On December 29, 2004 the Internal Revenue Service issued final regulations replacing proposed regulations issued on July 17, 2003 and final regulations issued on December 2, 1991 and December 22, 1994. These final regulations apply for plan years beginning on and after January 1, 2006. Plan sponsors are permitted to apply these final regulations to any plan year that ends after December 29, 2004, provided the plan applies the rules of these final regulations to the extent applicable for that plan year and all subsequent plan years. The final regulations include the following:

• Automatic Enrollment ("negative" 401(k) deferral elections).
  The regulations allow a plan to provide for an automatic salary deferral election for an employee unless the employee affirmatively elects otherwise. This may be considered a negative election that will not provide protection to plan fiduciaries.
  
  
• Employee deferral election process that applies where there is no automatic enrollment.
  The regulations require a plan to provide employees with an effective opportunity to make (or change) a cash or deferral election at least once during each plan year.

• General Distributions Restrictions — Change in status to leased employee.
  The regulations provide that a change in status from a common law employee to a leased employee is not a severance of employment that permits a distribution to the participant.
  
  
• Hardship Distributions — Reorganization.
  The hardship rules have been reorganized and revised to clarify the point that each of the two basic requirements (i.e. immediate and heavy financial need, and distribution is necessary to satisfy that need) have separate safe harbor rules that the plan may separately elect to apply.
  
  
• Hardship Distributions — Safe harbor for "immediate and heavy financial need."
  The regulations expand the list of circumstances that satisfy the safe harbor for an immediate and heavy financial need to include:
  • Expenses for medical care for a non-custodial child;
  • Funeral expenses for the employee's deceased parent, spouse, children, or dependents; and
  • Expenses for the repair of damage to the employee's principal residence that qualify for the casualty loss deduction under Code Section 165 (without regard to whether the loss exceeds 10% of adjusted gross income).
  
  
• Hardship Distributions — Definition of dependent.
  The regulations address the change in Code Section 152, which narrowed the definition of dependent, by modifying the medical expenses and tuition payment provisions in such a way that these provisions apply generally in the same manner that they applied before the change to Code Section 152.
  
  
• Hardship Distributions — "Determination of immediate and heavy financial need."
  The IRS has indicated that it intends to issue separate guidance addressing employee notice standards applicable to 401(k) plans generally.
  
  
• Plan-to-plan transfers and distribution restrictions.
  The regulations prohibit a plan from transferring accounts (except in the case of a direct rollover) to a plan that does not provide that the transferred amounts will remain subject to the 401(k) distribution limitation following a plan-to-plan transfer.
  
  
• Elective deferrals taken into account in determining if a participant is "nonvested" upon termination.
  Elective contributions under a cash or deferred arrangement are taken into account in determining whether a participant is vested for purposes of the break-in-service rules under Code Section 411(a)(6)(D)(iii). Accordingly, a terminated participant who does not have a vested interest in the employer's matching contribution will still be deemed vested due to his elective contributions and will have his service restored upon reemployment within 5 years.

• ADP/ACP Testing — Aggregation of ESOP and non-ESOP portions of a plan for testing purposes.
  The regulations eliminate the mandatory disaggregation of ESOPs and non-ESOPs for ADP/ACP testing.
  
  
• ACP Test — Use of elective deferrals.
  
  • The regulations add an additional restriction on the use of elective deferrals to pass the ACP test: elective deferrals under a safe harbor plan (or other plan that is not subject to ADP testing) cannot be taken into account for ACP test purposes.
  • A plan will not be treated as satisfying the applicable nondiscrimination testing rules for a cash or deferred arrangement if there are repeated changes to plan testing procedures or plan provisions that have the effect of distorting the actual deferral percentage so as to increase significantly the permitted percentage for highly compensated employees or otherwise manipulate the nondiscrimination rules.
  • Catch-up contributions in excess of a statutory or employer-provided limit, including elective contributions made by reason of an eligible employee's qualified military service, are not taken into account for testing. Excess deferrals that are distributed to highly-compensated employees are taken into account.
  
  
• Gap Period Income.
  To the extent an employee is or will be credited with allocable gain or loss on excess contributions for the period after the end of the plan year until the date of actual distribution (the gap period), the regulations require that the income be determined and distributed for that period. However, gap period income needs to be distributed only to the extent the employee is or would be credited with allocable gain or loss on those excess contributions for that period if the total account were to be distributed. In addition, a distribution of excess contributions is not required to include the income allocable to the excess contributions for a period that is no more than seven days before the distribution.

• ADP Safe Harbor — Suspension of contributions in association with hardship withdrawal.
  The regulations permit a participant who takes a hardship distribution from a safe harbor plan to continue making after-tax contributions that are matched without regard to the suspension of elective deferral contributions.

A contribution is made pursuant to a cash or deferred election only if it is made after the relevant election. Thus, a contribution made in anticipation of an employee's election is not treated as an elective contribution. A contribution can be made pursuant to a cash or deferral election only if the contribution is made after the employee has performed the services related to the compensation that, but for the election, would have been paid to the employee.