of section 401(k)(12) for purposes of section 410(b).
D. Restrictions on Withdrawals
    As discussed above, a qualified CODA must provide that elective 
contributions may only be distributed after certain events, including 
hardship and severance from employment. EGTRRA amended section 
401(k)(2)(B)(i)(I) by replacing ``separation from service'' with 
``severance from employment.'' This change eliminated the ``same desk 
rule'' as a standard for distributions under section 401(k) plans.
    In addition, EGTRRA amended Code section 401(k)(10) by deleting 
disposition by a corporation of substantially all of the assets of a 
trade or business and disposition of a corporation's interest in a 
subsidiary, leaving termination of the plan as the only distributable 
event described in section 401(k)(10). Finally, EGTRRA directs the 
Secretary of the Treasury to revise the regulations relating to 
distributions under section 401(k)(2)(B)(i)(IV) to provide that the 
period during which an employee is prohibited from making elective and 
employee contributions following a hardship distribution is 6 months 
(instead of 12 months as required under Sec.  1.401(k)-
1(d)(2)(iv)(B)(4) of the existing regulations).\2\
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    \2\ Under section 402(c), as amended by the IRS Restructuring 
and Reform Act of 1998, Public Law 105-206 (112 Stat. 685), and 
EGTRRA, a hardship distribution is not an eligible rollover 
distribution. While the change affects distributions from a section 
401(k) plan, there is not specific reference to the change in these 
proposed regulations because these regulations are under sections 
401(k) and 401(m).
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    Notice 2001-56 and Notice 2002-4 provided guidance on these EGTRRA 
changes to the distribution rules for elective contributions. That 
guidance is incorporated in these proposed regulations. In connection 
with the change to severance from employment, comments are requested on 
whether a change in status from employee to leased employee described 
in section 414(n) should be treated as a severance from employment that 
would permit a distribution to be made. In addition, the proposed 
regulations do not include reference to ``retirement'' (included in the 
existing regulation) as an event allowing distribution because 
retirement is not listed in the statute, and is subsumed by severance 
from employment.
    In addition to the statutory changes, the rules relating to 
hardship distributions have been reorganized in order to clarify 
certain ambiguities, including the relationship between the generally 
applicable rules, employee representations, and the safe harbors 
provided under the existing regulations. The existing regulations set 
forth two basic requirements (i.e., the employee has an immediate and 
heavy financial need and the distribution is necessary to satisfy that 
need) followed by safe harbor provisions. The proposed regulations 
would retain those basic requirements, but would clarify that each safe 
harbor is separately applicable to each basic requirement. In addition, 
the proposed regulations would provide that an employee representation 
used for purposes of determining that a distribution is necessary to 
satisfy an immediate and heavy financial need must provide that the 
need cannot reasonably be relieved by any available distribution or 
nontaxable plan loan (even if the distribution or loan would not be 
sufficient to satisfy the financial need), but need not provide that a 
loan from a commercial source will be taken if no such loan in an 
amount sufficient to satisfy the need is available on reasonable 
commercial terms.
    The proposed regulations would also modify the existing regulations 
to add other types of defined contribution plans to the list of plans 
that an employer may maintain after the termination of the plan that 
contains the qualified CODA while still providing for distribution of 
elective contributions upon plan termination. The list of such plans 
has been expanded to include not only an ESOP and a SEP, but also a 
SIMPLE IRA plan, a plan or contract that satisfies section 403(b) and a 
section 457 plan.
    Finally, under the existing regulations, a plan that receives a 
plan-to-plan transfer that includes elective contributions, QNECs, or 
QMACs, must provide that the restrictions on withdrawals continue after 
the transfer. These proposed regulations would also make explicit a 
requirement that the transferor plan will fail to comply with the 
restrictions on withdrawals if it transfers elective contributions, 
QNECs, or QMACs to a plan that does not provide for these restrictions. 
However, a transferor plan will not fail to comply with this 
requirement if it reasonably concludes that the transferee plan 
provides for restrictions on withdrawals. What constitutes a basis for 
a reasonable conclusion would be comparable to the rules related to 
acceptance of rollover distributions. See Sec.  1.401(a)(31)-1, A-14.
E. Other Rules for Qualified CODAs
    The proposed regulations would generally retain the additional 
requirements set forth in the existing regulations that a CODA must 
satisfy in order to be qualified, with some modifications. First, in 
order to be a qualified CODA the arrangement must provide an employee 
with an effective opportunity to elect to receive the amount in cash no 
less than once during the plan year. Under the proposed regulations, 
whether an employee has an effective opportunity is determined based on 
all the relevant facts and circumstances, including notice of the 
availability of the election, the period of time before the cash is 
currently available during which an election may be made, and any other 
conditions on elections.
    The proposed regulations would also provide that a plan must 
provide for satisfaction of one of the specific nondiscrimination 
alternatives described in section 401(k). As with the existing 
regulations, the plan may accomplish this by incorporating by reference 
the ADP test of section 401(k)(3) and the regulations under proposed 
Sec.  1.401(k)-2, if that is the nondiscrimination alternative being

[[Page 42481]]

used. If, with respect to the nondiscrimination alternative being used 
there are optional choices, the plan must provide which of the optional 
choices will apply. For example, a plan that uses the ADP test of 
section 401(k)(3) must specify whether it is using the current year 
testing method or prior year testing method. Additionally, a plan that 
uses the prior year testing method must specify whether the ADP for 
eligible NHCEs for the first plan year is 3% or the ADP for the 
eligible NHCEs for the first plan year. Similarly, a plan that uses the 
safe harbor method must specify whether the safe harbor contribution 
will be the nonelective safe harbor contribution or the matching safe 
harbor contribution and is not permitted to provide that ADP testing 
will be used if the requirements for the safe harbor are not satisfied. 
The safe harbors are intended to provide employees with a minimum 
threshold in benefits in exchange for easier compliance for the plan 
sponsor. It would be inconsistent with this approach to providing 
benefits to allow an employer to deliver smaller benefits to NHCEs and 
revert to testing.
    The proposed regulations would retain the existing rules relating 
to the section 401(k)(4)(A) prohibition on having benefits (other than 
a match) contingent on making or not making an elective contribution. 
However, the proposed regulations would specify that, in the case of a 
benefit that requires an amount to be withheld from an employee's pay, 
an employer is not violating the section 401(k)(4)(A) contingent 
benefit rule merely because the CODA restricts elective contributions 
to amounts available after such withholding from the employee's pay 
(after deduction of all applicable income and employment taxes). In 
addition, these proposed regulations also reflect the amendment to 
section 416(c)(2)(A) under which matching contributions can be taken 
into account for purposes of satisfying the top-heavy minimum 
contribution requirement without violating the prohibition on making 
benefits contingent on making or not making elective contributions.
    To reflect the amendment of section 401(k)(4)(B) by SBJPA to allow 
tax exempt organizations to maintain section 401(k) plans, the proposed 
regulations would also eliminate the provision prohibiting a tax-exempt 
employer from adopting a section 401(k) plan.
    As under the existing final regulations, these proposed regulations 
would provide that a partnership is permitted to maintain a CODA, and 
individual partners are permitted to make cash or deferred elections 
with respect to compensation attributable to services rendered to the 
entity, under the same rules that apply to common-law employees. This 
rule has been extended to sole proprietors. The provisions of these 
regulations also reflect the enactment of section 402(g)(8) (initially 
section 402(g)(9) as enacted by TRA '97) providing that matching 
contributions with respect to partners and sole proprietors are no 
longer treated as elective contributions.

3. Nonqualified CODAs

    The proposed regulations would generally retain the rules in the 
existing regulations applicable to a nonqualified CODA (i.e., a CODA 
that fails one or more of the applicable requirements to be a qualified 
CODA). Because elective contributions under such an arrangement are not 
entitled to the constructive receipt relief set forth in section 
402(e)(3), the contributions are currently taxable to the employee. In 
addition, the plan to which such contributions are made must satisfy 
any nondiscrimination requirements that would otherwise apply under 
section 401(a)(4).

4. The Actual Deferral Percentage (ADP) Test

A. General Rules Relating to the ADP Test
    Section 1.401(k)-2 sets forth the rules for a CODA that is applying 
the ADP test contained in section 401(k)(3). Under the ADP test, the 
percentage of compensation deferred for the eligible HCEs is compared 
annually to the percentage of compensation deferred for eligible NHCEs, 
and if certain limits are exceeded by the HCEs, corrective action must 
be taken by the plan. Correction can be made through the distribution 
of excess contributions, the recharacterization of excess 
contributions, or the contribution of additional employer 
contributions.
    Section 401(k)(3)(A), as amended by SBJPA, generally provides for 
the use of prior year data in determining the ADP of NHCEs, while 
current year data is used for HCEs. This testing option is referred to 
as the prior year testing method. Alternatively, a plan may provide for 
the use of current year data for determining the ADPs for both NHCEs 
and HCEs, which is known as the current year testing method. The 
proposed regulations would use the term applicable year to describe the 
year for which the ADP is determined for the NHCEs.
    Section 401(k)(3)(F), as added by SBJPA, provides that a plan 
benefitting otherwise excludable employees and that, pursuant to 
section 410(b)(4)(B), is being treated as two separate plans for 
purposes of section 410(b), is permitted to disregard NHCEs who have 
not met the minimum age and service requirements of section 
410(a)(1)(A). Thus, the proposed regulations would permit such a plan 
to perform the ADP test by comparing the ADP for all eligible HCEs for 
the plan year and the ADP of eligible NHCEs for the applicable year, 
disregarding all NHCEs who have not met the minimum age and service 
requirements of section 410(a)(1)(A). The proposed regulations treat 
this rule as permissive. Accordingly, the new statutory provision does 
not eliminate the existing testing option under which a plan 
benefitting otherwise excludable employees is disaggregated into 
separate plans where the ADP test is performed separately for all 
eligible employees who have completed the minimum age and service 
requirements of section 410(a)(1)(A) and for all eligible employees who 
have not completed the minimum age and service requirements of section 
410(a)(1)(A).
B. Elective Contributions Used in the ADP Test
    The proposed regulations would generally follow the existing 
regulations in defining which elective contributions are reflected in 
the ADP test and which ones are not. The proposed regulations would 
reflect the rule contained in the regulations under section 414(v), 
under which catch-up contributions that are in excess of a statutory 
limit or an employer-provided limit are not taken into account under 
the ADP test. See Sec.  1.414(v). In addition, the proposed regulations 
would incorporate the rule in Sec.  1.402(g)-1 that provides excess 
deferrals that are distributed are still taken into account under the 
ADP test (with the exception of deferrals made by NHCEs that were in 
violation of section 401(a)(30)). The proposed regulations retain the 
rule that elective contributions must be paid to the trust within 12 
months after the end of the plan year. However, for plans subject to 
Title I of ERISA, contributions must be paid to the trust much sooner 
in order to satisfy the Department of Labor's regulations relating to 
when elective contributions become plan assets.
    Section 401(k)(3) provides that the actual deferral ratio (ADR) of 
an HCE who is eligible to participate in 2 or more CODAs of the same 
employer is calculated by treating all CODAs in which the employee is 
eligible to participate as one CODA. The existing regulations implement 
this rule by aggregating the elective contributions of

[[Page 42482]]

such an HCE for all plan years that end with or within a single 
calendar year. This can yield an inappropriate result if the plan years 
are different, because more than 12 months of elective contributions 
could be included in an employee's ADR. These proposed regulations 
would modify this rule to provide that the ADR for each HCE 
participating in more than one CODA is determined by aggregating the 
HCE's elective contributions that are within the plan year of the CODA 
being tested. In addition, the definition of period of participation 
for purposes of determining compensation would be modified to take into 
account periods of participation under another plan where the elective 
contributions must be aggregated for an HCE. As a result, even in the 
case of plans with different plan years, each of the employer's CODAs 
will use 12 months of elective contributions and 12 months of 
compensation in determining the ADR for an HCE who participates in 
multiple arrangements.
    The proposed regulations would retain the rule in the existing 
regulations that provides that the HCE aggregation of elective 
contributions under CODAs does not apply where the CODAs are within 
plans that cannot be aggregated under Sec.  1.410(b)-7(d), but only 
after applying the modifications to the section 410(b) aggregation and 
disaggregation rules for section 401(k) plans provided in the proposed 
regulations. The non-application of the HCE aggregation rule would have 
less significance in light of the change described above relating to 
the elimination of the required disaggregation of ESOP and non-ESOP 
plans. In addition, the proposed regulations would clarify that, in 
determining whether two plans could be aggregated for this purpose, the 
prohibition on aggregating plans with CODAs that apply inconsistent 
testing methods set forth under these proposed regulations and the 
section 410(b) prohibition on aggregating plans that have different 
plan years would not apply.
C. Additional Employer Contributions Used in the ADP Test
    The proposed regulations would generally retain the rules in the 
existing regulations permitting a plan to take qualified nonelective 
contributions or qualified matching contributions (i.e., nonelective or 
matching contributions that satisfy the vesting and distribution 
limitations of section 401(k)(2)(B) and (C)) into account under the ADP 
test, except as described below. Thus, an employer whose CODA has 
failed the ADP test can correct this failure by making additional 
qualified nonelective contributions (QNECs) or qualified matching 
contributions (QMACs) for its NHCEs. The proposed regulations would no 
longer describe such contributions as being treated as elective 
contributions under the arrangement, but would nonetheless permit such 
contributions to be taken into account under the ADP test.
    As under the existing regulations, these proposed regulations would 
provide that QNECs must satisfy four requirements in addition to the 
vesting and distribution rules described above before they can be taken 
into account under the ADP test: (1) The amount of nonelective 
contributions, including the QNECs that are used under the ADP test or 
the ACP test, must satisfy section 401(a)(4); (2) the nonelective 
contributions, excluding the QNECs that are used under the ADP test or 
the ACP test, must satisfy section 401(a)(4); (3) the plan to which the 
QNEC or QMAC is made must be a plan that can be aggregated with the 
plan maintaining the CODA; and (4) the QNECs or QMACs must not be 
contingent on the performance of services after the allocation date and 
must be contributed within 12 months after the end of the plan year 
within which the contribution is to be allocated.\3\ Thus, in the case 
of a plan using prior year ADP testing, any QNECs that are to be 
allocated to the NHCEs for the prior plan year must be contributed 
before the last day of the current plan year in order to be taken into 
account.
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    \3\ With respect to this timing requirement, it should be noted 
that in order to be taken into account for purposes of section 
415(c) for a limitation year, the contributions will need to be made 
no later than 30 days after the end of the section 404(a)(6) period 
applicable to the taxable year with or within which the limitation 
year ends.
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    Some plans provide a correction mechanism for a failed ADP test 
that targets QNECs to certain NHCEs in order to reduce the total 
contributions to NHCEs under the correction. Under the method that 
minimizes the total QNECs allocated to NHCEs under the correction, the 
employer makes a QNEC to the extent permitted by the section 415 limits 
to the NHCE with the lowest compensation during the year in order to 
raise that NHCE's ADR. If the plan still fails to pass the ADP test, 
the employer continues expanding the group of NHCEs who receive QNECs 
to the next lowest-paid NHCE until the ADP test is satisfied. By using 
this bottom-up leveling technique, the employer can pass the ADP test 
by contributing small amounts of money to NHCEs who have very low 
compensation for the plan year (for example, an employee who terminated 
employment in early January with $300 of compensation). This is because 
of the fact that the ADP test is based on an unweighted average of ADRs 
and a small dollar (but high percentage of compensation) contribution 
to a terminated or other partial-year employee has a larger impact on 
the ADP test than a more significant contribution to a full-year 
employee.
    The IRS and Treasury have been concerned that, by using these types 
of techniques, employers may pass the ADP test by making high 
percentage QNECs to a small number of employees with low compensation 
rather than providing contributions to a broader group of NHCEs. In 
addition, the legislative history to EGTRRA expresses Congressional 
intent that the Secretary of the Treasury will use his existing 
authority to address situations where qualified nonelective 
contributions are targeted to certain participants with lower 
compensation in order to increase the ADP of the NHCEs. (See EGTRRA 
Conference Report, H.R. Conf. Rep. 107-84, 240).
    Accordingly, the proposed regulations would add a new requirement 
that a QNEC must satisfy in order to be taken into account under the 
ADP test. This requirement, designed to limit the use of targeted 
QNECs, would generally treat a plan as providing impermissibly targeted 
QNECs if less than half of all NHCEs are receiving QNECs and would also 
treat a QNEC as impermissibly targeted if the contribution is more than 
double the QNECs other nonhighly compensated employees are receiving, 
when expressed as a percentage of compensation. However, QNECs that do 
not exceed 5% of compensation are never treated as targeted and would 
always satisfy the new requirement.
    This restriction on targeting QNECs would be implemented in the 
proposed regulations by providing that a QNEC that exceeds 5% of 
compensation could be taken into account for the ADP test only to the 
extent the contribution, when expressed as a percentage of 
compensation, does not exceed two times the plan's representative 
contribution rate. The plan's representative contribution rate would be 
defined as the lowest contribution rate among a group of NHCEs that is 
half of all the eligible NHCEs under the arrangement (or the lowest 
contribution rate among all eligible NHCEs under the arrangement who 
are employed on the last day of the year, if greater). For purposes of 
determining an NHCE's contribution rate, the employee's qualified 
nonelective contributions and

[[Page 42483]]

the qualified matching contributions taken into account under the ADP 
test for the plan year are added together and the sum is divided by the 
employee's compensation for the same period. The proposed regulations 
under section 401(m) would provide parallel restrictions on QNECs taken 
into account in ACP testing, and a QNEC cannot be taken into account 
under both the ADP and ACP test (including for purposes of determining 
the representative contribution rate). As discussed more fully below, 
the proposed regulations would also have a limitation on targeting 
matching contributions, which would limit the extent to which QMACs can 
be targeted as a means of avoiding the restrictions on targeted QNECs.
    The proposed regulations would also implement a prohibition against 
double counting of QNECs that was set forth in Notice 98-1. Generally, 
QNECs used in an ADP or ACP test, used to satisfy the safe harbor under 
section 401(k), or under a SIMPLE 401(k) plan can not be used again to 
demonstrate compliance with another test under section 401(k)(3) or 
401(m)(2). For example, double counting could arise when QNECs on 
behalf of NHCEs are used to determine the ADP under current year 
testing in year 1 and then, if the employer elected prior year testing, 
are used again in year 2 to determine the ADP of NHCEs. However, unlike 
Notice 98-1, these proposed regulations would not contain the 
additional limitations on double counting elective contributions or 
matching contributions that were moved between the ADP and ACP tests.
D. Correction
    Section 401(k)(8)(C), as amended by the SBJPA, provides that, for 
purposes of correcting a plan's failure to meet the nondiscrimination 
requirements of section 401(k)(3), distribution of excess contributions 
is made on the basis of the amount of the contributions by, or on 
behalf of, each HCE. The proposed regulations would implement this 
correction procedure in the same manner as set forth in Notice 97-2. 
Thus, the total amount of excess contributions is determined using the 
rules under the existing final regulations (i.e., based on high 
percentages). Then that total amount is apportioned among the HCEs by 
assigning the excess to be distributed first to those HCEs who have the 
greatest dollar amount of contributions taken into account under the 
ADP test (as opposed to the highest deferral percentage). If these 
amounts are distributed or recharacterized in accordance with these 
regulations, the plan complies with the ADP test for the plan year with 
no obligation to recalculate the ADP test.
    The proposed regulations would provide a special rule for 
correcting through distribution of excess contributions in the case of 
an HCE who participates in multiple plans with CODAs. In that case, the 
proposed regulations would provide that, for purposes of determining 
which HCE will be apportioned a share of the total excess contributions 
to be distributed from a plan, all contributions in CODAs in which such 
an HCE participates are aggregated and the HCE with the highest dollar 
amount of contributions will apportioned excess contributions first. 
However, only actual contributions under the plan undergoing 
correction--rather than all contributions taken into account in 
calculating the employee's ADR--may be distributed from a plan. If the 
high dollar HCE's actual contributions under the plan are insufficient 
to allow full correction, then the HCE with the next highest dollar 
amount of contributions is apportioned the remaining excess 
contributions. If additional correction is needed, this process is 
repeated until the excess contributions are completely apportioned. 
This correction mechanism is applied independently to each CODA in 
which the HCE participates. If correction is needed in more than one 
CODA, the ADRs of HCEs who have received corrective distributions under 
the other arrangements are not recalculated after correction in the 
first plan.
    The proposed regulations would generally follow the rules in the 
existing regulations on the determination of net income attributable to 
excess contributions. The existing regulations provide for a reasonable 
determination of net income attributable to an excess contribution, but 
do not specify which contribution within the plan year is to be treated 
as the excess contribution to be distributed. This provision would be 
retained in the proposed regulations along with the existing 
alternative method of determining the net income, which approximates 
the result that would apply if the excess contribution is made on the 
first day of the plan year. However, to the extent the employee is or 
will be credited with allocable gain or loss on those excess 
contributions for the period after the end of the plan year (the gap 
period), the proposed regulations would now require that income be 
determined for that period. As under the existing regulations, the 
determination of the income for the gap period could be based on the 
income determined using the alternative method for the aggregate of the 
plan year and the gap period or using 10% of the income for the plan 
year (determined under the alternative method) for each month in the 
gap period.
    The proposed regulations would permit the recharacterization of 
excess contributions in a manner that generally follows the existing 
regulations. However, the year the employee must include the 
recharacterized contribution in current income has been changed to 
match the year that the employee would have had to include the excess 
contribution in income, had it been distributed. Thus, if the 
recharacterized amount is less than $100, it is included in gross 
income in the year that it is recharacterized, rather than the year of 
the earliest elective contributions for the employee.
    The proposed regulations would retain the rules in the existing 
regulations regarding the timing and tax treatment of distributions of 
excess contributions, coordination with the distribution of excess 
deferrals and the treatment of matches attributable to excess 
contributions.
E. Special Rules Relating to Prior Year Testing
    The proposed regulations would generally follow the rules set forth 
in Notice 98-1 regarding prior year testing, including the limitations 
on switching from current year testing to prior year testing. However, 
the proposed regulations would provide that a plan is permitted to be 
inconsistent between the choice of current year testing method and 
prior year testing method, as applied for ADP purposes and ACP 
purposes. In such a case, any movement of elective contributions or 
QMACs between the ADP and ACP tests (including recharacterization) 
would be prohibited.
    The proposed regulations would generally incorporate the rules set 
forth in Notice 98-1 relating to plan coverage changes in the case of a 
plan using prior year testing. Thus, in the case of a plan that uses 
prior year testing and experiences a plan coverage change affecting 
more than 10% of the NHCEs, the ADP of the NHCEs would generally be 
determined as the weighted average of the ADP of the NHCEs of the plans 
in which the NHCEs participated in the prior year. The definition of 
plan coverage change includes changes in the group of eligible 
employees under a plan resulting from the establishment or amendment of 
a plan, a plan merger or spin-off or a change in the way plans are 
combined or separated under the section 410(b) rules. The definition 
under the proposed regulations would

[[Page 42484]]

also include a reclassification of a substantial group of employees 
that has the same effect as amending the plan. These proposed 
regulations retain the rule that a plan that experiences coverage 
changes affecting 10% or less of the NHCEs disregards those changes in 
calculating the ADP for the NHCEs. Similarly, a plan that merely 
experiences a spin-off is not required to recalculate the ADP for the 
NHCEs.

5. Safe Harbor Section 401(k) Plans

    Section 401(k)(12) provides a design-based safe harbor method under 
which a CODA is treated as satisfying the ADP test if the arrangement 
meets certain contribution and notice requirements. Section 1.401(k)-3 
of these proposed regulations, which sets forth the requirements for 
these arrangements, generally follows the rules set forth in Notice 98-
52 and Notice 2000-3. Thus, a plan satisfies the section 401(k) safe 
harbor if it makes specified QMACs for all eligible NHCEs. The matching 
contributions can be under a basic matching formula that provides for 
QMACs equal to 100% of the first 3% of elective contributions and 50% 
of the next 2% or an enhanced matching formula that is at least as 
generous in the aggregate, provided the rate of matching contributions 
under the enhanced matching formula does not increase as the employee's 
rate of elective contributions increases. In lieu of QMACs, the plan is 
permitted to provide QNECs equal to 3% of compensation for all eligible 
NHCEs. In addition, notice must be provided to each eligible employee, 
within a reasonable time before the beginning of the year, of their 
right to defer under the plan.
    A plan using the safe harbor method must also comply with certain 
other requirements. Among these is the requirement in section 
401(k)(12)(B)(ii) that provides that the rate of matching contribution 
for any elective contribution on the part of any HCE cannot exceed the 
rate of matching contribution that would apply to any NHCE with the 
same rate of elective contribution. Notice 98-52 advised that the 
general rules on aggregating contributions for HCEs eligible under more 
than one CODA would apply for this purpose. The IRS and Treasury have 
determined that such aggregation is not applicable under the ADP safe 
harbor. Accordingly, these proposed regulations would not require that 
elective or matching contributions on behalf of an HCE who is eligible 
to participate in more than one plan of the same employer be aggregated 
for purposes of the requirement of section 401(k)(12)(B)(ii). Thus, the 
rate of match for purposes of determining whether an HCE has a higher 
matching rate is based only on matching contributions with respect to 
elective contributions under the safe harbor plan. However, for an 
employer that uses the safe harbor method of satisfying the ACP test, 
the rule in Notice 98-52 is retained for applying the ACP safe harbor, 
with an exception for nonsimultaneous participation (as discussed in 
connection with the ACP safe harbor below).
    These proposed regulations do not provide any rules relating to 
suspension of employee contributions under a plan that provides that 
safe harbor matching contributions are made with respect to the sum of 
elective contributions and employee contributions. Although Notice 
2000-3 specifically permitted suspension of employee contributions in 
certain circumstances, the IRS and Treasury have determined that there 
are no limits on suspending employee contributions, provided that safe 
harbor matching contributions are made with respect to elective 
contributions. This is because the restrictions on suspension of 
elective contributions are sufficient to ensure an eligible NHCE can 
get the full matching contribution.
    The proposed regulations do not include any exception to the 
requirements for safe harbor matching contributions with respect to 
catch-up contributions. Treasury and the IRS are aware that there are 
questions concerning the extent to which catch up contributions are 
required to be matched under a plan that provides for safe harbor 
matching contributions. Treasury and the IRS are interested in comments 
on the specific circumstances under which elective contributions by a 
NHCE to a safe harbor plan would be less than the amount required to be 
matched, e.g., less than 5% of safe harbor compensation, but would be 
treated by the plan as catch-up contributions, and on the extent to 
which a safe harbor plan should be required to match catch-up 
contributions under such circumstances.
    Section 401(k)(12)(D) contains a requirement that each eligible 
employee be provided with a notice of the employee's rights and 
obligations under the plan. These proposed regulations do not address 
the extent to which the notice can be provided through electronic 
media. As noted in the preamble to other regulations, the IRS and the 
Treasury Department are considering the extent to which the notice 
described in section 401(k)(12)(D), as well as other notices under the 
various Internal Revenue Code requirements relating to qualified 
retirement plans, can be provided electronically, taking into account 
the effect of the Electronic Signatures in Global and National Commerce 
Act (E-SIGN), Public Law 106-229 (114 Stat. 464 (2000)). The IRS and 
the Treasury Department anticipate issuing proposed regulations 
regarding these issues, and invite comments on these issues. Until 
those proposed regulations are issued, plan administrators and 
employers may continue to rely on the interim guidance in Q&A-7 of 
Notice 2000-3 on use of electronic media to satisfy the notice 
requirement in section 401(k)(12)(D).
    These proposed regulations would clarify that a section 401(k) safe 
harbor plan must generally be adopted before the beginning of the plan 
year and be maintained throughout a full 12-month plan year. This 
requirement is consistent with the notion that the statute specifies a 
certain contribution level for nonhighly compensated employees in order 
to be deemed to pass the nondiscrimination requirements. If the 
contribution level is not maintained for a full 12-month year, the 
employer contributions made on behalf of nonhighly compensated 
employees should not support what could be a full year's contribution 
by the highly compensated employees.
    The proposed regulations would adopt the exception to the 
requirement that a section 401(k) safe harbor plan be in place before 
the beginning of the plan year that was provided in Notice 2000-3. 
Under that option, an employer could adopt a section 401(k) safe harbor 
plan which has contingent non-elective contributions, provided the 
employer notifies employees of this contingent arrangement before the 
start of the year, amends the plan to provide the nonelective 
contributions no less than 30 days before the end of the year, and 
provides employees with a follow-up notice if the contribution will be 
made. Similarly, the proposed regulations would adopt the exception for 
a section 401(k) safe harbor plan that uses the matching contribution 
alternative. Under that exception, an employer can amend the plan to 
eliminate matching contributions with respect to future elective 
deferrals, provided that the matching contributions are made with 
respect to pre-amendment elective deferrals, employees are provided 
with notice of the change and the opportunity to change their 
elections, and the plan satisfies the ADP or ACP test for the plan year 
using the current year testing method.
    The proposed regulations would recognize the practical difficulty 
in a 12-

[[Page 42485]]

month requirement by following the rule in Notice 98-52 that allowed a 
short plan year in the first plan year and would allow a short plan 
year in certain other circumstances. Specifically, a section 401(k) 
safe harbor plan could have a short plan year in the year the plan 
terminates, if the plan termination is in connection with a merger or 
acquisition involving the employer, or the employer incurs a 
substantial business hardship comparable to a substantial business 
hardship described in section 412(d). In addition, a section 401(k) 
safe harbor plan could have a short plan year if the plan terminates, 
the employer makes the safe harbor contributions for the short year, 
employees are provided notice of the change, and the plan passes the 
ADP test. Finally, a safe harbor plan could have a short plan year if 
it is preceded and followed by 12-month plan years as a section 401(k) 
safe harbor plan.
    Under section 401(k)(12)(F), safe harbor contributions are 
permitted to be made to a plan other than the plan that contains the 
CODA. These proposed regulations reflect that rule and provide that the 
plan to which the safe harbor contributions are made need not be a plan 
that can be aggregated with the plan that contains the cash or deferred 
arrangement.
    Whether a contribution is taken into account for purposes of the 
safe harbor is determined in accordance with the rules regarding 
inclusion in ADP testing under proposed Sec.  1.401(k)-2(a). Thus, for 
example, a plan that provides for safe harbor matching contributions in 
2006 need not provide for a matching contribution with respect to an 
elective contribution made during the first 2\1/2\ months of 2007 and 
attributable to service during 2006, unless that elective contribution 
is taken into account for 2006.

6. SIMPLE 401(k) Plans

    Pursuant to section 401(k)(11), a SIMPLE 401(k) plan is treated as 
satisfying the requirements of section 401(k)(3)(A)(ii) if the 
contribution, vesting, notice and exclusive plan requirements of 
section 401(k)(11) are satisfied. Section 1.401(k)-4 of these proposed 
regulations reflects the provisions of section 401(k)(11) in a manner 
that follows the positions reflected in the model amendments set forth 
in Rev. Proc. 97-9.

7. Matching Contributions and Employee Contributions

    Section 401(m)(2) sets forth a nondiscrimination test, the ACP 
test, with respect to matching contributions and employee contributions 
that is parallel to the nondiscrimination test for elective 
contributions set forth in section 401(k). Section 1.401(m)-1 of the 
proposed regulations would set forth this test in a manner that is 
consistent with the nondiscrimination test set forth in proposed Sec.  
1.401(k)-1(b). Thus, satisfaction of the ACP test, the ACP safe harbor 
or the SIMPLE 401(k) provisions of the proposed regulations under 
section 401(k) are the exclusive means that matching contributions and 
employee contributions can use to satisfy the nondiscrimination in 
amount of contribution requirements of section 401(a)(4). An anti-abuse 
provision comparable to that provided in connection with the proposed 
regulations under section 401(k) limits the ability of an employer to 
make repeated changes in plan provisions or testing procedures that 
have the effect of distorting the ACP so as to increase significantly 
the permitted ACP for HCEs, or otherwise manipulate the 
nondiscrimination rules of section 401(m), if a principal purpose of 
the changes was to achieve such a result.
    These proposed regulations also include provisions regarding plan 
aggregation and disaggregation that are similar to those proposed for 
CODAs under section 401(k). For example, matching contributions made 
under the portion of a plan that is an ESOP and the portion of the same 
plan that is not an ESOP would not be disaggregated under these 
proposed regulations.
    The definitions of matching contribution and employee contribution 
under Sec.  1.401(m)-1 of the proposed regulations would generally 
follow the definitions in the existing regulations. Thus, whether an 
employer contribution is on account of an elective deferral or employee 
contribution--and thus is a matching contribution--is determined based 
on all the relevant facts and circumstances. However, the proposed 
regulations would provide that a contribution would not be treated as a 
matching contribution on account of an elective deferral if it is 
contributed before the employee's performance of services with respect 
to which the elective deferral is made (or when the cash that is 
subject to the cash or deferred election would be currently available, 
if earlier) and an employer contribution is not a matching contribution 
made on account of an employee contribution if it is contributed before 
the employee contribution. Thus, under these regulations, an employer 
would not be able to prefund matching contributions to accelerate the 
deduction for those contributions and, as noted above with respect to 
the timing of elective contributions, employer contributions made under 
the facts in Notice 2002-48 would not be taken into account under the 
ACP test and would not satisfy any plan requirement to provide matching 
contributions.

8. ACP Test for Matching Contributions and Employee Contributions

    Section 1.401(m)-2 of the proposed regulations would provide rules 
for the ACP test that generally parallel the rules applicable to the 
ADP test in proposed Sec.  1.401(k)-2. Thus, for example, the ACP test 
may be run by comparing the ACP for eligible HCEs for the current year 
with the ACP for eligible NHCEs for either the current plan year or the 
prior plan year. Similarly, the proposed regulations reflect the 
special ACP testing rule in section 401(m)(5)(C) for a plan that 
provides for early participation, comparable to the special ADP testing 
rule in section 401(k)(3)(F), as set forth in proposed Sec.  1.401(k)-
2(a)(1)(iii).
    The determination of the actual contribution ratio (ACR) for an 
eligible employee, and the contributions that are taken into account in 
determining that ACR, under these proposed regulations are comparable 
to the rules under the proposed section 401(k) regulations. Thus, for 
example, the ACR for an HCE who has matching contributions or employee 
contributions under two or more plans is determined by adding together 
matching contributions and employee contributions under all plans of 
the employer during the plan year of the plan being tested, in a manner 
comparable to that for determining the ADR of an HCE who participates 
in two or more CODAs.
    The proposed regulations would retain the rule from the existing 
regulations under which a QMAC that is taken into account in the ADP 
test is excluded from the ACP test. In addition, the proposed 
regulations would continue to allow QNECs to be taken into account for 
ACP testing, but would provide essentially the same restrictions on 
targeting QNECs to a small number of NHCEs as is provided in proposed 
Sec.  1.401(k)-2. The only difference in the rules would be that the 
contribution percentages used to determine the lowest contribution 
percentage would be based on the sum of the QNECs and those matching 
contributions taken into account in the ACP test, rather than the sum 
of the QNECs and the QMACs taken into account under the ADP test. 
Because QNECs that do not exceed 5% are not subject to the limits on 
targeted QNECs under either the ADP test or the ACP test, an employer 
is permitted to take into account up to 10% in QNECs

[[Page 42486]]

for an eligible NHCE, 5% in ADP testing and 5% in ACP testing, without 
regard to how many NHCEs receive QNECs.
    In addition, to prevent an employer from using targeted matching 
contributions to circumvent the limitation on targeted QNECs, the 
proposed regulations would provide that matching contributions are not 
taken into account in the ACP test to the extent the matching rate for 
the contribution exceeds the greater of 100% and 2 times the 
representative matching rate. Paralleling the rule to limit targeted 
QNECs, the representative plan matching rate is the lowest matching 
rate for any eligible employee in a group of NHCEs that consists of 
half of all eligible NHCEs in the plan for the plan year (or the lowest 
matching rate for all eligible NHCEs in the plan who are employed by 
the employer on the last day of the plan year, if greater). For this 
purpose, the matching rate is the ratio of the matching contributions 
to the contributions that are being matched, and only NHCEs who make 
elective deferrals or employee contributions for the plan year are 
taken into account.
    The proposed regulations would set limits on the use of elective 
contributions in the ACP test that are in addition to the rules in the 
existing regulations under which elective contributions may be taken 
into account for the ACP test only to the extent the plan satisfies the 
ADP test, determined by including such elective contributions in the 
ADP test. Under the new rule, the proposed regulations would provide 
that elective contributions under a plan that is not subject to the ADP 
test, such as a plan that uses the safe harbor method of section 
401(k)(12) or a contract or arrangement subject to the requirements of 
section 403(b)(12)(A)(ii), may not be taken into account for the ACP 
test. In the absence of this prohibition, contributions that are not 
properly considered ``excess'' could be taken into account under the 
ACP test.
    The provisions of these proposed regulations regarding correction 
of excess aggregate contributions, including allocation of excess 
aggregate contributions and determination of allocable income, would 
generally be consistent with the provisions of the proposed regulations 
under section 401(k). These proposed regulations continue the 
provisions of the current regulations regarding correction through 
distribution of vested matching contributions and forfeiture of 
unvested matching contributions. Similarly, the proposed regulations 
reflect the provisions of section 411(a)(3)(G) which permit the 
forfeiture of a matching contribution made with respect to an excess 
deferral, excess contribution, or excess aggregate contribution. This 
provision is necessary to allow forfeiture of matching contributions 
that would otherwise violate section 401(a)(4).

9. Safe Harbor Section 401(m) Plans

    Section 401(m)(11) provides a design-based safe harbor method of 
satisfying the ACP test contained in section 401(m)(2). Under section 
401(m)(11), a defined contribution plan is treated as satisfying the 
ACP test with respect to matching contributions if the plan satisfies 
the ADP safe harbor of section 401(k)(12) and matching contributions 
are not made with respect to employee contributions or elective 
contributions in excess of 6% of an employee's compensation. For a plan 
that satisfies the ADP safe harbor using a 3% nonelective contribution, 
two additional requirements that apply to a plan that satisfies the ADP 
safe harbor using matching contributions also apply: (1) The rate of an 
employer's matching contribution does not increase as the rate of 
employee contributions or elective deferrals increase; and 2) the 
matching contribution with respect to any HCE at any rate of employee 
contribution or elective deferral is not greater than with respect to 
any NHCE. In addition, the ratio of matching contributions on behalf of 
an HCE to that HCE's elective deferrals and employee contributions for 
a plan year cannot be greater than the ratio of matching contributions 
to elective deferrals or employee contributions that would apply with 
respect to any NHCE who contributes (as an elective deferral or 
employee contribution) the same percentage of safe harbor compensation 
for that plan year.
    Section 1.401(m)-3 of these proposed regulations, which sets forth 
the requirements for these plans, would generally follow the rules set 
forth in Notice 98-52 and Notice 2000-3. These proposed regulations 
would clarify that, for purposes of determining whether an HCE has a 
higher rate of matching contributions than any NHCE, any NHCE who is an 
eligible employee under the safe harbor CODA must be taken into 
account, even if the NHCE is not eligible for a matching contribution. 
This means that a plan with a provision which limits matching 
contributions to employees who are employed on the last day of the plan 
year will not be able to satisfy the ACP safe harbor, since a NHCE who 
is not eligible to receive a matching contribution on account of the 
last day requirement will nonetheless be taken into consideration in 
determining whether the plan satisfies section 401(m)(11)(B)(iii). The 
proposed regulations also include the requirement that matching 
contributions made at the employer's discretion with respect to any 
employee cannot exceed a dollar amount equal to 4% of the employee's 
compensation and that a safe harbor plan must permit all eligible NHCEs 
to make sufficient elective contributions (or employee contributions, 
if applicable) to receive the maximum matching contribution provided 
under the plan.
    The proposed regulations would provide a special rule for 
satisfying section 401(m)(11)(B)(iii) in the case of an HCE who 
participates in two or more plans that provide for matching 
contributions. Under this rule, a plan will not fail to satisfy the 
requirements of section 401(m)(11)(B)(iii) merely because an HCE 
participates during the plan year in more than one plan that provides 
for matching contributions, provided that the HCE is not simultaneously 
an eligible employee under two plans that provide for matching 
contributions maintained by an employer for a plan year; and the period 
used to determine compensation for purposes of determining matching 
contributions under each such plan is limited to periods when the HCE 
participated in the plan. In such a case, an HCE can transfer from a 
plan with a more generous matching schedule to an otherwise safe harbor 
section 401(m) plan (for example, as a result of switching jobs within 
the controlled group) without causing the safe harbor plan to violate 
section 401(m)(11). However, the plan which is not the safe harbor plan 
will still have to aggregate matching contributions for the HCE under 
the rule set forth in section 401(m)(2)(B).
    The safe harbor in section 401(m)(11) does not apply to employee 
contributions. Consequently, a plan that provides for employee 
contributions and matching contributions must satisfy the ACP test even 
though the matching contributions satisfy the safe harbor requirements 
for section 401(m)(11). However, the proposed regulations would also 
adopt the position in Notice 98-52 that the ACP test is permitted to be 
applied by disregarding all matching contributions with respect to all 
eligible employees. If the ADP safe harbor using matching contributions 
is satisfied but the ACP safe harbor is not satisfied, the proposed 
regulations would adopt the position in Notice 98-52 that the ACP test 
is permitted to be applied disregarding matching contributions for

[[Page 42487]]

any employee that do not exceed 4% of compensation.

