IRS Proposed Regulations Would Permit Forfeitures to Fund QNECs

Spring 2017Articles For Your Benefit

On January 18, 2017, the IRS published proposed regulations, which amend the definitions of qualified non-elective contributions (QNECs) and qualified matching contributions (QMACs). The following questions and answers explain the importance of QNECs and QMACs and how the proposed changes are beneficial to 401(k) plan sponsors.

Q: What are QNECs and QMACs?

A: QNECs and QMACs are “qualified” employer nonelective and matching contributions to 401(k) plans. To be “qualified,” a contribution must be nonforfeitable (i.e., 100% vested) and must not be distributed prior to a participant’s death, disability, separation from service, attainment of age 59 1/2 or the plan’s termination. Qualified contributions also cannot be used for hardship distributions.

Q: Why do plan sponsors make qualified contributions?

A: Contributions to 401(k) plans may not discriminate in favor of highly compensated employees (HCEs). To ensure deferrals and matching contributions are nondiscriminatory, the plan must pass actual deferral percentage (ADP) and actual contribution percentage (ACP) tests. These tests compare the differences in the average deferral and contribution percentages of HCEs to those of non-HCEs. If the difference in average deferral or contribution percentages is too great (i.e., if the plan fails either ADP or ACP testing), the sponsor must correct the disparity by making a QNEC or QMAC to eligible non-HCEs or by distributing excess contributions to HCEs.

Sponsors of safe harbor 401(k) plans may also use QNECs and QMACs to automatically pass ADP and ACP testing.

Q: How do the proposed regulations change qualified contributions?

A: Prior to the proposed regulations, the IRS considered nonelective or matching contributions “qualified” only if they satisfied the nonforfeitability and distribution restrictions at the time the contributions were made to a plan. As a result, a sponsor could not use amounts in a plan’s forfeiture account to fund QNECs, QMACs or safe harbor contributions because at the time the amounts were originally contributed to the plan they were not 100% vested. (Which is why the amounts ended up as forfeitures to begin with.) Even if the 401(k) plan permitted sponsors to use forfeitures to reduce employer contributions, sponsors had to make additional contributions to fund qualified contributions.

The proposed regulations revise the underlying definition of QNECs and QMACs so that the contributions are considered “qualified” if they satisfy the nonforfeitability and distribution restrictions at the time contributions are allocated to a participant’s account.

Q: What does the change mean for plan sponsors?

A: The change to the QNEC and QMAC definition provides plan sponsors more flexibility to fund qualified contributions and potentially makes correcting plan errors and safe harbor contributions less expensive for plan sponsors. By expanding the permitted uses of forfeitures, the proposed regulations may reduce the amount of additional contributions sponsors must make to their 401(k) plans.

Q: When can plan sponsors take advantage of the change?

A: The proposed regulations generally apply to taxable years beginning on or after the date the final rule is published. The IRS, however, stated that taxpayers may rely on the proposed changes immediately.

Q: What must plan sponsors do to take advantage of the proposed regulations?

A: Plans sponsors wanting to use forfeitures to fund QNECs, QMACs or safe harbor contributions must first review their plan documents to determine whether the plan allows forfeitures to be used to:

  1. Reduce employer contributions; and

  2. Fund QNECs, QMACs and safe harbor contributions.

If your plan does not permit one or both of the above, the plan must be amended before you can rely on the proposed regulations. Sponsors of safe harbor 401(k) plans could adopt such an amendment mid-year without violating IRS Notice 2016-16.