Generally, once an election is made and the plan year has begun, a permitted election change event must occur to allow a participant to change or revoke the election. However, our Plan Document allows the Administrator to change employee elections if they determine that it is necessary in order to pass Nondiscrimination Testing. This employee election change becomes more difficult the closer to the end of the plan year it is made, so for year-end tests, it generally becomes more of a burden to employ this option than it is worth.
Final Proposed Treasury Regulation § 1.125–2(a) provides the rules related to making and revoking pre-tax elections. Essentially, an election for the new plan year must be made before the plan year begins ((a)(2)(ii)). Once the plan year has begun, an election can be changed if a permitted election event occurs ((a)(4)).
However, under IRS guidance, the plan administrator (the employer) can allow a change in the election, outside of a permitted election change event occurring, under the following circumstances:
1. A participant requests that the employer revoke the election prior to the first payroll deduction being taken. This only allows the participant to revoke an election, not change the amount of the election (increase or decrease). The employer would need to notify us prior to the first payroll to revoke the election.
2. To correct a mistake – this could be an election for dependent care when the participant meant health care FSA and has no children eligible for day care expenses; or the employer entered an election as $100 instead of the $1,000 that the participant elected; or the employer started taking $15 per pay check instead of $150, etc.. In all cases, the employer must investigate, determine that a mistake actually occurred and fix the mistake during the plan year.
3. Unilateral change or revocation of an election due to failed nondiscrimination testing – the employer can change (decrease) or revoke the elections of affected highly compensated or key employees so that nondiscrimination testing will pass at the end of the plan year. We have a few clients who have us test their plan early in the plan year and, based on the results, the employer decreases or revokes certain participant’s elections so that the testing will pass at the end of the year. The participants have no choice in the matter.
4. Change due to failed underwriting – if a participant enrolls in a pre-tax insurance plan, such as supplemental group term life insurance, and it is later determined that the participant has been denied the coverage due to medical underwriting, the original elected amount can be changed, retroactively, to reflect the correct pre-tax amount. Any pre-tax deductions that were taken in excess of the correct amount are returned to the participant as taxable income.
The third option is what is supported and described in our Plan Document. This change, however, would need to be initiated by the Plan Administrator (employer) and the affected employee(s) must have no choice in the matter. The change must be unilateral for all employee(s) who are causing the failure. To perform this type of a change, the Administrator would have to send us a communication (e-mail or letter) indicating what change they would like to make, why (due to potential or actual Nondiscrimination Testing failure), and that the change is being made by the Administrator. Then we can change affected elections.
If this is something requested near or at the end of the plan year, it becomes very difficult to comply. At that point in time, most, if not all, of the payroll deductions have been taken. More than likely, claims have been paid out. Therefore, if an election is reduced or revoked due to failing a Nondiscrimination Test, it could result in reversal of payroll deposits (in their system and ours if they are Payroll Deduction Billing) as well as Overpayments. Since failing a test requires the individual to pay taxes on the deduction, it seems counter-intuitive to jump through the series of hoops necessary to have the same end result – taxation of their deductions. This option would only be taken if an Administrator explicitly requested it and we discussed these difficulties with them and they still insisted that we allow it to occur.
While changes to employee’s elections are allowable due to failed Nondiscrimination Test, there are many factors to consider as to whether or not it is a good idea for the Administrator to change them. If they do decide to change them, it is easier to do closer to the start of the plan year and it must be initiated by the Administrator. Documentation to support that it was initiated by the Administrator and that the change is due to testing would need to be supplied.