Proposed Effective Date

    The regulations are proposed to apply for plan years beginning no 
sooner than 12 months after publication of final regulations in the 
Federal Register. However, it is anticipated that the preamble for the 
final regulations will permit plan sponsors to implement the final 
regulations for the first plan year beginning after publication of 
final regulations in the Federal Register.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866. Therefore, a regulatory assessment is not required. It is hereby 
certified that the collection of information in these regulations will 
not have a significant economic impact on a substantial number of small 
entities. This certification is based upon the conclusion that few 
plans containing qualified CODAs will correct excess contributions 
through the recharacterization of these amounts as employee 
contributions under Sec.  1.401(k)-2(b)(3) of these proposed 
regulations. The collections of information contained in Sec. Sec.  
1.401(k)-3(d), (f) and 1.401(m)-3(e) are required by statutory 
provisions. However, the IRS has considered alternatives that would 
lessen the impact of these statutory requirements on small entities and 
has requested comments on the use of electronic media to satisfy these 
notice requirements. Thus, the collection of information in these 
regulations will not have a significant economic impact on a 
substantial number of small entities. Therefore, an analysis under the 
Regulatory Flexibility Act (5 U.S.C. chapter 6) is not required. 
Pursuant to section 7805(f) of the Code, this notice of proposed 
rulemaking will be submitted to the Chief Counsel for Advocacy of the 
Small Business Administration for comment on its impact on small 
business.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any electronic or written comments 
(preferably a signed original and eight (8) copies) that are submitted 
timely to the IRS. In addition to the other requests for comments set 
forth in this document, the IRS and Treasury also request comments on 
the clarity of the proposed rule and how it may be made easier to 
understand. All comments will be available for public inspection and 
copying.
    A public hearing has been scheduled for November 12, 2003, at 10 
a.m. in the IRS Auditorium (7th Floor), Internal Revenue Building, 1111 
Constitution Avenue NW., Washington, DC. Due to building security 
procedures, visitors must enter at the Constitution Avenue, NW., 
entrance, located between 10th and 12th Streets, NW. In addition, all 
visitors must present photo identification to enter the building. 
Because of access restrictions, visitors will not be admitted beyond 
the immediate entrance area more than 30 minutes before the hearing 
starts. For information about having your name placed on the building 
access list to attend the hearing, see the FOR FURTHER INFORMATION 
CONTACT section of this preamble.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing.
    Persons who wish to present oral comments at the hearing must 
submit written comments and an outline of the topics to be discussed 
and the time to be devoted to each topic (signed original and eight (8) 
copies) by October 22, 2003.
    A period of 10 minutes will be allotted to each person for making 
comments.
    An agenda showing the scheduling of the speakers will be prepared 
after the deadline for receiving outlines has passed. Copies of the 
agenda will be available free of charge at the hearing.

Drafting Information

    The principal authors of these regulations are R. Lisa Mojiri-Azad 
and John T. Ricotta of the Office of the Division Counsel/Associate 
Chief Counsel (Tax Exempt and Government Entities). However, other 
personnel from the IRS and Treasury participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:

    Authority: 26 U.S.C. 7805
    26 U.S.C. 401(m)(9) * * *

    Par. 2. Sections 1.401(k)-0 and 1.401(k)-1 are revised, and 
Sec. Sec.  1.401(k)-2 through 1.401(k)-6 are added to read as follows:


Sec.  1.401(k)-0  Table of contents.

    This section contains first a list of section headings and then a 
list of the paragraphs in each section in Sec. Sec.  1.401(k)-1 through 
1.401(k)-6.

List of Sections

Sec.  1.401(k)-1 Certain cash or deferred arrangements.
Sec.  1.401(k)-2 ADP test.
Sec.  1.401(k)-3 Safe harbor requirements.
Sec.  1.401(k)-4 SIMPLE 401(k) plan requirements.
Sec.  1.401(k)-5 Special rules for mergers, acquisitions and similar 
events. [Reserved].
Sec.  1.401(k)-6 Definitions.

List of Paragraphs

Sec.  1.401(k)-1 Certain cash or deferred arrangements.

(a) General rules.
(1) Certain plans permitted to include cash or deferred 
arrangements.
(2) Rules applicable to cash or deferred arrangements generally.
(i) Definition of cash or deferred arrangement.
(ii) Treatment of after-tax employee contributions.
(iii) Treatment of ESOP dividend election.
(iv) Treatment of elective contributions as plan assets.
(3) Rules applicable to cash or deferred elections generally.
(i) Definition of cash or deferred election.
(ii) Automatic enrollment.
(iii) Rules related to timing.
(A) Requirement that amounts not be currently available.
(B) Contribution may not precede election.
(iv) Current availability defined.
(v) Certain one-time elections not treated as cash or deferred 
elections.
(vi) Tax treatment of employees.
(vii) Examples.
(4) Rules applicable to qualified cash or deferred arrangements.
(i) Definition of qualified cash or deferred arrangement.
(ii) Treatment of elective contributions as employer contributions.
(iii) Tax treatment of employees.
(iv) Application of nondiscrimination requirements to plan that 
includes a qualified cash or deferred arrangement.
(A) Exclusive means of amounts testing.
(B) Testing benefits, rights and features.
(C) Minimum coverage requirement.
(5) Rules applicable to nonqualified cash or deferred arrangements.
(i) Definition of nonqualified cash or deferred arrangement.
(ii) Treatment of elective contributions as nonelective 
contributions.
(iii) Tax treatment of employees.
(iv) Qualification of plan that includes a nonqualified cash or 
deferred arrangement.
(A) In general.
(B) Application of section 401(a)(4) to certain plans.
(v) Example.
(6) Rules applicable to cash or deferred arrangements of self-
employed individuals.

[[Page 42488]]

(i) Application of general rules.
(ii) Treatment of matching contributions made on behalf of self-
employed individuals.
(iii) Timing of self-employed individual's cash or deferred 
election.
(b) Coverage and nondiscrimination requirements.
(1) In general.
(2) Automatic satisfaction by certain plans.
(3) Anti-abuse provisions.
(4) Aggregation and restructuring.
(i) In general.
(ii) Aggregation of cash or deferred arrangements within a plan.
(iii) Aggregation of plans.
(A) In general.
(B) Plans with inconsistent ADP testing methods.
(iv) Disaggregation of plans and separate testing.
(A) In general.
(B) Restructuring prohibited.
(v) Modifications to section 410(b) rules.
(A) Certain disaggregation rules not applicable.
(B) Permissive aggregation of collective bargaining units.
(C) Multiemployer plans.
(vi) Examples.
(c) Nonforfeitability requirements.
(1) General rule.
(2) Definition of immediately nonforfeitable.
(3) Example.
(d) Distribution limitation.
(1) General rule.
(2) Rules applicable to distributions upon severance from 
employment.
(3) Rules applicable to hardship distributions.
(i) Distribution must be on account of hardship.
(ii) Limit on maximum distributable amount.
(A) General rule.
(B) Grandfathered amounts.
(iii) Immediate and heavy financial need.
(A) In general.
(B) Deemed immediate and heavy financial need.
(iv) Distribution necessary to satisfy financial need.
(A) Distribution may not exceed amount of need.
(B) No alternative means available.
(C) Employer reliance on employee representation.
(D) Employee need not take counterproductive actions.
(E) Distribution deemed necessary to satisfy immediate and heavy 
financial need.
(F) Definition of other plans.
(v) Commissioner may expand standards.
(4) Rules applicable to distributions upon plan termination.
(i) No alternative defined contribution plan.
(ii) Lump sum requirement for certain distributions.
(5) Rules applicable to all distributions.
(i) Exclusive distribution rules.
(ii) Deemed distributions.
(iii) ESOP dividend distributions.
(iv) Limitations apply after transfer.
(6) Examples.
(e) Additional requirements for qualified cash or deferred 
arrangements.
(1) Qualified plan requirement.
(2) Election requirements.
(i) Cash must be available.
(ii) Frequency of elections.
(3) Separate accounting requirement.
(i) General rule.
(ii) Satisfaction of separate accounting requirement.
(4) Limitations on cash or deferred arrangements of state and local 
governments.
(i) General rule.
(ii) Rural cooperative plans and Indian tribal governments.
(iii) Adoption after May 6, 1986.
(iv) Adoption before May 7, 1986.
(5) One-year eligibility requirement.
(6) Other benefits not contingent upon elective contributions.
(i) General rule.
(ii) Definition of other benefits.
(iii) Effect of certain statutory limits.
(iv) Nonqualified deferred compensation.
(v) Plan loans and distributions.
(vi) Examples.
(7) Plan provision requirement.
(f) Effective dates.
(1) General rule.
(2) Collectively bargained plans.

Sec.  1.401(k)-2 ADP test.

(a) Actual deferral percentage (ADP) test.
(1) In general.
(i) ADP test formula.
(ii) HCEs as sole eligible employees.
(iii) Special rule for early participation.
(2) Determination of ADP.
(i) General rule.
(ii) Determination of applicable year under current year and prior 
year testing method.
(3) Determination of ADR.
(i) General rule.
(ii) ADR of HCEs eligible under more than one arrangement.
(A) General rule.
(B) Plans not permitted to be aggregated.
(iii) Examples.
(4) Elective contributions taken into account under the ADP test.
(i) General rule.
(ii) Elective contributions for partners and self-employed 
individuals.
(iii) Elective contributions for HCEs.
(5) Elective contributions not taken into account under the ADP 
test.
(i) General rule.
(ii) Elective contributions for NHCEs.
(iii) Elective contributions treated as catch-up contributions.
(iv) Elective contributions used to satisfy the ACP test.
(6) Qualified nonelective contributions and qualified matching 
contributions that may be taken into account under the ADP test.
(i) Timing of allocation.
(ii) Requirement that amount satisfy section 401(a)(4).
(iii) Aggregation must be permitted.
(iv) Disproportionate contributions not taken into account.
(A) General rule.
(B) Definition of representative contribution rate.
(C) Definition of applicable contribution rate.
(v) Qualified matching contributions.
(vi) Contributions only used once.
(7) Examples.
(b) Correction of excess contributions.
(1) Permissible correction methods.
(i) In general.
(A) Qualified nonelective contributions or qualified matching 
contributions.
(B) Excess contributions distributed.
(C) Excess contributions recharacterized.
(ii) Combination of correction methods.
(iii) Exclusive means of correction.
(2) Corrections through distribution.
(i) General rule.
(ii) Calculation of total amount to be distributed.
(A) Calculate the dollar amount of excess contributions for each 
HCE.
(B) Determination of the total amount of excess contributions.
(C) Satisfaction of ADP.
(iii) Apportionment of total amount of excess contributions among 
the HCEs.
(A) Calculate the dollar amount of excess contributions for each 
HCE.
(B) Limit on amount apportioned to any individual.
(C) Apportionment to additional HCEs.
(iv) Income allocable to excess contributions.
(A) General rule.
(B) Method of allocating income.
(C) Alternative method of allocating plan year income.
(D) Safe harbor method of allocating gap period income.
(E) Alternative method for allocating plan year and gap period 
income.
(v) Distribution.
(vi) Tax treatment of corrective distributions.
(A) General rule.
(B) Rule for de minimis distributions.
(vii) Other rules.
(A) No employee or spousal consent required.
(B) Treatment of corrective distributions as elective contributions.
(C) No reduction of required minimum distribution.
(D) Partial distributions.
(viii) Examples.
(3) Recharacterization of excess contributions.
(i) General rule.
(ii) Treatment of recharacterized excess contributions.
(iii) Additional rules.
(A) Time of recharacterization.
(B) Employee contributions must be permitted under plan.
(C) Treatment of recharacterized excess contributions.
(4) Rules applicable to all corrections.
(i) Coordination with distribution of excess deferrals.
(A) Treatment of excess deferrals that reduce excess contributions.
(B) Treatment of excess contributions that reduce excess deferrals.
(ii) Forfeiture of match on distributed excess contributions.
(iii) Permitted forfeiture of QMAC.
(iv) No requirement for recalculation.
(v) Treatment of excess contributions that are catch-up 
contributions.
(5) Failure to timely correct.
(i) Failure to correct within 2\1/2\ months after end of plan year.
(ii) Failure to correct within 12 months after end of plan year.

[[Page 42489]]

(c) Additional rules for prior year testing method.
(1) Rules for change in testing method.
(i) General rule.
(ii) Situations permitting a change to the prior year testing 
method.
(2) Calculation of ADP under the prior year testing method for the 
first plan year.
(i) Plans that are not successor plans.
(ii) First plan year defined.
(iii) Successor plans.
(3) Plans using different testing methods for the ADP and ACP test.
(4) Rules for plan coverage changes.
(i) In general.
(ii) Optional rule for minor plan coverage changes.
(iii) Definitions.
(A) Plan coverage change.
(B) Prior year subgroup.
(C) Weighted average of the ADPs for the prior year subgroups.
(iv) Examples.

Sec.  1.401(k)-3 Safe harbor requirements.

(a) ADP test safe harbor.
(b) Safe harbor nonelective contribution requirement.
(1) General rule.
(2) Safe harbor compensation defined.
(c) Safe harbor matching contribution requirement.
(1) In general.
(2) Basic matching formula.
(3) Enhanced matching formula.
(4) Limitation on HCE matching contributions.
(5) Use of safe harbor match not precluded by certain plan 
provisions.
(i) Safe harbor matching contributions on employee contributions.
(ii) Periodic matching contributions.
(6) Permissible restrictions on elective contributions by NHCEs.
(i) General rule.
(ii) Restrictions on election periods.
(iii) Restrictions on amount of elective contributions.
(iv) Restrictions on types of compensation that may be deferred.
(v) Restrictions due to limitations under the Internal Revenue Code.
(7) Examples.
(d) Notice requirement.
(1) General rule.
(2) Content requirement.
(i) General rule.
(ii) Minimum content requirement.
(iii) References to SPD.
(3) Timing requirement.
(i) General rule.
(ii) Deemed satisfaction of timing requirement.
(e) Plan year requirement.
(1) General rule.
(2) Initial plan year.
(3) Change of plan year.
(4) Final plan year.
(f) Plan amendments adopting safe harbor nonelective contributions.
(1) General rule.
(2) Contingent notice provided.
(3) Follow-up notice requirement.
(g) Permissible reduction or suspension of safe harbor matching 
contributions.
(1) General rule.
(2) Notice of suspension requirement.
(h) Additional rules.
(1) Contributions taken into account.
(2) Use of safe harbor nonelective contributions to satisfy other 
nondiscrimination tests.
(3) Early participation rules.
(4) Satisfying safe harbor contribution requirement under another 
defined contribution plan.
(5) Contributions used only once.

Sec.  1.401(k)-4 SIMPLE 401(k) plan requirements.

(a) General rule.
(b) Eligible employer.
(1) General rule.
(2) Special rule.
(c) Exclusive plan.
(1) General rule.
(2) Special rule.
(d) Election and notice.
(1) General rule.
(2) Employee elections.
(i) Initial plan year of participation.
(ii) Subsequent plan years.
(iii) Election to terminate.
(3) Employee notices.
(e) Contributions.
(1) General rule.
(2) Elective contributions.
(3) Matching contributions.
(4) Nonelective contributions.
(5) SIMPLE compensation.
(f) Vesting.
(g) Plan year.
(h) Other rules.

Sec.  1.401(k)-5 Special rules for mergers, acquisitions and similar 
events. [Reserved]

Sec.  1.401(k)-6 Definitions.


Sec.  1.401(k)-1  Certain cash or deferred arrangements.

    (a) General rules--(1) Certain plans permitted to include cash or 
deferred arrangements. A plan, other than a profit-sharing, stock 
bonus, pre-ERISA money purchase pension, or rural cooperative plan, 
does not satisfy the requirements of section 401(a) if the plan 
includes a cash or deferred arrangement. A profit-sharing, stock bonus, 
pre-ERISA money purchase pension, or rural cooperative plan does not 
fail to satisfy the requirements of section 401(a) merely because the 
plan includes a cash or deferred arrangement. A cash or deferred 
arrangement is part of a plan for purposes of this section if any 
contributions to the plan, or accruals or other benefits under the 
plan, are made or provided pursuant to the cash or deferred 
arrangement.
    (2) Rules applicable to cash or deferred arrangements generally--
(i) Definition of cash or deferred arrangement. Except as provided in 
paragraphs (a)(2)(ii) and (iii) of this section, a cash or deferred 
arrangement is an arrangement under which an eligible employee may make 
a cash or deferred election with respect to contributions to, or 
accruals or other benefits under, a plan that is intended to satisfy 
the requirements of section 401(a) (including a contract that is 
intended to satisfy the requirements of section 403(a)).
    (ii) Treatment of after-tax employee contributions. A cash or 
deferred arrangement does not include an arrangement under which 
amounts contributed under a plan at an employee's election are 
designated or treated at the time of contribution as after-tax employee 
contributions (e.g., by treating the contributions as taxable income 
subject to applicable withholding requirements). See also section 
414(h)(1). This is the case even if the employee's election to make 
after-tax employee contributions is made before the amounts subject to 
the election are currently available to the employee.
    (iii) Treatment of ESOP dividend election. A cash or deferred 
arrangement does not include an arrangement under an ESOP under which 
dividends are either distributed or invested pursuant to an election 
made by participants or their beneficiaries in accordance with section 
404(k)(2)(A)(iii).
    (iv) Treatment of elective contributions as plan assets. The extent 
to which elective contributions constitute plan assets for purposes of 
the prohibited transaction provisions of section 4975 and Title I of 
the Employee Retirement Income Security Act of 1974 is determined in 
accordance with regulations and rulings issued by the Department of 
Labor. See 29 CFR 2510.3-102.
    (3) Rules applicable to cash or deferred elections generally--(i) 
Definition of cash or deferred election. A cash or deferred election is 
any direct or indirect election (or modification of an earlier 
election) by an employee to have the employer either--
    (A) Provide an amount to the employee in the form of cash (or some 
other taxable benefit) that is not currently available; or
    (B) Contribute an amount to a trust, or provide an accrual or other 
benefit, under a plan deferring the receipt of compensation.
    (ii) Automatic enrollment. For purposes of determining whether an 
election is a cash or deferred election, it is irrelevant whether the 
default that applies in the absence of an affirmative election is 
described in paragraph (a)(3)(i)(A) of this section (i.e., the employee 
receives an amount in cash or some other taxable benefit) or in 
paragraph (a)(3)(i)(B) of this section (i.e.,

[[Page 42490]]

the employer contributes an amount to a trust or provides an accrual or 
other benefit under a plan deferring the receipt of compensation).
    (iii) Rules related to timing--(A) Requirement that amounts not be 
currently available. A cash or deferred election can only be made with 
respect to an amount that is not currently available to the employee on 
the date of the election. Further, a cash or deferred election can only 
be made with respect to amounts that would (but for the cash or 
deferred election) become currently available after the later of the 
date on which the employer adopts the cash or deferred arrangement or 
the date on which the arrangement first becomes effective.
    (B) Contribution may not precede election. A contribution is made 
pursuant to a cash or deferred election only if the contribution is 
made after the election is made. In addition, a contribution is made 
pursuant to a cash or deferred election only if the contribution is 
made after the employee's performance of services with respect to which 
the contribution is made (or when the cash or other taxable benefit 
would be currently available, if earlier).
    (iv) Current availability defined. Cash or another taxable benefit 
is currently available to the employee if it has been paid to the 
employee or if the employee is able currently to receive the cash or 
other taxable benefit at the employee's discretion. An amount is not 
currently available to an employee if there is a significant limitation 
or restriction on the employee's right to receive the amount currently. 
Similarly, an amount is not currently available as of a date if the 
employee may under no circumstances receive the amount before a 
particular time in the future. The determination of whether an amount 
is currently available to an employee does not depend on whether it has 
been constructively received by the employee for purposes of section 
451.
    (v) Certain one-time elections not treated as cash or deferred 
elections. A cash or deferred election does not include a one-time 
irrevocable election upon an employee's commencement of employment with 
the employer, or upon the employee's first becoming eligible under the 
plan or any other plan of the employer (whether or not such other plan 
has terminated), to have contributions equal to a specified amount or 
percentage of the employee's compensation (including no amount of 
compensation) made by the employer on the employee's behalf to the plan 
and a specified amount or percentage of the employee's compensation 
(including no amount of compensation) divided among all other plans of 
the employer (including plans not yet established) for the duration of 
the employee's employment with the employer, or in the case of a 
defined benefit plan to receive accruals or other benefits (including 
no benefits) under such plans. Thus, for example, employer 
contributions made pursuant to a one-time irrevocable election 
described in this paragraph are not treated as having been made 
pursuant to a cash or deferred election and are not includible in an 
employee's gross income by reason of Sec.  1.402(a)-1(d). In the case 
of an irrevocable election made on or before December 23, 1994--
    (A) The election does not fail to be treated as a one-time 
irrevocable election under this paragraph (a)(3)(v) merely because an 
employee was previously eligible under another plan of the employer 
(whether or not such other plan has terminated); and
    (B) In the case of a plan in which partners may participate, the 
election does not fail to be treated as a one-time irrevocable election 
under this paragraph (a)(3)(v) merely because the election was made 
after commencement of employment or after the employee's first becoming 
eligible under any plan of the employer, provided that the election was 
made before the first day of the first plan year beginning after 
December 31, 1988, or, if later, March 31, 1989.
    (vi) Tax treatment of employees. An amount generally is includible 
in an employee's gross income for the taxable year in which the 
employee actually or constructively receives the amount. But for 
sections 402(e)(3) and 401(k), an employee is treated as having 
received an amount that is contributed to a plan pursuant to the 
employee's cash or deferred election. This is the case even if the 
election to defer is made before the year in which the amount is 
earned, or before the amount is currently available. See Sec.  
1.402(a)-1(d).
    (vii) Examples. The following examples illustrate the application 
of paragraph (a)(3) of this section:

    Example 1. (i) An employer maintains a profit-sharing plan under 
which each eligible employee has an election to defer an annual 
bonus payable on January 30 each year. The bonus equals 10% of 
compensation during the previous calendar year. Deferred amounts are 
not treated as after-tax employee contributions. The bonus is 
currently available on January 30.
    (ii) An election made prior to January 30 to defer all or part 
of the bonus is a cash or deferred election, and the bonus deferral 
arrangement is a cash or deferred arrangement.
    Example 2. (i) An employer maintains a profit-sharing plan which 
provides for discretionary profit sharing contributions and under 
which each eligible employee may elect to reduce his compensation by 
up to 10% and to have the employer contribute such amount to the 
plan. The employer pays each employee every two weeks for services 
during the immediately preceding two weeks. The employee's election 
to defer compensation for a payroll period must be made prior to the 
date the amount would otherwise be paid. The employer contributes to 
the plan the amount of compensation that each employee elected to 
defer, at the time it would otherwise be paid to the employee, and 
does not treat the contribution as an after-tax employee 
contribution.
    (ii) The election is a cash or deferred election and the 
contributions are elective contributions.
    Example 3. (i) The facts are the same as in Example 2, except 
that the employer makes a $10,000 contribution on January 31 of the 
plan year that is in addition to the contributions that satisfy the 
employer's obligation to make contributions with respect to cash or 
deferred elections for prior payroll periods. Employee A makes an 
election on February 15 to defer $2,000 from compensation that is 
not currently available and the employer reduces the employee's 
compensation to reflect the election.
    (ii) None of the additional $10,000 contributed January 31 is a 
contribution made pursuant to Employee A's cash or deferred 
election, because the contribution was made before the election was 
made. Accordingly, the employer must make an additional contribution 
of $2,000 in order to satisfy its obligation to contribute an amount 
to the plan pursuant to Employee A's election. The $10,000 
contribution can be allocated under the plan terms providing for 
discretionary profit sharing contributions.
    Example 4. (i) The facts are the same as in Example 3, except 
that Employee A had an outstanding election to defer $500 from each 
payroll period's compensation.
    (ii) None of the additional $10,000 contributed January 31 is a 
contribution made pursuant to Employee A's cash or deferred election 
for future payroll periods, because the contribution was made before 
the earlier of Employee A's performance of services to which the 
contribution is attributable or when the compensation would be 
currently available. Accordingly, the employer must make an 
additional contribution of $500 per payroll period in order to 
satisfy its obligation to contribute an amount to the plan pursuant 
to Employee A's election. The $10,000 contribution can be allocated 
under the plan terms providing for discretionary profit sharing 
contributions.
    Example 5. (i) Employer B establishes a money purchase pension 
plan in 1986. This is the first qualified plan established by 
Employer B. All salaried employees are eligible to participate under 
the plan. Hourly-paid employees are not eligible to participate 
under the plan. In 2000, Employer B establishes a profit-sharing 
plan under which all employees (both salaried and hourly) are 
eligible. Employer B permits all employees on the effective date of 
the profit-sharing

[[Page 42491]]

plan to make a one-time irrevocable election to have Employer B 
contribute 5% of compensation on their behalf to the plan and make 
no other contribution to any other plan of Employer B (including 
plans not yet established) for the duration of the employee's 
employment with Employer B, and have their salaries reduced by 5%.
    (ii) The election provided under the profit-sharing plan is not 
a one-time irrevocable election within the meaning of paragraph 
(a)(3)(v) of this section with respect to the salaried employees of 
Employer B who, before becoming eligible to participate under the 
profit-sharing plan, became eligible to participate under the money 
purchase pension plan. The election under the profit-sharing plan is 
a one-time irrevocable election within the meaning of paragraph 
(a)(3)(v) of this section with respect to the hourly employees, 
because they were not previously eligible to participate under 
another plan of the employer.

    (4) Rules applicable to qualified cash or deferred arrangements--
(i) Definition of qualified cash or deferred arrangement. A qualified 
cash or deferred arrangement is a cash or deferred arrangement that 
satisfies the requirements of paragraphs (b), (c), (d), and (e) of this 
section.
    (ii) Treatment of elective contributions as employer contributions. 
Except as otherwise provided in Sec.  1.401(k)-2(b)(3), elective 
contributions under a qualified cash or deferred arrangement are 
treated as employer contributions. Thus, for example, elective 
contributions are treated as employer contributions for purposes of 
sections 401(a) and 401(k), 402, 404, 409, 411, 412, 415, 416, and 417.
    (iii) Tax treatment of employees. Except as provided in section 
402(g), 402A (effective for years beginning after December 31, 2005), 
or 1.401(k)-2(b)(3), elective contributions under a qualified cash or 
deferred arrangement are neither includible in an employee's gross 
income at the time the cash would have been includible in the 
employee's gross income (but for the cash or deferred election), nor at 
the time the elective contributions are contributed to the plan. See 
Sec.  1.402(a)-1(d)(2)(i).
    (iv) Application of nondiscrimination requirements to plan that 
includes a qualified cash or deferred arrangement--(A) Exclusive means 
of amounts testing. Elective contributions under a qualified cash or 
deferred arrangement satisfy the requirements of section 401(a)(4) with 
respect to amounts if and only if the amount of elective contributions 
satisfies the nondiscrimination test of section 401(k) under paragraph 
(b)(1) of this section. See Sec.  1.401(a)(4)-1(b)(2)(ii)(B).
    (B) Testing benefits, rights and features. A plan that includes a 
qualified cash or deferred arrangement must satisfy the requirements of 
section 401(a)(4) with respect to benefits, rights and features in 
addition to the requirements regarding amounts described in paragraph 
(a)(4)(iv)(A) of this section. For example, the right to make each 
level of elective contributions under a cash or deferred arrangement is 
a benefit, right or feature subject to the requirements of section 
401(a)(4). See Sec.  1.401(a)(4)-4(e)(3)(i) and (iii)(D). Thus, for 
example, if all employees are eligible to make a stated level of 
elective contributions under a cash or deferred arrangement, but that 
level of contributions can only be made from compensation in excess of 
a stated amount, such as the Social Security taxable wage base, the 
arrangement will generally favor HCEs with respect to the availability 
of elective contributions and thus will generally not satisfy the 
requirements of section 401(a)(4).
    (C) Minimum coverage requirement. A qualified cash or deferred 
arrangement is treated as a separate plan that must satisfy the 
requirements of section 410(b). See Sec.  1.410(b)-7(c)(1) for special 
rules. The determination of whether a cash or deferred arrangement 
satisfies the requirements of section 410(b) must be made without 
regard to the modifications to the disaggregation rules set forth in 
paragraph (b)(4)(v) of this section. See also Sec.  1.401(a)(4)-
11(g)(3)(vii)(A), relating to corrective amendments that may be made to 
satisfy the minimum coverage requirements of section 410(b).
    (5) Rules applicable to nonqualified cash or deferred 
arrangements--(i) Definition of nonqualified cash or deferred 
arrangement. A nonqualified cash or deferred arrangement is a cash or 
deferred arrangement that fails to satisfy one or more of the 
requirements in paragraph (b), (c), (d) or (e) of this section.
    (ii) Treatment of elective contributions as nonelective 
contributions. Except as specifically provided otherwise, elective 
contributions under a nonqualified cash or deferred arrangement are 
treated as nonelective employer contributions. Thus, for example, the 
elective contributions are treated as nonelective employer 
contributions for purposes of sections 401(a) (including section 
401(a)(4)) and 401(k), 404, 409, 411, 412, 415, 416, and 417 and are 
not subject to the requirements of section 401(m).
    (iii) Tax treatment of employees. Elective contributions under a 
nonqualified cash or deferred arrangement are includible in an 
employee's gross income at the time the cash or other taxable amount 
that the employee would have received (but for the cash or deferred 
election) would have been includible in the employee's gross income. 
See Sec.  1.402(a)-1(d)(1).
    (iv) Qualification of plan that includes a nonqualified cash or 
deferred arrangement--(A) In general. A profit-sharing, stock bonus, 
pre-ERISA money purchase pension, or rural cooperative plan does not 
fail to satisfy the requirements of section 401(a) merely because the 
plan includes a nonqualified cash or deferred arrangement. In 
determining whether the plan satisfies the requirements of section 
401(a)(4), the nondiscrimination tests of sections 401(k), paragraph 
(b)(1) of this section, section 401(m)(2) and Sec.  1.401(m)-1(b) may 
not be used. See Sec. Sec.  1.401(a)(4)-1(b)(2)(ii)(B) and 1.410(b)-9 
(definition of section 401(k) plan).
    (B) Application of section 401(a)(4) to certain plans. The amount 
of employer contributions under a nonqualified cash or deferred 
arrangement is treated as satisfying section 401(a)(4) if the 
arrangement is part of a collectively bargained plan that automatically 
satisfies the requirements of section 410(b). See Sec. Sec.  
1.401(a)(4)-1(c)(5) and 1.410(b)-2(b)(7). Additionally, the 
requirements of sections 401(a)(4) and 410(b) do not apply to a 
governmental plan (within the meaning of section 414(d)) maintained by 
a State or local government or political subdivision thereof (or agency 
or instrumentality thereof). See sections 401(a)(5) and 410(c)(1)(A).
    (v) Example. The following example illustrates the application of 
this paragraph (a)(5):

    Example. (i) For the 2006 plan year, Employer A maintains a 
collectively bargained plan that includes a cash or deferred 
arrangement. Employer contributions under the cash or deferred 
arrangement do not satisfy the nondiscrimination test of section 
401(k) and paragraph (b) of this section.
    (ii) The arrangement is a nonqualified cash or deferred 
arrangement. The employer contributions under the cash or deferred 
arrangement are considered to be nondiscriminatory under section 
401(a)(4), and the elective contributions are generally treated as 
employer contributions under paragraph (a)(5)(ii) of this section. 
Under paragraph (a)(5)(iii) of this section and under Sec.  
1.402(a)-1(d)(1), however, the elective contributions are includible 
in each employee's gross income.

    (6) Rules applicable to cash or deferred arrangements of self-
employed individuals--(i) Application of general rules. Generally, a 
partnership or sole proprietorship is permitted to maintain a cash or 
deferred arrangement, and individual partners or owners are

[[Page 42492]]

permitted to make cash or deferred elections with respect to 
compensation attributable to services rendered to the entity, under the 
same rules that apply to other cash or deferred arrangements. For 
example, any contributions made on behalf of an individual partner or 
owner pursuant to a cash or deferred arrangement of a partnership or 
sole proprietorship are elective contributions unless they are 
designated or treated as after-tax employee contributions. In the case 
of a partnership, a cash or deferred arrangement includes any 
arrangement that directly or indirectly permits individual partners to 
vary the amount of contributions made on their behalf. Consistent with 
Sec.  1.402(a)-1(d), the elective contributions under such an 
arrangement are includible in income and are not deductible under 
section 404(a) unless the arrangement is a qualified cash or deferred 
arrangement (i.e., the requirements of section 401(k) and this section 
are satisfied). Also, even if the arrangement is a qualified cash or 
deferred arrangement, the elective contributions are includible in 
gross income and are not deductible under section 404(a) to the extent 
they exceed the applicable limit under section 402(g). See also Sec.  
1.401(a)-30.
    (ii) Treatment of matching contributions made on behalf of self-
employed individuals. Under section 402(g)(8), matching contributions 
made on behalf of a self-employed individual are not treated as 
elective contributions made pursuant to a cash or deferred election, 
without regard to whether such matching contributions indirectly permit 
individual partners to vary the amount of contributions made on their 
behalf.
    (iii) Timing of self-employed individual's cash or deferred 
election. For purposes of paragraph (a)(3)(iv) of this section, a 
partner's compensation is deemed currently available on the last day of 
the partnership taxable year and a sole proprietor's compensation is 
deemed currently available on the last day of the individual's taxable 
year. Accordingly, a self-employed individual may not make a cash or 
deferred election with respect to compensation for a partnership or 
sole proprietorship taxable year after the last day of that year. See 
Sec.  1.401(k)-2(a)(4)(ii) for the rules regarding when these 
contributions are treated as allocated.
    (b) Coverage and nondiscrimination requirements--(1) In general. A 
cash or deferred arrangement satisfies this paragraph (b) for a plan 
year only if--
    (i) The group of eligible employees under the cash or deferred 
arrangement (including any employee taken into account for purposes of 
section 410(b) pursuant to Sec.  1.401(a)(4)-11(g)(3)(vii)(A)) 
satisfies the requirements of section 410(b) (including the average 
benefit percentage test, if applicable); and
    (ii) The cash or deferred arrangement satisfies--
    (A) The ADP test of section 401(k)(3) described in Sec.  1.401(k)-
2;
    (B) The ADP safe harbor provisions of section 401(k)(12) described 
in Sec.  1.401(k)-3; or
    (C) The SIMPLE 401(k) provisions of section 401(k)(11) described in 
Sec.  1.401(k)-4.
    (2) Automatic satisfaction by certain plans. Notwithstanding 
paragraph (b)(1) of this section, a governmental plan (within the 
meaning of section 414(d)) maintained by a State or local government or 
political subdivision thereof (or agency or instrumentality thereof) 
shall be treated as meeting the requirements of this paragraph (b).
    (3) Anti-abuse provisions. The regulations in this paragraph (b) 
are designed to provide simple, practical rules that accommodate 
legitimate plan changes. At the same time, the rules are intended to be 
applied by employers in a manner that does not make use of changes in 
plan testing procedures or other plan provisions to inflate 
inappropriately the ADP for NHCEs (which is used as a benchmark for 
testing the ADP for HCEs) or to otherwise manipulate the 
nondiscrimination testing requirements of this paragraph (b). Further, 
this paragraph (b) is part of the overall requirement that benefits or 
contributions not discriminate in favor of HCEs. Therefore, a plan will 
not be treated as satisfying the requirements of this paragraph (b) if 
there are repeated changes to plan testing procedures or plan 
provisions that have the effect of distorting the ADP so as to increase 
significantly the permitted ADP for HCEs, or otherwise manipulate the 
nondiscrimination rules of this paragraph, if a principal purpose of 
the changes was to achieve such a result.
    (4) Aggregation and restructuring--(i) In general. This paragraph 
(b)(4) contains the exclusive rules for aggregating and disaggregating 
plans and cash or deferred arrangements for purposes of this section, 
and Sec. Sec.  1.401(k)-2 through 1.401(k) -6.
    (ii) Aggregation of cash or deferred arrangements within a plan. 
Except as otherwise specifically provided in this paragraph (b)(4), all 
cash or deferred arrangements included in a plan are treated as a 
single cash or deferred arrangement and a plan must apply a single test 
under paragraph (b)(1)(ii) of this section with respect to all such 
arrangements within the plan. Thus, for example, if two groups of 
employees are eligible for separate cash or deferred arrangements under 
the same plan, all contributions under both cash or deferred 
arrangements must be treated as made under a single cash or deferred 
arrangement subject to a single test, even if they have significantly 
different features, such as different limits on elective contributions.
    (iii) Aggregation of plans--(A) In general. For purposes of this 
section and Sec. Sec.  1.401(k)-2 through 1.401(k)-6, the term plan 
means a plan within the meaning of Sec.  1.410(b)-7(a) and (b), after 
application of the mandatory disaggregation rules of Sec.  1.410(b)-
7(c), and the permissive aggregation rules of Sec.  1.410(b)-7(d), as 
modified by paragraph (b)(4)(v) of this section. Thus, for example, two 
plans (within the meaning of Sec.  1.410(b)-7(b)) that are treated as a 
single plan pursuant to the permissive aggregation rules of Sec.  
1.410(b)-7(d) are treated as a single plan for purposes of section 
401(k) and section 401(m).
    (B) Plans with inconsistent ADP testing methods. Pursuant to 
paragraph (b)(4)(ii) of this section, a single testing method must 
apply with respect to all cash or deferred arrangements under a plan. 
Thus, in applying the permissive aggregation rules of Sec.  1.410(b)-
7(d), an employer may not aggregate plans (within the meaning of Sec.  
1.410(b)-7(b)) that apply inconsistent testing methods. For example, a 
plan (within the meaning of Sec.  1.410(b)-7(b)) that applies the 
current year testing method may not be aggregated with another plan 
that applies the prior year testing method. Similarly, an employer may 
not aggregate a plan (within the meaning of Sec.  1.410(b)-7(b)) using 
the ADP safe harbor provisions of section 401(k)(12) and another plan 
that is using the ADP test of section 401(k)(3).
    (iv) Disaggregation of plans and separate testing--(A) In general. 
If a cash or deferred arrangement is included in a plan (within the 
meaning of Sec.  1.410(b)-7(b)) that is mandatorily disaggregated under 
the rules of section 410(b) (as modified by this paragraph (b)(4)), the 
cash or deferred arrangement must be disaggregated in a consistent 
manner. For example, in the case of an employer that is treated as 
operating qualified separate lines of business under section 414(r), if 
the eligible employees under a cash or deferred arrangement are in more 
than one qualified separate line of business, only those employees 
within each qualified separate line of business may be taken into 
account in determining whether each disaggregated portion of the plan

[[Page 42493]]

complies with the requirements of section 401(k), unless the employer 
is applying the special rule for employer-wide plans in Sec.  1.414(r)-
1(c)(2)(ii) with respect to the plan. Similarly, if a cash or deferred 
arrangement under which employees are permitted to participate before 
they have completed the minimum age and service requirements of section 
410(a)(1) applies section 410(b)(4)(B) for determining whether the plan 
complies with section 410(b)(1), then the arrangement must be treated 
as two separate arrangements, one comprising all eligible employees who 
have met the age and service requirements of section 410(a)(1) and one 
comprising all eligible employees who have not met the age and service 
requirements under section 410(a)(1), unless the plan is using the rule 
in Sec.  1.401(k)-2(a)(1)(iii)(A).
    (B) Restructuring prohibited. Restructuring under Sec.  
1.401(a)(4)-9(c) may not be used to demonstrate compliance with the 
requirements of section 401(k). See Sec.  1.401(a)(4)-9(c)(3)(ii).
    (v) Modifications to section 410(b) rules--(A) Certain 
disaggregation rules not applicable. The mandatory disaggregation rules 
relating to section 401(k) plans and section 401(m) plans set forth in 
Sec.  1.410(b)-7(c)(1) and ESOP and non-ESOP portions of a plan set 
forth in Sec.  1.410(b)-7(c)(2) shall not apply for purposes of this 
section and Sec. Sec.  1.401(k)-2 through 1.401(k)-6. Accordingly, 
notwithstanding Sec.  1.410(b)-7(d)(2), an ESOP and a non-ESOP which 
are different plans (within the meaning of Sec.  1.410(b)-7(b)) are 
permitted to be aggregated for these purposes.
    (B) Permissive aggregation of collective bargaining units. 
Notwithstanding the general rule under section 410(b) and Sec.  
1.410(b)-7(c) that a plan that benefits employees who are included in a 
unit of employees covered by a collective bargaining agreement and 
employees who are not included in the collective bargaining unit is 
treated as comprising separate plans, an employer can treat two or more 
separate collective bargaining units as a single collective bargaining 
unit for purposes of this section and Sec.  1.401(k)-2 through Sec.  
1.401(k)-6, provided that the combinations of units are determined on a 
basis that is reasonable and reasonably consistent from year to year. 
Thus, for example, if a plan benefits employees in three categories 
(e.g., employees included in collective bargaining unit A, employees 
included in collective bargaining unit B, and employees who are not 
included in any collective bargaining unit), the plan can be treated as 
comprising three separate plans, each of which benefits only one 
category of employees. However, if collective bargaining units A and B 
are treated as a single collective bargaining unit, the plan will be 
treated as comprising only two separate plans, one benefitting all 
employees who are included in a collective bargaining unit and another 
benefitting all other employees. Similarly, if a plan benefits only 
employees who are included in collective bargaining unit A and 
employees who are included in collective bargaining unit B, the plan 
can be treated as comprising two separate plans. However, if collective 
bargaining units A and B are treated as a single collective bargaining 
unit, the plan will be treated as a single plan. An employee is treated 
as included in a unit of employees covered by a collective bargaining 
agreement if and only if the employee is a collectively bargained 
employee within the meaning of Sec.  1.410(b)-6(d)(2).
    (C) Multiemployer plans. Notwithstanding Sec.  1.410(b)-
7(c)(4)(ii)(C), the portion of the plan that is maintained pursuant to 
a collective bargaining agreement (within the meaning of Sec.  1.413-
1(a)(2)) is treated as a single plan maintained by a single employer 
that employs all the employees benefitting under the same benefit 
computation formula and covered pursuant to that collective bargaining 
agreement. The rules of paragraph (b)(4)(v)(B) of this section 
(including the permissive aggregation of collective bargaining units) 
apply to the resulting deemed single plan in the same manner as they 
would to a single employer plan, except that the plan administrator is 
substituted for the employer where appropriate and appropriate 
fiduciary obligations are taken into account. The noncollectively 
bargained portion of the plan is treated as maintained by one or more 
employers, depending on whether the noncollectively bargaining unit 
employees who benefit under the plan are employed by one or more 
employers.
    (vi) Examples. The following examples illustrate the application of 
this paragraph (b)(4):

    Example 1. (i) Employer A maintains Plan V, a profit-sharing 
plan that includes a cash or deferred arrangement in which all of 
the employees of Employer A are eligible to participate. For 
purposes of applying section 410(b), Employer A is treated as 
operating qualified separate lines of business under section 414(r) 
in accordance with Sec.  1.414(r)-1(b). However, Employer A applies 
the special rule for employer-wide plans in Sec.  1.414(r)-
1(c)(2)(ii) to the portion of its profit-sharing plan that consists 
of elective contributions under the cash or deferred arrangement 
(and to no other plans or portions of plans).
    (ii) Under these facts, the requirements of this section and 
Sec. Sec.  1.401(k)-2 through 1.401(k)-6 must be applied on an 
employer-wide rather than a qualified separate line of business 
basis.
    Example 2. (i) Employer B maintains Plan W, a profit-sharing 
plan that includes a cash or deferred arrangement in which all of 
the employees of Employer B are eligible to participate. For 
purposes of applying section 410(b), the plan treats the cash or 
deferred arrangement as two separate plans, one for the employees 
who have completed the minimum age and service eligibility 
conditions under section 410(a)(1) and the other for employees who 
have not completed the conditions. The plan provides that it will 
satisfy the section 401(k) safe harbor requirement of Sec.  
1.401(k)-3 with respect to the employees who have met the minimum 
age and service conditions and that it will meet the ADP test 
requirements of Sec.  1.401(k)-2 with respect to the employees who 
have not met the minimum age and service conditions.
    (ii) Under these facts, the cash or deferred arrangement must be 
disaggregated on a consistent basis with the disaggregation of Plan 
W. Thus, the requirements of Sec.  1.401(k)-2 must be applied by 
comparing the ADP for eligible HCEs who have not completed the 
minimum age and service conditions with the ADP for eligible NHCEs 
for the applicable year who have not completed the minimum age and 
service conditions.
    Example 3. (i) Employer C maintains Plan X, a stock-bonus plan 
including an ESOP. The plan also includes a cash or deferred 
arrangement for participants in the ESOP and non-ESOP portions of 
the plan.
    (ii) Pursuant to paragraph (b)(4)(v)(A) of this section the ESOP 
and non-ESOP portions of the stock-bonus plan are a single cash or 
deferred arrangement for purposes of this section and Sec. Sec.  
1.401(k)-2 through 1.401(k)-6. However, as provided in paragraph 
(a)(4)(iv)(C) of this section, the ESOP and non-ESOP portions of the 
plan are still treated as separate plans for purposes of satisfying 
the requirements of section 410(b).

