By Lawrence Eisenberg (May 13, 2020)
In light of COVID-19, many people anticipate a new normal. In that spirit, employers may want to consider new ways of demonstrating appreciation of their extraordinary and valued rank-and-file employees (i.e., non-highly compensated employees, or NHCEs),[1] who have given and been through so much. One way to do this is to adopt an NHCE reward and compensation plan.
What Is an NHCE Plan?
An NHCE plan is a unique yet straightforward way for an employer to provide bonus, reward, incentive, performance, severance, change-in- control and other types of compensation to some or all of its NHCEs.
An NHCE plan is — at its core — a tax-qualified profit-sharing plan.[2] The plan includes provisions that allow an employer to contribute compensation that would otherwise be paid currently to one or more NHCEs, while also providing them with access to those contributions and the earnings thereon.
The NHCE being allocated the contribution may decide either to keep the contribution in the NHCE plan to grow tax-deferred. Or he or she may take a distribution of all or part of that contribution (and the earnings). The NHCE plan offers important advantages, including the potential for a tax-deferred raise (explained below) and an opportunity to significantly enhance retirement savings. The primary advantages are summarized below.
Note that an NHCE plan is not a 401(k) cash or deferred arrangement (although it may operate as part of a 401(k) plan). This is because the determination regarding whether and how much to contribute to the NHCE plan on behalf of an NHCE is solely within the discretion of the employer, and not the employee; i.e., the employee may not elect to have the contribution paid to him or her in cash or other benefits instead of being contributed to the NHCE plan.[3]
NHCE Plan Details
Profit-sharing plans typically allocate contributions on a nondiscriminatory basis among all eligible employees, including both NHCEs and highly compensated employees, or HCEs. However, many of today’s IRS preapproved defined contribution plan documents permit profit sharing (sometimes called nonelective) contributions to be allocated on a per- participant basis.
That is, a separate contribution amount may be determined for each participant, subject to applicable qualified plan limits.[4] This allows substantial flexibility regarding how much (if anything) to allocate to any employee.
How can a contribution be made to a single employee? Aren’t there nondiscrimination rules related to plan contributions? There are, but they apply to determine how much may be contributed on behalf of HCEs.[5] Nothing prohibits contributions that discriminate in favor of NHCEs. The ability to discriminate in favor of NHCEs allows an NHCE plan almost unlimited flexibility regarding NHCE contributions.[6]
While that sounds great, NHCEs are unlikely to embrace this arrangement if they cannot access the compensation they would otherwise have received currently. Fortunately, this access is possible by the NHCE plan including one or more of the generous in-service distribution alternatives permitted for profit-sharing plans. These alternatives include the following:
- The employee has been an NHCE plan participant for at least five years;
- The amount being withdrawn has been in the NHCE plan for at least two years; and
- The employee has attained a stated age described in the NHCE plan (which the IRS interprets to mean any age).[7] This any-age withdrawal opportunity provides the most flexibility for in-service distributions.
NHCE Plan Advantages
An NCHE plan offers valuable advantages to both the employer and NHCEs, including the following elements.
Who May Benefit and Types of Compensation
There is complete discretion regarding which NHCEs are allocated contributions and complete discretion regarding the types of compensation that may effectively be paid as an NHCE plan contribution; for example, reward compensation with respect to a particular project, any type of bonus compensation, recognition of the achievement of performance or long- or short-term incentive goals, recognition of the attainment of service or age requirements, severance compensation, or change-in-control compensation.
In addition, NHCE plan contributions could be provided in lieu of regular compensation. For example, 5% of the NHCE’s regular compensation would automatically be contributed to the NCHE plan in lieu of current pay.[8] This may provide a useful forced savings opportunity.
Contribution Amounts, Immediate Deduction, Current Taxes and Tax Deferral
There is complete discretion regarding each NHCE’s contribution amount, subject to the Internal Revenue Code Section 415 annual addition limits. The contribution is immediately deductible to the employer[9] and is not currently taxed to the NHCE, unlike current compensation.[10] Additionally, NHCE plan contributions grow tax-deferred while in the plan. Realized earnings on current compensation are immediately taxed.
No FICA Taxes
Neither NHCE plan contributions nor distributions are subject to Federal Insurance Contributions Act taxes.[11] This represents a combined 15.3% tax savings when considering both the employer and employee share of the FICA contributions.
This may result in a significant and important financial benefit to NHCEs. If the saved FICA taxes are paid to the NHCE as an NHCE plan contribution, then that amount constitutes an immediate tax-deferred raise to the employee.
As a simple example, an NHCE who has $10,000 contributed to the NHCE plan could receive
an additional $1,530 NHCE plan contribution (15.3% times $10,000) that could be either used to increase retirement savings or to defray an early distribution tax if the funds are currently needed.
