ESOPs & Employee Benefits Q4 2023 Client Update < Articles < News

ESOPs & Employee Benefits Q4 2023 Client Update

Another year has come and gone, but one thing remains (and, by all appearances, will continue to remain): Implementing the SECURE Act retirement plan rules.

Four years after the original SECURE Act, and two years after SECURE 2.0, additional details are beginning to trickle out on how some of the new rules will operate. With a number of the new rules taking effect in the 2024 plan year, as our most recent update explained, this guidance could not have come too soon, although most of it is far from final.

In the meantime, below are a few of the major items addressed by the IRS in the closing months of 2023:

Initial Guidance on SECURE 2.0 Topics

In the days before Christmas, the IRS issued Notice 2024-02, which offers very preliminary guidance on several SECURE 2.0 topics. Among other things, the guidance covers:

Roth Employer Contributions: SECURE 2.0 for the first time allows employer contributions to be treated directly as after-tax Roth contributions. Previously, all employer contributions were required to be made pre-tax (with the option for the participant to use an in-plan Roth conversion). The Notice lays out some initial ground rules for this treatment. Most importantly, the plan can choose whether to offer participants the election to treat employer contributions as after-tax Roth contributions; if the plan does not allow it, participants cannot use it. The Notice also confirms that the election can only be made for contribution types (e.g., matching, profit sharing) in which the participant is 100% vested. Under the new guidance, employer Roth contributions are taxed in the year that they are deposited to the plan (for example, an employer profit-sharing contribution deposited in early 2025 based on the 2024 plan year is taxed in 2025). Instead of being reported on a Form W-2 like Roth employee deferrals, Roth employer contributions are reported on a Form 1099-R similar to in-plan Roth conversions.
SIMPLE IRA Roth Contributions: Similar rules also apply to the newly available option of employees and employers making Roth contributions to SIMPLE IRA plans.
Terminal Illness Distributions: Turning out to be a somewhat-complex topic, the Notice also goes into detail on the exception to the 10% early withdrawal penalty for terminally ill participants. Among other things, it notes that terminal illness is not a separate right to distribution; in other words, a terminally ill participant still needs another distributable event such as an in-service or hardship distribution. A participant may not self-certify a terminal illness but instead must provide a comprehensive physician’s certification. The Notice also confirms that the plan can choose whether to offer to process a distribution as a terminal illness distribution, but that if it doesn’t the participant can still claim that treatment on his or her individual tax return. There is no limit on the dollar amount of a terminal illness distribution.
Plans Subject to Mandatory Auto-Enrollment: SECURE 2.0 requires that most new 401(k) plans established after the law was passed contain mandatory automatic enrollment provisions. The Notice provides initial guidance largely around plan mergers, plan spin-offs, and plan transitions during M&A activity, situations in which the SECURE 2.0 text is unclear on when a plan is considered “established.”
Extension of Amendment Deadline: Remarkably, the Notice also extends the deadline for plan amendments again for the original SECURE Act, the CARES Act, and SECURE 2.0. The new deadline for plan amendments implementing these changes is now December 31, 2026, for most plans. For governmental plans, the deadline has been extended until 2029, meaning a governmental plan may go a full decade operating under some of these rules without being amended. Given the volume of pending guidance, this relief is welcome, although it continues to place employers in the difficult spot of choosing to update their documents without final rules in place or continuing to wait and risk employee confusion over severely outdated plan and SPD terms.

Proposed Regulations on Long-Term, Part-Time Employee 401(k) Participation

Just a few weeks before the SECURE 2.0 guidance, the IRS released proposed regulations on the “long-term, part-time” employees rules enacted in the original SECURE Act. The proposed rules are still subject to public comment and finalization. While the proposed rules and explanations run more than 20 pages, some major open questions were answered:

As a reminder, the original SECURE Act required that plans allow employees to defer their own money into the plan if they work 500 hours in three consecutive years. The three-year counting period started in 2021, so the first year an employee can enter the plan under this rule is 2024. The measuring period was modified by SECURE 2.0 such that, starting in 2025, employees must be allowed to defer if they work 500 hours in two consecutive years.
Under the proposed regulations, the rules apply only to employees who become participants solely because of these eligibility rules (so-called “LTPT employees”). In other words, if the plan allows all employees to immediately defer their own money into the plan, regardless of the amount of time they have worked, these rules will not apply as no one will be an LTPT employee.
The proposal also confirms that plans can continue to exclude categories of employees, even if an LTPT employee is in that category, as long as the regular coverage testing rules are satisfied. For example, if a plan covers all employees working in Division A and excludes all employees working in Division B, LTPT employees in Division B can still be excluded from the plan altogether. However, like other rules in this context, the categorization cannot be tied directly or indirectly to LTPT status, so the employer cannot simply label all LTPT employees as “Division B” employees and exclude them on that basis.
Generally LTPT employees are not required to receive employer contributions. To the same end, they can also be excluded from most non-discrimination testing. More specifically, though, if the plan excludes LTPT employees from receiving safe harbor contributions, the plan document must expressly describe that exclusion.
Once an LTPT employee meets the plan’s regular eligibility criteria, they become “former LTPT employees” and largely become subject to the plan’s regular rules.

The long-term, part-time employee rules are new, still largely untested, and very complex. As a result, plan sponsors should work with their TPAs and recordkeepers to ensure they are tracking the necessary data and making informed decisions on the impact of the new rules.

Recent Round of Lawsuits Claims Use of Forfeitures Violated ERISA

Finally, although unrelated to SECURE 2.0, a new round of class action lawsuits has challenged several large employers’ decisions on using plan forfeitures. In those cases, plan participants allege that the employer used the funds in the plan’s forfeiture account – generated by terminated employees who were not fully vested in their employer contributions – to benefit itself instead of participants. Each of the plans apparently allowed the employer to use forfeitures to either pay plan expenses or reduce the amount of the required employer contribution. These are common options in 401(k) plans, some of which specify an order to use forfeitures but many of which allow the employer the flexibility to use forfeitures for any permissible reason. The lawsuits claim that, by using the forfeitures to reduce the employer’s contribution (which is funded by the employer) instead of paying plan expenses (which are paid by participants from their accounts), the employers violated several ERISA rules that require the employer to operate the plan in the best interests of participants.

While IRS guidance clearly allows qualified plan forfeitures to be used in either of these manners, the impact under the labor provisions of ERISA is not quite as clear, especially where the employer is given discretion on how to use them. However, where the plan only allows one method of using forfeitures, or specifies an order of using them, suits like these would be less likely (unless the plan is doing something different than what the plan terms require).

While many practitioners see a small likelihood of success in these class actions, they are a good reminder for employers to double-check their plan terms and make sure they are operating accordingly.