    (c) Nonforfeitability requirements--(1) General rule. A cash or 
deferred arrangement satisfies this paragraph (c) only if the amount 
attributable to an employee's elective contributions are immediately 
nonforfeitable, within the meaning of paragraph (c)(2) of this section, 
are disregarded for purposes of applying section 411(a) to other 
contributions or benefits, and the contributions remain nonforfeitable 
even if the employee makes no additional elective contributions under a 
cash or deferred arrangement.
    (2) Definition of immediately nonforfeitable. An amount is 
immediately nonforfeitable if it is immediately nonforfeitable within 
the meaning of section 411, and would be nonforfeitable under the plan 
regardless

[[Page 42494]]

of the age and service of the employee or whether the employee is 
employed on a specific date. An amount that is subject to forfeitures 
or suspensions permitted by section 411(a)(3) does not satisfy the 
requirements of this paragraph (c).
    (3) Example. The following example illustrates the application of 
this paragraph (c):

    Example. (i) Employees B and C are covered by Employer Y's stock 
bonus plan, which includes a cash or deferred arrangement. All 
employees participating in the plan have a nonforfeitable right to a 
percentage of their account balance derived from all contributions 
(including elective contributions) as shown in the following table:

------------------------------------------------------------------------
                                                         Nonforfeitable
                   Years of service                        percentage
------------------------------------------------------------------------
Less than 1...........................................                 0
1.....................................................                20
2.....................................................                40
3.....................................................                60
4.....................................................                80
5 or more.............................................               100
------------------------------------------------------------------------

    (ii) The cash or deferred arrangement does not satisfy paragraph 
(c) of this section because elective contributions are not 
immediately nonforfeitable. Thus, the cash or deferred arrangement 
is a nonqualified cash or deferred arrangement.

    (d) Distribution limitation--(1) General rule. A cash or deferred 
arrangement satisfies this paragraph (d) only if amounts attributable 
to elective contributions may not be distributed before one of the 
following events, and any distributions so permitted also satisfy the 
additional requirements of paragraphs (d)(2) through (5) of this 
section (to the extent applicable)--
    (i) The employee's death, disability, or severance from employment;
    (ii) In the case of a profit-sharing, stock bonus or rural 
cooperative plan, the employee's attainment of age 59\1/2\, or the 
employee's hardship; or
    (iii) The termination of the plan.
    (2) Rules applicable to distributions upon severance from 
employment. An employee has a severance from employment when the 
employee ceases to be an employee of the employer maintaining the plan. 
An employee does not have a severance from employment if, in connection 
with a change of employment, the employee's new employer maintains such 
plan with respect to the employee. For example, a new employer 
maintains a plan with respect to an employee by continuing or assuming 
sponsorship of the plan or by accepting a transfer of plan assets and 
liabilities (within the meaning of section 414(l)) with respect to the 
employee).
    (3) Rules applicable to hardship distributions--(i) Distribution 
must be on account of hardship. A distribution is treated as made after 
an employee's hardship for purposes of paragraph (d)(1)(ii) of this 
section if and only if it is made on account of the hardship. For 
purposes of this rule, a distribution is made on account of hardship 
only if the distribution both is made on account of an immediate and 
heavy financial need of the employee and is necessary to satisfy the 
financial need. The determination of the existence of an immediate and 
heavy financial need and of the amount necessary to meet the need must 
be made in accordance with nondiscriminatory and objective standards 
set forth in the plan.
    (ii) Limit on maximum distributable amount--(A) General rule. A 
distribution on account of hardship must be limited to the maximum 
distributable amount. The maximum distributable amount is equal to the 
employee's total elective contributions as of the date of distribution, 
reduced by the amount of previous distributions of elective 
contributions. Thus, the maximum distributable amount does not include 
earnings, QNECs or QMACs, unless grandfathered under paragraph 
(d)(3)(ii)(B) of this section.
    (B) Grandfathered amounts. If the plan provides, the maximum 
distributable amount may be increased for amounts credited to the 
employee's account as of a date specified in the plan that is no later 
than December 31, 1988, or if later, the end of the last plan year 
ending before July 1, 1989 (or in the case of a collectively bargained 
plan, the earlier of--
    (1) The later of January 1, 1989, or the date on which the last of 
the collective bargaining agreements in effect on March 1, 1986 
terminates (determined without regard to any extension thereof after 
February 28, 1986); or
    (2) January 1, 1991) and consisting of--
    (i) Income allocable to elective contributions;
    (ii) Qualified nonelective contributions and allocable income; and
    (iii) Qualified matching contributions and allocable income.
    (iii) Immediate and heavy financial need--(A) In general. Whether 
an employee has an immediate and heavy financial need is to be 
determined based on all the relevant facts and circumstances. 
Generally, for example, the need to pay the funeral expenses of a 
family member would constitute an immediate and heavy financial need. A 
distribution made to an employee for the purchase of a boat or 
television would generally not constitute a distribution made on 
account of an immediate and heavy financial need. A financial need may 
be immediate and heavy even if it was reasonably foreseeable or 
voluntarily incurred by the employee.
    (B) Deemed immediate and heavy financial need. A distribution is 
deemed to be on account of an immediate and heavy financial need of the 
employee if the distribution is for--
    (1) Expenses for medical care described in section 213(d) 
previously incurred by the employee, the employee's spouse, or any 
dependents of the employee (as defined in section 152) or necessary for 
these persons to obtain medical care described in section 213(d);
    (2) Costs directly related to the purchase of a principal residence 
for the employee (excluding mortgage payments);
    (3) Payment of tuition, related educational fees, and room and 
board expenses, for up to the next 12 months of post-secondary 
education for the employee, or the employee's spouse, children, or 
dependents (as defined in section 152); or
    (4) Payments necessary to prevent the eviction of the employee from 
the employee's principal residence or foreclosure on the mortgage on 
that residence.
    (iv) Distribution necessary to satisfy financial need--(A) 
Distribution may not exceed amount of need. A distribution is treated 
as necessary to satisfy an immediate and heavy financial need of an 
employee only to the extent the amount of the distribution is not in 
excess of the amount required to satisfy the financial need. For this 
purpose, the amount required to satisfy the financial need may include 
any amounts necessary to pay any federal, state, or local income taxes 
or penalties reasonably anticipated to result from the distribution.
    (B) No alternative means available. A distribution is not treated 
as necessary to satisfy an immediate and heavy financial need of an 
employee to the extent the need may be relieved from other resources 
that are reasonably available to the employee. This determination 
generally is to be made on the basis of all the relevant facts and 
circumstances. For purposes of this paragraph (d)(3)(iv), the 
employee's resources are deemed to include those assets of the 
employee's spouse and minor children that are reasonably available to 
the employee. Thus, for example, a vacation home owned by the employee 
and the employee's spouse, whether as community property, joint 
tenants, tenants by the entirety, or

[[Page 42495]]

tenants in common, generally will be deemed a resource of the employee. 
However, property held for the employee's child under an irrevocable 
trust or under the Uniform Gifts to Minors Act (or comparable State 
law) is not treated as a resource of the employee.
    (C) Employer reliance on employee representation. For purposes of 
paragraph (d)(3)(iv)(B) of this section, an immediate and heavy 
financial need generally may be treated as not capable of being 
relieved from other resources that are reasonably available to the 
employee, if the employer relies upon the employee's written 
representation, unless the employer has actual knowledge to the 
contrary, that the need cannot reasonably be relieved--
    (1) Through reimbursement or compensation by insurance or 
otherwise;
    (2) By liquidation of the employee's assets;
    (3) By cessation of elective contributions or employee 
contributions under the plan;
    (4) By other distributions or nontaxable (at the time of the loan) 
loans from plans maintained by the employer or by any other employer; 
or
    (5) By borrowing from commercial sources on reasonable commercial 
terms in an amount sufficient to satisfy the need.
    (D) Employee need not take counterproductive actions. For purposes 
of this paragraph (d)(3)(iv), a need cannot reasonably be relieved by 
one of the actions described in paragraph (d)(3)(iv)(C) of this section 
if the effect would be to increase the amount of the need. For example, 
the need for funds to purchase a principal residence cannot reasonably 
be relieved by a plan loan if the loan would disqualify the employee 
from obtaining other necessary financing.
    (E) Distribution deemed necessary to satisfy immediate and heavy 
financial need. A distribution is deemed necessary to satisfy an 
immediate and heavy financial need of an employee if each of the 
following requirements are satisfied--
    (1) The employee has obtained all distributions, other than 
hardship distributions, and all nontaxable (at the time of the loan) 
loans currently available under the plan and all other plans maintained 
by the employer; and
    (2) The employee is prohibited, under the terms of the plan or an 
otherwise legally enforceable agreement, from making elective 
contributions and employee contributions to the plan and all other 
plans maintained by the employer for at least 6 months after receipt of 
the hardship distribution.
    (F) Definition of other plans. For purposes of paragraph 
(d)(3)(iv)(C)(4) and (E)(1) of this section, the phrase ``plans 
maintained by the employer'' means all qualified and nonqualified plans 
of deferred compensation maintained by the employer, including a cash 
or deferred arrangement that is part of a cafeteria plan within the 
meaning of section 125. However, it does not include the mandatory 
employee contribution portion of a defined benefit plan or a health or 
welfare benefit plan (including one that is part of a cafeteria plan). 
In addition, for purposes of paragraph (d)(3)(iv)(E)(2) of this 
section, the phrase ``plans maintained by the employer'' also includes 
a stock option, stock purchase, or similar plan maintained by the 
employer. See Sec.  1.401(k)-6 for the continued treatment of suspended 
employees as eligible employees.
    (v) Commissioner may expand standards. The Commissioner may 
prescribe additional guidance of general applicability, published in 
the Internal Revenue Bulletin (see 601.601(d)(2) of this chapter), 
expanding the list of deemed immediate and heavy financial needs and 
prescribing additional methods for distributions to be deemed necessary 
to satisfy an immediate and heavy financial need.
    (4) Rules applicable to distributions upon plan termination--(i) No 
alternative defined contribution plan. A distribution may not be made 
under paragraph (d)(1)(iii) of this section if the employer establishes 
or maintains an alternative defined contribution plan. For purposes of 
the preceding sentence, the definition of the term ``employer'' 
contained in Sec.  1.401(k)-6 is applied as of the date of plan 
termination, and a plan is an alternative defined contribution plan 
only if it is a defined contribution plan that exists at any time 
during the period beginning on the date of plan termination and ending 
12 months after distribution of all assets from the terminated plan. 
However, if at all times during the 24-month period beginning 12 months 
before the termination, fewer than 2% of the employees who were 
eligible under the defined contribution plan that includes the cash or 
deferred arrangement as of the date of plan termination are eligible 
under the other defined contribution plan, the other plan is not an 
alternative defined contribution plan. In addition, a defined 
contribution plan is not treated as an alternative defined contribution 
plan if it is an employee stock ownership plan as defined in section 
4975(e)(7) or 409(a), a simplified employee pension as defined in 
section 408(k), a SIMPLE IRA plan as defined in section 408(p), a plan 
or contract that satisfies the requirements of section 403(b), or a 
plan that satisfies the requirements of section 457.
    (ii) Lump sum requirement for certain distributions. A distribution 
may be made under paragraph (d)(1)(iii) of this section only if it is a 
lump sum distribution. The term lump sum distribution has the meaning 
provided in section 402(e)(4)(D) (without regard to section 
402(e)(4)(D)(i)(I), (II), (III) and (IV)). In addition, a lump sum 
distribution includes a distribution of an annuity contract from a 
trust that is part of a plan described in section 401(a) and which is 
exempt from tax under section 501(a) or an annuity plan described in 
403(a).
    (5) Rules applicable to all distributions--(i) Exclusive 
distribution rules. Amounts attributable to elective contributions may 
not be distributed on account of any event not described in this 
paragraph (d), such as completion of a stated period of plan 
participation or the lapse of a fixed number of years. For example, if 
excess deferrals (and income) for an employee's taxable year are not 
distributed within the time prescribed in Sec.  1.402(g)-1(e)(2) or 
(3), the amounts may be distributed only on account of an event 
described in this paragraph (d). Pursuant to section 401(k)(8), the 
prohibition on distributions set forth in this section does not apply 
to a distribution of excess contributions under Sec.  1.401(k)-2(b). In 
addition, the prohibition on distributions set forth in this paragraph 
(d) does not apply to a distribution of excess annual additions 
pursuant to Sec.  1.415-6(b)(6)(iv).
    (ii) Deemed distributions. The cost of life insurance (determined 
under section 72) is not treated as a distribution for purposes of 
section 401(k)(2) and this paragraph (d). The making of a loan is not 
treated as a distribution, even if the loan is secured by the 
employee's accrued benefit attributable to elective contributions or is 
includible in the employee's income under section 72(p). However, the 
reduction, by reason of default on a loan, of an employee's accrued 
benefit derived from elective contributions is treated as a 
distribution.
    (iii) ESOP dividend distributions. A plan does not fail to satisfy 
the requirements of this paragraph (d) merely by reason of a dividend 
distribution described in section 404(k)(2).
    (iv) Limitations apply after transfer. The limitations of this 
paragraph (d) generally continue to apply to amounts

[[Page 42496]]

attributable to elective contributions (including QNECs and qualified 
matching contributions taken into account for the ADP test under Sec.  
1.401(k)-2(a)(6)) that are transferred to another qualified plan of the 
same or another employer. Thus, the transferee plan will generally fail 
to satisfy the requirements of section 401(a) and this section if 
transferred amounts may be distributed before the times specified in 
this paragraph (d). In addition, a cash or deferred arrangement fails 
to satisfy the limitations of this paragraph (d) if it transfers 
amounts to a plan that does not provide that the transferred amounts 
may not be distributed before the times specified in this paragraph 
(d). The transferor plan does not fail to comply with the preceding 
sentence if it reasonably concludes that the transferee plan provides 
that the transferred amounts may not be distributed before the times 
specified in this paragraph (d). What constitutes a basis for a 
reasonable conclusion is comparable to the rules related to acceptance 
of rollover distributions. See Sec.  1.401(a)(31)-1, A-14. The 
limitations of this paragraph (d) cease to apply after the transfer, 
however, if the amounts could have been distributed at the time of the 
transfer (other than on account of hardship), and the transfer is an 
elective transfer described in Sec.  1.411(d)-4, Q&A-3(b)(1). The 
limitations of this paragraph (d) also do not apply to amounts that 
have been paid in a direct rollover to the plan after being distributed 
by another plan.
    (6) Examples. The following examples illustrate the application of 
this paragraph (d):

    Example 1. Employer M maintains Plan V, a profit-sharing plan 
that includes a cash or deferred arrangement. Elective contributions 
under the arrangement may be withdrawn for any reason after two 
years following the end of the plan year in which the contributions 
were made. Because the plan permits distributions of elective 
contributions before the occurrence of one of the events specified 
in section 401(k)(2)(B) and this paragraph (d), the cash or deferred 
arrangement is a nonqualified cash or deferred arrangement and the 
elective contributions are currently includible in income under 
section 402.
    Example 2. (i) Employer N maintains Plan W, a profit-sharing 
plan that includes a cash or deferred arrangement. Plan W provides 
for distributions upon a participant's severance from employment, 
death or disability. All employees of Employer N and its wholly 
owned subsidiary, Employer O, are eligible to participate in Plan W. 
Employer N agrees to sell all issued and outstanding shares of 
Employer O to an unrelated entity, Employer T, effective on December 
31, 2006. Following the transaction, Employer O will be a wholly 
owned subsidiary of Employer T. Additionally, individuals who are 
employed by Employer O on the effective date of the sale continue to 
be employed by Employer O following the sale. Following the 
transaction, all employees of Employer O will cease to participate 
in Plan W and will become eligible to participate in the cash or 
deferred arrangement maintained by Employer T, Plan X. No assets 
will be transferred from Plan W to Plan X, except in the case of a 
direct rollover within the meaning of section 401(a)(31).
    (ii) Employer O ceases to be a member of Employer N's controlled 
group as a result of the sale. Therefore, employees of Employer O 
who participated in Plan W will have a severance from employment and 
are eligible to receive a distribution from Plan W.
    Example 3. (i) Employer Q maintains Plan Y, a profit-sharing 
plan that includes a cash or deferred arrangement. Plan Y, the only 
plan maintained by Employer Q, does not provide for loans. However, 
Plan Y provides that elective contributions under the arrangement 
may be distributed to an eligible employee on account of hardship 
using the deemed immediate and heavy financial need provisions of 
paragraph (d)(3)(iii)(B) of this section and provisions regarding 
distributions necessary to satisfy financial need of paragraphs 
(d)(3)(iv)(A) through (D) of this section. Employee A is an eligible 
employee in Plan Y with an account balance of $50,000 attributable 
to elective contributions made by Employee A. The total amount of 
elective contributions made by Employee A, who has not previously 
received a distribution from Plan Y, is $20,000. Employee A requests 
a $15,000 hardship distribution of his elective contributions to pay 
6 months of college tuition and room and board expenses for his 
dependent child. At the time of the distribution request, the sole 
asset of Employee A (that is reasonably available to Employee A 
within the meaning of paragraph (d)(3)(iv)(B) of this section) is a 
savings account with an available balance of $10,000.
    (ii) A distribution is made on account of hardship only if the 
distribution both is made on account of an immediate and heavy 
financial need of the employee and is necessary to satisfy the 
financial need. Under paragraph (d)(3)(iii)(B) of this section, a 
distribution for payment of up to the next 12 months of post-
secondary education and room and board expenses for Employee A's 
dependant child is deemed to be on account of an immediate and heavy 
financial need of Employee A.
    (iii) A distribution is treated as necessary to satisfy Employee 
A's immediate and heavy financial need to the extent the need may 
not be relieved from other resources reasonably available to 
Employee A. Under paragraph (d)(3)(iv)(B) of this section, Employee 
A's $10,000 savings account is a resource that is reasonably 
available to the employee and must be taken into account in 
determining the amount necessary to satisfy Employee A's immediate 
and heavy financial need. Thus, Employee A may receive a 
distribution of only $5,000 of his elective contributions on account 
of this hardship, plus an amount necessary to pay any federal, 
state, or local income taxes or penalties reasonably anticipated to 
result from the distribution.
    Example 4. (i) The facts are the same as in Example 3. Employee 
B, another employee of Employer Q has an account balance of $25,000, 
attributable to Employee B's elective contributions. The total 
amount of elective contributions made by Employee B, who has not 
previously received a distribution from Plan Y, is $15,000. Employee 
B requests a $10,000 distribution of his elective contributions to 
pay 6 months of college tuition and room and board expenses for his 
dependent child. Employee B makes a written representation (with 
respect to which Employer Q has no actual knowledge to the contrary) 
that the need cannot reasonably be relieved: (1) through 
reimbursement or compensation by insurance or otherwise; (2) by 
liquidation of the employee's assets; (3) by cessation of elective 
contributions or employee contributions under the plan; (4) by other 
distributions or nontaxable (at the time of the loan) loans from 
plans maintained by the employer or by any other employer; or (5) by 
borrowing from commercial sources on reasonable commercial terms in 
an amount sufficient to satisfy the need.
    (ii) Under paragraph (d)(3)(iii)(B) of this section, a 
distribution for payment of up to the next 12 months of post-
secondary education and room and board expenses for Employee B's 
dependant child is deemed to be on account of an Employee B's 
immediate and heavy financial need. In addition, because Employer Q 
can rely on Employee B's written representation, the distribution is 
considered necessary to satisfy Employee B's immediate and heavy 
financial need. Therefore, Employee B may receive a $10,000 
distribution of his elective contributions on account of hardship 
plus an amount necessary to pay any federal, state, or local income 
taxes or penalties reasonably anticipated to result from the 
distribution.
    Example 5. (i) The facts are the same as in Example 3, except 
Plan Y provides for hardship distributions using the safe harbor 
rule of paragraph (d)(3)(iv)(E) of this section. Accordingly, Plan Y 
provides for a 6 month suspension of an eligible employee's elective 
contributions and employee contributions to the plan after the 
receipt of a hardship distribution by such eligible employee.
    (ii) Under paragraph (d)(3)(iii)(B) of this section, a 
distribution for payment of up to the next 12 months of post-
secondary education and room and board expenses for Employee A's 
dependant child is deemed to be on account of an Employee A's 
immediate and heavy financial need. In addition, because Employee A 
is not eligible for any other distribution or loan from Plan Y and 
Plan Y suspends Employee A's elective contributions and employee 
contributions following receipt of the hardship distribution, the 
distribution will be deemed necessary to satisfy Employee A's 
immediate and heavy financial need (and Employee A is not required 
to first liquidate his savings account). Therefore, Employee A may 
receive a $15,000 distribution of his elective contributions on 
account of hardship plus an amount necessary to pay any federal, 
state, or local income taxes or penalties reasonably anticipated to 
result from the distribution.
    Example 6. Employer R maintains a pre-ERISA money purchase 
pension plan that

[[Page 42497]]

includes a cash or deferred arrangement that is not a rural 
cooperative plan. Elective contributions under the arrangement may 
be distributed to an employee on account of hardship. Under 
paragraph (d)(1) of this section, hardship is a permissible 
distribution event only in a profit-sharing, stock bonus or rural 
cooperative plan. Since elective contributions under the arrangement 
may be distributed before a permissible distribution event occurs, 
the cash or deferred arrangement does not satisfy this paragraph 
(d), and is not a qualified cash or deferred arrangement. Moreover, 
the plan is not a qualified plan because a money purchase pension 
plan may not provide for payment of benefits upon hardship. See 
Sec.  1.401-1(b)(1)(i).

    (e) Additional requirements for qualified cash or deferred 
arrangements--(1) Qualified plan requirement. A cash or deferred 
arrangement satisfies this paragraph (e) only if the plan of which it 
is a part is a profit-sharing, stock bonus, pre-ERISA money purchase or 
rural cooperative plan that otherwise satisfies the requirements of 
section 401(a) (taking into account the cash or deferred arrangement). 
A plan that includes a cash or deferred arrangement may provide for 
other contributions, including employer contributions (other than 
elective contributions), employee contributions, or both. However, 
except as expressly permitted under section 401(m), 410(b)(2)(A)(ii) or 
416(c)(2)(A), elective contributions and matching contributions taken 
into account under Sec.  1.401(k)-2(a) may not be taken into account 
for purposes of determining whether any other contributions under any 
plan (including the plan to which the contributions are made) satisfy 
the requirements of section 401(a).
    (2) Election requirements--(i) Cash must be available. A cash or 
deferred arrangement satisfies this paragraph (e) only if the 
arrangement provides that the amount that each eligible employee may 
defer as an elective contribution is available to the employee in cash. 
Thus, for example, if an eligible employee is provided the option to 
receive a taxable benefit (other than cash) or to have the employer 
contribute on the employee's behalf to a profit-sharing plan an amount 
equal to the value of the taxable benefit, the arrangement is not a 
qualified cash or deferred arrangement. Similarly, if an employee has 
the option to receive a specified amount in cash or to have the 
employer contribute an amount in excess of the specified cash amount to 
a profit-sharing plan on the employee's behalf, any contribution made 
by the employer on the employee's behalf in excess of the specified 
cash amount is not treated as made pursuant to a qualified cash or 
deferred arrangement. This cash availability requirement applies even 
if the cash or deferred arrangement is part of a cafeteria plan within 
the meaning of section 125.
    (ii) Frequency of elections. A cash or deferred arrangement 
satisfies this paragraph (e) only if the arrangement provides an 
employee with an effective opportunity to make (or change) a cash or 
deferred election at least once during each plan year. Whether an 
employee has an effective opportunity is determined based on all the 
relevant facts and circumstances, including notice of the availability 
of the election, the period of time during which an election may be 
made, and any other conditions on elections.
    (3) Separate accounting requirement--(i) General rule. A cash or 
deferred arrangement satisfies this paragraph (e) only if the portion 
of an employee's benefit subject to the requirements of paragraphs (c) 
and (d) of this section is determined by an acceptable separate 
accounting between that portion and any other benefits. Separate 
accounting is not acceptable unless gains, losses, withdrawals, and 
other credits or charges are separately allocated on a reasonable and 
consistent basis to the accounts subject to the requirements of 
paragraphs (c) and (d) of this section and to other accounts. Subject 
to section 401(a)(4), forfeitures are not required to be allocated to 
the accounts in which benefits are subject to paragraphs (c) and (d) of 
this section.
    (ii) Satisfaction of separate accounting requirement. The 
requirements of paragraph (e)(3)(i) of this section are treated as 
satisfied if all amounts held under a plan that includes a cash or 
deferred arrangement (and, if applicable, under another plan to which 
QNECs and QMACs are made) are subject to the requirements of paragraphs 
(c) and (d) of this section.
    (4) Limitations on cash or deferred arrangements of state and local 
governments--(i) General rule. A cash or deferred arrangement does not 
satisfy the requirements of this paragraph (e) if the arrangement is 
adopted after May 6, 1986, by a State or local government or political 
subdivision thereof, or any agency or instrumentality thereof (a 
governmental unit). For purposes of this paragraph (e)(4), an employer 
that has made a legally binding commitment to adopt a cash or deferred 
arrangement is treated as having adopted the arrangement on that date.
    (ii) Rural cooperative plans and Indian tribal governments. This 
paragraph (e)(4) does not apply to a rural cooperative plan or to a 
plan of an employer which is an Indian tribal government (as defined in 
section 7701(a)(40)), a subdivision of an Indian tribal government 
(determined in accordance with section 7871(d)), an agency or 
instrumentality of an Indian tribal government or subdivision thereof, 
or a corporation chartered under Federal, State or tribal law which is 
owned in whole or in part by any of the entities in this paragraph 
(e)(4)(ii).
    (iii) Adoption after May 6, 1986. A cash or deferred arrangement is 
treated as adopted after May 6, 1986, with respect to all employees of 
any employer that adopts the arrangement after such date.
    (iv) Adoption before May 7, 1986. If a governmental unit adopted a 
cash or deferred arrangement before May 7, 1986, then any cash or 
deferred arrangement adopted by the unit at any time is treated as 
adopted before that date. If an employer adopted an arrangement prior 
to such date, all employees of the employer may participate in the 
arrangement.
    (5) One-year eligibility requirement. A cash or deferred 
arrangement satisfies this paragraph (e) only if no employee is 
required to complete a period of service with the employer maintaining 
the plan extending beyond the period permitted under section 410(a)(1) 
(determined without regard to section 410(a)(1)(B)(i)) to be eligible 
to make a cash or deferred election under the arrangement.
    (6) Other benefits not contingent upon elective contributions--(i) 
General rule. A cash or deferred arrangement satisfies this paragraph 
(e) only if no other benefit is conditioned (directly or indirectly) 
upon the employee's electing to make or not to make elective 
contributions under the arrangement. The preceding sentence does not 
apply to--
    (A) Any matching contribution (as defined in Sec.  1.401(m)-
1(a)(2)) made by reason of such an election;
    (B) Any benefit, right or feature (such as a plan loan) that 
requires, or results in, an amount to be withheld from an employee's 
pay (e.g. to pay for the benefit or to repay the loan), to the extent 
the cash or deferred arrangement restricts elective contributions to 
amounts available after such withholding from the employee's pay (after 
deduction of all applicable income and employment taxes);
    (C) Any reduction in the employer's top-heavy contributions under 
section 416(c)(2) because of matching contributions that resulted from 
the elective contributions; or
    (D) Any benefit that is provided at the employee's election under a 
plan described in section 125(d) in lieu of an

[[Page 42498]]

elective contribution under a qualified cash or deferred arrangement.
    (ii) Definition of other benefits. For purposes of this paragraph 
(e)(6), other benefits include, but are not limited to, benefits under 
a defined benefit plan; nonelective contributions under a defined 
contribution plan; the availability, cost, or amount of health 
benefits; vacations or vacation pay; life insurance; dental plans; 
legal services plans; loans (including plan loans); financial planning 
services; subsidized retirement benefits; stock options; property 
subject to section 83; and dependent care assistance. Also, increases 
in salary and bonuses (other than those actually subject to the cash or 
deferred election) are benefits for purposes of this paragraph (e)(6). 
The ability to make after-tax employee contributions is a benefit, but 
that benefit is not contingent upon an employee's electing to make or 
not make elective contributions under the arrangement merely because 
the amount of elective contributions reduces dollar-for-dollar the 
amount of after-tax employee contributions that may be made. 
Additionally, benefits under any other plan or arrangement (whether or 
not qualified) are not contingent upon an employee's electing to make 
or not to make elective contributions under a cash or deferred 
arrangement merely because the elective contributions are or are not 
taken into account as compensation under the other plan or arrangement 
for purposes of determining benefits.
    (iii) Effect of certain statutory limits. Any benefit under an 
excess benefit plan described in section 3(36) of the Employee 
Retirement Income Security Act of 1974 that is dependent on the 
employee's electing to make or not to make elective contributions is 
not treated as contingent.
    (iv) Nonqualified deferred compensation. Participation in a 
nonqualified deferred compensation plan is treated as contingent for 
purposes of this paragraph (e)(6) only to the extent that an employee 
may receive additional deferred compensation under the nonqualified 
plan to the extent the employee makes or does not make elective 
contributions. Deferred compensation under a nonqualified plan of 
deferred compensation that is dependent on an employee's having made 
the maximum elective deferrals under section 402(g) or the maximum 
elective contributions permitted under the terms of the plan also is 
not treated as contingent.
    (v) Plan loans and distributions. A loan or distribution of 
elective contributions is not a benefit conditioned on an employee's 
electing to make or not make elective contributions under the 
arrangement merely because the amount of the loan or distribution is 
based on the amount of the employee's account balance.
    (vi) Examples. The following examples illustrate the application of 
this paragraph (e)(6):

    Example 1. Employer T maintains a cash or deferred arrangement 
for all of its employees. Employer T also maintains a nonqualified 
deferred compensation plan for two highly paid executives, Employees 
R and C. Under the terms of the nonqualified deferred compensation 
plan, R and C are eligible to participate only if they do not make 
elective contributions under the cash or deferred arrangement. 
Participation in the nonqualified plan is a contingent benefit for 
purposes of this paragraph (e)(6), because R's and C's participation 
is conditioned on their electing not to make elective contributions 
under the cash or deferred arrangement.
    Example 2. Employer T maintains a cash or deferred arrangement 
for all its employees. Employer T also maintains a nonqualified 
deferred compensation plan for two highly paid executives, Employees 
R and C. Under the terms of the arrangements, Employees R and C may 
defer a maximum of 10% of their compensation, and may allocate their 
deferral between the cash or deferred arrangement and the 
nonqualified deferred compensation plan in any way they choose 
(subject to the overall 10% maximum). Because the maximum deferral 
available under the nonqualified deferred compensation plan depends 
on the elective deferrals made under the cash or deferred 
arrangement, the right to participate in the nonqualified plan is a 
contingent benefit for purposes of paragraph (e)(6).

    (7) Plan provision requirement. A plan that includes a cash or 
deferred arrangement satisfies this paragraph (e) only if it provides 
that the nondiscrimination requirements of section 401(k) will be met. 
Thus, the plan must provide for satisfaction of one of the specific 
alternatives described in paragraph (b)(1)(ii) of this section and, if 
with respect to that alternative there are optional choices, which of 
the optional choices will apply. For example, a plan that uses the ADP 
test of section 401(k)(3), as described in paragraph (b)(1)(ii)(A) of 
this section, must specify whether it is using the current year testing 
method or prior year testing method. Additionally, a plan that uses the 
prior year testing method must specify whether the ADP for eligible 
NHCEs for the first plan year is 3% or the ADP for the eligible NHCEs 
for the first plan year. Similarly, a plan that uses the safe harbor 
method of section 401(k)(12), as described in paragraph (b)(1)(ii)(B) 
of this section, must specify whether the safe harbor contribution will 
be the nonelective safe harbor contribution or the matching safe harbor 
contribution and is not permitted to provide that ADP testing will be 
used if the requirements for the safe harbor are not satisfied. For 
purposes of this paragraph (e)(7), a plan may incorporate by reference 
the provisions of section 401(k)(3) and Sec.  1.401(k)-2 if that is the 
nondiscrimination test being applied.
    (f) Effective dates--(1) General rule. This section and Sec. Sec.  
1.401(k)-2 through 1.401(k)-6 apply to plan years that begin on or 
after the date that is 12 months after the issuance of these 
regulations in final form, except as otherwise provided in this 
paragraph (f).
    (2) Collectively bargained plans. In the case of a plan maintained 
pursuant to one or more collective bargaining agreements between 
employee representatives and one or more employers in effect on the 
date described in paragraph (f)(1) of this section, the provisions of 
this section and Sec. Sec.  1.401(k)-2 through 1.401(k)-6 apply to the 
later of the first plan year beginning after the termination of the 
last such agreement or the plan year described in paragraph (f)(1) of 
this section.


Sec.  1.401(k)-2  ADP test.

    (a) Actual deferral percentage (ADP) test--(1) In general--(i) ADP 
test formula. A cash or deferred arrangement satisfies the ADP test for 
a plan year only if--
    (A) The ADP for the eligible HCEs for the plan year is not more 
than the ADP for the eligible NHCEs for the applicable year multiplied 
by 1.25; or
    (B) The excess of the ADP for the eligible HCEs for the plan year 
over the ADP for the eligible NHCEs for the applicable year is not more 
than 2 percentage points, and the ADP for the eligible HCEs for the 
plan year is not more than the ADP for the eligible NHCEs for the 
applicable year multiplied by 2.
    (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.
    (iii) Special rule for early participation. If a cash or deferred 
arrangement provides that employees are eligible to participate before 
they have completed the minimum age and service requirements of section 
410(a)(1)(A), and if the plan applies section 410(b)(4)(B) in 
determining whether the cash or deferred arrangement meets the 
requirements of

[[Page 42499]]

section 410(b)(1), then in determining whether the arrangement meets 
the requirements under paragraph (a)(1) of this section, either--
    (A) Pursuant to section 401(k)(3)(F), the ADP test is performed 
under the plan (determined without regard to disaggregation under Sec.  
1.410(b)-7(c)(3)), using the ADP for all eligible HCEs for the plan 
year and the ADP of eligible NHCEs for the applicable year, 
disregarding all NHCEs who have not met the minimum age and service 
requirements of section 410(a)(1)(A); or
    (B) Pursuant to Sec.  1.401(k)-1(b)(4), the plan is disaggregated 
into separate plans and the ADP test is performed separately for all 
eligible employees who have completed the minimum age and service 
requirements of section 410(a)(1)(A) and for all eligible employees who 
have not completed the minimum age and service requirements of section 
410(a)(1)(A).
    (2) Determination of ADP--(i) General rule. The ADP for a group of 
eligible employees (either eligible HCEs or eligible NHCEs) for a plan 
year or applicable year is the average of the ADRs of the eligible 
employees in that group for that year. The ADP for a group of eligible 
employees is calculated to the nearest hundredth of a percentage point.
    (ii) Determination of applicable year under current year and prior 
year testing method. The ADP test is applied using the prior year 
testing method or the current year testing method. Under the prior year 
testing method, the applicable year for determining the ADP for the 
eligible NHCEs is the plan year immediately preceding the plan year for 
which the ADP test is being performed. Under the prior year testing 
method, the ADP for the eligible NHCEs is determined using the ADRs for 
the eligible employees who were NHCEs in that preceding plan year, 
regardless of whether those NHCEs are eligible employees or NHCEs in 
the plan year for which the ADP test is being calculated. Under the 
current year testing method, the applicable year for determining the 
ADP for the eligible NHCEs is the same plan year as the plan year for 
which the ADP test is being performed. Under either method, the ADP for 
eligible HCEs is the average of the ADRs of the eligible HCEs for the 
plan year for which the ADP test is being performed. See paragraph (c) 
of this section for additional rules for the prior year testing method.
    (3) Determination of ADR--(i) General rule. The ADR of an eligible 
employee for a plan year or applicable year is the sum of the 
employee's elective contributions taken into account with respect to 
such employee for the year, determined under the rules of paragraphs 
(a)(4) and (5) of this section, and the qualified nonelective 
contributions and qualified matching contributions taken into account 
with respect to such employee under paragraph (a)(6) of this section 
for the year, divided by the employee's compensation taken into account 
for the year. The ADR is calculated to the nearest hundredth of a 
percentage point. If no elective contributions, qualified nonelective 
contributions, or qualified matching contributions are taken into 
account under this section with respect to an eligible employee for the 
year, the ADR of the employee is zero.
    (ii) ADR of HCEs eligible under more than one arrangement--(A) 
General rule. Pursuant to section 401(k)(3)(A), the ADR of an HCE who 
is an eligible employee in more than one cash or deferred arrangement 
of the same employer is calculated by treating all contributions with 
respect to such HCE under any such arrangement as being made under the 
cash or deferred arrangement being tested. Thus, the ADR for such an 
HCE is calculated by accumulating all contributions under any cash or 
deferred arrangement (other than a cash or deferred arrangement 
described in paragraph (a)(3)(ii)(B) of this section) that would be 
taken into account under this section for the plan year, if the cash or 
deferred arrangement under which the contribution was made applied this 
section and had the same plan year. For example, in the case of a plan 
with a 12-month plan year, the ADR for the plan year of that plan for 
an HCE who participates in multiple cash or deferred arrangements of 
the same employer is the sum of all contributions during such 12-month 
period that would be taken into account with respect to the HCE under 
all such arrangements in which the HCE is an eligible employee, divided 
by the HCE's compensation for that 12-month period (determined using 
the compensation definition for the plan being tested), without regard 
to the plan year of the other plans and whether those plans are 
satisfying this section or Sec.  1.401(k)-3.
    (B) Plans not permitted to be aggregated. Cash or deferred 
arrangements under plans that are not permitted to be aggregated under 
Sec.  1.401(k)-1(b)(4) (determined without regard to the prohibition on 
aggregating plans with inconsistent testing methods set forth in Sec.  
1.401(k)-1(b)(4)(iii)(B) and the prohibition on aggregating plans with 
different plan years set forth in Sec.  1.410(b)-7(d)(5)) are not 
aggregated under this paragraph (a)(3)(ii).
    (iii) Examples. The following examples illustrate the application 
of this paragraph (a)(3):

    Example 1.  (i) Employee A, an HCE with compensation of 
$120,000, is eligible to make elective contributions under Plan S 
and Plan T, two profit-sharing plans maintained by Employer H with 
calendar year plan years, each of which includes a cash or deferred 
arrangement. During the current plan year, Employee A makes elective 
contributions of $6,000 to Plan S and $4,000 to Plan T.
    (ii) Under each plan, the ADR for Employee A is determined by 
dividing Employee A's total elective contributions under both 
arrangements by Employee A's compensation taken into account under 
the plan for the year. Therefore, Employee A's ADR under each plan 
is 8.33% ($10,000/$120,000).
    Example 2.  (i) The facts are the same as in Example 1, except 
that Plan T defines compensation (for deferral and testing purposes) 
to exclude all bonuses paid to an employee. Plan S defines 
compensation (for deferral and testing purposes) to include bonuses 
paid to an employee. During the current year, Employee A's 
compensation included a $10,000 bonus. Therefore, Employee A's 
compensation under Plan T is $110,000 and Employee A's compensation 
under Plan S is $120,000.
    (ii) Employee A's ADR under Plan T is 9.09% ($10,000/$110,000) 
and under Plan S, Employee A's ADR is 8.33% ($10,000/$120,000).
    Example 3. (i) Employer J sponsors two profit-sharing plans, 
Plan U and Plan V, each of which includes a cash or deferred 
arrangement. Plan U's plan year begins on July 1 and ends on June 
30. Plan V has a calendar year plan year. Compensation under both 
plans is limited to the participant's compensation during the period 
of participation. Employee B is an HCE who participates in both 
plans. Employee B's monthly compensation and elective contributions 
to each plan for the 2005 and 2006 calendar years are as follows:

----------------------------------------------------------------------------------------------------------------
                                                                             Monthly elective   Monthly elective
                     Calendar year                            Monthly        contribution to    contribution to
                                                            compensation          Plan U             Plan V
----------------------------------------------------------------------------------------------------------------
2005...................................................            $10,000               $500               $400
2006...................................................             11,500                700                550
----------------------------------------------------------------------------------------------------------------


[[Page 42500]]

    (ii) Under Plan U, Employee B's ADR for the plan year ended June 
30, 2006, is equal to Employee B's total elective contributions 
under Plan U and Plan V for the plan year ending June 30, 2006 
divided by Employee B's compensation for that period. Therefore, 
Employee B's ADR under Plan U for the plan year ending June 30, 
2006, is (($900 x 6) + ($1,250 x 6 ))/(($10,000 x 6) + ($11,500 x 
6)), or 10%.
    (iii) Under Plan V, Employee B's ADR for the plan year ended 
December 31, 2005, is equal to total elective contributions under 
Plan U and V for the plan year ending December 31, 2005, divided by 
Employee B's compensation for that period. Therefore, Employee B's 
ADR under Plan V for the plan year ending December 31, 2005, is 
($10,800/$120,000), or 9%.
    Example 4. (i) The facts are the same as Example 3, except that 
Employee B first becomes eligible to participate in Plan U on 
January 1, 2006.
    (ii) Under Plan U, Employee B's ADR for the plan year ended June 
30, 2006, is equal to Employee B's total elective contributions 
under Plan U and V for the plan year ending June 30, 2006, divided 
by Employee B's compensation for that period. Therefore, Employee 
B's ADR under Plan U for the plan year ending June 30, 2006, is 
(($400 x 6)+ ($1,250 x 6 ))/(($10,000 x 6) + ($11,500 x 6)), or 
7.67%.