If this occurs for 20 years and these contributions grow at 5% annually, then the NHCE would have approximately $62,000 more in his or her NHCE plan account at the end of the 20-year period. Also, contributing FICA taxes to the NHCE plan should be well received by those who do not think Social Security will be there when they retire.
Immediate Access
A NHCE may access his or her account at any time by using the NHCE plan in-service distribution provisions. This avoids the NHCE having to take a plan loan or hardship distribution.
The distribution decision is entirely that of the NHCE. Hopefully, however, NHCEs can keep as much of their additional contributions in the NHCE plan as possible to enhance retirement savings.
One-Time Election Opportunity
The employer’s ability to reduce a portion of NHCE regular compensation in favor of NHCE plan contributions may not be a preferred course of action. Instead, the NHCE plan may allow NHCEs to make a one-time irrevocable election prior to their participation in the plan to have a portion of their regular compensation automatically contributed to the NHCE plan.
Such elections are not treated as 401(k) deferrals.[12] As such, those amounts would not be subject to FICA taxes and could be immediately withdrawn in accordance with the NHCE plan’s in-service distribution provisions.
Roth Conversion and Tax-Free Rollover Opportunities
An NHCE may convert all or part of his or her account into a Roth — either as an in-plan Roth conversion if the NHCE plan is part of a 401(k) plan that permits such conversions, or by a transfer to a Roth individual retirement account using the NHCE plan’s in-service distribution provisions. While the converted amount is currently taxed, subsequent earnings are never taxed if the Roth qualified distribution requirements are met (and the 10% early distribution tax will not apply if the Roth five-year holding requirement is satisfied).[13]
Additionally, an NHCE plan account may be transferred tax-free to an IRA using the in- service distribution provisions.
Confidentiality, Creditor Protection, Testing Compliance and ERISA Nonqualified Plan Rules
Each employee’s NHCE plan contribution will be confidential and plan assets are creditor- protected. No discrimination testing is required and there is automatic compliance with the Code Section 410(b) minimum coverage rules.
The Employee Retirement Income Security Act nonqualified deferred compensation rules do not apply (e.g., limiting participation to a select group), since the NHCE plan is tax- qualified.
NHCE Plan Legal Compliance Matters
There are important legal compliance requirements for a tax-qualified plan to function as an NHCE plan. The following is a summary of the principal requirements.
The NHCE plan must be a profit-sharing plan and may be a stand-alone plan. Alternatively, an existing profit-sharing plan (including a 401(k) plan) may be amended to include NHCE plan provisions.
The plan must be adopted and in effect before contributions are made and it must include contribution provisions that permit different contributions (or no contribution) to be made for each NHCE. This is easily accomplished by using an IRS preapproved prototype plan that allows contributions to be allocated on a one-participant-per-group, or OPPG, basis.
If an existing plan document does not include the OPPG option, then it may be amended to include the necessary provisions.[14] It is not necessary for the NHCE plan to specify the type of current compensation being replaced by the NHCE plan contribution.
The NHCE plan should provide for 100% vesting of the NHCE plan accounts.[15] Also, it must include the desired in-service distribution plan provisions. Allowing a distribution after a stated age provides the most flexibility. Since any age may be used for this purpose, the younger the age the better.
This in-service distribution option may be limited to NHCE plan contributions. As with the OPPG provision, if an existing plan document does not offer this in-service distribution option, then the plan may be amended to include it.[16]
The plan should permit partial withdrawals for NHCEs wanting an in-service distribution of only part of their NHCE plan account. Additionally, contributions must not cause a violation of either the Code Section 415 annual addition limit or the Code Section 404 deduction limit.[17] Usually there will be sufficient room under these limits to provide the desired NHCE plan contributions.
If in-plan Roth conversions are desired, then the NHCE plan must be included as part of a 401(k) plan that includes that option. If the NHCE plan is not part of a 401(k) plan, then essentially the same result may be accomplished by a direct transfer to a Roth IRA once the NHCE qualifies for an in-service distribution.
There must be a summary plan description for the NHCE plan. If an existing plan is being amended to include NHCE plan provisions, then the summary plan description must be amended to reflect the NHCE provisions.
Additional NHCE Plan Considerations
Since an NHCE plan will be a new concept for employees, it is important that it be implemented in a way that supports NHCE understanding and satisfaction. The following are some key considerations.
Effective communication is crucial to clearly explaining the NHCE plan and its benefits. In particular, NHCEs should be encouraged to keep their contribution in the NHCE plan to maximize retirement savings, although the funds will be available if needed.
