A distribution may be treated as necessary to satisfy an immediate and heavy financial need only in so far as the need cannot be relieved by any of the following alternative sources and if the employer reasonably relies upon the employee's representation. The alternative sources include:

For purposes of applying the safe harbor rule, an employee needs to demonstrate financial necessity. An employee will be deemed to lack other resources, and thus financial necessity would exist if:

Because of this restrictive safe harbor rule, employers may want to provide greater access to 401(k) funds by reviewing their plan loan arrangements. If they have no arrangements, they might want to implement some plan loan provisions. Such access encourages participation and thus ensures a 401(k) plan's viability. Moreover, an employer's payroll system may not be able to implement the individual limits on elective contributions required in the year following a hardship distribution.

Further, employers will need to adjust their payroll systems to take into account income earned as of Dec. 31, 1986. Such adjustment is needed since TRA '86 limits the amount of a hardship distribution to an employer's elective contributions and income earned as of Dec. 31, 1988. Income earned on elective contributions after 1988 may not be included in a hardship distribution.

Normally, employers embrace protective safe harbor provisions. However, many employers may not adopt these safe harbor provisions because they seemingly are very hard on employees.

As a result, employers should consider whether they intend to limit the availability of hardship distributions to those situations where the safe harbor rules apply. To the extent plan sponsors desire to use the safe harbor plan, procedures need to conform to these rules for plan years beginning on or after Jan. 1, 1989.

The final regulations clarify the point that actual compensation for part of a year may not be annualized for the purpose of determining whether a 401(k) plan passes the actual deferral percentage (ADP) test. Compensation for 401(k) testing purposes is that which is received for services performed for the employer and that is currently includable in income. Toward this end, an employer may include employee elective contributions under a 401(k), tax-sheltered annuity, simplified employee pension or cafeteria plan.

The final regulations extend the time period for making elective contributions that may be used in the ADP test for a plan year from 30 days after the end of the plan year to the last day of the 12month period immediately following the plan year to which the contributions relate. The contributions must then be allocated to the participant's account for the plan year for which the ADP test is performed.

Additionally, TRA '86 permits the recharacterization of excess contributions as employee contributions for the purpose of applying the ADP tests for years after 1986. Accordingly, plans may be amended to permit retroactive recharacterization and, therefore, plans under audit for compliance with ADP limits can utilize this recharacterization provision retroactively. Although contributions made within this 12-month period may be used for the ADP test, these contributions would arguably violate the Department of Labor rules that require employee contributions to be deposited in a plan's trust account within a reasonable time, but no later than 90 days after being withheld by the employer.

Also, recharacterized amounts continue to be subject to the 401(k) withdrawal restrictions applicable to elective contributions, even though these contributions have been recharacterized for ADP testing purposes. Moreover, recharacterized amounts are subject to FICA and FUTA taxes for the year to which the contributions relate.

Recharacterization may result in the issuance of amended W-2 forms to affected employees, and employees may have to file amended federal income tax returns for the year in question. In addition, administrators will need to take into account an employee's tax basis in the recharacterized amounts.

The proposed regulations also include provisions dealing with non-discrimination requirements, limitations on elective deferrals and partnerships.

Generally, the ADP test applies only to elective contributions made by an employee. However, certain nonelective contributions and matching contributions may be treated as elective contributions for purposes of performing the ADP test. These contributions may be included if they meet certain vesting and withdrawal restriction requirements applicable to elective contributions. TRA '86 requires all qualified plans, which include matching employer contributions or after-tax employee contributions, to satisfy a non-discrimination test substantially similar to the ADP test that applies to 401(k) plans.

The rules impose a 10 percent excise tax on excess aggregate contributions (i.e., excess matching or excess employee contributions) if not corrected within 2l/2 months following the close of the plan year to which they relate. In all events, a plan will be disqualified for the plan year in which these excess aggregate contributions relate and all subsequent plan years that the amounts remain in the plan, if a plan fails to make a correction by the end of the plan year following the plan year to which they relate.

Employers must keep records demonstrating compliance with the ADP tests as well as the non-discrimination test applicable to non-elective and matching contributions.

In regard to limitations on elective deferrals, an employee is permitted to defer up to $7,000 (subject to cost-of-living adjustments, i.e. $7,313 for 1988) under a 401(k) plan for any taxable year. The proposed regulations set forth the methods and requirements for correcting deferrals in excess of the limitations. Excess deferrals may be corrected by making a distribution in the taxable year in which they were made or until April 15 of the subsequent taxable year. Recharacterization is not available as a method of correction, but rather distributions to affected employees need to be made by the plan.

Additionally, a 401(k) plan that permits partners to vary contributions on their behalf needs to satisfy the applicable 401(k) rules. As such, the proposed regulations would require that matching contributions allocated to accounts maintained for partners will be treated as elective deferrals. Therefore, the $7,000 limitation (as indexed) will apply to employee elective deferrals as well as employer matching contributions when dealing with the account of a partner. In effect, this could devastate a 401(k) plan sponsored by, for example, a law or accounting firm wherein significant matching contributions are being made at the time.

In establishing a 401(k) plan, an employer must formally adopt, by resolution, a section 401(k) plan or a qualified plan containing a section 401(k) plan arrangement. Further, an employer's election may not relate to amounts previously designated or treated as after-tax employee matching contributions. And separate accounting in respect to 401(k) money as well as other monies, such as employer matching contributions, needs to be maintained by the employer.

Remedial period

The regulations also provide a special "remedial amendment period" with respect to amendments required under these regulations as well as under TRA '86. Therefore, proposed plan amendments generally must be submitted to the IRS for approval before the due date of the sponsoring employer's tax return, including extensions, for the year coinciding with or including the first day of the 1989 plan year. For calendar year taxpayers who maintain calendar year plans and receive an extention to file their federal income tax returns, proposed plan amendments generally may be submitted as late as Sept. 15, 1990.

However, it may be desirable to prepare these amendments together with other changes that need to be made to reflect certain other provisions of TRA '86, which will presumably be submitted sometime during 1989. Regardless of when plan amendments are made, the plan must operate in accordance with applicable laws or regulations as of the effective dates thereof and amendments must be retroactive to these dates.

Overall, these regulations clarify many open issues regarding the implementation and administration of 401(k) plans and employers need to review their 401(k) plans to make certain that they are in compliance with these regulations. Significant changes may need to be made to recordkeeping and payroll systems because these systems may have an impact on plan design, such as whether to conform with the safe harbor provisions regarding hardship distributions. Fortunately, practitioners and employers have been granted additional time to prepare plan amendments required by these regulations.