    (4) Elective contributions taken into account under the ADP test--
(i) General rule. An elective contribution is taken into account in 
determining the ADR for an eligible employee for a plan year or 
applicable year only if each of the following requirements is 
satisfied:
    (A) The elective contribution is allocated to the eligible 
employee's account under the plan as of a date within that year. For 
purposes of this rule, an elective contribution is considered allocated 
as of a date within a year only if--
    (1) The allocation is not contingent on the employee's 
participation in the plan or performance of services on any date 
subsequent to that date; and
    (2) The elective contribution is actually paid to the trust no 
later than the end of the 12-month period immediately following the 
year to which the contribution relates.
    (B) The elective contribution relates to compensation that either--
    (1) Would have been received by the employee in the year but for 
the employee's election to defer under the arrangement; or
    (2) Is attributable to services performed by the employee in the 
year and, but for the employee's election to defer, would have been 
received by the employee within 2\1/2\ months after the close of the 
year, but only if the plan so provides for elective contributions that 
relate to compensation that would have been received after the close of 
a year to be allocated to such prior year rather than the year in which 
the compensation would have been received.
    (ii) Elective contributions for partners and self-employed 
individuals. For purposes of this paragraph (a)(4), a partner's 
distributive share of partnership income is treated as received on the 
last day of the partnership taxable year and a sole proprietor's 
compensation is treated as received on the last day of the individual's 
taxable year. Thus, an elective contribution made on behalf of a 
partner or sole proprietor is treated as allocated to the partner's 
account for the plan year that includes the last day of the partnership 
taxable year, provided the requirements of paragraph (a)(4)(i) of this 
section are met.
    (iii) Elective contributions for HCEs. Elective contributions of an 
HCE must include any excess deferrals, as described in Sec.  1.402(g)-
1(a), even if those excess deferrals are distributed, pursuant to Sec.  
1.402(g)-1(e).
    (5) Elective contributions not taken into account under the ADP 
test--(i) General rule. Elective contributions that do not satisfy the 
requirements of paragraph (a)(4)(i) of this section may not be taken 
into account in determining the ADR of an eligible employee for the 
plan year or applicable year with respect to which the contributions 
were made, or for any other plan year. Instead, the amount of the 
elective contributions must satisfy the requirements of section 
401(a)(4) (without regard to the ADP test) for the plan year for which 
they are allocated under the plan as if they were nonelective 
contributions and were the only nonelective contributions for that 
year. See Sec. Sec.  1.401(a)(4)-1(b)(2)(ii)(B) and 1.410(b)-7(c)(1).
    (ii) Elective contributions for NHCEs. Elective contributions of an 
NHCE shall not include any excess deferrals, as described in Sec.  
1.402(g)-1(a), to the extent the excess deferrals are prohibited under 
section 401(a)(30). However, to the extent that the excess deferrals 
are not prohibited under section 401(a)(30), they are included in 
elective contributions even if distributed pursuant to Sec.  1.402(g)-
1(e).
    (iii) Elective contributions treated as catch-up contributions. 
Elective contributions that are treated as catch-up contributions under 
section 414(v) because they exceed a statutory limit or employer-
provided limit (within the meaning of Sec.  1.414(v)-1(b)(1)) are not 
taken into account under paragraph (a)(4) of this section for the plan 
year for which the contributions were made, or for any other plan year.
    (iv) Elective contributions used to satisfy the ACP test. Except to 
the extent necessary to demonstrate satisfaction of the requirement of 
Sec.  1.401(m)-2(a)(6)(ii), elective contributions taken into account 
for the ACP test under Sec.  1.401(m)-2(a)(6) are not taken into 
account under paragraph (a)(4) of this section.
    (6) Qualified nonelective contributions and qualified matching 
contributions that may be taken into account under the ADP test. 
Qualified nonelective contributions and qualified matching 
contributions may be taken into account in determining the ADR for an 
eligible employee for a plan year or applicable year but only to the 
extent the contributions satisfy the following requirements.
    (i) Timing of allocation. The qualified nonelective contribution or 
qualified matching contribution is allocated to the employee's account 
as of a date within that year within the meaning of paragraph 
(a)(4)(i)(A) of this section. Consequently, under the prior year 
testing method, in order to be taken into account in calculating the 
ADP for the eligible NHCEs for the applicable year, a qualified 
nonelective contribution or qualified matching contribution must be 
contributed no later than the end of the 12-month period immediately 
following the applicable year even though the applicable year is 
different than the plan year being tested.
    (ii) Requirement that amount satisfy section 401(a)(4). The amount 
of nonelective contributions, including those qualified nonelective 
contributions taken into account under this paragraph (a)(6) and those 
qualified nonelective contributions taken into account for the ACP test 
of section 401(m)(2) under Sec.  1.401(m)-2(a)(6), satisfies the 
requirements of section 401(a)(4). See Sec.  1.401(a)(4)-1(b)(2). The 
amount of nonelective contributions, excluding those qualified 
nonelective contributions taken into account under this paragraph 
(a)(6) and those qualified nonelective contributions taken into account 
for the ACP test of section 401(m)(2) under Sec.  1.401(m)-2(a)(6), 
satisfies the requirements of section 401(a)(4). See Sec.  1.401(a)(4)-
1(b)(2). In the case of an employer that is applying the special rule 
for employer-wide plans in Sec.  1.414(r)-1(c)(2)(ii) with respect to 
the cash or deferred arrangement, the determination of whether the 
qualified nonelective contributions satisfy the requirements of this 
paragraph (a)(6)(ii) must be made on an employer-wide basis regardless 
of whether the plans to which the qualified nonelective contributions 
are made are satisfying the requirements of section 410(b) on an

[[Page 42501]]

employer-wide basis. Conversely, in the case of an employer that is 
treated as operating qualified separate lines of business, and does not 
apply the special rule for employer-wide plans in Sec.  1.414(r)-
1(c)(2)(ii) with respect to the cash or deferred arrangement, then the 
determination of whether the qualified nonelective contributions 
satisfy the requirements of this paragraph (a)(6)(ii) is not permitted 
to be made on an employer-wide basis regardless of whether the plans to 
which the qualified nonelective contributions are made are satisfying 
the requirements of section 410(b) on that basis.
    (iii) Aggregation must be permitted. The plan that contains the 
cash or deferred arrangement and the plan or plans to which the 
qualified nonelective contributions or qualified matching contributions 
are made, are plans that would be permitted to be aggregated under 
Sec.  1.401(k)-1(b)(4). If the plan year of the plan that contains the 
cash or deferred arrangement is changed to satisfy the requirement 
under Sec.  1.410(b)-7(d)(5) that aggregated plans have the same plan 
year, qualified nonelective contributions and qualified matching 
contributions may be taken into account in the resulting short plan 
year only if such qualified nonelective contributions and qualified 
matching contributions could have been taken into account under an ADP 
test for a plan with the same short plan year.
    (iv) Disproportionate contributions not taken into account--(A) 
General rule. Qualified nonelective contributions cannot be taken into 
account for a plan year for an NHCE to the extent such contributions 
exceed the product of that NHCE's compensation and the greater of 5% or 
two times the plan's representative contribution rate. Any qualified 
nonelective contribution taken into account under an ACP test under 
Sec.  1.401(m)-2(a)(6) (including the determination of the 
representative contribution rate for purposes of Sec.  1.401(m)-
2(a)(6)(v)(B)), is not permitted to be taken into account for purposes 
of this paragraph (a)(6) (including the determination of the 
representative contribution rate under paragraph (a)(6)(iv)(B) of this 
section).
    (B) Definition of representative contribution rate. For purposes of 
this paragraph (a)(6)(iv), the plan's representative contribution rate 
is the lowest applicable contribution rate of any eligible NHCE among a 
group of eligible NHCEs that consists of half of all eligible NHCEs for 
the plan year (or, if greater, the lowest applicable contribution rate 
of any eligible NHCE in the group of all eligible NHCEs for the plan 
year and who is employed by the employer on the last day of the plan 
year).
    (C) Definition of applicable contribution rate. For purposes of 
this paragraph (a)(6)(iv), the applicable contribution rate for an 
eligible NHCE is the sum of the qualified matching contributions taken 
into account under this paragraph (a)(6) for the eligible NHCE for the 
plan year and the qualified nonelective contributions made for that 
eligible NHCE for the plan year, divided by that eligible NHCE's 
compensation for the same period.
    (v) Qualified matching contributions. Qualified matching 
contributions satisfy this paragraph (a)(6) only to the extent that 
such qualified matching contributions are matching contributions that 
are not precluded from being taken into account under the ACP test for 
the plan year under the rules of Sec.  1.401(m)-2(a)(5)(ii).
    (vi) Contributions only used once. Qualified nonelective 
contributions and qualified matching contributions can not be taken 
into account under this paragraph (a)(6) to the extent such 
contributions are taken into account for purposes of satisfying any 
other ADP test, any ACP test, or the requirements of Sec.  1.401(k)-3, 
1.401(m)-3 or 1.401(k)-4. Thus, for example, matching contributions 
that are made pursuant to Sec.  1.401(k)-3(c) cannot be taken into 
account under the ADP test. Similarly, if a plan switches from the 
current year testing method to the prior year testing method pursuant 
to Sec.  1.401(k)-2(c), qualified nonelective contributions that are 
taken into account under the current year testing method for a year may 
not be taken into account under the prior year testing method for the 
next year.
    (7) Examples. The following examples illustrate the application of 
this paragraph (a):

    Example 1. (i) Employer X has three employees, A, B, and C. 
Employer X sponsors a profit-sharing plan (Plan Z) that includes a 
cash or deferred arrangement. Each year, Employer X determines a 
bonus attributable to the prior year. Under the cash or deferred 
arrangement, each eligible employee may elect to receive none, all 
or any part of the bonus in cash. X contributes the remainder to 
Plan Z. The portion of the bonus paid in cash, if any, is paid 2 
months after the end of the plan year and thus is included in 
compensation for the following plan year. Employee A is an HCE, 
while Employees B and C are NHCEs. The plan uses the current year 
testing method and defines compensation to include elective 
contributions and bonuses paid during each plan year. In February of 
2005, Employer X determined that no bonuses will be paid for 2004. 
In February of 2006, Employer X provided a bonus for each employee 
equal to 10% of regular compensation for 2005. For the 2005 plan 
year, A, B, and C have the following compensation and make the 
following elections:

------------------------------------------------------------------------
                                                            Elective
             Employee                  Compensation       contribution
------------------------------------------------------------------------
A.................................           $100,000             $4,340
B.................................             60,000              2,860
C.................................             45,000              1,250
------------------------------------------------------------------------

    (ii) For each employee, the ratio of elective contributions to 
the employee's compensation for the plan year is:

------------------------------------------------------------------------
                                           Ratio of elective
                 Employee                   contribution to       ADR
                                              compensation
------------------------------------------------------------------------
A........................................    $4,340/$100,000       4.34%
B........................................       2,860/60,000       4.77
C........................................       1,250/45,000       2.78
------------------------------------------------------------------------


[[Page 42502]]

    (iii) The ADP for the HCEs (Employee A) is 4.34%. The ADP for 
the NHCEs is 3.78% ((4.77% + 2.78%)/2). Because 4.34% is less than 
4.73% (3.78% multiplied by 1.25), the plan satisfies the ADP test 
under paragraph (a)(1)(i) of this section.
    Example 2. (i) The facts are the same as in Example 1, except 
that elective contributions are made pursuant to a salary reduction 
agreement throughout the plan year, and no bonuses are paid. As 
provided by section 414(s)(2), Employer X includes elective 
contributions in compensation. During the year, B and C defer the 
same amount as in Example 1, but A defers $5,770. Thus, the 
compensation and elective contributions for A, B, and C are:

----------------------------------------------------------------------------------------------------------------
                                                                      Gross             Elective
                           Employee                                compensation      contributions        ADR
----------------------------------------------------------------------------------------------------------------
A.............................................................           $100,000             $5,770       5.77%
B.............................................................             60,000              2,860       4.77
C.............................................................             45,000              1,250       2.78
----------------------------------------------------------------------------------------------------------------

    (ii) The ADP for the HCEs (Employee A) is 5.77%. The ADP for the 
NHCEs is 3.78% ((4.77% + 2.78%)/2). Because 5.77% exceeds 4.73% 
(3.78% x 1.25), the plan does not satisfy the ADP test under 
paragraph (a)(1)(i) of this section. However, because the ADP for 
the HCEs does not exceed the ADP for the NHCEs by more than 2 
percentage points and the ADP for the HCEs does not exceed the ADP 
for the NHCEs multiplied by 2 (3.78% x 2 = 7.56%), the plan 
satisfies the ADP test under paragraph (a)(1)(ii) of this section.
    Example 3. (i) Employees D through L are eligible employees in 
Plan T, a profit-sharing plan that contains a cash or deferred 
arrangement. The plan is a calendar year plan that uses the prior 
year testing method. Plan T provides that elective contributions are 
included in compensation (as provided under section 414(s)(2)). Each 
eligible employee may elect to defer up to 6% of compensation under 
the cash or deferred arrangement. Employees D and E are HCEs. The 
compensation, elective contributions, and ADRs of Employees D and E 
for the 2006 plan year are shown below:

----------------------------------------------------------------------------------------------------------------
                                                                                       Elective        ADR for
                           Employee                             Compensation for  contributions for   2006 plan
                                                                 2006 plan year     2006 plan year       year
----------------------------------------------------------------------------------------------------------------
D............................................................           $100,000            $10,000          10%
E............................................................             95,000              4,750           5
----------------------------------------------------------------------------------------------------------------

    (ii) During the 2005 plan year, Employees F through L were 
eligible NHCEs. The compensation, elective contributions and ADRs of 
Employees F through L for the 2005 plan year are shown in the 
following table:

----------------------------------------------------------------------------------------------------------------
                                                                                       Elective        ADR for
                           Employee                             Compensation for  contributions for   2005 plan
                                                                 2005 plan year     2005 plan year       year
----------------------------------------------------------------------------------------------------------------
F............................................................            $60,000             $3,600           6%
G............................................................             40,000              1,600           4
H............................................................             30,000              1,200           4
I............................................................             20,000                600           3
J............................................................             20,000                600           3
K............................................................             10,000                300           3
L............................................................              5,000                150           3
----------------------------------------------------------------------------------------------------------------

    (iii) The ADP for 2006 for the HCEs is 7.5%. Because Plan T is 
using the prior year testing method, the applicable year for 
determining the NHCE ADP is the prior plan year (i.e., 2005). The 
NHCE ADP is determined using the ADRs for NHCEs eligible during the 
prior plan year (without regard to whether they are eligible under 
the plan during the plan year). The ADP for the NHCEs is 3.71% (the 
sum of the individual ADRs, 26%, divided by 7 employees). Because 
7.5% exceeds 4.64% (3.71% x 1.25), Plan T does not satisfy the ADP 
test under paragraph (a)(1)(i) of this section. In addition, because 
the ADP for the HCEs exceeds the ADP for the NHCEs by more than 2 
percentage points, Plan T does not satisfy the ADP test under 
paragraph (a)(1)(ii) of this section. Therefore, the cash or 
deferred arrangement fails to be a qualified cash or deferred 
arrangement unless the ADP failure is corrected under paragraph (b) 
of this section.
    Example 4.  (i) Plan U is a calendar year profit-sharing plan 
that contains a cash or deferred arrangement and uses the current 
year testing method. Plan U provides that elective contributions are 
included in compensation (as provided under section 414(s)(2)). The 
following amounts are contributed under Plan U for the 2006 plan 
year: (A) QNECs equal to 2% of each employee's compensation; (B) 
Contributions equal to 6% of each employee's compensation that are 
not immediately vested under the terms of the plan; (C) 3% of each 
employee's compensation that the employee may elect to receive as 
cash or to defer under the plan. Both types of nonelective 
contributions are made for the HCEs (employees M and N) and the 
NHCEs (employees O through S) for the plan year and are contributed 
after the end of the plan year and before the end of the following 
plan year. In addition, neither type of nonelective contributions is 
used for any other ADP or ACP test.
    (ii) For the 2006 plan year, the compensation, elective 
contributions, and actual deferral ratios of employees M through S 
are shown in the following table:

----------------------------------------------------------------------------------------------------------------
                                                                                   Elective           Actual
                         Employee                             Compensation      contributions     deferral ratio
----------------------------------------------------------------------------------------------------------------
M........................................................           $100,000             $3,000               3%
N........................................................            100,000              2,000               2
O........................................................             60,000              1,800               3

[[Page 42503]]

 
P........................................................             40,000                  0               0
Q........................................................             30,000                  0               0
R........................................................              5,000                  0               0
S........................................................             20,000                  0               0
----------------------------------------------------------------------------------------------------------------

    (iii) The elective contributions alone do not satisfy the ADP 
test of section 401(k)(3) and paragraph (a)(1) of this section 
because the ADP for the HCEs, consisting of employees M and N, is 
2.5% and the ADP for the NHCEs is 0.6%.
    (iv) The 2% QNECs satisfies the timing requirement of paragraph 
(a)(6)(i) of this section because it is paid within 12-month after 
the plan year for which allocated. All nonelective contributions 
also satisfy the requirements relating to section 401(a)(4) set 
forth in paragraph (a)(6)(ii) of this section (because all employees 
receive an 8% nonelective contribution and the nonelective 
contributions excluding the QNECs is 6% for all employees). In 
addition, the QNECs are not disproportionate under paragraph 
(a)(6)(iv) of this section because no QNEC for an NHCE exceeds the 
product of the plan's applicable contribution rate (2%) and that 
NHCE's compensation.
    (v) Because the rules of paragraph (a)(6) of this section are 
satisfied, the 2% QNECs may be taken into account in applying the 
ADP test of section 401(k)(3) and paragraph (a)(1) of this section. 
The 6% nonelective contributions, however, may not be taken into 
account because they are not QNECs.
    (vi) If the 2% QNECs are taken into account, the ADP for the 
HCEs is 4.5%, and the actual deferral percentage for the NHCEs is 
2.6%. Because 4.5% is not more than two percentage points greater 
than 2.6 percent, and not more than two times 2.6, the cash or 
deferred arrangement satisfies the ADP test of section 401(k)(3) 
under paragraph (a)(1)(ii) of this section.
    Example 5. (i) The facts are the same as Example 4, except the 
plan uses the prior year testing method. In addition, the NHCE ADP 
for the 2005 plan year (the prior plan year) is 0.8% and no QNECs 
are contributed for the 2005 plan year during 2005 or 2006.
    (ii) In 2007, it is determined that the elective contributions 
alone do not satisfy the ADP test of section 401(k)(3) and paragraph 
(a)(1) of this section for 2006 because the 2006 ADP for the 
eligible HCEs, consisting of employees M and N, is 2.5% and the 2005 
ADP for the eligible NHCEs is 0.8%. An additional QNEC of 2% of 
compensation is made for each eligible NHCE in 2007 and allocated 
for 2005.
    (iii) The 2% QNECs that are made in 2007 and allocated for the 
2005 plan year do not satisfy the timing requirement of paragraph 
(a)(6)(i) of this section for the applicable year for the 2005 plan 
year because they were not contributed before the last day of the 
2006 plan year. Accordingly, the 2% QNECs do not satisfy the rules 
of paragraph (a)(6) of this section and may not be taken into 
account in applying the ADP test of section 401(k)(3) and paragraph 
(a)(1) of this section for the 2006 plan year. The cash or deferred 
arrangement fails to be a qualified cash or deferred arrangement 
unless the ADP failure is corrected under paragraph (b) of this 
section.
    Example 6. (i) The facts are the same as Example 4, except that 
the ADP for the HCEs is 4.6% and there is no 6% nonelective 
contribution under the plan. The employer would like to take into 
account the 2% QNEC in determining the ADP for the NHCEs but not in 
determining the ADP for the HCEs.
    (ii) The elective contributions alone fail the requirements of 
section 401(k) and paragraph (a)(1) of this section because the HCE 
ADP for the plan year (4.6%) exceeds 0.75% (0.6% x 1.25) and 1.2% 
(0.6% x 2).
    (iii) The 2% QNECs may not be taken into account in determining 
the ADP of the NHCEs because they fail to satisfy the requirements 
relating to section 401(a)(4) set forth in paragraph (a)(6)(ii) of 
this section. This is because the amount of nonelective 
contributions, excluding those QNECs that would be taken into 
account under the ADP test, would be 2% of compensation for the HCEs 
and 0% for the NHCEs. Therefore, the cash or deferred arrangement 
fails to be a qualified cash or deferred arrangement unless the ADP 
failure is corrected under paragraph (b) of this section.
    Example 7. (i) The facts are the same as Example 6, except that 
Employee R receives a QNEC in an amount of $500 and no QNECs are 
made on behalf of the other employees.
    (ii) If the QNEC could be taken into account under paragraph 
(a)(6) of this section, the ADP for the NHCEs would be 2.6% and the 
plan would satisfy the ADP test. The QNEC is disproportionate under 
paragraph (a)(6)(iv) of this section, and cannot be taken into 
account under paragraph (a)(6) of this section, to the extent it 
exceeds the greater of 5% and two times the plan's representative 
contribution rate (0%), multiplied by Employee R's compensation. The 
plan's representative contribution rate is 0% because it is the 
lowest applicable contribution rate among a group of NHCEs that is 
at least half of all NHCEs, or all the NHCEs who are employed on the 
last day of the plan year. Therefore, the QNEC may be taken into 
account under the ADP test only to the extent it does not exceed 5% 
times Employee R's compensation (or $250) and the cash or deferred 
arrangement fails to satisfy the ADP test and must be corrected 
under paragraph (b) of this section.
    Example 8. (i) The facts are the same as in Example 4 except 
that the plan changes from the current year testing method to the 
prior year testing method for the following plan year (2006 plan 
year). The ADP for the HCEs for the 2006 plan year is 3.5%.
    (ii) The 2% QNECs may not be taken into account in determining 
the ADP for the NHCEs for the applicable year (2005 plan year) in 
satisfying the ADP test for the 2006 plan year because they were 
taken into account in satisfying the ADP test for the 2005 plan 
year. Accordingly, the NHCE ADP for the applicable year is 0.6%. The 
elective contributions for the plan year fail the requirements of 
section 401(k) and paragraph (a)(1) of this section because the HCE 
ADP for the plan year (3.5%) exceeds the ADP limit of 1.2% (the 
greater of 0.75% (0.6% x 1.25) and 1.2% (0.6% x 2)), determined 
using the applicable year ADP for the NHCEs. Therefore, the cash or 
deferred arrangement fails to be a qualified cash or deferred 
arrangement unless the ADP failure is corrected under paragraph (b) 
of this section.
    Example 9. (i)(A) Employer N maintains Plan X, a profit sharing 
plan that contains a cash or deferred arrangement and that uses the 
current year testing method. Plan X provides for employee 
contributions, elective contributions, and matching contributions. 
Matching contributions on behalf of nonhighly compensated employees 
are qualified matching contributions (QMACs) and are contributed 
during the 2005 plan year. Matching contributions on behalf of 
highly compensated employees are not QMACs, because they fail to 
satisfy the nonforfeitability requirement of Sec.  1.401(k)-1(c). 
The elective contributions and matching contributions with respect 
to HCEs for the 2005 plan year are shown in the following table:

----------------------------------------------------------------------------------------------------------------
                                                                                        Matching
                                                  Elective        Total matching     contributions
                                               contributions      contributions       that are not       QMACs
                                                                                         QMACs
----------------------------------------------------------------------------------------------------------------
Highly compensated employees...............                15%                 5%                 5%          0%
----------------------------------------------------------------------------------------------------------------

    (B) The elective contributions and matching contributions with 
respect to the NHCEs for the 2005 plan year are shown in the 
following table:

[[Page 42504]]



----------------------------------------------------------------------------------------------------------------
                                                                                        Matching
                                                  Elective        Total matching     contributions
                                               contributions      contributions       that are not       QMACs
                                                                                         QMACs
----------------------------------------------------------------------------------------------------------------
Nonhighly compensated employees............                11%                 4%                 0%          4%
----------------------------------------------------------------------------------------------------------------

    (ii) The plan fails to satisfy the ADP test of section 
401(k)(3)(A) and paragraph (a)(1) of this section because the ADP 
for HCEs (15%) is more than 125% of the ADP for NHCEs (11%), and 
more than 2 percentage points greater than 11%. However, the plan 
provides that QMACs may be used to meet the requirements of section 
401(k)(3)(A)(ii) provided that they are not used for any other ADP 
or ACP test. QMACs equal to 1% of compensation are taken into 
account for each NHCE in applying the ADP test. After this 
adjustment, the applicable ADP and ACP (taking into account the 
provisions of Sec.  1.401(m)-2(a)(5)(ii)) for the plan year are as 
follows:

------------------------------------------------------------------------
                                                             Actual
                                     Actual deferral      contribution
                                        percentage         percentage
------------------------------------------------------------------------
HCEs..............................                 15                  5
Nonhighly compensated employees...                 12                  3
------------------------------------------------------------------------

    (iii) The elective contributions and QMACs taken into account 
for purposes of the ADP test of section 401(k)(3) satisfy the 
requirements of section 401(k)(3)(A)(ii) under paragraph (a)(1)(ii) 
of this section because the ADP for HCEs (15%) is not more than the 
ADP for NHCEs multiplied by 1.25 (12% x 1.25 = 15%).

    (b) Correction of excess contributions--(1) Permissible correction 
methods--(i) In general. A cash or deferred arrangement does not fail 
to satisfy the requirements of section 401(k)(3) and paragraph (a)(1) 
of this section if the employer, in accordance with the terms of the 
plan that includes the cash or deferred arrangement, uses any of the 
following correction methods--
    (A) Qualified nonelective contributions or qualified matching 
contributions. The employer makes qualified nonelective contributions 
or qualified matching contributions that are taken into account under 
this section and, in combination with other amounts taken into account 
under paragraph (a) of this section, allow the cash or deferred 
arrangement to satisfy the requirements of paragraph (a)(1) of this 
section.
    (B) Excess contributions distributed. Excess contributions are 
distributed in accordance with paragraph (b)(2) of this section.
    (C) Excess contributions recharacterized. Excess contributions are 
recharacterized in accordance with paragraph (b)(3) of this section.
    (ii) Combination of correction methods. A plan may provide for the 
use of any of the correction methods described in paragraph (b)(1)(i) 
of this section, may limit elective contributions in a manner designed 
to prevent excess contributions from being made, or may use a 
combination of these methods, to avoid or correct excess contributions. 
A plan may require or permit an HCE to elect whether any excess 
contributions are to be recharacterized or distributed. If the plan 
uses a combination of correction methods, any contribution made under 
paragraph (b)(1)(i)(A) of this section must be taken into account 
before application of the correction methods in paragraph (b)(1)(i)(B) 
or (C) of this section.
    (iii) Exclusive means of correction. A failure to satisfy the 
requirements of paragraph (a)(1) of this section may not be corrected 
using any method other than the ones described in paragraphs (b)(1)(i) 
and (ii) of this section. Thus, excess contributions for a plan year 
may not remain unallocated or be allocated to a suspense account for 
allocation to one or more employees in any future year. In addition, 
excess contributions may not be corrected using the retroactive 
correction rules of Sec.  1.401(a)(4)-11(g). See Sec.  1.401(a)(4)-
11(g)(3)(vii) and (5).
    (2) Corrections through distribution--(i) General rule. This 
paragraph (b)(2) contains the rules for correction of excess 
contributions through a distribution from the plan. Correction through 
a distribution generally involves a 4 step process. First, the plan 
must determine, in accordance with paragraph (b)(2)(ii) of this 
section, the total amount of excess contributions that must be 
distributed under the plan. Second, the plan must apportion the total 
amount of excess contributions among HCEs in accordance with paragraph 
(b)(2)(iii) of this section. Third, the plan must determine the income 
allocable to excess contributions in accordance with paragraph 
(b)(2)(iv) of this section. Finally, the plan must distribute the 
apportioned excess contributions and allocable income in accordance 
with paragraph (b)(2)(v) of this section. Paragraph (b)(2)(vi) of this 
section provides rules relating to the tax treatment of these 
distributions. Paragraph (b)(2)(vii) provides other rules relating to 
these distributions.
    (ii) Calculation of total amount to be distributed. The following 
procedures must be used to determine the total amount of the excess 
contributions to be distributed--
    (A) Calculate the dollar amount of excess contributions for each 
HCE. The amount of excess contributions attributable to a given HCE for 
a plan year is the amount (if any) by which the HCE's contributions 
taken into account under this section must be reduced for the HCE's ADR 
to equal the highest permitted ADR under the plan. To calculate the 
highest permitted ADR under a plan, the ADR of the HCE with the highest 
ADR is reduced by the amount required to cause that HCE's ADR to equal 
the ADR of the HCE with the next highest ADR. If a lesser reduction 
would enable the arrangement to satisfy the requirements of paragraph 
(b)(2)(ii)(C) of this section, only this lesser reduction is used in 
determining the highest permitted ADR.
    (B) Determination of the total amount of excess contributions. The 
process described in paragraph (b)(2)(ii)(A) of this section must be 
repeated until the arrangement would satisfy the requirements of 
paragraph (b)(2)(ii)(C) of this section. The sum of all reductions for 
all HCEs determined under paragraph (b)(2)(ii)(A) of this section is 
the total amount of excess contributions for the plan year.
    (C) Satisfaction of ADP. A cash or deferred arrangement satisfies 
this paragraph (b)(2)(ii)(C) if the arrangement would satisfy the 
requirements of paragraph (a)(1)(ii) of this section if the ADR for 
each HCE were determined after the reductions described in paragraph 
(b)(2)(ii)(A) of this section.
    (iii) Apportionment of total amount of excess contributions among 
the HCEs. The following procedures must be used

[[Page 42505]]

in apportioning the total amount of excess contributions determined 
under paragraph (b)(2)(ii) of this section among the HCEs:
    (A) Calculate the dollar amount of excess contributions for each 
HCE. The contributions of the HCE with the highest dollar amount of 
contributions taken into account under this section are reduced by the 
amount required to cause that HCE's contributions to equal the dollar 
amount of the contributions taken into account under this section for 
the HCE with the next highest dollar amount of contributions taken 
account under this section. If a lesser apportionment to the HCE would 
enable the plan to apportion the total amount of excess contributions, 
only the lesser apportionment would apply.
    (B) Limit on amount apportioned to any individual. For purposes of 
this paragraph (b)(2)(iii), the amount of contributions taken into 
account under this section with respect to an HCE who is an eligible 
employee in more than one plan of an employer is determined by taking 
into account all contributions otherwise taken into account with 
respect to such HCE under any plan of the employer during the plan year 
of the plan being tested as being made under the plan being tested. 
However, the amount of excess contributions apportioned for a plan year 
with respect to any HCE must not exceed the amount of contributions 
actually contributed to the plan for the HCE for the plan year. Thus, 
in the case of an HCE who is an eligible employee in more than one plan 
of the same employer to which elective contributions are made and whose 
ADR is calculated in accordance with paragraph (a)(3)(ii) of this 
section, the amount required to be distributed under this paragraph 
(b)(2)(iii) shall not exceed the contributions actually contributed to 
the plan and taken into account under this section for the plan year.
    (C) Apportionment to additional HCEs. The procedure in paragraph 
(b)(2)(iii)(A) of this section must be repeated until the total amount 
of excess contributions determined under paragraph (b)(2)(ii) of this 
section have been apportioned.
    (iv) Income allocable to excess contributions--(A) General rule. 
The income allocable to excess contributions is equal to the sum of the 
allocable gain or loss for the plan year and, to the extent the excess 
contributions are or will be credited with allocable gain or loss for 
the period after the close of the plan year (gap period), the allocable 
gain or loss for the gap period.
    (B) Method of allocating income. A plan may use any reasonable 
method for computing the income allocable to excess contributions, 
provided that the method does not violate section 401(a)(4), is used 
consistently for all participants and for all corrective distributions 
under the plan for the plan year, and is used by the plan for 
allocating income to participant's accounts. See Sec.  1.401(a)(4)-
1(c)(8).
    (C) Alternative method of allocating plan year income. A plan may 
allocate income to excess contributions for the plan year by 
multiplying the income for the plan year allocable to the elective 
contributions and other amounts taken account under this section 
(including contributions made for the plan year), by a fraction, the 
numerator of which is the excess contributions for the employee for the 
plan year, and the denominator of which is the account balance 
attributable to elective contributions and other contributions taken 
into account under this section as of the beginning of the plan year 
(including any additional amount of such contributions made for the 
plan year).
    (D) Safe harbor method of allocating gap period income. A plan may 
use the safe harbor method in this paragraph (b)(2)(iv)(D) to determine 
income on excess contributions for the gap period. Under this safe 
harbor method, income on excess contributions for the gap period is 
equal to 10% of the income allocable to excess contributions for the 
plan year that would be determined under paragraph (b)(2)(iv)(C) of 
this section, multiplied by the number of calendar months that have 
elapsed since the end of the plan year. For purposes of calculating the 
number of calendar months that have elapsed under the safe harbor 
method, a corrective distribution that is made on or before the 
fifteenth day of a month is treated as made on the last day of the 
preceding month and a distribution made after the fifteenth day of a 
month is treated as made on the last day of the month.
    (E) Alternative method for allocating plan year and gap period 
income. A plan may determine the allocable gain or loss for the 
aggregate of the plan year and the gap period by applying the 
alternative method provided by paragraph (b)(2)(iv)(C) of this section 
to this aggregate period. This is accomplished by substituting the 
income for the plan year and the gap period for the income for the plan 
year and by substituting the contributions taken into account under 
this section for the plan year and the gap period for the contributions 
taken account under this section for the plan year in determining the 
fraction that is multiplied by that income.
    (v) Distribution. Within 12 months after the close of the plan year 
in which the excess contribution arose, the plan must distribute to 
each HCE the excess contributions apportioned to such HCE under 
paragraph (b)(2)(iii) of this section and the allocable income. Except 
as otherwise provided in this paragraph (b)(2)(v) and paragraph 
(b)(4)(i) of this section, a distribution of excess contributions must 
be in addition to any other distributions made during the year and must 
be designated as a corrective distribution by the employer. In the 
event of a complete termination of the plan during the plan year in 
which an excess contribution arose, the corrective distribution must be 
made as soon as administratively feasible after the date of termination 
of the plan, but in no event later than 12 months after the date of 
termination. If the entire account balance of an HCE is distributed 
prior to when the plan makes a distribution of excess contributions in 
accordance with this paragraph (b)(2), the distribution is deemed to 
have been a corrective distribution of excess contributions (and 
income) to the extent that a corrective distribution would otherwise 
have been required.
    (vi) Tax treatment of corrective distributions--(A) General rule. 
Except as provided in paragraph (b)(2)(vi)(B) of this section, a 
corrective distribution of excess contributions (and income) that is 
made within 2\1/2\ months after the end of the plan year for which the 
excess contributions were made is includible in the employee's gross 
income on the earliest date any elective contributions by the employee 
during the plan year would have been received by the employee had the 
employee originally elected to receive the amounts in cash. A 
corrective distribution of excess contributions (and income) that is 
made more than 2\1/2\ months after the end of the plan year for which 
the contributions were made is includible in the employee's gross 
income in the employee's taxable year in which distributed. Regardless 
of when the corrective distribution is made, it is not subject to the 
early distribution tax of section 72(t). See paragraph (b)(4) of this 
section for additional rules relating to the employer excise tax on 
amounts distributed more than 2\1/2\ months after the end of the plan 
year. See also Sec.  1.402(c)-2, A-4 for restrictions on rolling over 
distributions that are excess contributions.
    (B) Rule for de minimis distributions. If the total amount of 
excess contributions, determined under this paragraph (b)(2), and 
excess aggregate contributions determined under Sec.  1.401(m)-2(b)(2) 
distributed to a

[[Page 42506]]

recipient under a plan for any plan year is less than $100 (excluding 
income), a corrective distribution of excess contributions (and income) 
is includible in the gross income of the recipient in the taxable year 
of the recipient in which the corrective distribution is made.
    (vii) Other rules--(A) No employee or spousal consent required. A 
corrective distribution of excess contributions (and income) may be 
made under the terms of the plan without regard to any notice or 
consent otherwise required under sections 411(a)(11) and 417.
    (B) Treatment of corrective distributions as elective 
contributions. Excess contributions are treated as employer 
contributions for purposes of sections 404 and 415 even if distributed 
from the plan.
    (C) No reduction of required minimum distribution. A distribution 
of excess contributions (and income) is not treated as a distribution 
for purposes of determining whether the plan satisfies the minimum 
distribution requirements of section 401(a)(9). See Sec.  1.401(a)(9)-
5, Q&A-9(b).
    (D) Partial distributions. Any distribution of less than the entire 
amount of excess contributions (and allocable income) with respect to 
any HCE is treated as a pro rata distribution of excess contributions 
and allocable income.
    (viii) Examples. The following examples illustrate the application 
of this paragraph (b)(2). For purposes of these examples, none of the 
plans provide for catch-up contributions under section 414(v). The 
examples are as follows:

    Example 1. (i) Plan P, a calendar year profit-sharing plan that 
includes a cash or deferred arrangement, provides for distribution 
of excess contributions to HCEs to the extent necessary to satisfy 
the ADP test. Employee A, an HCE, has elective contributions of 
$12,000 and $200,000 in compensation, for an ADR of 6%, and Employee 
B, a second HCE, has elective contributions of $8,960 and 
compensation of $128,000, for an ADR of 7%. The ADP for the NHCEs is 
3%. Under the ADP test, the ADP of the two HCEs under the plan may 
not exceed 5% (i.e., 2 percentage points more than the ADP of the 
NHCEs under the plan). The ADP for the 2 HCEs under the plan is 
6.5%. Therefore, there must be a correction of excess contributions.
    (ii) The total amount of excess contributions for the HCEs is 
determined under paragraph (b)(2)(ii) of this section as follows: 
the elective contributions of Employee B (the HCE with the highest 
ADR) are reduced by $1,280 in order to reduce his ADR to 6% ($7,680/
$128,000), which is the ADR of Employee A.
    (iii) Because the ADP of the HCEs determined after the $1,280 
reduction to Employee B still exceeds 5%, further reductions in 
elective contributions are necessary in order to reduce the ADP of 
the HCEs to 5%. The elective contributions of Employee A and 
Employee B are each reduced by 1% of compensation ($2,000 and $1,280 
respectively). Because the ADP of the HCEs determined after the 
reductions equals 5%, the plan would satisfy the requirements of 
(a)(1)(ii) of this section.
    (iv) The total amount of excess contributions ($4,560 = $1,280 + 
$2,000 + $1,280) is apportioned among the HCEs under paragraph 
(b)(2)(iii) of this section first to the HCE with the highest amount 
of elective contributions. Therefore, Employee A is apportioned 
$3,040 (the amount required to cause Employee A's elective 
contributions to equal the next highest dollar amount of elective 
contributions).
    (v) Because the total amount of excess contributions has not 
been apportioned, further apportionment is necessary. The balance 
($1,520) of the total amount of excess contributions is apportioned 
equally among Employee A and Employee B ($760 to each).
    (vi) Therefore, the cash or deferred arrangement will satisfy 
the requirements of paragraph (a)(1) of this section if, by the end 
of the 12 month period following the end of the 2006 plan year, 
Employee A receives a corrective distribution of excess 
contributions equal to $3,800 ($3,040 + $760) and allocable income 
and Employee B receives a corrective distribution of $760 and 
allocable income.
    Example 2. (i) The facts are the same as in Example 1, except 
Employee A's ADR is based on $3,000 of elective contributions to 
this plan and $9,000 of elective contributions to another plan of 
the employer.
    (ii) The total amount of excess contributions ($4,560 = $1,280 + 
$2,000 + $1,280) is apportioned among the HCEs under paragraph 
(b)(2)(iii) of this section first to the HCE with the highest amount 
of elective contributions. The amount of elective contributions for 
Employee A is $12,000. Therefore, Employee A is apportioned $3,040 
(the amount required to cause Employee A's elective contributions to 
equal the next highest dollar amount of elective contributions). 
However, pursuant to paragraph (b)(2)(iii)(B) of this section, no 
more than the amount actually contributed to the plan may be 
apportioned to an HCE. Accordingly, no more than $3,000 may be 
apportioned to Employee A. Therefore, the remaining $1,560 must be 
apportioned to Employee B.
    (ii) The cash or deferred arrangement will satisfy the 
requirements of paragraph (a)(1) of this section if, by the end of 
the 12 month period following the end of the 2006 plan year, 
Employee A receives a corrective distribution of excess 
contributions equal to $3,000 (total amount of elective 
contributions actually contributed to the plan for Employee A) and 
allocable income and Employee B receives a corrective distribution 
of $1,560 and allocable income.
    Example 3. (i) The facts are the same as in Example 1. The plan 
allocates income on a daily basis. The corrective distributions are 
made in February 2007. The excess contribution that must be 
distributed to Employee A as a corrective distribution is $3,800. 
This amount must be increased (or decreased) to reflect gains (or 
losses) allocable to that amount during the 2006 plan year. The plan 
uses a reasonable method that satisfies paragraph (b)(2)(iv)(B) of 
this section to determine the gain during the 2006 plan year 
allocable to the $3,800 as $145. Therefore, as of the end of the 
2006 plan year, the amount of corrective distribution that is 
required would be $3,945.
    (ii) Because the plan allocates income on a daily basis, excess 
contributions are credited with gain or loss during the gap period. 
Therefore, the corrective distribution must include income allocable 
to $3,945 through the date of distribution. For the period from 
January 1 through the date of distribution, the income allocable to 
$3,945 is $105. Therefore, the plan will satisfy the requirements of 
paragraph (a)(1) of this section if Employee A receives a corrective 
distribution of $4,050.
    Example 4. (i) The facts are the same as in Example 1. The plan 
determines plan year income using the alternative method for 
calculating income provided in paragraph (b)(2)(iv)(C) of this 
section and using the portion of the participant's account 
attributable to elective contributions, including elective 
contributions made for the plan year. The plan uses the safe harbor 
method provided in paragraph (b)(2)(iv)(D) of this section for 
allocating gap period income. The corrective distribution is made 
during the last week of February 2007. At the beginning of the 2006 
plan year, $100,000 of Employee A's plan account was attributable to 
elective contributions. During the 2006 plan year, $10,000 in 
elective contributions were contributed to the plan for Employee A. 
The income allocable to Employee A's account attributable to 
elective contributions for the 2006 plan year is $8,000.
    (ii) Therefore, the plan year income allocable to the $3,800 
corrective distribution for Employee A is $266.65 ($8,000 multiplied 
by $3,800 divided by $110,000). Therefore, as of the end of the 2006 
plan year, the amount of corrective distribution that is required is 
$4,066.65. This amount must be increased by the gap period income of 
$53.32 (10% multiplied by $266.65 (2006 plan year income 
attributable to the excess contribution) multiplied by 2 (number of 
calendar months since end of 2006 plan year). Therefore, the plan 
will satisfy the requirements of paragraph (a)(1) of this section if 
Employee A receives a corrective distribution of $4,119.97.
    Example 5. (i) The facts are the same as in Example 4, except 
that the plan provides for quarterly valuations based on the account 
balance at the end of the quarter.
    (ii) Because the plan's method for allocating income does not 
allocate any income to amounts distributed during the quarter, 
Employee A will not be credited with an allocation of income with 
respect to the amount distributed. Accordingly, Plan P need not plan 
adjust the distribution of excess contribution for income during the 
gap period and thus satisfies paragraph (a)(1) of this section if 
Employee A receives a corrective distribution of $4,066.65.