Employees also should understand that Social Security benefits may be reduced as a result
of lower FICA contributions (which of course would be offset by the potential enhanced retirement savings). In addition, employees should understand that in-service distributions prior to age 59.5 will be subject to the 10% early distribution tax unless a permitted exception applies.
If regular compensation is contributed to the NHCE plan, employees should understand the change to their take-home pay and how they benefit.
FICA savings are not required to be passed through to the NHCEs. However, it is strongly suggested that at least the employee portion of the FICA taxes (7.65% of the NHCE plan contribution) be contributed to the NHCE plan or paid currently, so that the NHCE effectively receives full pay.
Alternatively, FICA tax savings equal to at least 10% of the NHCE plan contribution (or more) could be contributed. This would provide the NHCE with sufficient funds to pay potential early distribution taxes attributable to an in-service distribution while allowing employers to share in the FICA tax savings. [18]
The number of employees who may benefit from an NHCE plan may increase if the NHCE plan limits HCEs to the top-paid group (i.e., limiting HCEs to the top 20% of employees ranked by compensation).[19] Note that all qualified plans maintained within the controlled group must use the same HCE definition.[20]
Conclusion
Great effort is taken to compensate officers, executives and high earners, on the basis that they are essential employees. We are recognizing, more than ever, that rank-and-file employees are essential employees as well.
The NHCE plan takes advantage of long-standing qualified plan rules to provide NCHEs with the rewards, compensation and benefits that they deserve.
Lawrence J. Eisenberg is of counsel at Hall Benefits Law.
The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.
[1] NHCEs are generally defined as employees who are not 5% owners during the current or preceding year and whose total compensation during the preceding year is less than $125,000 (for determining HCE status in 2020). This amount increases to $130,000 for purposes of determining NHCE status in 2021. The NHCE group may be expanded by using the so-called “top-paid group” election, discussed infra. See Code Section 414(q).
[2] It may be possible to structure NHCE plans that are defined benefit plans. However, this would be more complicated and beyond the scope of this article.
[3] See the definition of “nonelective contributions” in Treas. Reg. Section 1.401(k)-6.
[4] The primary limit is Code Section 415(c), which limits a participant’s “annual additions”
to the lesser of 100% of compensation or $57,000 (in 2020).
[5] Treas. Reg. Sec. 1.401(a)(4)-2 sets out the primary nondiscrimination rules for defined contribution plans.
[6] Vesting provisions could be applied to NHCE plan contributions, but since the amounts would have been paid currently, this does seem appropriate, except perhaps for incentive or service-based contributions.
[7] See, Treas. Reg. Sec. 1.401-1(b)(1)(ii). The IRS website describing profit-sharing plans makes it clear that “any age” may be used. https://www.irs.gov/retirement-plans/plan- participant-employee/when-can-a-retirement-plan-distribute-benefits. Compare to in- service distributions from 401(k) elective deferrals, which may only occur after age 59.5. Code Section 401(k)(2)(B)(III). Compare also Code Section 401(a)(36), which generally precludes pension plans from using a pre-age 62 an in-service distribution age.
[8] Regular compensation must be contributed without an election by the employee, to avoid the contribution being treated as an elective deferral. Care must be taken to satisfy state and local wage laws. Furthermore, this option is not available with respect to union employees, unless pursuant to a collective bargaining agreement.
[9] Subject to the Code Section 404 deduction limits. Note that these contributions are not subject to unlimited deductions because they are not 401(k) elective deferrals. Compare Code Section 404(n).
[10] Code Section 402(a).
[11] Code Section 3121(a)(5)(A). Compare to Code Section 3121(v)(1)(A), which subjects 401(k) deferrals to FICA taxes.
[12] See Treas. Reg. Sec. 1.401(k)-1(a)(3)(v).
[13] See Code Sections 402A(c)(4) and 408A(d)(3)(A). See Code Section 408A(d)(2) for rules related to “qualifying distributions.”
[14] This special language might cause the plan to be considered “individually designed,” which moves it out of IRS preapproved status (meaning that the plan sponsor may not rely on the IRS opinion letter with respect to plan’s tax-qualified status in form). Accordingly, it is preferable to use a preapproved plan that includes the OPPG option.
[15] Care should be taken to avoid inadvertently applying 100% vesting to other plan accounts.
[16] In-service distributions are a “benefit, right or feature” that should not be eliminated without consideration of the Code Section 411(d)(6) anti-cutback requirements.
[17] Annual additions and contributions under other qualified plans maintained within the controlled group must be taken into account when applying these limits.
[18] See Code Section 72(t).
[19] See Code Sections 414(q)(1)(B)(ii) and 414(q)(3).
[20] See IRS Notice 97-45.
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