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IRS ISSUING GUIDANCE ON 401(K) TESTS

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WASHINGTON-The Internal Revenue Service is giving employers limited guidance on how to take advantage of a congressionally ordered change in tax law that gives companies a new and easier option for running non-discrimination tests on 401(k) plans.

But guidance still is needed on how to account for certain matching and non-elective contributions by employers under the change.

Under a provision of pension simplification legislation that took effect Jan. 1, employers now can choose from two methods to run the tests. Those tests are used to compare 401(k) plan salary deferrals made by highly and non-highly compensated employees. Generally, average deferrals by highly compensated employees as a group cannot exceed deferrals by the rank and file by more than two percentage points.

The new testing method allows employers to compare the prior-year deferrals of non-highly compensated employees to the current-year deferrals of highly compensated employees.

Through this technique, an employer would know at the start of a plan year how much highly compensated employees could contribute to a 401(k) plan without violating non-discrimination rules.

This approach will reduce the constant monitoring and testing of plan contributions that many employers currently have to conduct to be sure that non-discrimination rules are not violated.

For example, if non-highly compensated rank-and-file employees contributed, for example, an average of 4% of salary to the company's 401(k) plan in 1996, an employer would know at the start of the year that highly paid employees as a group could defer no more than 6% of salary to the plan in 1997.

Alternatively, employers can continue to use the conventional 401(k) plan testing method, in which current-year contributions of highly and non-highly compensated employees are compared.

For employers that intend to adopt the new testing procedure, the IRS, in Notice 1997-2, has provided answers to some nagging questions.

For example, the IRS has made clear that in calculating the average deferral percentage of non-highly compensated employees during the prior year, contributions should be included for:

Employees, who, because of salary increases, now are highly compensated.

Employees who left during the prior year.

"This is a common-sense answer to questions some people had been raising," said Henry Saveth, a principal with A. Foster Higgins & Co. Inc. in New York.

But the IRS left unanswered in the guidelines how employers who match employees' salary deferrals or provide non-elective contributions can use the new technique. A non-elective contribution is one in which an employer agrees to kick money into the savings plan regardless of whether employees make their own salary deferrals.

The IRS said "further guidance will address the conditions" under which matching contributions and non-elective contributions can be taken into account when running the non-discrimination tests.

Benefit experts say the IRS is concerned about what they describe as "double-counting" of matching and non-elective contributions made on behalf of non-highly compensated employees.

In such a scenario, an employer in 1997 might automatically contribute an amount equal to 1% of pay to the plan for all non-highly compensated employees.

This employer contribution would effectively allow more highly paid employees in 1997 to increase their salary deferrals to the plan since the average deferrals of the rank and file-courtesy of the employer contribution-would increase.

Then, in 1998, through the new testing procedure, highly compensated employees also would be able to boost their contributions. That is because the prior-year contributions of rank-and-file employees and employer contributions made on their behalf would be compared to highly compensated employees' current-year contributions.

The IRS, benefit experts say, is not concerned about typical matching features, such as those in which employers match 50% of employees' 401(k) salary deferrals.

"Plain vanilla plans should be OK," said John Woyke, a principal with Towers Perrin in Valhalla, N.Y.

Instead, experts speculate, the IRS wants to prevent possible manipulation of the new testing procedure, such as could occur if an employer reverses a historic rate of contributions and suddenly increases contributions on behalf of lower-paid employees as a way to allow highly compensated employees to defer more in two consecutive years.

Until the IRS provides additional guidance, though, employers probably will want to continue to use the conventional non-discrimination testing technique in which current-year contributions of highly and non-highly compensated employees are compared, said Pam Scott, a principal with Kwasha Lipton L.L.C. in Fort Lee, N.J.