[[Page 42507]]


    (3) Recharacterization of excess contributions--(i) General rule. 
Excess contributions are recharacterized in accordance with this 
paragraph (b)(3) only if the excess contributions that would have to be 
distributed under (b)(2) of this section if the plan was correcting 
through distribution of excess contributions are recharacterized as 
described in paragraph (b)(3)(ii) of this section, and all of the 
conditions set forth in paragraph (b)(3)(iii) of this section are 
satisfied.
    (ii) Treatment of recharacterized excess contributions. 
Recharacterized excess contributions are includible in the employee's 
gross income as if such amounts were distributed under paragraph (b)(2) 
of this section. The recharacterized excess contributions must be 
treated as employee contributions for purposes of section 72, sections 
401(a)(4) and 401(m). This requirement is not treated as satisfied 
unless the payor or plan administrator reports the recharacterized 
excess contributions as employee contributions to the Internal Revenue 
Service and the employee by timely providing such Federal tax forms and 
accompanying instructions and timely taking such other action as 
prescribed by the Commissioner in revenue rulings, notices and other 
guidance published in the Internal Revenue Bulletin (see 601.601(d)(2) 
of this chapter) as well as the applicable federal tax forms and 
accompanying instructions.
    (iii) Additional rules--(A) Time of recharacterization. Excess 
contributions may not be recharacterized under this paragraph (b)(3) 
after 2\1/2\ months after the close of the plan year to which the 
recharacterization relates. Recharacterization is deemed to have 
occurred on the date on which the last of those HCEs with excess 
contributions to be recharacterized is notified in accordance with 
paragraph (b)(3)(ii) of this section.
    (B) Employee contributions must be permitted under plan. The amount 
of recharacterized excess contributions, in combination with the 
employee contributions actually made by the HCE, may not exceed the 
maximum amount of employee contributions (determined without regard to 
the ACP test of section 401(m)(2)) permitted under the provisions of 
the plan as in effect on the first day of the plan year.
    (C) Treatment of recharacterized excess contributions. 
Recharacterized excess contributions continue to be treated as employer 
contributions for all other purposes under the Internal Revenue Code, 
including sections 401(a) (other than sections 401(a)(4) and 401(m)), 
404, 409, 411, 412, 415, 416, and 417. Thus, for example, 
recharacterized excess contributions remain subject to the requirements 
of Sec.  1.401(k)-1(c) and (d); must be deducted under section 404; and 
are treated as employer contributions described in section 415(c)(2)(A) 
and Sec.  1.415-6(b).
    (4) Rules applicable to all corrections--(i) Coordination with 
distribution of excess deferrals--(A) Treatment of excess deferrals 
that reduce excess contributions. The amount of excess contributions 
(and allocable income) to be distributed under paragraph (b)(2) of this 
section or the amount of excess contributions recharacterized under 
paragraph (b)(3) of this section with respect to an employee for a plan 
year, is reduced by any amounts previously distributed to the employee 
from the plan to correct excess deferrals for the employee's taxable 
year ending with or within the plan year in accordance with section 
402(g)(2).
    (B) Treatment of excess contributions that reduce excess deferrals. 
Under Sec.  1.402(g)-1(e), the amount required to be distributed to 
correct an excess deferral to an employee for a taxable year is reduced 
by any excess contributions (and allocable income) previously 
distributed or excess contributions recharacterized with respect to the 
employee for the plan year beginning with or within the taxable year. 
The amount of excess contributions includible in the gross income of 
the employee, and the amount of excess contributions reported by the 
payer or plan administrator as includible in the gross income of the 
employee, does not include the amount of any reduction under Sec.  
1.402(g)-1(e)(6).
    (ii) Forfeiture of match on distributed excess contributions. A 
matching contribution is taken into account under section 401(a)(4) 
even if the match is with respect to an elective contribution that is 
distributed or recharacterized under this paragraph (b). This requires 
that, after correction of excess contributions, each level of matching 
contributions be currently and effectively available to a group of 
employees that satisfies section 410(b). See Sec.  1.401(a)(4)-
4(e)(3)(iii)(G). Thus, a plan that provides the same rate of matching 
contributions to all employees will not meet the requirements of 
section 401(a)(4) if elective contributions are distributed under this 
paragraph (b) to HCEs to the extent needed to meet the requirements of 
section 401(k)(3), while matching contributions attributable to those 
elective contributions remain allocated to the HCEs' accounts. Under 
section 411(a)(3)(G) and Sec.  1.411(a)-4(b)(7), a plan may forfeit 
matching contributions attributable to excess contributions, excess 
aggregate contributions or excess deferrals to avoid a violation of 
section 401(a)(4). See also Sec.  1.401(a)(4)-11(g)(vii)(B) regarding 
the use of additional allocations to the accounts of NHCEs for the 
purpose of correcting a discriminatory rate of matching contributions.
    (iii) Permitted forfeiture of QMAC. Pursuant to section 
401(k)(8)(E), a qualified matching contribution is not treated as 
forfeitable under Sec.  1.401(k)-1(c) merely because under the plan it 
is forfeited in accordance with paragraph (b)(4)(ii) of this section.
    (iv) No requirement for recalculation. If excess contributions are 
distributed or recharacterized in accordance with paragraphs (b)(2) and 
(3) of this section, the cash or deferred arrangement is treated as 
meeting the nondiscrimination test of section 401(k)(3) regardless of 
whether the ADP for the HCEs, if recalculated after the distributions 
or recharacterizations, would satisfy section 401(k)(3).
    (v) Treatment of excess contributions that are catch-up 
contributions. A cash or deferred arrangement does not fail to meet the 
requirements of section 401(k)(3) and paragraph (a)(1) of this section 
merely because excess contributions that are catch-up contributions 
because they exceed the ADP limit, as described in Sec.  1.414(v)-
1(b)(1)(iii), are not corrected in accordance with this paragraph (b).
    (5) Failure to timely correct--(i) Failure to correct within 2\1/2\ 
months after end of plan year. If a plan does not correct excess 
contributions within 2\1/2\ months after the close of the plan year for 
which the excess contributions are made, the employer will be liable 
for a 10% excise tax on the amount of the excess contributions. See 
section 4979 and Sec.  54.4979-1 of this chapter. Qualified nonelective 
contributions and qualified matching contributions properly taken into 
account under paragraph (a)(6) of this section for a plan year may 
enable a plan to avoid having excess contributions, even if the 
contributions are made after the close of the 2\1/2\ month period.
    (ii) Failure to correct within 12 months after end of plan year. If 
excess contributions are not corrected within 12 months after the close 
of the plan year for which they were made, the cash or deferred 
arrangement will fail to satisfy the requirements of section 401(k)(3) 
for the plan year for which the excess contributions are made and all

[[Page 42508]]

subsequent plan years during which the excess contributions remain in 
the trust.
    (c) Additional rules for prior year testing method--(1) Rules for 
change in testing method--(i) General rule. A plan is permitted to 
change from the prior year testing method to the current year testing 
method for any plan year. A plan is permitted to change from the 
current year testing method to the prior year testing method only in 
situations described in paragraph (c)(1)(ii) of this section. For 
purposes of this paragraph (c)(1), a plan that uses the safe harbor 
method described in Sec.  1.401(k)-3 or a SIMPLE 401(k) plan is treated 
as using the current year testing method for that plan year.
    (ii) Situations permitting a change to the prior year testing 
method. The situations described in this paragraph (c)(1)(ii) are:
    (A) The plan is not the result of the aggregation of two or more 
plans, and the current year testing method was used under the plan for 
each of the 5 plan years preceding the plan year of the change (or if 
lesser, the number of plan years the plan has been in existence, 
including years in which the plan was a portion of another plan).
    (B) The plan is the result of the aggregation of two or more plans, 
and for each of the plans that are being aggregated (the aggregating 
plans), the current year testing method was used for each of the 5 plan 
years preceding the plan year of the change (or if lesser, the number 
of plan years since that aggregating plan has been in existence, 
including years in which the aggregating plan was a portion of another 
plan).
    (C) A transaction described in section 410(b)(6)(C)(i) and Sec.  
1.410(b)-2(f) occurs and--
    (1) As a result of the transaction, the employer maintains both a 
plan using the prior year testing method and a plan using the current 
year testing method; and
    (2) The change from the current year testing method to the prior 
year testing method occurs within the transition period described in 
section 410(b)(6)(C)(ii).
    (2) Calculation of ADP under the prior year testing method for the 
first plan year--(i) 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.
    (ii) First plan year defined. For purposes of this paragraph 
(c)(2), the first plan year of any plan is the first year in which the 
plan provides for elective contributions. Thus, the rules of this 
paragraph (c)(2) do not apply to a plan (within the meaning of Sec.  
1.410(b)-7(b)) for a plan year if for such plan year the plan is 
aggregated under Sec.  1.401(k)-1(b)(4) with any other plan that 
provides for elective contributions in the prior year.
    (iii) Successor plans. A plan is a successor plan if 50% or more of 
the eligible employees for the first plan year were eligible employees 
under a qualified cash or deferred arrangement maintained by the 
employer in the prior year. If a plan that is a successor plan uses the 
prior year testing method for its first plan year, the ADP for the 
group of NHCEs for the applicable year must be determined under 
paragraph (c)(4) of this section.
    (3) Plans using different testing methods for the ADP and ACP test. 
Except as otherwise provided in this paragraph (c)(3), a plan may use 
the current year testing method or prior year testing method for the 
ADP test for a plan year without regard to whether the current year 
testing method or prior year testing method is used for the ACP test 
for that year. For example, a plan may use the prior year testing 
method for the ADP test and the current year testing method for its ACP 
test for the plan year. However, plans that use different testing 
methods under this paragraph (c)(3) cannot use--
    (i) The recharacterization method of paragraph (b)(3) of this 
section to correct excess contributions for a plan year;
    (ii) The rules of Sec.  1.401(m)-2(a)(6)(ii) to take elective 
contributions into account under the ACP test (rather than the ADP 
test); or
    (iii) The rules of paragraph (a)(6)(v) of this section to take 
qualified matching contributions into account under the ADP test 
(rather than the ACP test).
    (4) Rules for plan coverage changes--(i) In general. A plan that 
uses the prior year testing method and experiences a plan coverage 
change during a plan year satisfies the requirements of this section 
for that year only if the plan provides that the ADP for the NHCEs for 
the plan year is the weighted average of the ADPs for the prior year 
subgroups.
    (ii) Optional rule for minor plan coverage changes. If a plan 
coverage change occurs and 90% or more of the total number of the NHCEs 
from all prior year subgroups are from a single prior year subgroup, 
then, in lieu of using the weighted averages described in paragraph 
(c)(4)(i) of this section, the plan may provide that the ADP for the 
group of eligible NHCEs for the prior year under the plan is the ADP of 
the NHCEs for the prior year of the plan under which that single prior 
year subgroup was eligible.
    (iii) Definitions. The following definitions apply for purposes of 
this paragraph (c)(4):
    (A) Plan coverage change. The term plan coverage change means a 
change in the group or groups of eligible employees under a plan on 
account of--
    (1) The establishment or amendment of a plan;
    (2) A plan merger or spinoff under section 414(l);
    (3) A change in the way plans (within the meaning of Sec.  
1.410(b)-7(b)) are combined or separated for purposes of Sec.  
1.401(k)-1(b)(4) (e.g., permissively aggregating plans not previously 
aggregated under Sec.  1.410(b)-7(d), or ceasing to permissively 
aggregate plans under Sec.  1.410(b)-7(d));
    (4) A reclassification of a substantial group of employees that has 
the same effect as amending the plan (e.g., a transfer of a substantial 
group of employees from one division to another division); or
    (5) A combination of any of the situations described in this 
paragraph (c)(4)(iii)(A).
    (B) Prior year subgroup. The term prior year subgroup means all 
NHCEs for the prior plan year who, in the prior year, were eligible 
employees under a specific plan maintained by the employer that 
included a qualified cash or deferred arrangement and who would have 
been eligible employees in the prior year under the plan being tested 
if the plan coverage change had first been effective as of the first 
day of the prior plan year instead of first being effective during the 
plan year. The determination of whether an NHCE is a member of a prior 
year subgroup is made without regard to whether the NHCE terminated 
employment during the prior year.
    (C) Weighted average of the ADPs for the prior year subgroups. The 
term weighted average of the ADPs for the prior year subgroups means 
the sum, for all prior year subgroups, of the adjusted ADPs for the 
plan year. The term adjusted ADP with respect to a prior year subgroup 
means the ADP for the prior plan year of the specific plan under which 
the members of the prior year subgroup were eligible employees on the 
first day of the prior plan year,

[[Page 42509]]

multiplied by a fraction, the numerator of which is the number of NHCEs 
in the prior year subgroup and denominator of which is the total number 
of NHCEs in all prior year subgroups.
    (iv) Examples. The following examples illustrate the application of 
this paragraph (c)(4):

    Example 1. (i) Employer B maintains two calendar year plans, 
Plan O and Plan P, each of which includes a cash or deferred 
arrangement. The plans were not permissively aggregated under Sec.  
1.410(b)-7(d) for the 2005 plan year. Both plans use the prior year 
testing method. Plan O had 300 eligible employees who were NHCEs for 
the 2005 plan year, and their ADP for that year was 6%. Sixty of the 
eligible employees who were NHCEs for the 2005 plan year under Plan 
O, terminated their employment during that year. Plan P had 100 
eligible employees who were NHCEs for 2005, and the ADP for those 
NHCEs for that plan was 4%. Plan O and Plan P are permissively 
aggregated under Sec.  1.410(b)-7(d) for the 2006 plan year.
    (ii) The permissive aggregation of Plan O and Plan P for the 
2006 plan year under Sec.  1.410(b)-7(d) is a plan coverage change 
that results in treating the plans as one plan (Plan OP) for 
purposes of Sec.  1.401(k)-1(b)(4). Therefore, the prior year ADP 
for the NHCEs under Plan OP for the 2006 plan year is the weighted 
average of the ADPs for the prior year subgroups: the Plan O prior 
year subgroup and the Plan P prior year subgroup.
    (iii) The Plan O prior year subgroup consists of the 300 
employees who, in the 2005 plan year, were eligible NHCEs under Plan 
O and who would have been eligible under Plan OP for the 2005 plan 
year if Plan O and Plan P had been permissively aggregated for that 
plan year. The Plan P prior year subgroup consists of the 100 
employees who, in the 2005 plan year, were eligible NHCEs under Plan 
P and would have been eligible under Plan OP for the 2005 plan year 
if Plan O and Plan P had been permissively aggregated for that plan 
year.
    (iv) The weighted average of the ADPs for the prior year 
subgroups is the sum of the adjusted ADP for the Plan O prior year 
subgroup and the adjusted ADP for the Plan P prior year subgroup. 
The adjusted ADP for the Plan O prior year subgroup is 4.5%, 
calculated as follows: 6% (the ADP for the NHCEs under Plan O for 
the 2005 plan year) x 300/400 (the number of NHCEs in the Plan O 
prior year subgroup divided by the total number of NHCEs in all 
prior year subgroups). The adjusted ADP for the Plan P prior year 
subgroup is 1%, calculated as follows: 4% (the ADP for the NHCEs 
under Plan P for the 2005 plan year) x 100/400 (the number of NHCEs 
in the Plan P prior year subgroup divided by the total number of 
NHCEs in all prior year subgroups). Thus, the prior year ADP for 
NHCEs under Plan OP for the 2006 plan year is 5.5% (the sum of 
adjusted ADPs for the prior year subgroups, 4.5% plus 1%).
    (v) As provided in paragraph (c)(4)(iii)(B) of this section, the 
determination of whether an NHCE is a member of a prior year 
subgroup is made without regard to whether that NHCE terminated 
employed during the prior year. Thus, the prior ADP for the NHCEs 
under Plan OP for the 2006 plan year is unaffected by the 
termination of the 60 NHCEs covered by Plan O during the 2005 plan 
year.
    Example 2. (i) The facts are the same as Example 1, except that 
the 60 employees who terminated employment during the 2005 plan are 
instead spun-off to another plan.
    (ii) The permissive aggregation of Plan O and Plan P for the 
2006 plan year under Sec.  1.410(b)-7(d) is a plan coverage change 
that results in treating the plans as one plan (Plan OP) for 
purposes of Sec.  1.401(k)-1(b)(4) and the spin-off of the 60 
employees is a plan coverage change. Therefore, the prior year ADP 
for the NHCEs under Plan OP for the 2006 plan year is the weighted 
average of the ADPs for the prior year subgroups: the Plan O prior 
year subgroup and the Plan P prior year subgroup.
    (iii) For purposes of determining the prior year subgroups, the 
employees who would have been eligible employees in the prior year 
under the plan being tested are determined as if both plan coverage 
changes had first been effective as of the first day of the prior 
plan year. The Plan O prior year subgroup consists of the 240 
employees who, in the 2005 plan year, were eligible NHCEs under Plan 
O and would have been eligible under Plan OP for the 2005 plan year 
if the spin-off had occurred at the beginning of the 2005 plan year 
and Plan O and Plan P had been permissively aggregated under Sec.  
1.410(b)-7(d) for that plan year. The Plan P prior year subgroup 
consists of the 100 employees who, in the 2005 plan year, were 
eligible NHCEs under Plan P and would have been eligible under Plan 
OP for the 2005 plan year if Plan O and Plan P had been permissively 
aggregated under Sec.  1.410(b)-7(d) for that plan year.
    (iv) The weighted average of the ADPs for the prior year 
subgroups is the sum of the adjusted ADP with respect to the prior 
year subgroup consisting of eligible NHCEs from Plan O and the 
adjusted ADP with respect to the prior year subgroup consisting of 
eligible NHCEs from Plan P. The adjusted ADP for the prior year 
subgroup consisting of eligible NHCEs under Plan O is 4.23%, 
calculated as follows: 6% (the ADP for the NHCEs under Plan O for 
the 2005 plan year) x 240/340 (the number of NHCEs in that prior 
year subgroup divided by the total number of NHCEs in all prior year 
subgroups). The adjusted ADP for the prior year subgroup consisting 
of the eligible NHCEs from Plan P is 1.18%, calculated as follows: 
4% (the ADP for the NHCEs under Plan P for the 2005 plan year) x 
100/340 (the number of NHCEs in that prior year subgroup divided by 
the total number of NHCEs in all prior year subgroups). Thus, the 
prior year ADP for NHCEs under Plan OP for the 2006 plan year is 
5.41% (the sum of adjusted ADPs for the prior year subgroups, 4.23% 
plus 1.18%).
    Example 3. (i) The facts are the same as in Example 1, except 
that instead of Plan O and Plan P being permissively aggregated for 
the 2006 plan year, 200 of the employees eligible under Plan O were 
spun-off from Plan O and merged into Plan P.
    (ii) The spin-off from Plan O and merger to Plan P for the 2006 
plan year are plan coverage changes for Plan P. Therefore, the prior 
year ADP for the NHCEs under Plan P for the 2006 plan year is the 
weighted average of the ADPs for the prior year subgroups under Plan 
P. There are 2 subgroups under Plan P for the 2006 plan year. The 
Plan O prior year subgroup consists of the 200 employees who, in the 
2005 plan year, were eligible NHCEs under Plan O and who would have 
been eligible under Plan P for the 2005 plan year if the spin-off 
and merger had occurred on the first day of the 2005 plan year. The 
Plan P prior year subgroup consists of the 100 employees who, in the 
2005 plan year, were eligible NHCEs under Plan P for the 2005 plan 
year.
    (iii) The weighted average of the ADPs for the prior year 
subgroups is the sum of the adjusted ADP for the Plan O prior year 
subgroup and the adjusted ADP for the Plan P prior year subgroup. 
The adjusted ADP for the Plan O prior year subgroup is 4.0%, 
calculated as follows: 6% (the ADP for the NHCEs under Plan O for 
the 2005 plan year) x 200/300 (the number of NHCEs in the Plan O 
prior year subgroup divided by the total number of NHCEs in all 
prior year subgroups). The adjusted ADP for the Plan P prior year 
subgroup is 1.33%, calculated as follows: 4% (the ADP for the NHCEs 
under Plan P for the 2005 plan year) x 100/300 (the number of NHCEs 
in the Plan P prior year subgroup divided by the total number of 
NHCEs in all prior year subgroups). Thus, the prior year ADP for 
NHCEs under Plan P for the 2006 plan year is 5.33% (the sum of 
adjusted ADPs for the 2 prior year subgroups, 4.0% plus 1.33%).
    (iv) The spin-off from Plan O for the 2006 plan year is a plan 
coverage change for Plan O. Therefore, the prior year ADP for the 
NHCEs under Plan O for the 2006 plan year is the weighted average of 
the ADPs for the prior year subgroups under Plan O. In this case, 
there is only one prior year subgroup under Plan O, the employees 
who were NHCEs of Employer B for the 2005 plan year and who were 
eligible for the 2005 plan year under Plan O. Because there is only 
one prior year subgroup under Plan O, the weighted average of the 
ADPs for the prior year subgroup under Plan O is equal to the NHCE 
ADP for the prior year (2005 plan year) under Plan O, or 6%.
    Example 4. (i) Employer C maintains a calendar year plan, Plan 
Q, which includes a cash or deferred arrangement that uses the prior 
year testing method. Plan Q covers employees of Division A and 
Division B. In 2005, Plan Q had 500 eligible employees who were 
NHCEs, and the ADP for those NHCEs for 2005 was 2%. Effective 
January 1, 2006, Employer C amends the eligibility provisions under 
Plan Q to exclude employees of Division B effective January 1, 2006. 
In addition, effective on that same date, Employer C establishes a 
new calendar year plan, Plan R, which includes a cash or deferred 
arrangement that uses the prior year testing method. The only 
eligible employees under Plan R are the 100 employees of Division B 
who were eligible employees under Plan Q.
    (ii) Plan R is a successor plan, within the meaning of paragraph 
(c)(2)(iii) of this section (because all of the employees were

[[Page 42510]]

eligible employees under Plan Q in the prior year). Therefore, Plan 
R cannot use the first plan year rule set forth in paragraph 
(c)(2)(i) of this section.
    (iii) The amendment to the eligibility provisions of Plan Q and 
the establishment of Plan R are plan coverage changes within the 
meaning of paragraph (c)(4)(iii)(A) of this section for Plan Q and 
Plan R. Accordingly, each plan must determine the NHCE ADP for the 
2006 plan year under the rules set forth in paragraph (c)(4) of this 
section.
    (iv) The prior year ADP for NHCEs under Plan Q is the weighted 
average of the ADPs for the prior year subgroups. Plan Q has only 
one prior year subgroup (because the only NHCEs who would have been 
eligible employees under Plan Q for the 2005 plan year if the 
amendment to the Plan Q eligibility provisions had occurred as of 
the first day of that plan year were eligible employees under Plan 
Q). Therefore, for purposes of the 2006 plan year under Plan Q, the 
ADP for NHCEs for the prior year is the weighted average of the ADPs 
for the prior year subgroups, or 2%, the same as if the plan 
amendment had not occurred.
    (v) Similarly, Plan R has only one prior year subgroup (because 
the only NHCEs who would have been eligible employees under Plan R 
for the 2005 plan year if the plan were established as of the first 
day of that plan year were eligible employees under Plan Q). 
Therefore, for purposes of the 2006 testing year under Plan R, the 
ADP for NHCEs for the prior year is the weighted average of the ADPs 
for the prior year subgroups, or 2%, the same as that of Plan Q.
    Example 5. (i) The facts are the same as in Example 4, except 
that the provisions of Plan R extend eligibility to 50 hourly 
employees who previously were not eligible employees under any 
qualified cash or deferred arrangement maintained by Employer C.
    (ii) Plan R is a successor plan (because 100 of Plan R's 150 
eligible employees were eligible employees under another qualified 
cash or deferred arrangement maintained by Employer C in the prior 
year). Therefore, Plan R cannot use the first plan year rule set 
forth in paragraph (c)(2)(i) of this section.
    (iii) The establishment of Plan R is a plan coverage change that 
affects Plan R. Because the 50 hourly employees were not eligible 
employees under any qualified cash or deferred arrangement of 
Employer C for the prior plan year, they do not comprise a prior 
year subgroup. Accordingly, Plan R still has only one prior year 
subgroup. Therefore, for purposes of the 2006 testing year under 
Plan R, the ADP for NHCEs for the prior year is the weighted average 
of the ADPs for the prior year subgroups, or 2%, the same as that of 
Plan Q.

Sec.  1.401(k)-3  Safe harbor requirements.

    (a) ADP test safe harbor. A cash or deferred arrangement satisfies 
the ADP safe harbor provision of section 401(k)(12) for a plan year if 
the arrangement satisfies the safe harbor contribution requirement of 
paragraph (b) or (c) of this section for the plan year, the notice 
requirement of paragraph (d) of this section, the plan year 
requirements of paragraph (e) of this section, and the additional rules 
of paragraphs (f), (g) and (h) of this section, as applicable. Pursuant 
to section 401(k)(12)(E)(ii), the safe harbor contribution requirement 
of paragraph (b) or (c) of this section must be satisfied without 
regard to section 401(l). The contributions made under paragraphs (b) 
and (c) of this section are referred to as safe harbor nonelective 
contributions and safe harbor matching contributions, respectively.
    (b) Safe harbor nonelective contribution requirement--(1) General 
rule. The safe harbor nonelective contribution requirement of this 
paragraph is satisfied if, under the terms of the plan, the employer is 
required to make a qualified nonelective contribution on behalf of each 
eligible NHCE equal to at least 3% of the employee's safe harbor 
compensation.
    (2) Safe harbor compensation defined. For purposes of this section, 
safe harbor compensation means compensation as defined in Sec.  
1.401(k)-6 (which incorporates the definition of compensation in Sec.  
1.414(s)-1); provided, however, that the rule in the last sentence of 
Sec.  1.414(s)-1(d)(2)(iii) (which generally permits a definition of 
compensation to exclude all compensation in excess of a specified 
dollar amount) does not apply in determining the safe harbor 
compensation of NHCEs. Thus, for example, the plan may limit the period 
used to determine safe harbor compensation to the eligible employee's 
period of participation.
    (c) Safe harbor matching contribution requirement--(1) In general. 
The safe harbor matching contribution requirement of this paragraph (c) 
is satisfied if, under the plan, qualified matching contributions are 
made on behalf of each eligible NHCE in an amount determined under the 
basic matching formula of section 401(k)(12)(B)(i)(I), as described in 
paragraph (c)(2) of this section, or under an enhanced matching formula 
of section 401(k)(12)(B)(i)(II), as described in paragraph (c)(3) of 
this section.
    (2) Basic matching formula. Under the basic matching formula, each 
eligible NHCE receives qualified matching contributions in an amount 
equal to the sum of--
    (i) 100% of the amount of the employee's elective contributions 
that do not exceed 3% of the employee's safe harbor compensation; and
    (ii) 50% of the amount of the employee's elective contributions 
that exceed 3% of the employee's safe harbor compensation but that do 
not exceed 5% of the employee's safe harbor compensation.
    (3) Enhanced matching formula. Under an enhanced matching formula, 
each eligible NHCE receives a matching contribution under a formula 
that, at any rate of elective contributions by the employee, provides 
an aggregate amount of qualified matching contributions at least equal 
to the aggregate amount of qualified matching contributions that would 
have been provided under the basic matching formula of paragraph (c)(2) 
of this section. In addition, under an enhanced matching formula, the 
ratio of matching contributions on behalf of an employee under the plan 
for a plan year to the employee's elective contributions may not 
increase as the amount of an employee's elective contributions 
increases.
    (4) Limitation on HCE matching contributions. The safe harbor 
matching contribution requirement of this paragraph (c) is not 
satisfied if the ratio of matching contributions made on account of an 
HCE's elective contributions under the cash or deferred arrangement for 
a plan year to those elective contributions is greater than the ratio 
of matching contributions to elective contributions that would apply 
with respect to any eligible NHCE with elective contributions at the 
same percentage of safe harbor compensation.
    (5) Use of safe harbor match not precluded by certain plan 
provisions--(i) Safe harbor matching contributions on employee 
contributions. The safe harbor matching contribution requirement of 
this paragraph (c) will not fail to be satisfied merely because safe 
harbor matching contributions are made on both elective contributions 
and employee contributions if safe harbor matching contributions are 
made with respect to the sum of elective contributions and employee 
contributions on the same terms as safe harbor matching contributions 
are made with respect to elective contributions. Alternatively, the 
safe harbor matching contribution requirement of this paragraph (c) 
will not fail to be satisfied merely because safe harbor matching 
contributions are made on both elective contributions and employee 
contributions if safe harbor matching contributions on elective 
contributions are not affected by the amount of employee contributions.
    (ii) Periodic matching contributions. The safe harbor matching 
contribution requirement of this paragraph (c) will not fail to be 
satisfied merely because the plan provides that safe harbor matching 
contributions will be made separately with respect to each payroll 
period (or with respect to all payroll

[[Page 42511]]

periods ending with or within each month or quarter of a plan year) 
taken into account under the plan for the plan year, provided that safe 
harbor matching contributions with respect to any elective 
contributions made during a plan year quarter are contributed to the 
plan by the last day of the immediately following plan year quarter.
    (6) Permissible restrictions on elective contributions by NHCEs--
(i) General rule. The safe harbor matching contribution requirement of 
this paragraph (c) is not satisfied if elective contributions by NHCEs 
are restricted, unless the restrictions are permitted by this paragraph 
(c)(6).
    (ii) Restrictions on election periods. A plan may limit the 
frequency and duration of periods in which eligible employees may make 
or change cash or deferred elections under a plan. However, an employee 
must have a reasonable opportunity (including a reasonable period after 
receipt of the notice described in paragraph (d) of this section) to 
make or change a cash or deferred election for the plan year. For 
purposes of this paragraph (c)(6)(ii), a 30-day period is deemed to be 
a reasonable period to make or change a cash or deferred election.
    (iii) Restrictions on amount of elective contributions. A plan is 
permitted to limit the amount of elective contributions that may be 
made by an eligible employee under a plan, provided that each NHCE who 
is an eligible employee is permitted (unless the employee is restricted 
under paragraph (c)(6)(v) of this section) to make elective 
contributions in an amount that is at least sufficient to receive the 
maximum amount of matching contributions available under the plan for 
the plan year, and the employee is permitted to elect any lesser amount 
of elective contributions. However, a plan may require eligible 
employees to make cash or deferred elections in whole percentages of 
compensation or whole dollar amounts.
    (iv) Restrictions on types of compensation that may be deferred. A 
plan may limit the types of compensation that may be deferred by an 
eligible employee under a plan, provided that each eligible NHCE is 
permitted to make elective contributions under a definition of 
compensation that would be a reasonable definition of compensation 
within the meaning of Sec.  1.414(s)-1(d)(2). Thus, the definition of 
compensation from which elective contributions may be made is not 
required to satisfy the nondiscrimination requirement of Sec.  
1.414(s)-1(d)(3).
    (v) Restrictions due to limitations under the Internal Revenue 
Code. A plan may limit the amount of elective contributions made by an 
eligible employee under a plan--
    (A) Because of the limitations of section 402(g) or section 415; or
    (B) Because, on account of a hardship distribution, an employee's 
ability to make elective contributions has been suspended for 6 months 
in accordance with Sec.  1.401(k)-1(d)(3)(iv)(E).
    (7) Examples. The following examples illustrate the safe h

    arbor contribution requirement of this paragraph (c):Example 1. 
(i) Beginning January 1, 2006, Employer A maintains Plan L covering 
employees (including HCEs and NHCEs) in Divisions D and E. Plan L 
contains a cash or deferred arrangement and provides qualified 
matching contributions equal to 100% of each eligible employee's 
elective contributions up to 3% of compensation and 50% of the next 
2% of compensation. For purposes of the matching contribution 
formula, safe harbor compensation is defined as all compensation 
within the meaning of section 415(c)(3) (a definition that satisfies 
section 414(s)). Also, each employee is permitted to make elective 
contributions from all safe harbor compensation within the meaning 
of section 415(c)(3) and may change a cash or deferred election at 
any time. Plan L limits the amount of an employee's elective 
contributions for purposes of section 402(g) and section 415, and, 
in the case of a hardship distribution, suspends an employee's 
ability to make elective contributions for 6 months in accordance 
with Sec.  1.401(k)-1(d)(3)(iv)(E). All contributions under Plan L 
are nonforfeitable and are subject to the withdrawal restrictions of 
section 401(k)(2)(B). Plan L provides for no other contributions and 
Employer A maintains no other plans. Plan L is maintained on a 
calendar-year basis and all contributions for a plan year are made 
within 12 months after the end of the plan year.
    (ii) Based on these facts, matching contributions under Plan L 
are safe harbor matching contributions because they are qualified 
matching contributions equal to the basic matching formula. 
Accordingly, Plan L satisfies the safe harbor contribution 
requirement of this paragraph (c).
    Example 2. (i) The facts are the same as in Example 1, except 
that instead of providing a basic matching contribution, Plan L 
provides a qualified matching contribution equal to 100% of each 
eligible employee's elective contributions up to 4% of safe harbor 
compensation.
    (ii) Plan L's formula is an enhanced matching formula because 
each eligible NHCE receives safe harbor matching contributions at a 
rate that, at any rate of elective contributions, provides an 
aggregate amount of qualified matching contributions at least equal 
to the aggregate amount of qualified matching contributions that 
would have been received under the basic safe harbor matching 
formula, and the rate of matching contributions does not increase as 
the rate of an employee's elective contributions increases. 
Accordingly, Plan L satisfies the safe harbor contribution 
requirement of this paragraph (c).
    Example 3. (i) The facts are the same as in Example 1, except 
that instead of permitting each employee to make elective 
contributions from all compensation within the meaning of section 
415(c)(3), each employee's elective contributions under Plan L are 
limited to 15% of the employee's ``basic compensation.'' Basic 
compensation is defined under Plan L as compensation within the 
meaning of section 415(c)(3), but excluding overtime pay.
    (ii) The definition of basic compensation under Plan L is a 
reasonable definition of compensation within the meaning of Sec.  
1.414(s)-1(d)(2).
    (iii) Plan L will not fail to satisfy the safe harbor 
contribution requirement of this paragraph (c) merely because Plan L 
limits the amount of elective contributions and the types of 
compensation that may be deferred by eligible employees, provided 
that each eligible NHCE may make elective contributions equal to at 
least 4% of the employee's safe harbor compensation.
    Example 4. (i) The facts are the same as in Example 1, except 
that Plan L provides that only employees employed on the last day of 
the plan year will receive a safe harbor matching contribution.
    (ii) Even if the plan that provides for employee contributions 
and matching contributions satisfies the minimum coverage 
requirements of section 410(b)(1) taking into account this last-day 
requirement, Plan L would not satisfy the safe harbor contribution 
requirement of this paragraph (c) because safe harbor matching 
contributions are not made on behalf of all eligible NHCEs who make 
elective contributions.
    (iii) The result would be the same if, instead of providing safe 
harbor matching contributions under an enhanced formula, Plan L 
provides for a 3% safe harbor nonelective contribution that is 
restricted to eligible employees under the cash or deferred 
arrangement who are employed on the last day of the plan year.
    Example 5. (i) The facts are the same as in Example 1, except 
that instead of providing qualified matching contributions under the 
basic matching formula to employees in both Divisions D and E, 
employees in Division E are provided qualified matching 
contributions under the basic matching formula, while safe harbor 
matching contributions continue to be provided to employees in 
Division D under the enhanced matching formula described in Example 
2.
    (ii) Even if Plan L satisfies Sec.  1.401(a)(4)-4 with respect 
to each rate of matching contributions available to employees under 
the plan, the plan would fail to satisfy the safe harbor 
contribution requirement of this paragraph (c) because the rate of 
matching contributions with respect to HCEs in Division D at a rate 
of elective contributions between 3% and 5% would be greater than 
that with respect to NHCEs in Division E at the same rate of 
elective contributions. For example, an HCE in Division D who would 
have a 4% rate of elective contributions would have a rate of 
matching contributions of 100% while an NHCE in Division E who

[[Page 42512]]

would have the same rate of elective contributions would have a 
lower rate of matching contributions.

    (d) Notice requirement--(1) General rule. The notice requirement of 
this paragraph (d) is satisfied for a plan year if each eligible 
employee is given written notice of the employee's rights and 
obligations under the plan and the notice satisfies the content 
requirement of paragraph (d)(2) of this section and the timing 
requirement of paragraph (d)(3) of this section.
    (2) Content requirement--(i) General rule. The content requirement 
of this paragraph (d)(2) is satisfied if the notice is--
    (A) Sufficiently accurate and comprehensive to inform the employee 
of the employee's rights and obligations under the plan; and
    (B) Written in a manner calculated to be understood by the average 
employee eligible to participate in the plan.
    (ii) Minimum content requirement. Subject to the requirements of 
paragraph (d)(2)(iii) of this section, a notice is not considered 
sufficiently accurate and comprehensive unless the notice accurately 
describes--
    (A) The safe harbor matching contribution or safe harbor 
nonelective contribution formula used under the plan (including a 
description of the levels of safe harbor matching contributions, if 
any, available under the plan);
    (B) Any other contributions under the plan or matching 
contributions to another plan on account of elective contributions or 
employee contributions under the plan (including the potential for 
discretionary matching contributions) and the conditions under which 
such contributions are made;
    (C) The plan to which safe harbor contributions will be made (if 
different than the plan containing the cash or deferred arrangement);
    (D) The type and amount of compensation that may be deferred under 
the plan;
    (E) How to make cash or deferred elections, including any 
administrative requirements that apply to such elections;
    (F) The periods available under the plan for making cash or 
deferred elections;
    (G) Withdrawal and vesting provisions applicable to contributions 
under the plan; and
    (H) Information that makes it easy to obtain additional information 
about the plan (including an additional copy of the summary plan 
description) such as telephone numbers, addresses and, if applicable, 
electronic addresses, of individuals or offices from whom employees can 
obtain such plan information.
    (iii) References to SPD. A plan will not fail to satisfy the 
content requirements of this paragraph (d)(2) merely because, in the 
case of information described in paragraph (d)(2)(ii)(B) of this 
section (relating to any other contributions under the plan), paragraph 
(d)(2)(ii)(C) of this section (relating to the plan to which safe 
harbor contributions will be made) or paragraph (d)(2)(ii)(D) of this 
section (relating to the type and amount of compensation that may be 
deferred under the plan), the notice cross-references the relevant 
portions of a summary plan description that provides the same 
information that would be provided in accordance with such paragraphs 
and that has been provided (or is concurrently provided) to employees.
    (3) Timing requirement--(i) General rule. The timing requirement of 
this paragraph (d)(3) is satisfied if the notice is provided within a 
reasonable period before the beginning of the plan year (or, in the 
year an employee becomes eligible, within a reasonable period before 
the employee becomes eligible). The determination of whether a notice 
satisfies the timing requirement of this paragraph (d)(3) is based on 
all of the relevant facts and circumstances.
    (ii) Deemed satisfaction of timing requirement. The timing 
requirement of this paragraph (d)(3) is deemed to be satisfied if at 
least 30 days (and no more than 90 days) before the beginning of each 
plan year, the notice is given to each eligible employee for the plan 
year. In the case of an employee who does not receive the notice within 
the period described in the previous sentence because the employee 
becomes eligible after the 90th day before the beginning of the plan 
year, the timing requirement is deemed to be satisfied if the notice is 
provided no more than 90 days before the employee becomes eligible (and 
no later than the date the employee becomes eligible). Thus, for 
example, the preceding sentence would apply in the case of any employee 
eligible for the first plan year under a newly established plan that 
provides for elective contributions, or would apply in the case of the 
first plan year in which an employee becomes eligible under an existing 
plan that provides for elective contributions.
    (e) Plan year requirement--(1) General rule. Except as provided in 
this paragraph (e) or in paragraph (f) of this section, a plan will 
fail to satisfy the requirements of section 401(k)(12) and this section 
unless plan provisions that satisfy the rules of this section are 
adopted before the first day of the plan year and remain in effect for 
an entire 12-month plan year. Moreover, if, as described under 
paragraph (g)(4) of this section, safe harbor matching or nonelective 
contributions will be made to another plan for a plan year, provisions 
specifying that the safe harbor contributions will be made in the other 
plan and providing that the contributions will be QNECs or QMACs must 
also be adopted before the first day of that plan year.
    (2) Initial plan year. A newly established plan (other than a 
successor plan within the meaning of Sec.  1.401(k)-2(c)(2)(iii)) will 
not be treated as violating the requirements of this paragraph (e) 
merely because the plan year is less than 12 months, provided that the 
plan year is at least 3 months long (or, in the case of a newly 
established employer that establishes the plan as soon as 
administratively feasible after the employer comes into existence, a 
shorter period). Similarly, a cash or deferred arrangement will not 
fail to satisfy the requirement of this paragraph (e) if it is added to 
an existing profit sharing, stock bonus, or pre-ERISA money purchase 
pension plan for the first time during that year provided that--
    (i) The plan is not a successor plan; and
    (ii) The cash or deferred arrangement is made effective no later 
than 3 months prior to the end of the plan year.
    (3) Change of plan year. A plan that has a short plan year as a 
result of changing its plan year will not fail to satisfy the 
requirements of paragraph (e)(1) of this section merely because the 
plan year has less than 12 months, provided that--
    (i) The plan satisfied the requirements of this section for the 
immediately preceding plan year; and
    (ii) The plan satisfies the requirements of this section for the 
immediately following plan year.
    (4) Final plan year. A plan that terminates during a plan year will 
not fail to satisfy the requirements of paragraph (e)(1) of this 
section merely because the final plan year is less than 12 months, 
provided that--
    (i) The plan would satisfy the requirements of paragraph (g) of 
this section, treating the termination of the plan as a reduction or 
suspension of safe harbor matching contributions, other than the 
requirement that employees have a reasonable opportunity to change 
their cash or deferred elections and, if applicable, employee 
contribution elections; or
    (ii) The plan termination is in connection with a transaction 
described

[[Page 42513]]

in section 410(b)(6)(C) or the employer incurs a substantial business 
hardship comparable to a substantial business hardship described in 
section 412(d).
    (f) Plan amendments adopting safe harbor nonelective 
contributions--(1) General rule. Notwithstanding paragraph (e)(1) of 
this section, a plan that provides for the use of the current year 
testing method may be amended after the first day of the plan year and 
no later than 30 days before the last day of the plan year to adopt the 
safe harbor method of this section using nonelective contributions 
under paragraph (b) of this section, but only if the plan provides the 
contingent and follow-up notices described in this section. A plan 
amendment made pursuant to this paragraph (f)(1) for a plan year may 
provide for the use of the safe harbor method described in this section 
solely for that plan year and a plan sponsor is not limited in the 
number of years for which it is permitted to adopt an amendment 
providing for the safe harbor method of this section using nonelective 
contributions under paragraph (b) of this section.
    (2) Contingent notice provided. A plan satisfies the requirement to 
provide the contingent notice under this paragraph (f)(2) if it 
provides a notice that would satisfy the requirements of paragraph (d) 
of this section, except that, in lieu of setting forth the safe harbor 
contributions used under the plan as set forth in paragraph 
(d)(2)(ii)(A) of this section, the notice specifies that the plan may 
be amended during the plan year to include the safe harbor nonelective 
contribution and that, if the plan is amended, a follow-up notice will 
be provided.
    (3) Follow-up notice requirement. A plan satisfies the requirement 
to provide a follow-up notice under this paragraph (f)(3) if, no later 
than 30 days before the last day of the plan year, each eligible 
employee is given a notice that states that the safe harbor nonelective 
contributions will be made for the plan year. This notice is permitted 
to be combined with a contingent notice provided under paragraph (f)(2) 
of this section for the next plan year.
    (g) Permissible reduction or suspension of safe harbor matching 
contributions--(1) General rule. A plan that provides for safe harbor 
matching contributions will not fail to satisfy the requirements of 
section 401(k)(3) for a plan year merely because the plan is amended 
during a plan year to reduce or suspend safe harbor matching 
contributions on future elective contributions (and, if applicable, 
employee contributions) provided that--
    (i) All eligible employees are provided the supplemental notice in 
accordance with paragraph (g)(2) of this section;
    (ii) The reduction or suspension of safe harbor matching 
contributions is effective no earlier than the later of 30 days after 
eligible employees are provided the notice described in paragraph 
(g)(2) of this section and the date the amendment is adopted;
    (iii) Eligible employees are given a reasonable opportunity 
(including a reasonable period after receipt of the supplemental 
notice) prior to the reduction or suspension of safe harbor matching 
contributions to change their cash or deferred elections and, if 
applicable, their employee contribution elections;
    (iv) The plan is amended to provide that the ADP test will be 
satisfied for the entire plan year in which the reduction or suspension 
occurs using the current year testing method described in Sec.  
1.401(k)-2(a)(2)(ii); and
    (v) The plan satisfies the requirements of this section (other than 
this paragraph (g)) with respect to amounts deferred through the 
effective date of the amendment.
    (2) Notice of suspension requirement. The notice of suspension 
requirement of this paragraph (g)(2) is satisfied if each eligible 
employee is given a written notice that explains--
    (i) The consequences of the amendment which reduces or suspends 
matching contributions on future elective contributions and, if 
applicable, employee contributions;
    (ii) The procedures for changing their cash or deferred election 
and, if applicable, their employee contribution elections; and
    (iii) The effective date of the amendment.
    (h) Additional rules--(1) Contributions taken into account. A 
contribution is taken into account for purposes of this section for a 
plan year if and only if the contribution would be taken into account 
for such plan year under the rules of Sec.  1.401(k)-2(a) or 1.401(m)-
2(a). Thus, for example, a safe harbor matching contribution must be 
made within 12 months of the end of the plan year. Similarly, an 
elective contribution that would be taken into account for a plan year 
under Sec.  1.401(k)-2(a)(4)(i)(B)(2) must be taken into account for 
such plan year for purposes of this section, even if the compensation 
would have been received after the close of the plan year.
    (2) Use of safe harbor nonelective contributions to satisfy other 
nondiscrimination tests. A safe harbor nonelective contribution used to 
satisfy the nonelective contribution requirement under paragraph (b) of 
this section may also be taken into account for purposes of determining 
whether a plan satisfies section 401(a)(4). Thus, these contributions 
are not subject to the limitations on qualified nonelective 
contributions under Sec.  1.401(k)-2(a)(6)(ii), but are subject to the 
rules generally applicable to nonelective contributions under section 
401(a)(4). See Sec.  1.401(a)(4)-1(b)(2)(ii). However, pursuant to 
section 401(k)(12)(E)(ii), to the extent they are needed to satisfy the 
safe harbor contribution requirement of paragraph (b) of this section, 
safe harbor nonelective contributions may not be taken into account 
under any plan for purposes of section 401(l) (including the imputation 
of permitted disparity under Sec.  1.401(a)(4)-7).
    (3) Early participation rules. Section 401(k)(3)(F) and Sec.  
1.401(k)-2(a)(1)(iii)(A), which provide an alternative 
nondiscrimination rule for certain plans that provide for early 
participation, do not apply for purposes of section 401(k)(12) and this 
section. Thus, a plan is not treated as satisfying this section with 
respect to the eligible employees who have not completed the minimum 
age and service requirements of section 410(a)(1)(A) unless the plan 
satisfies the requirements of this section with respect to such 
eligible employees.
    (4) Satisfying safe harbor contribution requirement under another 
defined contribution plan. Safe harbor matching or nonelective 
contributions may be made to the plan that contains the cash or 
deferred arrangement or to another defined contribution plan that 
satisfies section 401(a) or 403(a). If safe harbor contributions are 
made to another defined contribution plan, the safe harbor plan must 
specify the plan to which the safe harbors are made and contribution 
requirement of paragraph (b) or (c) of this section must be satisfied 
in the other defined contribution plan in the same manner as if the 
contributions were made to the plan that contains the cash or deferred 
arrangement. Consequently, the plan to which the contributions are made 
must have the same plan year as the plan containing the cash and 
deferred arrangement and each employee eligible under the plan 
containing the cash or deferred arrangement must be eligible under the 
same conditions under the other defined contribution plan. The plan to 
which the safe harbor contributions are made need not be a plan that 
can be aggregated with the plan that contains the cash or deferred 
arrangement.
    (5) Contributions used only once. Safe harbor matching or 
nonelective contributions cannot be used to satisfy

[[Page 42514]]

the requirements of this section with respect to more than one plan.


Sec.  1.401(k)-4  SIMPLE 401(k) plan requirements.

    (a) General rule. A cash or deferred arrangement satisfies the 
SIMPLE 401(k) plan provision of section 401(k)(11) for a plan year if 
the arrangement satisfies the requirements of paragraphs (b) through 
(i) of this section for that year. A plan that contains a cash or 
deferred arrangement that satisfies this section is referred to as a 
SIMPLE 401(k) plan. Pursuant to section 401(k)(11), a SIMPLE 401(k) 
plan is treated as satisfying the ADP test of section 401(k)(3)(A)(ii) 
for that year.
    (b) Eligible employer--(1) General rule. A SIMPLE 401(k) plan must 
be established by an eligible employer. Eligible employer for purposes 
of this section means, with respect to any plan year, an employer that 
had no more than 100 employees who received at least $5,000 of SIMPLE 
compensation, as defined in paragraph (e)(5) of this section, from the 
employer for the prior calendar year.
    (2) Special rule. An eligible employer that establishes a SIMPLE 
401(k) plan for a plan year and that fails to be an eligible employer 
for any subsequent plan year, is treated as an eligible employer for 
the 2 plan years following the last plan year the employer was an 
eligible employer. If the failure is due to any acquisition, 
disposition, or similar transaction involving an eligible employer, the 
preceding sentence applies only if the provisions of section 
410(b)(6)(C)(i) are satisfied.
    (c) Exclusive plan--(1) General rule. The SIMPLE 401(k) plan must 
be the exclusive plan for each SIMPLE 401(k) plan participant for the 
plan year. This requirement is satisfied if there are no contributions 
made, or benefits accrued, for services during the plan year on behalf 
of any SIMPLE 401(k) plan participant under any other qualified plan 
maintained by the employer. Other qualified plan for purposes of this 
section means any plan, contract, pension, or trust described in 
section 219(g)(5)(A) or (B).
    (2) Special rule. A SIMPLE 401(k) plan will not be treated as 
failing the requirements of this paragraph (c) merely because any 
SIMPLE 401(k) plan participant receives an allocation of forfeitures 
under another plan of the employer.
    (d) Election and notice--(1) General rule. An eligible employer 
establishing or maintaining a SIMPLE 401(k) plan must satisfy the 
election and notice requirements in paragraphs (d)(2) and (d)(3) of 
this section.
    (2) Employee elections--(i) Initial plan year of participation. For 
the plan year in which an employee first becomes eligible under the 
SIMPLE 401(k) plan, the employee must be permitted to make a cash or 
deferred election under the plan during a 60-day period that includes 
either the day the employee becomes eligible or the day before.
    (ii) Subsequent plan years. For each subsequent plan year, each 
eligible employee must be permitted to make or modify his cash or 
deferred election during the 60-day period immediately preceding such 
plan year.
    (iii) Election to terminate. An eligible employee must be permitted 
to terminate his cash or deferred election at any time. If an employee 
does terminate his cash or deferred election, the plan is permitted to 
provide that such employee cannot have elective contributions made 
under the plan for the remainder of the plan year.
    (3) Employee notices. The employer must notify each eligible 
employee within a reasonable time prior to each 60-day election period, 
or on the day the election period starts, that he or she can make a 
cash or deferred election, or modify a prior election, if applicable, 
during that period. The notice must state whether the eligible employer 
will make the matching contributions described in paragraph (e)(3) of 
this section or the nonelective contributions described in paragraph 
(e)(4) of this section.
    (e) Contributions--(1) General rule. A SIMPLE 401(k) plan satisfies 
the contribution requirements of this paragraph (e) for a plan year 
only if no contributions may be made to the SIMPLE 401(k) plan during 
such year, other than contributions described in this paragraph (e) and 
rollover contributions described in Sec.  1.402(c)-2, Q&A-1(a).
    (2) Elective contributions. Subject to the limitations on annual 
additions under section 415, each eligible employee must be permitted 
to make an election to have up to $10,000 of elective contributions 
made on the employee's behalf under the SIMPLE 401(k) plan for a plan 
year. The $10,000 limit is increased beginning in 2006 in the same 
manner as the $160,000 amount is adjusted under section 415(d), except 
that pursuant to section 408(p)(2)(E)(ii) the base period shall be the 
calendar quarter beginning July 1, 2004 and any increase which is not a 
multiple of $500 is rounded to the next lower multiple of $500.
    (3) Matching contributions. Each plan year, the eligible employer 
must contribute a matching contribution to the account of each eligible 
employee on whose behalf elective contributions were made for the plan 
year. The amount of the matching contribution must equal the lesser of 
the eligible employee's elective contributions for the plan year or 3% 
of the eligible employee's SIMPLE compensation for the entire plan 
year.
    (4) Nonelective contributions. For any plan year, in lieu of 
contributing matching contributions described in paragraph (e)(3) of 
this section, an eligible employer may, in accordance with plan terms, 
contribute a nonelective contribution to the account of each eligible 
employee in an amount equal to 2% of the eligible employee's SIMPLE 
compensation for the entire plan year. The eligible employer may limit 
the nonelective contributions to those eligible employees who received 
at least $5,000 of SIMPLE compensation from the employer for the entire 
plan year.
    (5) SIMPLE compensation. Except as otherwise provided, the term 
SIMPLE compensation for purposes of this section means the sum of 
wages, tips, and other compensation from the eligible employer subject 
to federal income tax withholding (as described in section 6051(a)(3)) 
and the employee's elective contributions made under any other plan, 
and if applicable, elective deferrals under a section 408(p) SIMPLE IRA 
plan, a section 408(k)(6) SARSEP, or a plan or contract that satisfies 
the requirements of section 403(b), and compensation deferred under a 
section 457 plan, required to be reported by the employer on Form W-2 
(as described in section 6051(a)(8)). For self-employed individuals, 
SIMPLE compensation means net earnings from self-employment determined 
under section 1402(a) prior to subtracting any contributions made under 
the SIMPLE 401(k) plan on behalf of the individual.
    (f) Vesting. All benefits attributable to contributions described 
in paragraph (e) of this section must be nonforfeitable at all times.
    (g) Plan year. The plan year of a SIMPLE 401(k) plan must be the 
whole calendar year. Thus, in general, a SIMPLE 401(k) plan can be 
established only on January 1 and can be terminated only on December 
31. However, in the case of an employer that did not previously 
maintain a SIMPLE 401(k) plan, the establishment date can be as late as 
October 1 (or later in the case of an employer that comes into 
existence after October 1 and establishes the SIMPLE 401(k) plan as 
soon as administratively feasible after the employer comes into 
existence).

[[Page 42515]]

    (h) Other rules. A SIMPLE 401(k) plan is not treated as a top-heavy 
plan under section 416. See section 416(g)(4)(G).


Sec.  1.401(k)-5  Special rules for mergers, acquisitions and similar 
events. [Reserved].


Sec.  1.401(k)-6  Definitions.

    Unless otherwise provided, the definitions of this section govern 
for purposes of section 401(k) and the regulations thereunder.
    Actual contribution percentage (ACP) test. Actual contribution 
percentage test or ACP test means the test described in Sec.  1.401(m)-
2(a)(1).
    Actual deferral percentage (ADP). Actual deferral percentage or ADP 
means the ADP of the group of eligible employees as defined in Sec.  
1.401(k)-2(a)(2).
    Actual deferral percentage (ADP) test. Actual deferral percentage 
test or ADP test means the test described in Sec.  1.401(k)-2(a)(1).
    Actual deferral ratio (ADR). Actual deferral ratio or ADR means the 
ADR of an eligible employee as defined in Sec.  1.401(k)-2(a)(3).
    Cash or deferred arrangement. Cash or deferred arrangement is 
defined in Sec.  1.401(k)-1(a)(2).
    Cash or deferred election. Cash or deferred election is defined in 
Sec.  1.401(k)-1(a)(3).
    Compensation. Compensation means compensation as defined in section 
414(s) and Sec.  1.414(s)-1. The period used to determine an employee's 
compensation for a plan year must be either the plan year or the 
calendar year ending within the plan year. Whichever period is selected 
must be applied uniformly to determine the compensation of every 
eligible employee under the plan for that plan year. A plan may, 
however, limit the period taken into account under either method to 
that portion of the plan year or calendar year in which the employee 
was an eligible employee, provided that this limit is applied uniformly 
to all eligible employees under the plan for the plan year. In the case 
of an HCE whose ADR is determined under Sec.  1.401(k)-2(a)(3)(ii), 
period of participation includes periods under another plan for which 
elective contributions are aggregated under Sec.  1.401(k)-2(a)(3)(ii). 
See also section 401(a)(17) and Sec.  1.401(a)(17)-1(c)(1).
    Current year testing method. Current year testing method means the 
testing method described in Sec.  1.401(k)-2(a)(2)(ii) or Sec.  
1.401(m)-2(a)(2)(ii) under which the applicable year is the current 
plan year.
    Elective contributions. Elective contributions means employer 
contributions made to a plan pursuant to a cash or deferred election 
under a cash or deferred arrangement (whether or not the arrangement is 
a qualified cash or deferred arrangement under Sec.  1.401(k)-1(a)(4)).
    Eligible employee--(1) General rule. Eligible employee means an 
employee who is directly or indirectly eligible to make a cash or 
deferred election under the plan for all or a portion of the plan year. 
For example, if an employee must perform purely ministerial or 
mechanical acts (e.g., formal application for participation or consent 
to payroll withholding) in order to be eligible to make a cash or 
deferred election for a plan year, the employee is an eligible employee 
for the plan year without regard to whether the employee performs the 
acts.
    (2) Conditions on eligibility. An employee who is unable to make a 
cash or deferred election because the employee has not contributed to 
another plan is also an eligible employee. By contrast, if an employee 
must perform additional service (e.g., satisfy a minimum period of 
service requirement) in order to be eligible to make a cash or deferred 
election for a plan year, the employee is not an eligible employee for 
the plan year unless the service is actually performed. See Sec.  
1.401(k)-1(e)(5), however, for certain limits on the use of minimum 
service requirements. An employee who would be eligible to make 
elective contributions but for a suspension due to a distribution, a 
loan, or an election not to participate in the plan, is treated as an 
eligible employee for purposes of section 401(k)(3) for a plan year 
even though the employee may not make a cash or deferred election by 
reason of the suspension. Finally, an employee does not fail to be 
treated as an eligible employee merely because the employee may receive 
no additional annual additions because of section 415(c)(1).
    (3) Certain one-time elections. An employee is not an eligible 
employee merely because the employee, upon commencing employment with 
the employer or upon the employee's first becoming eligible to make a 
cash or deferred election under any arrangement of the employer, is 
given the one-time opportunity to elect, and the employee does in fact 
elect, not to be eligible to make a cash or deferred election under the 
plan or any other plan maintained by the employer (including plans not 
yet established) for the duration of the employee's employment with the 
employer. This rule applies in addition to the rules in Sec.  1.401(k)-
1(a)(3)(v) relating to the definition of a cash or deferred election. 
In no event is an election made after December 23, 1994, treated as a 
one-time irrevocable election under this paragraph if the election is 
made by an employee who previously became eligible under another plan 
(whether or not terminated) of the employer.
    Eligible HCE. Eligible HCE means an eligible employee who is an 
HCE.
    Eligible NHCE. Eligible NHCE means an eligible employee who is not 
an HCE.
    Employee. Employee means an employee within the meaning of Sec.  
1.410(b)-9.
    Employee stock ownership plan (ESOP). Employee stock ownership plan 
or ESOP means the portion of a plan that is an ESOP within the meaning 
of Sec.  1.410(b)-7(c)(2).
    Employer. Employer means an employer within the meaning of Sec.  
1.410(b)-9.
    Excess contributions. Excess contributions means, with respect to a 
plan year, the amount of total excess contributions apportioned to an 
HCE under Sec.  1.401(k)-2(b)(2)(iii).
    Excess deferrals. Excess deferrals means excess deferrals as 
defined in Sec.  1.402(g)-1(e)(3).
    Highly compensated employee (HCE). Highly compensated employee or 
HCE has the meaning provided in section 414(q).
    Matching contributions. Matching contributions means matching 
contributions as defined in Sec.  1.401(m)-1(a)(2).
    Nonelective contributions. Nonelective contributions means employer 
contributions (other than matching contributions) with respect to which 
the employee may not elect to have the contributions paid to the 
employee in cash or other benefits instead of being contributed to the 
plan.
    Non-employee stock ownership plan (non-ESOP). Non-employee stock 
ownership plan or non-ESOP means the portion of a plan that is not an 
ESOP within the meaning of Sec.  1.410(b)-7(c)(2).
    Non-highly compensated employee (NHCE). Non-highly compensated 
employee or NHCE means an employee who is not an HCE.
    Plan. Plan is defined in Sec.  1.401(k)-1(b)(4).
    Pre-ERISA money purchase pension plan. (1) Pre-ERISA money purchase 
pension plan is a pension plan--
    (i) That is a defined contribution plan (as defined in section 
414(i));
    (ii) That was in existence on June 27, 1974, and as in effect on 
that date, included a salary reduction agreement; and
    (iii) Under which neither the employee contributions nor the 
employer contributions, including

[[Page 42516]]

elective contributions, may exceed the levels (as a percentage of 
compensation) provided for by the contribution formula in effect on 
June 27, 1974.
    (2) A plan was in existence on June 27, 1974, if it was a written 
plan adopted on or before that date, even if no funds had yet been paid 
to the trust associated with the plan.
    Prior year testing method. Prior year testing method means the 
testing method under which the applicable year is the prior plan year, 
as described in Sec.  1.401(k)-2(a)(2)(ii) or Sec.  1.401(m)-
2(a)(2)(ii).
    Qualified matching contributions (QMACs). Qualified matching 
contributions or QMACs means matching contributions that, except as 
provided otherwise in Sec.  1.401(k)-1(c) and (d), satisfy the 
requirements of Sec.  1.401(k)-1(c) and (d) as though the contributions 
were elective contributions, without regard to whether the 
contributions are actually taken into account under the ADP test under 
Sec.  1.401(k)-2(a)(6) or the ACP test under Sec.  1.401(m)-2(a)(6). 
Thus, the matching contributions must satisfy the vesting requirements 
of Sec.  1.401(k)-1(c) and be subject to the distribution requirements 
of Sec.  1.401(k)-1(d) when they are contributed to the plan. See also 
Sec.  1.401(k)-2(b)(4)(iii) for a rule providing that a matching 
contribution does not fail to qualify as a QMAC solely because it is 
forfeitable under section 411(a)(3)(G) because it is a matching 
contribution with respect to an excess deferral, excess contribution, 
or excess aggregate contribution.
    Qualified nonelective contributions (QNECs). Qualified nonelective 
contributions or QNECs means employer contributions, other than 
elective contributions or matching contributions, that, except as 
provided otherwise in Sec.  1.401(k)-1(c) and (d), satisfy the 
requirements of Sec.  1.401(k)-1(c) and (d) as though the contributions 
were elective contributions, without regard to whether the 
contributions are actually taken into account under the ADP test under 
Sec.  1.401(k)-2(a)(6) or the ACP test under Sec.  1.401(m)-2(a)(6). 
Thus, the nonelective contributions must satisfy the vesting 
requirements of Sec.  1.401(k)-1(c) and be subject to the distribution 
requirements of Sec.  1.401(k)-1(d) when they are contributed to the 
plan.
    Rural cooperative plans. Rural cooperative plan means a plan 
described in section 401(k)(7).
    Par. 3. Sections 1.401(m)-0 through 1.401(m)-2 are revised and 
Sec. Sec. 1.401(m)-3 through 1.401(m)-5 are added to read as follows:


Sec.  1.401(m)-0  Table of contents.

    This section contains first a list of section headings and then a 
list of the paragraphs in each section in Sec. Sec.  1.401(m)-1 through 
1.401(m)-5.

List of Sections

Sec.  1.401(m)-1 Employee contributions and matching contributions.
Sec.  1.401(m)-2 ACP test.
Sec.  1.401(m)-3 Safe harbor requirements.
Sec.  1.401(m)-4 Special rules for mergers, acquisitions and similar 
events. [Reserved].
Sec.  1.401(m)-5 Definitions.

List of Paragraphs

Sec.  1.401(m)-1 Employee contributions and matching contributions.

(a) General nondiscrimination rules.
(1) Nondiscriminatory amount of contributions.
(i) Exclusive means of amounts testing.
(ii) Testing benefits, rights and features.
(2) Matching contributions.
(i) In general.
(ii) Employer contributions made on account of an employee 
contribution or elective deferral.
(iii) Employer contributions not on account of an employee 
contribution or elective deferral.
(3) Employee contributions.
(i) In general.
(ii) Certain contributions not treated as employee contributions.
(iii) Qualified cost-of-living arrangements.
(b) Nondiscrimination requirements for amount of contributions.
(1) Matching contributions and employee contributions.
(2) Automatic satisfaction by certain plans.
(3) Anti-abuse provisions.
(4) Aggregation and restructuring.
(i) In general.
(ii) Aggregation of employee contributions and matching 
contributions within a plan.
(iii) Aggregation of plans.
(A) In general.
(B) Arrangements with inconsistent ACP testing methods.
(iv) Disaggregation of plans and separate testing.
(A) In general.
(B) Restructuring prohibited.
(v) Certain disaggregation rules not applicable.
(c) Additional requirements.
(1) Separate testing for employee contributions and matching 
contributions.
(2) Plan provision requirement.
(d) Effective date.

Sec.  1.401(m)-2 ACP test.

(a) Actual contribution percentage (ACP) test.
(1) In general.
(i) ACP test formula.
(ii) HCEs as sole eligible employees.
(iii) Special rule for early participation.
(2) Determination of ACP.
(i) General rule.
(ii) Determination of applicable year under current year and prior 
year testing method.
(3) Determination of ACR.
(i) General rule.
(ii) ACR of HCEs eligible under more than one plan.
(A) General rule.
(B) Plans not permitted to be aggregated.
(iii) Example.
(4) Employee contributions and matching contributions taken into 
account under the ACP test.
(i) Employee contributions.
(ii) Recharacterized elective contributions.
(iii) Matching contributions.
(5) Matching contributions not taken into account under the ACP 
test.
(i) General rule.
(ii) Disproportionate matching contributions.
(A) Matching contributions in excess of 100%.
(B) Representative matching rate.
(C) Definition of matching rate.
(iii) Qualified matching contributions used to satisfy the ACP test.
(iv) Matching contributions taken into account under safe harbor 
provisions.
(v) Treatment of forfeited matching contributions.
(6) Qualified nonelective contributions and elective contributions 
that may be taken into account under the ACP test.
(i) Timing of allocation.
(ii) Elective contributions taken into account under the ACP test.
(iii) Requirement that amount satisfy section 401(a)(4).
(iv) Aggregation must be permitted.
(v) Disproportionate contributions not taken into account.
(A) General rule.
(B) Definition of representative contribution rate.
(C) Definition of applicable contribution rate.
(vi) Contribution only used once.
(7) Examples.
(b) Correction of excess aggregate contributions.
(1) Permissible correction methods.
(i) In general.
(A) Additional contributions.
(B) Excess aggregate contributions distributed or forfeited.
(ii) Combination of correction methods.
(iii) Exclusive means of correction.
(2) Correction through distribution.
(i) General rule.
(ii) Calculation of total amount to be distributed.
(A) Calculate the dollar amount of excess aggregate contributions 
for each HCE.
(B) Determination of the total amount of excess aggregate 
contributions.
(C) Satisfaction of ACP.
(iii) Apportionment of total amount of excess aggregate 
contributions among the HCEs.
(A) Calculate the dollar amount of excess aggregate contributions 
for each HCE.
(B) Limit on amount apportioned to any HCE.
(C) Apportionment to additional HCEs.
(iv) Income allocable to excess aggregate contributions.
(A) General rule.
(B) Method of allocating income.
(C) Alternative method of allocating income for the plan year.
(D) Safe harbor method of allocating gap period income.
(E) Alternative method of allocating plan year and gap period 
income.
(F) Allocable income for recharacterized elective contributions.

[[Page 42517]]

(v) Distribution and forfeiture.
(vi) Tax treatment of corrective distributions.
(A) General rule.
(B) Rule for de minimis distributions.
(3) Other rules.
(i) No employee or spousal consent required.
(ii) Treatment of corrective distributions and forfeited 
contributions as employer contributions.
(iii) No reduction of required minimum distribution.
(iv) Partial correction.
(v) Matching contributions on excess contributions, excess deferrals 
and excess aggregate contributions.
(A) Corrective distributions not permitted.
(B) Coordination with section 401(a)(4).
(vi) No requirement for recalculation.
(4) Failure to timely correct.
(i) Failure to correct within 2\1/2\ months after end of plan year.
(ii) Failure to correct within 12 months after end of plan year.
(5) Examples.
(c) Additional rules for prior year testing method.
(1) Rules for change in testing method.
(2) Calculation of ACP under the prior year testing method for the 
first plan year.
(i) Plans that are not successor plans.
(ii) First plan year defined.
(iii) Plans that are successor plans.
(3) Plans using different testing methods for the ACP and ADP test.
(4) Rules for plan coverage change.
(i) In general.
(ii) Optional rule for minor plan coverage changes.
(iii) Definitions.
(A) Plan coverage change.
(B) Prior year subgroup.
(C) Weighted average of the ACPs for the prior year subgroups.
(iv) Examples.

Sec.  1.401(m)-3 Safe harbor requirements.

(a) ACP test safe harbor.
(b) Safe harbor nonelective contribution requirement.
(c) Safe harbor matching contribution requirement.
(d) Limitation on contributions.
(1) General rule.
(2) Matching rate must not increase.
(3) Limit on matching contributions.
(4) Limitation on rate of match.
(5) HCEs participating in multiple plans.
(6) Permissible restrictions on elective deferrals by NHCEs.
(i) General rule.
(ii) Restrictions on election periods.
(iii) Restrictions on amount of contributions.
(iv) Restrictions on types of compensation that may be deferred.
(v) Restrictions due to limitations under the Internal Revenue Code.
(e) Notice requirement.
(f) Plan year requirement.
(1) General rule.
(2) Initial plan year.
(3) Change of plan year.
(4) Final plan year.
(g) Plan amendments adopting nonelective safe harbor contributions.
(h) Permissible reduction or suspension of safe harbor matching 
contributions.
(1) General rule.
(2) Notice of suspension requirement.
(i) Reserved.
(j) Other rules.
(1) Contributions taken into account.
(2) Use of safe harbor nonelective contributions to satisfy other 
nondiscrimination tests.
(3) Early participation rules.
(4) Satisfying safe harbor contribution requirement under another 
defined contribution plan.
(5) Contributions used only once.
(6) Plan must satisfy ACP with respect to employee contributions.

Sec.  1.401(m)- Special rules for mergers, acquisitions and similar 
events. [Reserved].

Sec.  1.401(m)-5 Definitions.


Sec.  1.401(m)-1  Employee contributions and matching contributions.

    (a) General nondiscrimination rules--(1) Nondiscriminatory amount 
of contributions--(i) Exclusive means of amounts testing. A defined 
contribution plan does not satisfy section 401(a) for a plan year 
unless the amount of employee contributions and matching contributions 
to the plan for the plan year satisfies section 401(a)(4). The amount 
of employee contributions and matching contributions under a plan 
satisfies the requirements of section 401(a)(4) with respect to amounts 
if and only if the amount of employee contributions and matching 
contributions satisfies the nondiscrimination test of section 401(m) 
under paragraph (b) of this section and the plan satisfies the 
additional requirements of paragraph (c) of this section. See Sec.  
1.401(a)(4)-1(b)(2)(ii)(B).
    (ii) Testing benefits, rights and features. A plan that provides 
for employee contributions or matching contributions must satisfy the 
requirements of section 401(a)(4) relating to benefits, rights and 
features in addition to the requirement regarding amounts described in 
paragraph (a)(1)(i) of this section. For example, the right to make 
each level of employee contributions and the right to each level of 
matching contributions under the plan are benefits, rights or features 
subject to the requirements of section 401(a)(4). See Sec.  
1.401(a)(4)-4(e)(3)(i) and (iii)(F) through (G).
    (2) Matching contributions--(i) In general. For purposes of section 
401(m), this section and Sec. Sec.  1.401(m)-2 through 1.401(m)-5, 
matching contributions are--
    (A) Any employer contribution (including a contribution made at the 
employer's discretion) to a defined contribution plan on account of an 
employee contribution to a plan maintained by the employer;
    (B) Any employer contribution (including a contribution made at the 
employer's discretion) to a defined contribution plan on account of an 
elective deferral; and
    (C) Any forfeiture allocated on the basis of employee 
contributions, matching contributions, or elective deferrals.
    (ii) Employer contributions made on account of an employee 
contribution or elective deferral. Whether an employer contribution is 
made on account of an employee contribution or an elective deferral is 
determined on the basis of all the relevant facts and circumstances, 
including the relationship between the employer contribution and 
employee actions outside the plan. An employer contribution made to a 
defined contribution plan on account of contributions made by an 
employee under an employer-sponsored savings arrangement that are not 
held in a plan that is intended to be a qualified plan or a plan 
described in Sec.  1.402(g)-1(b) is not a matching contribution.
    (iii) Employer contributions not on account of an employee 
contribution or elective deferral. An employer contribution is not a 
matching contribution made on account of an elective deferral if it is 
contributed before the cash or deferred election is made or before the 
employee's performance of services with respect to which the elective 
deferral is made (or when the cash that is subject to the cash or 
deferred election would be currently available, if earlier). In 
addition, an employer contribution is not a matching contribution made 
on account of an employee contribution if it is contributed before the 
employee contribution.
    (3) Employee contributions--(i) In general. For purposes of section 
401(m), this section and Sec. Sec.  1.401(m)-2 through 1.401(m)-5, 
employee contributions are contributions to a plan that are designated 
or treated at the time of contribution as after-tax employee 
contributions (e.g., by treating the contributions as taxable income 
subject to applicable withholding requirements) and are allocated to an 
individual account for each eligible employee to which attributable 
earnings and losses are allocated. See Sec.  1.401(k)-1(a)(2)(ii). The 
term employee contributions includes--
    (A) Employee contributions to the defined contribution portion of a 
plan described in section 414(k);
    (B) Employee contributions applied to the purchase of whole life 
insurance protection or survivor benefit protection under a defined 
contribution plan;

[[Page 42518]]

    (C) Amounts attributable to excess contributions within the meaning 
of section 401(k)(8)(B) that are recharacterized as employee 
contributions under Sec.  1.401(k)-2(b)(3); and
    (D) Employee contributions to a plan or contract that satisfies the 
requirements of section 403(b).
    (ii) Certain contributions not treated as employee contributions. 
The term employee contributions does not include repayment of loans, 
repayment of distributions described in section 411(a)(7)(C), or 
employee contributions that are transferred to the plan from another 
plan.
    (iii) Qualified cost-of-living arrangements. Employee contributions 
to a qualified cost-of-living arrangement described in section 
415(k)(2)(B) are treated as employee contributions to a defined 
contribution plan, without regard to the requirement that the employee 
contributions be allocated to an individual account to which 
attributable earnings and losses are allocated.
    (b) Nondiscrimination requirements for amount of contributions--(1) 
Matching contributions and employee contributions. The matching 
contributions and employee contributions under a plan satisfy this 
paragraph (b) for a plan year only if the plan satisfies--
    (i) The ACP test of section 401(m)(2) described in Sec.  1.401(m)-
2;
    (ii) The ACP safe harbor provisions of section 401(m)(11) described 
in Sec.  1.401(m)-3; or
    (iii) The SIMPLE 401(k) provisions of sections 401(k)(11) and 
401(m)(10) described in Sec.  1.401(k)-4.
    (2) Automatic satisfaction by certain plans. Notwithstanding 
paragraph (b)(1) of this section, the requirements of this section are 
treated as satisfied with respect to employee contributions and 
matching contributions under a collectively bargained plan (or the 
portion of a plan) that automatically satisfies section 410(b). See 
Sec. Sec.  1.401(a)(4)-1(c)(5) and 1.410(b)-2(b)(7). Additionally, the 
requirements of sections 401(a)(4) and 410(b) do not apply to a 
governmental plan (within the meaning of section 414(d)) maintained by 
a State or local government or political subdivision thereof (or agency 
or instrumentality thereof). See sections 401(a)(5)(G), 403(b)(12)(C) 
and 410(c)(1)(A).
    (3) Anti-abuse provisions. The regulations in this paragraph (b) 
are designed to provide simple, practical rules that accommodate 
legitimate plan changes. At the same time, the rules are intended to be 
applied by employers in a manner that does not make use of changes in 
plan testing procedures or other plan provisions to inflate 
inappropriately the ACP for NHCEs (which is used as a benchmark for 
testing the ACP for HCEs) or to otherwise manipulate the 
nondiscrimination testing requirements of this paragraph (b). Further, 
this paragraph (b) is part of the overall requirement that benefits or 
contributions not discriminate in favor of HCEs. Therefore, a plan will 
not be treated as satisfying the requirements of this paragraph (b) if 
there are repeated changes to plan testing procedures or plan 
provisions that have the effect of distorting the ACP so as to increase 
significantly the permitted ACP for HCEs, or otherwise manipulate the 
nondiscrimination rules of this paragraph, if a principal purpose of 
the changes was to achieve such a result.
    (4) Aggregation and restructuring--(i) In general. This paragraph 
(b)(4) contains the exclusive rules for aggregating and disaggregating 
plans that provide for employee contributions and matching 
contributions for purposes of this section and Sec. Sec.  1.401(m)-2 
through 1.401(m)-5.
    (ii) Aggregation of employee contributions and matching 
contributions within a plan. Except as otherwise specifically provided 
in this paragraph (b)(4) and Sec.  1.401(m)-3(f)(1), a plan must be 
subject to a single test under paragraph (b)(1) of this section with 
respect to all employee contributions and matching contributions and 
all eligible employees under the plan. Thus, for example, if two groups 
of employees are eligible for matching contributions under a plan, all 
employee contributions and matching contributions under the plan must 
be subject to a single test, even if they have significantly different 
features, such as different rates of match.
    (iii) Aggregation of plans--(A) In general. The term plan means a 
plan within the meaning of Sec.  1.410(b)-7(a) and (b), after 
application of the mandatory disaggregation rules of Sec.  1.410(b)-
7(c), and the permissive aggregation rules of Sec.  1.410(b)-7(d), as 
modified by paragraph (b)(4)(v) of this section. Thus, for example, two 
plans (within the meaning of Sec.  1.410(b)-7(b)) that are treated as a 
single plan pursuant to the permissive aggregation rules of Sec.  
1.410(b)-7(d) are treated as a single plan for purposes of sections 
401(k) and 401(m).
    (B) Arrangements with inconsistent ACP testing methods. Pursuant to 
paragraph (b)(4)(ii) of this section, a single testing method must 
apply with respect to all employee contributions and matching 
contributions and all eligible employees under a plan. Thus, in 
applying the permissive aggregation rules of Sec.  1.410(b)-7(d), an 
employer may not aggregate plans (within the meaning of Sec.  1.410(b)-
7(b)) that apply inconsistent testing methods. For example, a plan 
(within the meaning of Sec.  1.410(b)-7) that applies the current year 
testing method may not be aggregated with another plan that applies the 
prior year testing method. Similarly, an employer may not aggregate a 
plan (within the meaning of Sec.  1.410(b)-7) that is using the ACP 
safe harbor provisions of section 401(m)(11) and another plan that is 
using the ACP test of section 401(m)(2).
    (iv) Disaggregation of plans and separate testing--(A) In general. 
If employee contributions or matching contributions are included in a 
plan (within the meaning of Sec.  1.410(b)-7(b)) that is mandatorily 
disaggregated under the rules of section 410(b) (as modified by this 
paragraph (b)(4)), the matching contributions and employee 
contributions under that plan must be disaggregated in a consistent 
manner. For example, in the case of an employer that is treated as 
operating qualified separate lines of business under section 414(r), if 
the eligible employees under a plan which provides for employee 
contributions or matching contributions are in more than one qualified 
separate line of business, only those employees within each qualified 
separate line of business may be taken into account in determining 
whether each disaggregated portion of the plan complies with the 
requirements of section 401(m), unless the employer is applying the 
special rule for employer-wide plans in Sec.  1.414(r)-1(c)(2)(ii) with 
respect to the plan. Similarly, if a plan that provides for employee 
contributions or matching contributions under which employees are 
permitted to participate before they have completed the minimum age and 
service requirements of section 410(a)(1) applies section 410(b)(4)(B) 
for determining whether the plan complies with section 410(b)(1), then 
the plan must be treated as two separate plans, one comprising all 
eligible employees who have met the minimum age and service 
requirements of section 410(a)(1) and one comprising all eligible 
employees who have not met the minimum age and service requirements of 
section 410(a)(1), unless the plan is using the rule in Sec.  1.401(m)-
2(a)(1)(iii)(A).
    (B) Restructuring prohibited. Restructuring under Sec.  
1.401(a)(4)-9(c) may not be used to demonstrate compliance with the 
requirements of

[[Page 42519]]

section 401(m). See Sec.  1.401(a)(4)-9(c)(3)(ii).
    (v) Certain disaggregation rules not applicable. The mandatory 
disaggregation rules relating to section 401(k) plans and section 
401(m) plans set forth in Sec.  1.410(b)-7(c)(1) and to ESOP and non-
ESOP portions of a plan set forth in Sec.  1.410(b)-7(c)(2) shall not 
apply for purposes of this section and Sec. Sec.  1.401(m)-2 through 
1.401(m)-5. Accordingly, notwithstanding Sec.  1.410(b)-7(d)(2), an 
ESOP and a non-ESOP which are different plans (within the meaning of 
Sec.  1.410(b)-7(b)) are permitted to be aggregated for these purposes.
    (c) Additional requirements--(1) Separate testing for employee 
contributions and matching contributions. Under Sec.  1.410(b)-7(c)(1), 
the group of employees who are eligible to make employee contributions 
or eligible to receive matching contributions must satisfy the 
requirements of section 410(b) as if those employees were covered under 
a separate plan. The determination of whether the separate plan 
satisfies the requirements of section 410(b) must be made without 
regard to the modifications to the disaggregation rules set forth in 
paragraph (b)(4)(v) of this section. In addition, except as expressly 
permitted under section 401(k), 410(b)(2)(A)(ii), or 416(c)(2)(A), 
employee contributions, matching contributions and elective 
contributions taken into account under Sec.  1.401(m)-2(a)(6) may not 
be taken into account for purposes of determining whether any other 
contributions under any plan (including the plan to which the employee 
contributions or matching contributions are made) satisfy the 
requirements of section 401(a). See also Sec.  1.401(a)(4)-
11(g)(3)(vii) for special rules relating to corrections of violations 
of the minimum coverage requirements or discriminatory rates of 
matching contributions.
    (2) Plan provision requirement. A plan that provides for employee 
contributions or matching contributions satisfies this section only if 
it provides that the nondiscrimination requirements of section 401(m) 
will be met. Thus, the plan must provide for satisfaction of one of the 
specific alternatives described in paragraph (b)(1) of this section 
and, if with respect to that alternative there are optional choices, 
which of the optional choices will apply. For example, a plan that uses 
the ACP test of section 401(m)(2), as described in paragraph (b)(1)(i) 
of this section, must specify whether it is using the current year 
testing method or prior year testing method. Additionally, a plan that 
uses the prior year testing method must specify whether the ACP for 
eligible NHCEs for the first plan year is 3% or the ACP for the 
eligible NHCEs for the first plan year. Similarly, a plan that uses the 
safe harbor method of section 401(m)(11), as described in paragraph 
(b)(1)(ii) of this section, must specify whether the safe harbor 
contribution will be the nonelective safe harbor contribution or the 
matching safe harbor contribution and is not permitted to provide that 
ACP testing will be used if the requirements for the safe harbor are 
not satisfied. For purposes of this paragraph (c)(2), a plan may 
incorporate by reference the provisions of section 401(m)(2) and Sec.  
1.401(m)-2 if that is the nondiscrimination test being applied.
    (d) Effective date. This section and Sec. Sec.  1.401(m)-2 through 
1.401(m)-5 apply to plan years that begin on or after the date that is 
12 months after the issuance of these regulations in final form.


Sec.  1.401(m)-2  ACP test.

    (a) Actual contribution percentage (ACP) test--(1) In general--(i) 
ACP test formula. A plan satisfies the ACP test for a plan year only 
if--
    (A) The ACP for the eligible HCEs for the plan year is not more 
than the ACP for the eligible NHCEs for the applicable year multiplied 
by 1.25; or
    (B) The excess of the ACP for the eligible HCEs for the plan year 
over the ACP for the eligible NHCEs for the applicable year is not more 
than 2 percentage points, and the ACP for the eligible HCEs for the 
plan year is not more than the ACP for the eligible NHCEs for the 
applicable year multiplied by 2.
    (ii) HCEs as sole eligible employees. If, for the applicable year 
there are no eligible NHCEs (i.e., all of the eligible employees under 
the plan for the applicable year are HCEs), the plan is deemed to 
satisfy the ACP test.
    (iii) Special rule for early participation. If a plan providing for 
employee contributions or matching contributions provides that 
employees are eligible to participate before they have completed the 
minimum age and service requirements of section 410(a)(1)(A), and if 
the plan applies section 410(b)(4)(B) in determining whether the plan 
meets the requirements of section 410(b)(1), then in determining 
whether the plan meets the requirements under paragraph (a)(1) of this 
section either--
    (A) Pursuant to section 401(m)(5)(C), the ACP test is performed 
under the plan (determined without regard to disaggregation under Sec.  
1.410(b)-7(c)(3)), using the ACP for all eligible HCEs for the plan 
year and the ACP of eligible NHCEs for the applicable year, 
disregarding all NHCEs who have not met the minimum age and service 
requirements of section 410(a)(1)(A); or
    (B) Pursuant to Sec.  1.401(m)-1(b)(4), the plan is disaggregated 
into separate plans and the ACP test is performed separately for all 
eligible employees who have completed the minimum age and service 
requirements of section 410(a)(1)(A) and for all eligible employees who 
have not completed the minimum age and service requirements of section 
410(a)(1)(A).
    (2) Determination of ACP--(i) General rule. The ACP for a group of 
eligible employees (either eligible HCEs or eligible NHCEs) for a plan 
year or applicable year is the average of the ACRs of eligible 
employees in the group for that year. The ACP for a group of eligible 
employees is calculated to the nearest hundredth of a percentage point.
    (ii) Determination of applicable year under current year and prior 
year testing method. The ACP test is applied using the prior year 
testing method or the current year testing method. Under the prior year 
testing method, the applicable year for determining the ACP for the 
eligible NHCEs is the plan year immediately preceding the plan year for 
which the ACP test is being calculated. Under the prior year testing 
method, the ACP for the eligible NHCEs is determined using the ACRs for 
the eligible employees who were NHCEs in that preceding plan year, 
regardless of whether those NHCEs are eligible employees or NHCEs in 
the plan year for which the ACP test is being performed. Under the 
current year testing method, the applicable year for determining the 
ACP for eligible NHCEs is the same plan year as the plan year for which 
the ACP test is being calculated. Under either method, the ACP for the 
eligible HCEs is the determined using the ACRs of eligible employees 
who are HCEs for the plan year for which the ACP test is being 
performed. See paragraph (c) of this section for additional rules for 
the prior year testing method.
    (3) Determination of ACR--(i) General rule. The ACR of an eligible 
employee for the plan year or applicable year is the sum of the 
employee contributions and matching contributions taken into account 
with respect to such employee (determined under the rules of paragraphs 
(a)(4) and (a)(5) of this section), and the qualified nonelective and 
elective contributions taken into account under paragraph (a)(6) of 
this section for the year, divided by the employee's compensation taken 
into account for the year. The ACR is calculated to the nearest 
hundredth of a

[[Page 42520]]

percentage point. If no employee contributions, matching contributions, 
elective contributions, or qualified nonelective contributions are 
taken into account under this section with respect to an eligible 
employee for the year, the ACR of the employee is zero.
    (ii) ACR of HCEs eligible under more than one plan--(A) General 
rule. Pursuant to section 401(m)(2)(B), the ACR of an HCE who is an 
eligible employee in more than one plan of an employer to which 
matching contributions or employee contributions are made is calculated 
by treating all contributions with respect to such HCE under any such 
plan as being made under the plan being tested. Thus, the ACR for such 
an HCE is calculated by accumulating all matching contributions and 
employee contributions under any plan (other than a plan described in 
paragraph (a)(3)(ii)(B) of this section) that would be taken into 
account under this section for the plan year, if the plan under which 
the contribution was made applied this section and had the same plan 
year. For example, in the case of a plan with a 12-month plan year, the 
ACR for the plan year of that plan for an HCE who participates in 
multiple plans of the same employer that provide for matching 
contributions or employee contributions is the sum of all such 
contributions during such 12-month period that would be taken into 
account with respect to the HCE under all plans in which the HCE is an 
eligible employee, divided by the HCE's compensation for that 12-month 
period (determined using the compensation definition for the plan being 
tested), without regard to the plan year of the other plans and whether 
those plans are satisfying this section or Sec.  1.401(m)-3.
    (B) Plans not permitted to be aggregated. Contributions under plans 
that are not permitted to be aggregated under Sec.  1.401(m)-1(b)(4) 
(determined without regard to the prohibition on aggregating plans with 
inconsistent testing methods set forth in Sec.  1.401(m)-
1(b)(4)(iii)(B) and the prohibition on aggregating plans with different 
plan years set forth in Sec.  1.410(b)-7(d)(5)) are not aggregated 
under this paragraph (a)(3)(ii).
    (iii) Example. The following example illustrates the application of 
paragraph (a)(3)(ii) of this section. See also Sec.  1.401(k)-
2(a)(3)(iii) for additional examples of the application of the parallel 
rule under section 401(k)(3)(A). The example is as follows:

    Example. Employee A, an HCE with compensation of $120,000, is 
eligible to make employee contributions under Plan S and Plan T, two 
calendar-year profit-sharing plans of Employer H. Plan S and Plan T 
use the same definition of compensation. Plan S provides a match 
equal to 50% of each employee's contributions and Plan T has no 
match. During the current plan year, Employee A elects to contribute 
$4,000 in employee contributions to Plan T and $4,000 in employee 
contributions to Plan S. There are no other contributions made on 
behalf of Employee A. Each plan must calculate Employee A's ACR by 
dividing the total employee contributions by Employee A and matching 
contributions under both plans by $120,000. Therefore, Employee A's 
ACR under each plan is 8.33% ($4,000 + $4,000 + $2,000/$120,000).

    (4) Employee contributions and matching contributions taken into 
account under the ACP test--(i) Employee contributions. An employee 
contribution is taken into account in determining the ACR for an 
eligible employee for the plan year or applicable year in which the 
contribution is made. For purposes of the preceding sentence, an amount 
withheld from an employee's pay (or a payment by the employee to an 
agent of the plan) is treated as contributed at the time of such 
withholding (or payment) if the funds paid are transmitted to the trust 
within a reasonable period after the withholding (or payment).
    (ii) Recharacterized elective contributions. Excess contributions 
recharacterized in accordance with Sec.  1.401(k)-2(b)(3) are taken 
into account as employee contributions for the plan year that includes 
the time at which the excess contribution is includible in the gross 
income of the employee under Sec.  1.401(k)-2(b)(3)(ii)(A).
    (iii) Matching contributions. A matching contribution is taken into 
account in determining the ACR for an eligible employee for a plan year 
or applicable year only if each of the following requirements is 
satisfied--
    (A) The matching contribution is allocated to the employee's 
account under the terms of the plan as of a date within that year;
    (B) The matching contribution is made on account of (or the 
matching contribution is allocated on the basis of) the employee's 
elective deferrals or employee contributions for that year; and
    (C) The matching contribution is actually paid to the trust no 
later than the end of the 12-month period immediately following the 
year that contains that date.
    (5) Matching contributions not taken into account under the ACP 
test--(i) General rule. Matching contributions that do not satisfy the 
requirements of paragraph (a)(4)(iii) of this section may not be taken 
into account in the ACP test for the plan year with respect to which 
the contributions were made, or for any other plan year. Instead, the 
amount of the matching contributions must satisfy the requirements of 
section 401(a)(4) (without regard to the ACP test) for the plan year 
for which they are allocated under the plan as if they were nonelective 
contributions and were the only nonelective contributions for that 
year. See Sec. Sec.  1.401(a)(4)-1(b)(2)(ii)(B) and 1.410(b)-7(c)(1).
    (ii) Disproportionate matching contributions--(A) Matching 
contributions in excess of 100%. A matching contribution with respect 
to any employee contribution or elective deferral for an NHCE is not 
taken into account under the ACP test to the extent the matching rate 
with respect to the employee contribution or elective deferral exceeds 
the greater of 100% and 2 times the plan's representative matching 
rate.
    (B) Representative matching rate. For purposes of this paragraph 
(a)(5)(ii), the plan's representative matching rate is the lowest 
matching rate for any eligible NHCE among a group of NHCEs that 
consists of half of all eligible NHCEs in the plan for the plan year 
who make elective deferrals or employee contributions for the plan year 
(or, if greater, the lowest matching rate for all eligible NHCEs in the 
plan who are employed by the employer on the last day of the plan year 
and who make elective deferrals or employee contributions for the plan 
year).
    (C) Definition of matching rate. For purposes of this paragraph 
(a)(5)(ii), the matching rate for an employee is the matching 
contributions made for such employee divided by the elective deferrals 
or employee contributions that are being matched.
    (iii) Qualified matching contributions used to satisfy the ADP 
test. Qualified matching contributions that are taken into account for 
the ADP test of section 401(k)(3) under Sec.  1.401(k)-2(a)(6) are not 
taken into account in determining an eligible employee's ACR.
    (iv) Matching contributions taken into account under safe harbor 
provisions. A plan that satisfies the ACP safe harbor requirements of 
section 401(m)(11) for a plan year but nonetheless must satisfy the 
requirements of this section because it provides for employee 
contributions for such plan year is permitted to apply this section 
disregarding all matching contributions with respect to all eligible 
employees. In addition, a plan that satisfies the ADP safe harbor 
requirements of Sec.  1.401(k)-3 for a plan year using qualified 
matching contributions but does not satisfy the ACP safe harbor 
requirements of section 401(m)(11) for such plan year is permitted to 
apply this section by

[[Page 42521]]

excluding matching contributions with respect to all eligible employees 
that do not exceed 4% of each employee's compensation. If a plan 
disregards matching contributions pursuant to this paragraph 
(a)(5)(iv), the disregard must apply with respect to all eligible 
employees.
    (v) Treatment of forfeited matching contributions. A matching 
contribution that is forfeited because the contribution to which it 
relates is treated as an excess contribution, excess deferral, or 
excess aggregate contribution is not taken into account for purposes of 
this section.
    (6) Qualified nonelective contributions and elective contributions 
that may be taken into account under the ACP test. Qualified 
nonelective contributions and elective contributions may be taken into 
account in determining the ACR for an eligible employee for a plan year 
or applicable year, but only to the extent the contributions satisfy 
the following requirements--
    (i) Timing of allocation. The qualified nonelective contribution is 
allocated to the employee's account as of a date within that year 
(within the meaning of Sec.  1.401(k)-2(a)(4)(i)(A)) and the elective 
contribution satisfies Sec.  1.401(k)-2(a)(4)(i). Consequently, under 
the prior year testing method, in order to be taken into account in 
calculating the ACP for the group of eligible NHCEs for the applicable 
year, a qualified nonelective contribution must be contributed no later 
than the end of the 12-month period following the applicable year even 
though the applicable year is different than the plan year being 
tested.
    (ii) Elective contributions taken into account under the ACP test. 
Elective contributions may be taken into account for the ACP test only 
if the cash or deferred arrangement under which the elective 
contributions are made is required to satisfy the ADP test in Sec.  
1.401(k)-2(a)(1) and, then only to the extent that the cash or deferred 
arrangement would satisfy that test, including such elective 
contributions in the ADP for the plan year or applicable year. Thus, 
for example, elective deferrals made pursuant to a salary reduction 
agreement under an annuity described in section 403(b) are not 
permitted to be taken into account in an ACP test. Similarly, elective 
contributions under a cash or deferred arrangement that is using the 
section 401(k) safe harbor described in Sec.  1.401(k)-3 can not be 
taken into account in an ACP test.
    (iii) Requirement that amount satisfy section 401(a)(4). The amount 
of nonelective contributions, including those qualified nonelective 
contributions taken into account under this paragraph (a)(6) and those 
qualified nonelective contributions taken into account for the ADP test 
under paragraph Sec.  1.401(k)-2(a)(6), and the amount of nonelective 
contributions, excluding those qualified nonelective contributions 
taken into account under this paragraph (a)(6) for the ACP test and 
those qualified nonelective contributions taken into account for the 
ADP test under paragraph Sec.  1.401(k)-2(a)(6), satisfies the 
requirements of section 401(a)(4). See Sec.  1.401(a)(4)-1(b)(2). In 
the case of an employer that is applying the special rule for employer-
wide plans in Sec.  1.414(r)-1(c)(2)(ii) with respect to the plan, the 
determination of whether the qualified nonelective contributions 
satisfy the requirements of this paragraph (a)(6)(iii) must be made on 
an employer-wide basis regardless of whether the plans to which the 
qualified nonelective contributions are made are satisfying the 
requirements of section 410(b) on an employer-wide basis. Conversely, 
in the case of an employer that is treated as operating qualified 
separate lines of business, and does not apply the special rule for 
employer-wide plans in Sec.  1.414(r)-1(c)(2)(ii) with respect to the 
plan, then the determination of whether the qualified nonelective 
contributions satisfy the requirements of this paragraph (a)(6)(iii) is 
not permitted to be made on an employer-wide basis regardless of 
whether the plans to which the qualified nonelective contributions are 
made are satisfying the requirements of section 410(b) on that basis.
    (iv) Aggregation must be permitted. The plan that provides for 
employee or matching contributions and the plan or plans to which the 
qualified nonelective contributions or elective contributions are made 
are plans that would be permitted to be aggregated under Sec.  
1.401(m)-1(b)(4). If the plan year of the plan that provides for 
employee or matching contributions is changed to satisfy the 
requirement under Sec.  1.410(b)-7(d)(5) that aggregated plans have the 
same plan year, qualified nonelective contributions and elective 
contributions may be taken into account in the resulting short plan 
year only if such qualified nonelective and elective contributions 
could have been taken into account under an ADP test for a plan with 
that same short plan year.
    (v) Disproportionate contributions not taken into account--(A) 
General rule. Qualified nonelective contributions cannot be taken into 
account for an applicable year for an NHCE to the extent such 
contributions exceed the product that NHCE's compensation and the 
greater of 5% and 2 times the plan's representative contribution rate. 
Any qualified nonelective contribution taken into account in an ADP 
test under Sec.  1.401(k)-2(a)(6) (including the determination of the 
representative contribution rate for purposes of Sec.  1.401(k)-
2(a)(6)(iv)(B)) is not permitted to be taken into account for purposes 
of this paragraph (a)(6) (including the determination of the 
representative contribution rate for purposes of paragraph (a)(6)(v)(B) 
of this section).
    (B) Definition of representative contribution rate. For purposes of 
this paragraph (a)(6)(v), the plan's representative contribution rate 
is the lowest applicable contribution rate of any eligible NHCE among a 
group of eligible NHCEs that consists of half of all eligible NHCEs for 
the plan year (or, if greater, the lowest applicable contribution rate 
of any eligible NHCE in the group of all eligible NHCEs for the 
applicable year and who is employed by the employer on the last day of 
the applicable year).
    (C) Definition of applicable contribution rate. For purposes of 
this paragraph (a)(6)(v), the applicable contribution rate for an 
eligible NHCE is the sum of the matching contributions taken into 
account under this section for the employee for the plan year and the 
qualified nonelective contributions made for that employee for the plan 
year, divided by that employee's compensation for the same period.
    (vi) Contribution only used once. Qualified nonelective 
contributions cannot be taken into account under this paragraph (a)(6) 
to the extent such contributions are taken into account for purposes of 
satisfying any other ACP test, any ADP test, or the requirements of 
Sec.  1.401(k)-3, 1.401(m)-3 or 1.401(k)-4. Thus, for example, 
qualified nonelective contributions that are made pursuant to Sec.  
1.401(k)-3(b) cannot be taken into account under the ACP test. 
Similarly, if a plan switches from the current year testing method to 
the prior year testing method pursuant to Sec.  1.401(m)-2(c)(1), 
qualified nonelective contributions that are taken into account under 
the current year testing method for a plan year may not be taken into 
account under the prior year testing method for the next plan year.
    (7) Examples. The following examples illustrate the application of 
this paragraph (a). See Sec.  1.401(k)-2(a)(6) for additional examples 
of the parallel rules under section 401(k)(3)(A). The examples are as 
follows:

    Example 1. (i) Employer L maintains Plan U, a profit-sharing 
plan under which $.50 matching contributions are made for each 
dollar of employee contributions. Plan U uses

[[Page 42522]]

the current year testing method. The chart below shows the average 
employee contributions (as a percentage of compensation) and 
matching contributions (as a percentage of compensation) for Plan 
U's highly compensated employees and nonhighly compensated employees 
for the 2006 plan year:

----------------------------------------------------------------------------------------------------------------
                                                                                                     Actual
                                                              Employee           Matching        contributions
                                                           contributions      contributions        percentage
----------------------------------------------------------------------------------------------------------------
Highly compensated employees...........................                 4%                 2%                 6%
Nonhighly compensated employees........................                 3%               1.5%               4.5%
----------------------------------------------------------------------------------------------------------------

    (ii) The matching rate for all NHCEs is 50% and thus the 
matching contributions are not disproportionate under paragraph 
(a)(5)(ii) of this section. Accordingly, they are taken into account 
in determining the ACR of eligible employees, as shown in the 
following table.
    (iii) Because the ACP for the HCEs (6.0%) exceeds 5.63% (4.5% x 
1.25), Plan U does not satisfy the ACP test under paragraph 
(a)(1)(i)(A) of this section. However, because the ACP for the HCEs 
does not exceed the ACP for the NHCEs by more than 2 percentage 
points and the ACP for the HCEs does not exceed the ACP for the 
NHCEs multiplied by 2 (4.5% x 2 = 9%), the plan satisfies the ACP 
test under paragraph (a)(1)(i)(B) of this section.
    Example 2. (i) Employees A through F are eligible employees in 
Plan V, a profit-sharing plan of Employer M that includes a cash or 
deferred arrangement and permits employee contributions. Under Plan 
V, a $.50 matching contribution is made for each dollar of elective 
contributions and employee contributions. Plan V uses the current 
year testing method and does not provide for elective contributions 
to be taken into account in determining an eligible employee's ACR. 
For the 2006 plan year, Employees A and B are HCEs and the remaining 
employees are NHCEs. The compensation, elective contributions, 
employee contributions, and matching contributions for the 2006 plan 
year are shown in the following table:

----------------------------------------------------------------------------------------------------------------
                                                              Elective           Employee           Matching
              Employee                   Compensation      contributions      contributions      contributions
----------------------------------------------------------------------------------------------------------------
A...................................           $190,000            $15,000             $3,500             $9,250
B...................................            100,000              5,000             10,000              7,500
C...................................             85,000             12,000                  0              6,000
D...................................             70,000              9,500                  0              4,750
E...................................             40,000             10,000                  0              5,000
F...................................             10,000                  0                  0                  0
----------------------------------------------------------------------------------------------------------------

    (ii) The matching rate for all NHCEs is 50% and thus the 
matching contributions are not disproportionate under paragraph 
(a)(5)(ii) of this section. Accordingly, they are taken into account 
in determining the ACR of eligible employees, as shown in the 
following table:

----------------------------------------------------------------------------------------------------------------
                                                              Elective           Matching
              Employee                   Compensation      contributions      contributions           ACR
----------------------------------------------------------------------------------------------------------------
A...................................           $190,000             $3,500             $9,250              6.71%
B...................................            100,000             10,000              7,500             17.50%
C...................................             85,000                  0              6,000              7.06%
D...................................             70,000                  0              4,750              6.79%
E...................................             40,000                  0              5,000             12.50%
F...................................             10,000                  0                  0                  0
----------------------------------------------------------------------------------------------------------------

    (iii) The ACP for the HCEs is 12.11% ((6.71% + 17.50%)/2). The 
ACP for the NHCEs is 6.59% ((7.06% + 6.79% + 12.50% + 0.%)/4). Plan 
V fails to satisfy the ACP test under paragraph (a)(1)(i)(A) of this 
section because the ACP of highly compensated employees is more than 
125% of the ACP of the nonhighly compensated employees (6.59% x 1.25 
= 8.24%). In addition, Plan V fails to satisfy the ACP test under 
paragraph (a)(1)(i)(B) of this section because the ACP for the HCEs 
exceeds the ACP of the other employees by more than 2 percentage 
points (6.59% + 2% = 8.59%). Therefore, the plan fails to satisfy 
the requirements of section 401(m)(2) and paragraph (a)(1) of this 
section unless the ACP failure is corrected under paragraph (b) of 
this section.
    Example 3. (i) The facts are the same as Example 2, except that 
the plan provides that the nonhighly compensated employees' elective 
contributions may be used to meet the requirements of section 401(m) 
to the extent needed under that section.
    (ii) Pursuant to paragraph (a)(6)(ii) of this section, the 
$10,000 of elective contributions for Employee E may be taken into 
account in determining the ACP rather than the ADP to the extent 
that the plan satisfies the requirements of Sec.  1.401(k)-2(a)(1) 
excluding from the ADP this $10,000. In this case, if the $10,000 
were excluded from the ADP for the NHCEs, the ADP for the highly 
compensated employees is 6.45% (7.89% + 5.00%)/2and the ADP for the 
nonhighly compensated employees would be 6.92% (14.12% + 13.57% + 0% 
+0%)/4) and the plan would satisfy the requirements of Sec.  
1.401(k)-2(a)(1) excluding from the ADP the elective contributions 
for NHCEs that are taken into account under section 401(m).
    (iii) After taking into account the $10,000 of elective 
contributions for Employee E in the ACP test, the ACP for the 
nonhighly compensated employees is 12.84% (7.06% + 6.79% + 37.50% + 
0%)/4. Therefore the plan satisfies the ACP test because the ACP for 
the HCEs (12.11%) is less than 1.25 times the ACP for the nonhighly 
compensated employees.
    Example 4. (i) The facts are the same as Example 2, except that 
Plan V provides for a higher than 50% match rate on the elective 
contributions and employee contributions for all NHCEs. The match 
rate is defined as the rate, rounded up to the next whole percent, 
necessary to allow the plan to satisfy the ACP test, but not in 
excess of 100%. In this case, an increase in the match rate from 50% 
to 74% will be sufficient to allow the plan to satisfy the ACP test. 
Thus, for the 2006 plan year, the compensation, elective 
contributions, employee contributions, matching contributions at a 
74% match rate of the eligible NHCEs (employees C through F) are 
shown in the following table:

[[Page 42523]]



----------------------------------------------------------------------------------------------------------------
                                                              Elective           Employee           Matching
              Employee                   Compensation      contributions      contributions      contributions
----------------------------------------------------------------------------------------------------------------
C...................................            $85,000            $12,000                 $0             $8,880
D...................................             70,000              9,500                  0              7,030
E...................................             40,000             10,000                  0              7,400
F...................................             10,000                  0                  0                  0
----------------------------------------------------------------------------------------------------------------

    (ii) The matching rate for all NHCEs is 74% and thus the 
matching contributions are not disproportionate under paragraph 
(a)(5)(ii) of this section. Therefore, the matching contributions 
may be taken into account in determining the ACP for the NHCEs.

    (iii) The ACP for the NHCEs is 9.75% (10.45% + 10.04% + 18.50% + 
0%)/4. Because the ACP for the HCEs (12.11%) is less than 1.25 times 
the ACP for the NHCEs, the plan satisfies the requirements of 
section 401(m).
    Example 5. (i) The facts are the same as Example 4, except that: 
Employee E's elective contributions are $2,000 (rather than $10,000) 
and pursuant to paragraph (a)(6)(ii) of this section, the $2,000 of 
elective contributions for Employee E are taken into account in 
determining the ACP rather than the ADP. In addition, Plan V 
provides that the higher match rate is not limited to 100% and 
applies only for a specified group of nonhighly compensated 
employees. The only member of that group is Employee E. Under the 
plan provision, the higher match rate is a 400% match. Thus, for the 
2006 plan year, the compensation, elective contributions, employee 
contributions, matching contributions of the eligible NHCEs 
(employees C through F) are shown in the following table:

----------------------------------------------------------------------------------------------------------------
                                                              Elective           Employee           Matching
              Employee                   Compensation      contributions      contributions      contributions
----------------------------------------------------------------------------------------------------------------
C...................................            $85,000            $12,000                 $0             $6,000
D...................................             70,000              9,500                  0              4,750
E...................................             40,000              2,000                  0              8,000
F...................................             10,000                  0                  0                  0
----------------------------------------------------------------------------------------------------------------

    (ii) If the entire matching contribution made on behalf of 
Employee E were taken into account under the ACP test, Plan V would 
satisfy the test, because the ACP for the NHCEs would be 9.71% 
(7.06% + 6.79% + 25.00% + 0%)/4. Because the ACP for the HCEs 
(12.11%) is less than 1.25 times what the ACP for the NHCEs would 
be, the plan would satisfy the requirements of section 401(m).
    (iii) Pursuant to paragraph (a)(5)(ii) of this section, however, 
matching contributions for an eligible NHCE that are based on a 
matching rate in excess of the greater of 100% and twice the plan's 
representative matching rate cannot be taken into account in 
applying the ACP test. The plan's representative matching rate is 
the lowest matching rate for any eligible employee in a group of 
NHCEs that is at least half of all eligible employees who are NHCEs 
in the plan for the plan year who make elective contributions or 
employee contributions for the plan year. For Plan V, the group of 
NHCEs who make such contributions consists of Employees C, D and E. 
The matching rates for these three employees are 50%, 50% and 400% 
respectively. The lowest matching rate for a group of NHCEs that is 
at least \1/2\ of all the NHCEs who make elective contributions or 
employee contributions (or 2 NHCEs) is 50%. Because 400% is more 
than twice the plan's representative matching rate, only the 
matching contributions made on behalf of Employee E that do not 
exceed 100% (or in this case $2,000) satisfy the requirements of 
paragraph (a)(5)(ii) of this section and may be taken into account 
under the ACP test. Accordingly, the ACP for the NHCEs is 5.96% 
(7.06% + 6.79% + 10% + 0%)/4 and the plan fails to satisfy the 
requirements of section 401(m)(2) and paragraph (a)(1) of this 
section unless the ACP failure is corrected under paragraph (b) of 
this section.
    Example 6. (i) The facts are the same as Example 2, except that 
Plan V provides a QNEC equal to 13% of pay for Employee F that will 
be taken into account under the ACP test to the extent the 
contributions satisfy the requirements of paragraph (a)(6) of this 
section.
    (ii) Pursuant to paragraph (a)(6)(v) of this section, a QNEC 
cannot be taken into account in determining an NHCE's ACR to the 
extent it exceeds the greater of 5% and the product of the 
employee's compensation and the plan's representative contribution 
rate. The plan's representative contribution rate is two times the 
lowest applicable contribution rate for any eligible employee in a 
group of NHCEs that is at least half of all eligible employees who 
are NHCEs in the plan for the plan year. For Plan V, the applicable 
contribution rates for Employees C, D, E and F are 7.06%, 6.79%, 
12.5% and 13% respectively. The lowest applicable rate for a group 
of NHCEs that is at least \1/2\ of all the NHCEs is 12.50% (the 
lowest applicable rate for the group of NHCEs that consists of 
Employees E and F).
    (iii) Under paragraph (a)(6)(v)(B) of this section, the plan's 
representative contribution rate is 2 times 12.50% or 25.00%. 
Accordingly, the QNECs for Employee F can be taken into account 
under the ACP test only to the extent they do not exceed 25.00% of 
compensation. In this case, all of the QNECs for Employee F may be 
taken into account under the ACP test.
    (iv) After taking into account the QNECs for Employee F, the ACP 
for the NHCEs is 9.84% (7.06% + 6.79% + 12.50% + 13%)/4. Because the 
ACP for the HCEs (12.11%) is less than 1.25 times the ACP for the 
NHCEs, the plan satisfies the requirements of section 401(m)(2) and 
paragraph (a)(1) of this section.

    (b) Correction of excess aggregate contributions--(1) Permissible 
correction methods--(i) In general. A plan that provides for employee 
contributions or matching contributions does not fail to satisfy the 
requirements of section 401(m)(2) and paragraph (a)(1) of this section 
if the employer, in accordance with the terms of the plan, uses either 
of the following correction methods--
    (A) Additional contributions. The employer makes additional 
contributions that are taken into account for the ACP test under this 
section that, in combination with the other contributions taken into 
account under this section, allow the plan to satisfy the requirements 
of paragraph (a)(1) of this section.
    (B) Excess aggregate contributions distributed or forfeited. Excess 
aggregate contributions are distributed or forfeited in accordance with 
paragraph (b)(2) of this section.
    (ii) Combination of correction methods. A plan may provide for the 
use of either of the correction methods described in paragraph 
(b)(1)(i) of this section, may limit employee contributions or matching 
contributions in a manner that prevents excess aggregate contributions 
from being made, or may use a combination of these methods, to avoid or 
correct excess aggregate contributions. If a plan uses a combination of 
correction methods, any contributions made under paragraph (b)(1)(i)(A) 
of this section must be taken into account before application of the 
correction method in paragraph (b)(1)(i)(B) of this section.

[[Page 42524]]

    (iii) Exclusive means of correction. A failure to satisfy the 
requirements of paragraph (a)(1) of this section may not be corrected 
using any method other than one described in paragraph (b)(1)(i) or 
(ii) of this section. Thus, excess aggregate contributions for a plan 
year may not be corrected by forfeiting vested matching contributions, 
distributing nonvested matching contributions, recharacterizing 
matching contributions, or not making matching contributions required 
under the terms of the plan. Similarly, excess aggregate contributions 
for a plan year may not remain unallocated or be allocated to a 
suspense account for allocation to one or more employees in any future 
year. In addition, excess aggregate contributions may not be corrected 
using the retroactive correction rules of Sec.  1.401(a)(4)-11(g). See 
Sec.  1.401(a)(4)-11(g)(3)(vii) and (5).
    (2) Correction through distribution--(i) General rule. This 
paragraph (b)(2) contains the rules for correction of excess aggregate 
contributions through a distribution from the plan. Correction through 
a distribution generally involves a four step process. First, the plan 
must determine, in accordance with paragraph (b)(2)(ii) of this 
section, the total amount of excess aggregate contributions that must 
be distributed under the plan. Second, the plan must apportion the 
total amount of excess aggregate contributions among the HCEs in 
accordance with paragraph (b)(2)(iii) of this section. Third, the plan 
must determine the income allocable to excess aggregate contributions 
in accordance with paragraph (b)(2)(iv) of this section. Finally, the 
plan must distribute the apportioned contributions, together with 
allocable income (or forfeit the apportioned matching contributions, if 
forfeitable) in accordance with paragraph (b)(2)(v) of this section. 
Paragraph (b)(2)(vi) of this section provides rules relating to the tax 
treatment of these distributions.
    (ii) Calculation of total amount to be distributed. The following 
procedures must be used to determine the total amount of the excess 
aggregate contributions to be distributed--
    (A) Calculate the dollar amount of excess aggregate contributions 
for each HCE. The amount of excess aggregate contributions attributable 
to an HCE for a plan year is the amount (if any) by which the HCE's 
contributions taken into account under this section must be reduced for 
the HCE's ACR to equal the highest permitted ACR under the plan. To 
calculate the highest permitted ACR under a plan, the ACR of the HCE 
with the highest ACR is reduced by the amount required to cause that 
HCE's ACR to equal the ACR of the HCE with the next highest ACR. If a 
lesser reduction would enable the plan to satisfy the requirements of 
paragraph (b)(2)(ii)(C) of this section, only this lesser reduction 
applies.
    (B) Determination of the total amount of excess aggregate 
contributions. The process described in paragraph (b)(2)(ii)(A) of this 
section must be repeated until the plan would satisfy the requirements 
of paragraph (b)(2)(ii)(C) of this section. The sum of all reductions 
for all HCEs determined under paragraph (b)(2)(ii)(A) of this section 
is the total amount of excess aggregate contributions for the plan 
year.
    (C) Satisfaction of ACP. A plan satisfies this paragraph 
(b)(2)(ii)(C) if the plan would satisfy the requirements of paragraph 
(a)(1)(i) of this section if the ACR for each HCE were determined after 
the reductions described in paragraph (b)(2)(ii)(A) of this section.
    (iii) Apportionment of total amount of excess aggregate 
contributions among the HCEs. The following procedures must be used in 
apportioning the total amount of excess aggregate contributions 
determined under paragraph (b)(2)(ii) of this section among the HCEs--
    (A) Calculate the dollar amount of excess aggregate contributions 
for each HCE. The contributions with respect to the HCE with the 
highest dollar amount of contributions taken into account under this 
section are reduced by the amount required to cause that HCE's 
contributions to equal the dollar amount of contributions taken into 
account under this section for the HCE with the next highest dollar 
amount of such contributions. If a lesser apportionment to the HCE 
would enable the plan to apportion the total amount of excess aggregate 
contributions, only the lesser apportionment would apply.
    (B) Limit on amount apportioned to any HCE. For purposes of this 
paragraph (b)(2)(iii), the contributions for an HCE who is an eligible 
employee in more than one plan of an employer to which matching 
contributions and employee contributions are made is determined by 
adding together all contributions otherwise taken into account in 
determining the ACR of the HCE under the rules of paragraph (a)(3)(ii) 
of this section. However, the amount of contributions apportioned with 
respect to an HCE must not exceed the amount of contributions taken 
into account under this section that were actually made on behalf of 
the HCE to the plan for the plan year. Thus, in the case of an HCE who 
is an eligible employee in more than one plan of the same employer to 
which employee contributions or matching contributions are made and 
whose ACR is calculated in accordance with paragraph (a)(3)(ii) of this 
section, the amount distributed under this paragraph (b)(2)(iii) will 
not exceed such contributions actually contributed to the plan for the 
plan year that are taken into account under this section for the plan 
year.
    (C) Apportionment to additional HCEs. The procedure in paragraph 
(b)(2)(iii)(A) of this section must be repeated until the total amount 
of excess aggregate contributions have been apportioned.
    (iv) Income allocable to excess aggregate contributions--(A) 
General rule. The income allocable to excess aggregate contributions is 
equal to the sum of the allocable gain or loss for the plan year and, 
to the extent the excess aggregate contributions are or will be 
credited with allocable gain or loss for the period after the close of 
the plan year (the gap period), the allocable gain or loss for the gap 
period.
    (B) Method of allocating income. A plan may use any reasonable 
method for computing the income allocable to excess aggregate 
contributions, provided that the method does not violate section 
401(a)(4), is used consistently for all participants and for all 
corrective distributions under the plan for the plan year, and is used 
by the plan for allocating income to participants' accounts. See Sec.  
1.401(a)(4)-1(c)(8).
    (C) Alternative method of allocating income for the plan year. A 
plan may allocate income to excess aggregate contributions for the plan 
year by multiplying the income for the plan year allocable to employee 
contributions, matching contributions and other amounts taken into 
account under this section (including the contributions for the year), 
by a fraction, the numerator of which is the excess aggregate 
contributions for the employee for the plan year, and the denominator 
of which is the account balance attributable to employee contributions 
and matching contributions and other amounts taken into account under 
this section as of the beginning of the plan year (including any 
additional such contributions for the plan year).
    (D) Safe harbor method of allocating gap period income. A plan may 
use the safe harbor method in this paragraph (b)(2)(iv)(D) to determine 
income on excess aggregate contributions for the gap period. Under this 
safe harbor method, income on excess aggregate contributions for the 
gap period is equal to 10% of the income allocable to excess aggregate 
contributions for the plan year that would be determined under 
paragraph (b)(2)(iv)(C) of this section,

[[Page 42525]]

multiplied by the number of calendar months that have elapsed since the 
end of the plan year. For purposes of calculating the number of 
calendar months that have elapsed under the safe harbor method, a 
corrective distribution that is made on or before the fifteenth day of 
a month is treated as made on the last day of the preceding month and a 
distribution made after the fifteenth day of a month is treated as made 
on the last day of the month.
    (E) Alternative method of allocating plan year and gap period 
income. A plan may determine the allocable gain or loss for the 
aggregate of the plan year and the gap period by applying the 
alternative method provided by paragraph (b)(2)(iv)(C) of this section 
to that aggregate period. This is accomplished by substituting the 
income for the plan year and the gap period for the income for the plan 
year and by substituting the contributions taken into account under 
this section for the plan year and the gap period for the contributions 
taken into account for the plan year in determining the fraction that 
is multiplied by that income.
    (F) Allocable income for recharacterized elective contributions. If 
recharacterized elective contributions are distributed as excess 
aggregate contributions, the income allocable to the excess aggregate 
contributions is determined as if recharacterized elective 
contributions had been distributed as excess contributions. Thus, 
income must be allocated to the recharacterized amounts distributed 
using the methods in Sec.  1.401(k)-2(b)(2)(iv).
    (v) Distribution and forfeiture. Within 12 months after the close 
of the plan year in which the excess aggregate contribution arose, the 
plan must distribute to each HCE the contributions apportioned to such 
HCE under paragraph (b)(2)(iii) of this section (and the allocable 
income) to the extent they are vested or forfeit such amounts, if 
forfeitable. Except as otherwise provided in this paragraph (b)(2)(v), 
a distribution of excess aggregate contributions must be in addition to 
any other distributions made during the year and must be designated as 
a corrective distribution by the employer. In the event of a complete 
termination of the plan during the plan year in which an excess 
aggregate contribution arose, the corrective distribution must be made 
as soon as administratively feasible after the date of termination of 
the plan, but in no event later than 12 months after the date of 
termination. If the entire account balance of an HCE is distributed 
prior to when the plan makes a distribution of excess aggregate 
contributions in accordance with this paragraph (b)(2), the 
distribution is deemed to have been a corrective distribution of excess 
aggregate contributions (and income) to the extent that a corrective 
distribution would otherwise have been required.
    (vi) Tax treatment of corrective distributions--(A) General rule. 
Except as otherwise provided in paragraph (b)(2)(vi)(B) of this 
section, a corrective distribution of excess aggregate contributions 
(and income) that is made within 2\1/2\ months after the end of the 
plan year for which the excess aggregate contributions were made is 
includible in the employee's gross income for the taxable year of the 
employee ending with or within the plan year for which the excess 
aggregate contributions were made. A corrective distribution of excess 
aggregate contributions (and income) that is made more than 2\1/2\ 
months after the plan year for which the excess aggregate contributions 
were made is includible in the employee's gross income in the taxable 
year of the employee in which distributed. The portion of the 
distribution that is treated as an investment in the contract under 
section 72 is determined without regard to any plan contributions other 
than those distributed as excess aggregate contributions. Regardless of 
when the corrective distribution is made, it is not subject to the 
early distribution tax of section 72(t). See paragraph (b)(4) of this 
section for additional rules relating to the employer excise tax on 
amounts distributed more than 2\1/2\ months after the end of the plan 
year. See also Sec.  1.402(c)-2, A-4 prohibiting rollover of 
distributions that are excess aggregate contributions.
    (B) Rule for de minimis distributions. If the total amount of 
excess aggregate contributions determined under this paragraph (b)(2), 
and excess contributions determined under Sec.  1.401(k)-2(b)(2) 
distributed to a recipient under a plan for any plan year is less than 
$100 (excluding income), a corrective distribution of excess aggregate 
contributions (and income) is includible in gross income in the 
recipient's taxable year in which the corrective distribution is made.
    (3) Other rules--(i) No employee or spousal consent required. A 
distribution of excess aggregate contributions (and income) may be made 
under the terms of the plan without regard to any notice or consent 
otherwise required under sections 411(a)(11) and 417.
    (ii) Treatment of corrective distributions and forfeited 
contributions as employer contributions. Excess aggregate contributions 
(other than amounts attributable to employee contributions), including 
forfeited matching contributions, are treated as employer contributions 
for purposes of sections 404 and 415 even if distributed from the plan. 
Forfeited matching contributions that are reallocated to the accounts 
of other participants for the plan year in which the forfeiture occurs 
are treated under section 415 as annual additions for the participants 
to whose accounts they are reallocated and for the participants from 
whose accounts they are forfeited.
    (iii) No reduction of required minimum distribution. A distribution 
of excess aggregate contributions (and income) is not treated as a 
distribution for purposes of determining whether the plan satisfies the 
minimum distribution requirements of section 401(a)(9). See Sec.  
1.401(a)(9)-5, A-9(b).
    (iv) Partial correction. Any distribution of less than the entire 
amount of excess aggregate contributions (and allocable income) is 
treated as a pro rata distribution of excess aggregate contributions 
and allocable income.
    (v) Matching contributions on excess contributions, excess 
deferrals and excess aggregate contributions--(A) Corrective 
distributions not permitted. A matching contribution may not be 
distributed merely because the contribution to which it relates is 
treated as an excess contribution, excess deferral, or excess aggregate 
contribution.
    (B) Coordination with section 401(a)(4). A matching contribution is 
taken into account under section 401(a)(4) even if the match is 
distributed, unless the distributed contribution is an excess aggregate 
contribution. This requires that, after correction of excess aggregate 
contributions, each level of matching contributions be currently and 
effectively available to a group of employees that satisfies section 
410(b). See Sec.  1.401(a)(4)-4(e)(3)(iii)(G). Thus, a plan that 
provides the same rate of matching contributions to all employees will 
not meet the requirements of section 401(a)(4) if employee 
contributions are distributed under this paragraph (b) to HCEs to the 
extent needed to meet the requirements of section 401(m)(2), while 
matching contributions attributable to employee contributions remain 
allocated to the HCEs' accounts. This is because the level of matching 
contributions will be higher for a group of employees that consists 
entirely of HCEs. Under section 411(a)(3)(G) and Sec.  1.411(a)-
4(b)(7), a plan may forfeit matching contributions attributable to 
excess contributions, excess aggregate contributions and excess 
deferrals to avoid a violation of

[[Page 42526]]

section 401(a)(4). See also Sec.  1.401(a)(4)-11(g)(3)(vii)(B) 
regarding the use of additional allocations to the accounts of NHCEs 
for the purpose of correcting a discriminatory rate of matching 
contributions. A plan is permitted to provide for which contributions 
are to be distributed to satisfy the ACP test so as to avoid 
discriminatory matching rates that would otherwise violate section 
401(a)(4). For example, the plan may provide that unmatched employee 
contributions will be distributed before matched employee 
contributions.
    (vi) No requirement for recalculation. If the distributions and 
forfeitures described in paragraph (b)(2) of this section are made, the 
employee contributions and matching contributions are treated as 
meeting the nondiscrimination test of section 401(m)(2) regardless of 
whether the ACP for the HCEs, if recalculated after the distributions 
and forfeitures, would satisfy section 401(m)(2).
    (4) Failure to timely correct--(i) Failure to correct within 2\1/2\ 
months after end of plan year. If a plan does not correct excess 
aggregate contributions within 2\1/2\ months after the close of the 
plan year for which the excess aggregate contributions are made, the 
employer will be liable for a 10% excise tax on the amount of the 
excess aggregate contributions. See section 4979 and Sec.  54.4979-1 of 
this chapter. Qualified nonelective contributions properly taken into 
account under paragraph (a)(6) of this section for a plan year may 
enable a plan to avoid having excess aggregate contributions, even if 
the contributions are made after the close of the 2\1/2\ month period.
    (ii) Failure to correct within 12 months after end of plan year. If 
excess aggregate contributions are not corrected within 12 months after 
the close of the plan year for which they were made, the plan will fail 
to meet the requirements of section 401(a)(4) for the plan year for 
which the excess aggregate contributions were made and all subsequent 
plan years in which the excess aggregate contributions remain in the 
trust.
    (5) Examples. The following examples illustrate the application of 
this paragraph. See also Sec.  1.401(k)-2(b) for additional examples of 
the parallel correction rules applicable to cash or deferred 
arrangements. For purposes of these examples, none of the plans provide 
for catch-up contributions under section 414(v). The examples are as 
follows:

    Example 1. (i) Employer L maintains a plan that provides for 
employee contributions and fully vested matching contributions. The 
plan provides that failures of the ACP test are corrected by 
distribution. In 2006, the ACP for the eligible NHCEs is 6%. Thus, 
the ACP for the eligible HCEs may not exceed 8%. The three HCEs who 
participate have the following compensation, contributions, and 
ACRs:

----------------------------------------------------------------------------------------------------------------
                                                                                 Employee            Actual
                                                                            contributions and     contribution
                        Employee                            Compensation         matching          ratio (in
                                                                              contributions         percent)
----------------------------------------------------------------------------------------------------------------
A......................................................            200,000             14,000                  7
B......................................................            150,000             13,500                  9
C......................................................            100,000             12,000                 12
Average................................................  .................  .................               9.33
----------------------------------------------------------------------------------------------------------------

    (ii) The total amount of excess aggregate contributions for the 
HCEs is determined under paragraph (b)(2)(ii) of this section as 
follows: the matching and employee contributions of Employee C (the 
HCE with the highest ACR) is reduced by 3% of compensation (or 
$3,000) in order to reduce the ACR of that HCE to 9%, which is the 
ACR of Employee B.
    (iii) Because the ACP of the HCEs determined after the $3,000 
reduction still exceeds 8%, further reductions in matching 
contributions and employee contributions are necessary in order to 
reduce the ACP of the HCEs to 8%. The employee contributions and 
matching contributions for Employees B and C are reduced by an 
additional .5% of compensation or $1,250 ($750 and $500 
respectively). Because the ACP of the HCEs determined after the 
reductions now equals 8%, the plan would satisfy the requirements of 
(a)(1)(ii) of this section.
    (iv) The total amount of excess aggregate contributions ($4,250) 
is apportioned among the HCEs under paragraph (b)(2)(iii) of this 
section first to the HCE with the highest amount of matching 
contributions and employee contributions. Therefore, Employee A is 
apportioned $500 (the amount required to cause A's matching 
contributions and employee contributions to equal the next highest 
dollar amount of matching contributions and employee contributions).
    (v) Because the total amount of excess aggregate contributions 
has not been apportioned, further apportionment is necessary. The 
balance ($3,750) of the total amount of excess aggregate 
contributions is apportioned equally among Employees A and B ($1,500 
to each, the amount required to cause their contributions to equal 
the next highest dollar amount of matching contributions and 
employee contributions).
    (vi) Because the total amount of excess aggregate contributions 
has not been apportioned, further apportionment is necessary. The 
balance ($750) of the total amount of excess aggregate contributions 
is apportioned equally among Employees A, B and C ($250 to each, the 
amount required to allocate the total amount of excess aggregate 
contributions for the plan).
    (vii) Therefore, the plan will satisfy the requirements of 
paragraph (a)(1) of this section if, by the end of the 12 month 
period following the end of the 2006 plan year, Employee A receives 
a corrective distribution of excess aggregate contributions equal to 
$2,250 ($500 + $1,500 + $250) and allocable income, Employee B 
receives a corrective distribution of $250 and allocable income and 
Employee C receives a corrective distribution of $1,750 ($1,500 + 
$250) and allocable income.
    Example 2. (i) Employee D is the sole HCE who is eligible to 
participate in a cash or deferred arrangement maintained by Employer 
M. The plan that includes the arrangement, Plan X, permits employee 
contributions and provides a fully vested matching contribution 
equal to 50% of elective contributions. Plan X is a calendar year 
plan. Plan X corrects excess contributions by recharacterization and 
provides that failures of the ACP test are corrected by 
distribution. For the 2006 plan year, D's compensation is $200,000, 
and D's elective contributions are $15,000. The actual deferral 
percentages and actual contribution percentages for Employee D and 
the other eligible employees under Plan X are shown in the following 
table:

------------------------------------------------------------------------
                                                             Actual
                                     Actual deferral      contribution
                                        percentage         percentage
------------------------------------------------------------------------
Employee D........................                7.5               3.75
NHCEs.............................                4                 2
------------------------------------------------------------------------


[[Page 42527]]

    (ii) In February 2007, Employer M determines that D's actual 
deferral ratio must be reduced to 6%, or $12,000, which requires a 
recharacterization of $3,000 as an employee contribution. This 
increases D's actual contribution ratio to 5.25% ($7,500 in matching 
contributions plus $3,000 recharacterized as employee contributions, 
divided by $200,000 in compensation). Since D's actual contribution 
ratio must be limited to 4% for Plan X to satisfy the actual 
contribution percentage test, Plan X must distribute 1.25% or $2,500 
of D's employee contributions and matching contributions together 
with allocable income. If $2,500 in matching contributions and 
allocable income is distributed, this will correct the excess 
aggregate contributions and will not result in a discriminatory rate 
of matching contributions. See Example 8.
    Example 3. (i) The facts are the same as in Example 2, except 
that Employee D also had elective contributions under Plan Y, 
maintained by an employer unrelated to M. In January 2007, D 
requests and receives a distribution of $1,200 in excess deferrals 
from Plan X. Pursuant to the terms of Plan X, D forfeits the $600 
match on the excess deferrals to correct a discriminatory rate of 
match.
    (ii) The $3,000 that would otherwise have been recharacterized 
for Plan X to satisfy the actual deferral percentage test is reduced 
by the $1,200 already distributed as an excess deferral, leaving 
$1,800 to be recharacterized. See Sec.  1.401(k)-2(b)(4)(i)(A). D's 
actual contribution ratio is now 4.35% ($7,500 in matching 
contributions plus $1,800 in recharacterized contributions less $600 
forfeited matching contributions attributable to the excess 
deferrals, divided by $200,000 in compensation).
    (iii) The matching and employee contributions for Employee D 
must be reduced by .35% of compensation in order to reduce the ACP 
of the HCEs to 4%. The plan must provide for forfeiture of 
additional matching contributions to prevent a discriminatory rate 
of matching contributions. See Example 8.
    Example 4. (i) The facts are the same as in Example 3, except 
that D does not request a distribution of excess deferrals until 
March 2007. Employer X has already recharacterized $3,000 as 
employee contributions.
    (ii) Under Sec.  1.402(g)-1(e)(6), the amount of excess 
deferrals is reduced by the amount of excess contributions that are 
recharacterized. Because the amount recharacterized is greater than 
the excess deferrals, Plan X is neither required nor permitted to 
make a distribution of excess deferrals, and the recharacterization 
has corrected the excess deferrals.
    Example 5. (i) For the 2006 plan year, Employee F defers $10,000 
under Plan M and $6,000 under Plan N. Plans M and N, which have 
calendar plan years, are maintained by unrelated employers. Plan M 
provides a fully vested, 100% matching contribution, does not take 
elective contributions into account under section 401(m) or take 
matching contributions into account under section 401(k) and 
provides that excess contributions and excess aggregate 
contributions are corrected by distribution. Under Plan M, Employee 
F is allocated excess contributions of $600 and excess aggregate 
contributions of $1,600. Employee F timely requests and receives a 
distribution of the $1,000 excess deferral from Plan M and, pursuant 
to the terms of Plan M, forfeits the corresponding $1,000 matching 
contribution.
    (ii) No distribution is required or permitted to correct the 
excess contributions because $1,000 has been distributed by Plan M 
as excess deferrals. The distribution required to correct the excess 
aggregate contributions (after forfeiting the matching contribution) 
is $600 ($1,600 in excess aggregate contributions minus $1,000 in 
forfeited matching contributions). If Employee F had corrected the 
excess deferrals of $1,000 by withdrawing $1,000 from Plan N, Plan M 
would have had to correct the $600 excess contributions in Plan M by 
distributing $600. Since Employee F then would have forfeited $600 
(instead of $1,000) in matching contributions, Employee F would have 
had $1,000 ($1,600 in excess aggregate contributions minus $600 in 
forfeited matching contributions) remaining of excess aggregate 
contributions in Plan M. These would have been corrected by 
distributing an additional $1,000 from Plan M.
    Example 6. (i) Employee G is the sole highly compensated 
employee in a profit sharing plan under which the employer matches 
100% of employee contributions up to 2% of compensation, and 50% of 
employee contributions up to the next 4% of compensation. For the 
2008 plan year, Employee G has compensation of $100,000 and makes a 
7% employee contribution of $7,000. Employee G receives a 4% 
matching contribution or $4,000. Thus, Employee G's actual 
contribution ratio (ACR) is 11%. The actual contribution percentage 
for the nonhighly compensated employees is 5%, and the employer 
determines that Employee G's ACR must be reduced to 7% to comply 
with the rules of section 401(m).
    (ii) In this case, the plan satisfies the requirements of 
section if it distributes the unmatched employee contributions of 
$1,000, and $2,000 of matched employee contributions with their 
related matches of $1,000. This would leave Employee G with 4% 
employee contributions, and 3% matching contributions, for an ACR of 
7%. Alternatively, the plan could distribute all matching 
contributions and satisfy this section. However, the plan could not 
distribute $4,000 of Employee G's employee contributions without 
forfeiting the related matching contributions because this would 
result in a discriminatory rate of matching contributions. See also 
Example 7.
    Example 7. (i) Employee H is an HCE in Employer X's profit 
sharing plan, which matches 100% of employee contributions up to 5% 
of compensation. The matching contribution is vested at the rate of 
20% per year. In 2006, Employee H makes $5,000 in employee 
contributions and receives $5,000 of matching contributions. 
Employee H is 60% vested in the matching contributions at the end of 
the 2006 plan year. In February 2007, Employer X determines that 
Employee H has excess aggregate contributions of $1,000. The plan 
provides that only matching contributions will be distributed as 
excess aggregate contributions.
    (ii) Employer X has two options available in distributing 
Employee H's excess contributions. The first option is to distribute 
$600 of vested matching contributions and forfeit $400 of nonvested 
matching contributions. These amounts are in proportion to Employee 
H's vested and nonvested interests in all matching contributions. 
The second option is to distribute $1,000 of vested matching 
contributions, leaving the nonvested matching contributions in the 
plan.
    (iii) If the second option is chosen, the plan must also provide 
a separate vesting schedule for vesting these nonvested matching 
contributions. This is necessary because the nonvested matching 
contributions must vest as rapidly as they would have had no 
distribution been made. Thus, 50% must vest in each of the next 2 
years.
    (iv) The plan will not satisfy the nondiscriminatory 
availability requirement of section 401(a)(4) if only nonvested 
matching contributions are distributed because the effect is that 
matching contributions for HCEs vest more rapidly than those for 
NHCEs. See Sec.  1.401(m)-1(e)(4).
    Example 8. (i) Employer Y maintains a calendar year profit 
sharing plan that includes a cash or deferred arrangement. Elective 
contributions are matched at the rate of 100%. After-tax employee 
contributions are permitted under the plan only for nonhighly 
compensated employees and are matched at the same rate. No employees 
make excess deferrals. Employee J, a highly compensated employee, 
makes an $8,000 elective contribution and receives an $8,000 
matching contribution.
    (ii) Employer Y performs the actual deferral percentage (ADP) 
and the actual contribution percentage (ACP). To correct failures of 
the ADP and ACP tests, the plan distributes to A $1,000 of excess 
contributions and $500 of excess aggregate contributions. After the 
distributions, Employee J's contributions for the year are $7,000 of 
elective contributions and $7,500 of matching contributions. As a 
result, Employee J has received a higher effective rate of matching 
contributions than nonhighly compensated employees ($7,000 of 
elective contributions matched by $7,500 is an effective matching 
rate of 107 percent). If this amount remains in Employee J's account 
without correction, it will cause the plan to fail to satisfy 
section 401(a)(4), because only a highly compensated employee 
receives the higher matching contribution rate. The remaining $500 
matching contribution may be forfeited (but not distributed) under 
section 411(a)(3)(G), if the plan so provides. The plan could 
instead correct the discriminatory rate of matching contributions by 
making additional allocations to the accounts of nonhighly 
compensated employees. See Sec.  1.401(a)(4)-11(g)(3)(vii)(B) and 
(6), Example 7.

    (c) Additional rules for prior year testing method--(1) Rules for 
change in testing method. A plan is permitted to change from the prior 
year testing method to the current year testing method for any plan 
year. A plan is permitted to change from the current

[[Page 42528]]

year testing method to the prior year testing method only in situations 
described in Sec.  1.401(k)-2(c)(1)(ii). For purposes of this paragraph 
(c)(1), a plan that uses the safe harbor method described in Sec.  
1.401(m)-3 or a SIMPLE 401(k) plan is treated as using the current year 
testing method for that plan year.
    (2) Calculation of ACP under the prior year testing method for the 
first plan year--(i) Plans that are not successor plans. If, for the 
first plan year of any plan (other than a successor plan), a 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 ACP for the 
eligible NHCEs, or 3% as the ACP for eligible NHCEs, for applying the 
ACP 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 for determining the 
ACP for the eligible NHCEs is not treated as changing its testing 
method in the second plan year and is not subject to the limitations on 
double counting under paragraph (a)(6)(vi) of this section for the 
second plan year.
    (ii) First plan year defined. For purposes of this paragraph 
(c)(2), the first plan year of any plan is the first year in which the 
plan provides for employee contributions or matching contributions. 
Thus, the rules of this paragraph (c)(2) do not apply to a plan (within 
the meaning of Sec.  1.410(b)-7) for a plan year if for such plan year 
the plan is aggregated under Sec.  1.401(m)-1(b)(4) with any other plan 
that provides for employee or matching contributions in the prior year.
    (iii) Plans that are successor plans. A plan is a successor plan if 
50% or more of the eligible employees for the first plan year were 
eligible employees under another plan maintained by the employer in the 
prior year that provides for employee contributions or matching 
contributions. If a plan that is a successor plan uses the prior year 
testing method for its first plan year, the ACP for the group of NHCEs 
for the applicable year must be determined under paragraph (c)(4) of 
this section.
    (3) Plans using different testing methods for the ACP and ADP test. 
Except as otherwise provided in this paragraph (c)(3), a plan may use 
the current year testing method or prior year testing method for the 
ACP test for a plan year without regard to whether the current year 
testing method or prior year testing method is used for the ADP test 
for that year. For example, a plan may use the prior year testing 
method for the ACP test and the current year testing method for its ADP 
test for the plan year. However, plans that use different testing 
methods under this paragraph (c)(3) cannot use--
    (i) The recharacterization method of Sec.  1.401(k)-2(b)(3) to 
correct excess contributions for a plan year;
    (ii) The rules of paragraph (a)(6)(ii) of this section to take 
elective contributions into account under the ACP test (rather than the 
ADP test); or
    (iii) The rules of paragraph Sec.  1.401(k)-2(a)(6) to take 
qualified matching contributions into account under the ADP test 
(rather than the ACP test).
    (4) Rules for plan coverage change--(i) In general. A plan that 
uses the prior year testing method that experiences a plan coverage 
change during a plan year satisfies the requirements of this section 
for that year only if the plan provides that the ACP for the NHCEs for 
the plan year is the weighted average of the ACPs for the prior year 
subgroups.
    (ii) Optional rule for minor plan coverage changes. If a plan 
coverage change occurs and 90% or more of the total number of the NHCEs 
from all prior year subgroups are from a single prior year subgroup, 
then, in lieu of using the weighted averages described in paragraph 
(c)(4)(i) of this section, the plan may provide that the ACP for the 
group of eligible NHCEs for the prior year under the plan is the ACP of 
the NHCEs for the prior year of the plan under which that single prior 
year subgroup was eligible.
    (iii) Definitions. The following definitions apply for purposes of 
this paragraph (c)(4)--
    (A) Plan coverage change. The term plan coverage change means a 
change in the group or groups of eligible employees under a plan on 
account of--
    (1) The establishment or amendment of a plan;
    (2) A plan merger or spinoff under section 414(l);
    (3) A change in the way plans (within the meaning of Sec.  
1.410(b)-7) are combined or separated for purposes of Sec.  1.401(m)-
1(b)(4) (e.g., permissively aggregating plans not previously aggregated 
under Sec.  1.410(b)-7(d), or ceasing to permissively aggregate plans 
under Sec.  1.410(b)-7(d));
    (4) A reclassification of a substantial group of employees that has 
the same effect as amending the plan (e.g., a transfer of a substantial 
group of employees from one division to another division); or
    (5) A combination of any of the situations described in this 
paragraph (c)(4)(iii)(A).
    (B) Prior year subgroup. The term prior year subgroup means all 
NHCEs for the prior plan year who, in the prior year, were eligible 
employees under a specific plan that provides for employee 
contributions or matching contributions maintained by the employer and 
who would have been eligible employees in the prior year under the plan 
being tested if the plan coverage change had first been effective as of 
the first day of the prior plan year instead of first being effective 
during the plan year. The determination of whether an NHCE is a member 
of a prior year subgroup is made without regard to whether the NHCE 
terminated employment during the prior year.
    (C) Weighted average of the ACPs for the prior year subgroups. The 
term weighted average of the ACPs for the prior year subgroups means 
the sum, for all prior year subgroups, of the adjusted ACPs for the 
plan year. The term adjusted ACP with respect to a prior year subgroup 
means the ACP for the prior plan year of the specific plan under which 
the members of the prior year subgroup were eligible employees on the 
first day of the prior plan year, multiplied by a fraction, the 
numerator of which is the number of NHCEs in the prior year subgroup 
and denominator of which is the total number of NHCEs in all prior year 
subgroups.
    (iv) Example. The following example illustrates the application of 
this paragraph (c)(4). See also Sec.  1.401(k)-2(c)(4) for examples of 
the parallel rules applicable to the ADP test. The example is as 
follows:

    Example. (i) Employer B maintains two plans, Plan N and Plan P, 
each of which provides for employee contributions or matching 
contributions. The plans were not permissively aggregated under 
Sec.  1.410(b)-7(d) for the 2005 testing year. Both plans use the 
prior year testing method. Plan N had 300 eligible employees who 
were NHCEs for 2005, and their ACP for that year was 6%. Plan P had 
100 eligible employees who were NHCEs for 2005, and the ACP for 
those NHCEs for that plan was 4%. Plan N and Plan P are permissively 
aggregated under Sec.  1.410(b)-7(d) for the 2006 plan year.
    (ii) The permissive aggregation of Plan N and Plan P for the 
2006 testing year under Sec.  1.410(b)-7(d) is a plan coverage 
change that results in treating the plans as one plan (Plan NP). 
Therefore, the prior year ACP for the NHCEs under Plan NP for the 
2006 testing year is the weighted average of the ACPs for the prior 
year subgroups.
    (iii) The first step in determining the weighted average of the 
ACPs for the prior year subgroups is to identify the prior year 
subgroups. With respect to the 2006 testing year, an employee is a 
member of a prior year subgroup if the employee was an NHCE of 
Employer B for the 2005 plan year, was an eligible employee for the 
2005 plan year under any section 401(k) plan maintained by Employer 
B, and would have been an eligible employee in the 2005 plan year 
under Plan NP if Plan N and Plan P had been

[[Page 42529]]

permissively aggregated under Sec.  1.410(b)-7(d) for that plan 
year. The NHCEs who were eligible employees under separate plans for 
the 2005 plan year comprise separate prior year subgroups. Thus, 
there are two prior year subgroups under Plan NP for the 2006 
testing year: the 300 NHCEs who were eligible employees under Plan N 
for the 2005 plan year and the 100 NHCEs who were eligible employees 
under Plan P for the 2005 plan year.
    (iv) The weighted average of the ACPs for the prior year 
subgroups is the sum of the adjusted ACP with respect to the prior 
year subgroup that consists of the NHCEs who were eligible employees 
under Plan N, and the adjusted ACP with respect to the prior year 
subgroup that consists of the NHCEs who were eligible employees 
under Plan P. The adjusted ACP for the prior year subgroup that 
consists of the NHCEs who were eligible employees under Plan N is 
4.5%, calculated as follows: 6% (the ACP for the NHCEs under Plan N 
for the prior year) x 300/400 (the number of NHCEs in that prior 
year subgroup divided by the total number of NHCEs in all prior year 
subgroups), which equals 4.5%. The adjusted ACP for the prior year 
subgroup that consists of the NHCEs who were eligible employees 
under Plan P is 1%, calculated as follows: 4% (the ACP for the NHCEs 
under Plan P for the prior year) x 100/400 (the number of NHCEs in 
that prior year subgroup divided by the total number of NHCEs in all 
prior year subgroups), which equals 1%. Thus, the prior year ACP for 
NHCEs under Plan NP for the 2006 testing year is 5.5% (the sum of 
adjusted ACPs for the prior year subgroups, 4.5% plus 1%).


Sec.  1.401(m)-3  Safe harbor requirements.

    (a) ACP test safe harbor. Matching contributions under a plan 
satisfy the ACP safe harbor provisions of section 401(m)(11) for a plan 
year if the plan satisfies the safe harbor contribution requirement of 
paragraphs (b) or (c) of this section for the plan year, the 
limitations on matching contributions of paragraph (d) of this section, 
the notice requirement of paragraph (e) of this section, the plan year 
requirements of paragraph (f) of this section, and the additional rules 
of paragraphs (g), (h) and (j) of this section, as applicable. Pursuant 
to section 401(k)(12)(E)(ii), the safe harbor contribution requirement 
of paragraphs (b) and (c) of this section must be satisfied without 
regard to section 401(l). The contributions made under paragraphs (b) 
and (c) of this section are referred to as safe harbor nonelective 
contributions and safe harbor matching contributions, respectively.
    (b) Safe harbor nonelective contribution requirement. A plan 
satisfies the safe harbor nonelective contribution requirement of this 
paragraph (b) if it satisfies the safe harbor nonelective contribution 
requirement of Sec.  1.401(k)-3(b).
    (c) Safe harbor matching contribution requirement. A plan satisfies 
the safe harbor matching contribution requirement of this paragraph (c) 
if it satisfies the safe harbor matching contribution requirement of 
Sec.  1.401(k)-3(c).
    (d) Limitation on contributions--(1) General rule. A plan that 
provides for matching contributions meets the requirements of this 
section only if it satisfies the limitations on contributions set forth 
in this paragraph (d).
    (2) Matching rate must not increase. A plan that provides for 
matching contributions meets the requirements of this paragraph (d) 
only if the ratio of matching contributions on behalf of an employee 
under the plan for a plan year to the employee's elective deferrals and 
employee contributions, does not increase as the amount of an 
employee's elective deferrals and employee contributions increases.
    (3) Limit on matching contributions. A plan that provides for 
matching contributions satisfies the requirements of this section only 
if--
    (i) Matching contributions are not made with respect to elective 
deferrals or employee contributions that exceed 6% of the employee's 
safe harbor compensation (within the meaning of Sec.  1.401(k)-
3(b)(2)); and
    (ii) Matching contributions that are discretionary do not exceed 4% 
of the employee's safe harbor compensation.
    (4) Limitation on rate of match. A plan meets the requirements of 
this section only if the ratio of matching contributions on behalf of 
an HCE to that HCE's elective deferrals or employee contributions (or 
the sum of elective deferrals and employee contributions) for that plan 
year is no greater than the ratio of matching contributions to elective 
deferrals or employee contributions (or the sum of elective deferrals 
and employee contributions) that would apply with respect to any NHCE 
for whom the elective deferrals or employee contributions (or the sum 
of elective deferrals and employee contributions) are the same 
percentage of safe harbor compensation. An employee is taken into 
account for purposes of this paragraph (d)(4) if the employee is an 
eligible employee under the cash or deferred arrangement with respect 
to which the contributions required by paragraph (b) or (c) of this 
section are being made for a plan year. A plan will not fail to satisfy 
this paragraph (d)(4) merely because the plan provides that matching 
contributions will be made separately with respect to each payroll 
period (or with respect to all payroll periods ending with or within 
each month or quarter of a plan year) taken into account under the plan 
for the plan year, provided that matching contributions with respect to 
any elective deferrals or employee contributions made during a plan 
year quarter are contributed to the plan by the last day of the 
immediately following plan year quarter.
    (5) HCEs participating in multiple plans. The rules of section 
401(m)(2)(B) and Sec.  1.401(m)-2(a)(3)(ii) apply for purposes of 
determining the rate of matching contributions under paragraph (d)(4) 
of this section. However, a plan will not fail to satisfy the safe 
harbor matching contribution requirements of this section merely 
because an HCE participates during the plan year in more than one plan 
that provides for matching contributions, provided that--
    (i) The HCE is not simultaneously an eligible employee under two 
plans that provide for matching contributions maintained by an employer 
for a plan year; and
    (ii) The period used to determine compensation for purposes of 
determining matching contributions under each such plan is limited to 
periods when the HCE participated in the plan.
    (6) Permissible restrictions on elective deferrals by NHCEs--(i) 
General rule. A plan does not satisfy the safe harbor requirements of 
this section, if elective deferrals or employee contributions by NHCEs 
are restricted, unless the restrictions are permitted by this paragraph 
(d)(6).
    (ii) Restrictions on election periods. A plan may limit the 
frequency and duration of periods in which eligible employees may make 
or change contribution elections under a plan. However, an employee 
must have a reasonable opportunity (including a reasonable period after 
receipt of the notice described in paragraph (e) of this section) to 
make or change a contribution election for the plan year. For purposes 
of this section, a 30-day period is deemed to be a reasonable period to 
make or change a contribution election.
    (iii) Restrictions on amount of contributions. A plan is permitted 
to limit the amount of contributions that may be made by an eligible 
employee under a plan, provided that each NHCE who is an eligible 
employee is permitted (unless the employee is restricted under 
paragraph (d)(6)(v) of this section) to make contributions in an amount 
that is at least sufficient to receive the maximum amount of matching 
contributions available under the plan for the plan year, and the 
employee is permitted to elect any lesser amount of

[[Page 42530]]

contributions. However, a plan may require eligible employees to make 
contribution elections in whole percentages of compensation or whole 
dollar amounts.
    (iv) Restrictions on types of compensation that may be deferred. A 
plan may limit the types of compensation that may be deferred or 
contributed by an eligible employee under a plan, provided that each 
eligible NHCE is permitted to make contributions under a definition of 
compensation that would be a reasonable definition of compensation 
within the meaning of Sec.  1.414(s)-1(d)(2). Thus, the definition of 
compensation from which contributions may be made is not required to 
satisfy the nondiscrimination requirement of Sec.  1.414(s)-1(d)(3).
    (v) Restrictions due to limitations under the Internal Revenue 
Code. A plan may limit the amount of contributions made by an eligible 
employee under a plan--
    (A) Because of the limitations of section 402(g) or section 415; or
    (B) Because, on account of a hardship distribution, an employee's 
ability to make contributions has been suspended for 6 months in 
accordance with Sec.  1.401(k)-1(d)(3)(iv)(E).
    (e) Notice requirement. A plan satisfies the notice requirement of 
this paragraph (e) if it satisfies the notice requirement of Sec.  
1.401(k)-3(d).
    (f) Plan year requirement--(1) General rule. Except as provided in 
this paragraph (f) or in paragraph (g) of this section, a plan will 
fail to satisfy the requirements of section 401(m)(11) and this section 
unless plan provisions that satisfy the rules of this section are 
adopted before the first day of that plan year and remain in effect for 
an entire 12-month plan year. Moreover, if, as described in paragraph 
(j)(4) of this section, safe harbor matching or nonelective 
contributions will be made to another plan for a plan year, provisions 
specifying that the safe harbor contributions will be made in the other 
plan and providing that the contributions will be QNECs or QMACs must 
be also be adopted before the first day of that plan year.
    (2) Initial plan year. A newly established plan (other than a 
successor plan within the meaning of Sec.  1.401(m)-2(c)(2)(iii)) will 
not be treated as violating the requirements of this paragraph (f) 
merely because the plan year is less than 12 months, provided that the 
plan year is at least 3 months long (or, in the case of a newly 
established employer that establishes the plan as soon as 
administratively feasible after the employer comes into existence, a 
shorter period). Similarly, a plan will not fail to satisfy the 
requirements of this paragraph (f) for the first plan year in which 
matching contributions are provided under the plan provided that--
    (i) The plan is not a successor plan; and
    (ii) The amendment providing for matching contributions is made 
effective at the same time as the adoption of a cash or deferred 
arrangement that satisfies the requirements of Sec.  1.401(k)-3, taking 
into account the rules of Sec.  1.401(k)-3(e)(2).
    (3) Change of plan year. A plan that has a short plan year as a 
result of changing its plan year will not fail to satisfy the 
requirements of paragraph (f)(1) of this section merely because the 
plan year has less than 12 months, provided that--
    (i) The plan satisfied the requirements of this section for the 
immediately preceding plan year; and
    (ii) The plan satisfies the requirements of this section for the 
immediately following plan year.
    (4) Final plan year. A plan that terminates during a plan year will 
not fail to satisfy the requirements of paragraph (f)(1) of this 
section merely because the final plan year is less than 12 months, 
provided that--
    (i) The plan would satisfy the requirements of paragraph (h) of 
this section, treating the termination of the plan as a reduction or 
suspension of safe harbor matching contributions, other than the 
requirement that employees have a reasonable opportunity to change 
their cash or deferred elections and, if applicable, employee 
contribution elections; or
    (ii) The plan termination is in connection with a transaction 
described in section 410(b)(6)(C) or the employer incurs a substantial 
business hardship, comparable to a substantial business hardship 
described in section 412(d).
    (g) Plan amendments adopting nonelective safe harbor contributions. 
Notwithstanding paragraph (f)(1) of this section, a plan that provides 
for the use of the current year testing method may be amended after the 
first day of the plan year and no later than 30 days before the last 
day of the plan year to adopt the safe harbor method of this section 
using nonelective contributions under paragraph (b) of this section if 
the plan satisfies the requirements of Sec.  1.401(k)-3(f).
    (h) Permissible reduction or suspension of safe harbor matching 
contributions--(1) General rule. A plan that provides for safe harbor 
matching contributions will not fail to satisfy the requirements of 
section 401(m)(2) for a plan year merely because the plan is amended 
during a plan year to reduce or suspend safe harbor matching 
contributions on future elective deferrals and, if applicable, employee 
contributions provided--
    (i) All eligible employees are provided the supplemental notice in 
accordance with paragraph (h)(2) of this section;
    (ii) The reduction or suspension of safe harbor matching 
contributions is effective no earlier than the later of 30 days after 
eligible employees are provided the notice described in paragraph 
(h)(2) of this section and the date the amendment is adopted;
    (iii) Eligible employees are given a reasonable opportunity 
(including a reasonable period after receipt of the supplemental 
notice) prior to the reduction or suspension of safe harbor matching 
contributions to change their cash or deferred elections and, if 
applicable, their employee contribution elections;
    (iv) The plan is amended to provide that the ACP test will be 
satisfied for the entire plan year in which the reduction or suspension 
occurs using the current year testing method described in Sec.  
1.401(m)-2(a)(1)(ii); and
    (v) The plan satisfies the requirements of this section (other than 
this paragraph (h)) with respect to amounts deferred through the 
effective date of the amendment.
    (2) Notice of suspension requirement. The notice of suspension 
requirement of this paragraph (h)(2) is satisfied if each eligible 
employee is given a written notice that satisfies the content 
requirements of Sec.  1.401(k)-3(e)(3).
    (i) [Reserved]
    (j) Other rules--(1) Contributions taken into account. A 
contribution is taken into account for purposes of this section for a 
plan year under the same rules as Sec.  1.401(k)-3(h)(1).
    (2) Use of safe harbor nonelective contributions to satisfy other 
nondiscrimination tests. A safe harbor nonelective contribution used to 
satisfy the nonelective contribution requirement under paragraph (b) of 
this section may also be taken into account for purposes of determining 
whether a plan satisfies section 401(a)(4) under the same rules as 
Sec.  1.401(k)-3(h)(2).
    (3) Early participation rules. Section 401(m)(5)(C) and Sec.  
1.401(m)-2(a)(1)(iii)(A) which provide an alternative nondiscrimination 
rule for certain plans that provide for early participation, does not 
apply for purposes of section 401(m)(11) and this section. Thus, a plan 
is not treated as satisfying this section with respect to the eligible 
employees who have not completed the minimum age and service

[[Page 42531]]

requirements of section 410(a)(1)(A) unless the plan satisfies the 
requirements of this section with respect to such eligible employees.
    (4) Satisfying safe harbor contribution requirement under another 
defined contribution plan. Safe harbor matching or nonelective 
contributions may be made to another defined contribution plan under 
the same rules as Sec.  1.401(k)-3(h)(4). Consequently, each NHCE under 
the plan providing for matching contributions must be eligible under 
the same conditions under the other defined contribution plan and the 
plan to which the contributions are made must have the same plan year 
as the plan providing for matching contributions.
    (5) Contributions used only once. Safe harbor matching or 
nonelective contributions cannot be used to satisfy the requirements of 
this section with respect to more than one plan.
    (6) Plan must satisfy ACP with respect to employee contributions. 
If the plan provides for employee contributions, in addition to 
satisfying the requirements of this section, it must also satisfy the 
ACP test of Sec.  1.401(m)-2. See Sec.  1.401(m)-2(a)(5)(iii) for 
specials rules under which the ACP test is permitted to be run taking 
into account only employee contributions when this section is satisfied 
with respect to the matching contributions.


Sec.  1.401(m)-4  Special rules for mergers, acquisitions and similar 
events. [Reserved]


Sec.  1.401(m)-5  Definitions.

    Unless otherwise provided, the definitions of this section govern 
for purposes of section 401(m) and the regulations thereunder.
    Actual contribution percentage (ACP). Actual contribution 
percentage or ACP means the ACP of the group of eligible employees as 
defined in Sec.  1.401(m)-2(a)(2)(i).
    Actual contribution percentage (ACP) test. Actual contribution 
percentage test or ACP test means the test described in Sec.  1.401(m)-
2(a)(1).
    Actual contribution ratio (ACR). Actual contribution ratio or ACR 
means the ACR of an eligible employee as defined in Sec.  1.401(m)-
2(a)(3).
    Actual deferral percentage (ADP) test. Actual deferral percentage 
test or ADP test means the test described in Sec.  1.401(k)-2(a)(1).
    Compensation. Compensation means compensation as defined in section 
414(s) and Sec.  1.414(s)-1. The period used to determine an employee's 
compensation for a plan year must be either the plan year or the 
calendar year ending within the plan year. Whichever period is selected 
must be applied uniformly to determine the compensation of every 
eligible employee under the plan for that plan year. A plan may, 
however, limit the period taken into account under either method to 
that portion of the plan year or calendar year in which the employee 
was an eligible employee, provided that this limit is applied uniformly 
to all eligible employees under the plan for the plan year. See also 
section 401(a)(17) and Sec.  1.401(a)(17)-1(c)(1). For this purpose, in 
case of an HCE whose ACR is determined under Sec.  1.401(m)-
2(a)(3)(ii), period of participation includes periods under another 
plan for which matching contributions or employee contributions are 
aggregated under Sec.  1.401(m)-2(a)(3)(ii).
    Current year testing method. Current year testing method means the 
testing method under which the applicable year is the current plan 
year, as described in Sec.  1.401(m)-2(a)(2)(ii) or 1.401(k)-
2(a)(2)(ii).
    Elective contributions. Elective contributions means elective 
contributions as defined in Sec.  1.401(k)-6.
    Elective deferrals. Elective deferrals means elective deferrals 
described in section 402(g)(3).
    Eligible employee--(1) General rule. Eligible employee means an 
employee who is directly or indirectly eligible to make an employee 
contribution or to receive an allocation of matching contributions 
(including matching contributions derived from forfeitures) under the 
plan for all or a portion of the plan year. For example, if an employee 
must perform purely ministerial or mechanical acts (e.g., formal 
application for participation or consent to payroll withholding) in 
order to be eligible to make an employee contribution for a plan year, 
the employee is an eligible employee for the plan year without regard 
to whether the employee performs these acts.
    (2) Conditions on eligibility. An employee who is unable to make 
employee contributions or to receive an allocation of matching 
contributions because the employee has not contributed to another plan 
is also an eligible employee. By contrast, if an employee must perform 
additional service (e.g., satisfy a minimum period of service 
requirement) in order to be eligible to make an employee contribution 
or to receive an allocation of matching contributions for a plan year, 
the employee is not an eligible employee for the plan year unless the 
service is actually performed. An employee who would be eligible to 
make employee contributions but for a suspension due to a distribution, 
a loan, or an election not to participate in the plan, is treated as an 
eligible employee for purposes of section 401(m) for a plan year even 
though the employee may not make employee contributions or receive an 
allocation of matching contributions by reason of the suspension. 
Finally, an employee does not fail to be treated as an eligible 
employee merely because the employee may receive no additional annual 
additions because of section 415(c)(1).
    (3) Certain one-time elections. An employee is not an eligible 
employee merely because the employee, upon commencing employment with 
the employer or upon the employee's first becoming eligible under any 
plan of the employer providing for employee or matching contributions, 
is given a one-time opportunity to elect, and the employee in fact does 
elect, not to be eligible to make employee contributions or to receive 
allocations of matching contributions under the plan or any other plan 
maintained by the employer (including plans not yet established) for 
the duration of the employee's employment with the employer. In no 
event is an election made after December 23, 1994, treated as one-time 
irrevocable election under this paragraph if the election is made by an 
employee who previously became eligible under another plan (whether or 
not terminated) of the employer.
    Eligible HCE. Eligible HCE means an eligible employee who is an 
HCE.
    Eligible NHCE. Eligible NHCE means an eligible employee who is not 
an HCE.
    Employee. Employee means an employee within the meaning of Sec.  
1.410(b)-9.
    Employee contributions. Employee contributions means employee 
contributions as defined in 1.401(m)-1(a)(3).
    Employee stock ownership plan (ESOP). Employee stock ownership plan 
or ESOP means the portion of a plan that is an ESOP within the meaning 
of Sec.  1.410(b)-7(c)(2).
    Employer. Employer means an employer within the meaning of Sec.  
1.410(b)-9.
    Excess aggregate contributions. Excess aggregate contributions 
means, with respect to a plan year, the amount of excess aggregate 
contributions apportioned to an HCE under Sec.  1.401(m)-2(b)(2)(iii).
    Excess contributions. Excess contribution means with respect to a 
plan year, the amount of excess contribution apportioned to an HCE 
under Sec.  1.401(k)-2(b)(2)(iii).
    Excess deferrals. Excess deferrals means excess deferrals as 
defined in Sec.  1.402(g)-1(e)(3).

[[Page 42532]]

    Highly compensated employee (HCE). Highly compensated employee or 
HCE has the meaning provided in section 414(q).
    Matching contributions. Matching contribution is defined in Sec.  
1.401(m)-1(a)(2).
    Nonelective contributions. Nonelective contributions means employer 
contributions (other than matching contributions) with respect to which 
the employee may not elect to have the contributions paid to the 
employee in cash or other benefits instead of being contributed to the 
plan.
    Non-employee stock ownership plan (non-ESOP). Non-employee stock 
ownership plan or non-ESOP means the portion of a plan that is not an 
ESOP within the meaning of Sec.  1.410(b)-7(c)(2).
    Non-highly compensated employee (NHCE). Non-highly compensated 
employee or NHCE means an employee who is not an HCE.
    Plan. Plan means plan as defined in Sec.  1.401(m)-1(b)(4).
    Prior year testing method. Prior year testing method means the 
testing method under which the applicable year is the prior plan year, 
as described in Sec.  1.401(m)-2(a)(2)(ii) or Sec.  1.401(k)-
2(a)(2)(ii).
    Qualified matching contributions (QMAC). Qualified matching 
contributions or QMAC means matching contributions that satisfy the 
requirements of Sec.  1.401(k)-1(c) and (d) at the time the 
contribution is made, without regard to whether the contributions are 
actually taken into account as elective contributions under Sec.  
1.401(k)-2(a)(6). See also Sec.  1.401(k)-2(b)(4)(iii) for a rule 
providing that a matching contribution does not fail to qualify as a 
QMAC solely because it is forfeitable under section 411(a)(3)(G) 
because it is a matching contribution with respect to an excess 
deferral, excess contribution, or excess aggregate contribution.
    Qualified nonelective contributions (QNEC). Qualified nonelective 
contributions or QNEC means employer contributions, other than elective 
contributions or matching contributions, that satisfy the requirements 
of Sec.  1.401(k)-1(c) and (d) at the time the contribution is made, 
without regard to whether the contributions are actually taken into 
account under the ADP test under Sec.  1.401(k)-2(a)(6) or the ADP test 
under Sec.  1.401(m)-2(a)(6).

Judith B. Tomaso,
Acting Deputy Commissioner for Services and Enforcement.
[FR Doc. 03-17755 Filed 7-16-03; 8:45 am]
BILLING CODE 4830-01-P