401(k) plans are new again.
Now's a good time to consider offering employees this attractive retirement benefit.HIGHLIGHTS
* Since January, all associations have again had the opportunity to offer 401(k) plans as a viable benefit option.
* A 401(k) PLAN saves employee tax dollars and results in employer savings.
* The new law will allow employers to meet nondiscrimination tests without the current testing requirements.
* Offering a 401 (k) carries serious fiduciary responsibilities - so plan carefully.
Association benefit planners take note: With the 10-year blackout on 401(k) plans ended, you're well-advised to consider offering employees a 401(k).
For many employers, 401(k) plans have become a common and popular form of defined-contribution retirement plan. They enable employees to contribute toward their own retirement and provide organizations with an effective, low-cost benefit that can increase employee loyalty.
Unfortunately, after the enactment of the Tax Reform Act of 1986, most associations and other private nonprofit organizations were precluded from offering 401(k) plans to employees. Only tax-exempt organizations that offered these plans before July 2, 1986, could continue to sponsor them.
Now that's all changed. After a 10-year battle by ASAE and its partners in the nonprofit community, 401(k) plans are once again available to associations, other private nonprofit organizations, and their employees. Provisions in the Small Business Job Protection Act of 1996, enacted August 20, 1996, allow associations and other nonprofit organizations to offer 401(k) plans beginning generally on or after January 1, 1997.
How does a 401(k) plan work? What are its benefits? How do they differ from other plans? And how can you incorporate a 401(k) into an existing plan? Read on.
401(k) plans defined
A 401(k) is a qualified retirement plan (specifically authorized by the Internal Revenue Code) that allows employees to voluntarily save a portion of their pretax income by placing it directly into a retirement account. An employee can defer a specified maximum amount before taxes are withheld from regular salary, bonuses, and other forms of direct compensation. An employer may elect to match a percentage of employee contributions or to make contributions for the benefit of all employees whether or not they make a 401(k) contribution. A 401(k) is a type of profit-sharing or discretionary contribution plan.
In addition to providing an attractive retirement savings vehicle, a 401(k) plan offers significant income tax advantages. Annual employee and employer contributions, as well as retirement trust account earnings, are exempt from federal income tax in the current year. The employee pays no income tax until he or she withdraws money from the trust upon retirement or some other defined event. And employers do not owe employment taxes on the deferred amount.
Since income taxes do not reduce the invested principal and its earnings while in the 401(k) plan, the employee's contribution can appreciate more quickly. Additionally, because many individuals experience a lower income tax rate after retirement, income tax ultimately paid on plan contributions and earnings likely will be lower.
Although 401(k) plans are very flexible, the tax code imposes important limitations. These include the following:
* Through 1998, employer and employee contributions must meet certain nondiscrimination tests; generally, plans must be open to all employees. (Check the rules for "top heavy" plans, plans where the benefits are concentrated for the officers or key staff employees, with your plan administrator.)
* Starting in 1999, employers can avoid the minimum participation rules by contributing 3 percent of everyone's compensation (whether they make 401(k) contributions or not) or by matching 100 percent of deferrals up to 3 percent of compensation and 50 percent of deferrals for the next 2 percent of compensation.
* Employees may contribute an annual maximum in 1997 of $9,500 of their own pretax money (adjusted for inflation). The employer's limit generally provides that the total annual contribution (both employee and employer share) does not exceed 15 percent of the total of compensation paid to all eligible employees.
* The employee must be fully vested in his or her elective contributions and accrued benefits at all times.
* Vesting rules impact when a participant is fully entitled to employer contributions to his or her account. Different rules apply to elective employee deferrals and employer contributions used to satisfy nondiscrimination tests.
* The plan may not distribute funds to the employee (or his or her beneficiary) before the earliest of the employee's death, disability, or separation from service, or upon termination of the plan (for instance, if the employer went out of business). Distributions are also permitted upon hardship or after attainment of age 59 1/2.
With a 401(k) plan, employers are accountable for making sound investment decisions. Many plans are self-directed, allowing participants to select investments from a variety of choices. These options allow participants to materially affect the potential return on the assets in their own accounts. Do offer a variety of investment choices to participants and ensure that participants understand them. The U.S. Department of Labor and the Securities and Exchange Commission have guidelines to help employers educate and inform employees about self-directed plans.
401(k) plan benefits
A 401(k) plan allows you to flexibly design a plan that meets employer and employee needs. For example, a 401(k) plan may have a vesting schedule for employer contributions and may exclude employees under the age of 21 or employees who quit within their first year of employment. A 401(k) may or may not allow participant loans. Plans may also allow employees to tap into their funds in the event of an extreme financial or medical hardship.
Employees perceive a number of benefits from having access to a 401(k) plan:
* The plan is an easy way to save for retirement and long-term income needs.
* Employees view the plan as an important benefit of working at the association.
* The plan allows flexibility in both the amount saved and how those savings are invested.
* The plan empowers an employee to save for his or her retirement.
* The plan provides both immediate and long-term tax savings.
Organizations can also realize significant benefits from 401(k) plans:
* The plan can be used to attract and retain valued employees and increase employee loyalty.
* The plan can save the organization money by letting employees share in the cost of their retirement program.
* The plan can reduce pressure to improve other employee benefit programs.
* The plan's value can be enhanced by providing greater employer contributions or allowing additional direct contributions.
Disadvantages to 401(k) plans
The plans have their disadvantages as well. One issue has been the potential liability of plan fiduciaries for investment losses in a participant-directed plan. The Department of Labor has issued regulations providing that plan fiduciaries are not subject to fiduciary liability for losses resulting from a participant's investment decisions if the plan meets certain minimum standards. Understanding and complying with these standards is essential to protect fiduciaries from potential liability and penalties.
Another issue affecting 401(k) plans is their rising cost. Expenses are rapidly increasing primarily because mutual funds comprise the bulk of 401(k) plan assets. Mutual fund expenses - administrative fees, for instance - have been going up. These costs cut into the yield of plan assets. Therefore, it is imperative that organizations shop around among plan administrators to minimize expenses.
Set-up and maintenance costs also vary among plan administrators. Investment management fees typically range from 1 to 1 1/2 percent of the fund's underlying assets, a cost frequently passed along to employees.
Another disadvantage to 401(k) plans is the tax rules that apply to distributions and payments to participants. All distributions generally are subject to ordinary income tax. If a participant dies with assets in a 401(k) plan with a taxable estate, applicable estate taxes are soon due unless the spouse (and only the spouse) is named as beneficiary. Participants who wish to leave their plan assets to other beneficiaries - such as children or relatives - have difficulty avoiding estate taxes. There are ways to reduce the tax bite, but it takes planning by both the participant and the employer.
401(k) plans versus other retirement plans
Depending mainly on their size and resources, associations offer employees a range of retirement benefits.
These include defined-benefit pension plans; defined-contribution plans; Section 457 deferred-compensation plans; and, in the case of 501(c)(3) organizations, 403(b) plans.
The 401(k) plans can be cheaper and easier to use than traditional defined-benefit and defined-contribution plans because 1) contribution requirements are usually substantially lower and more manageable and 2) organizations have to deal with fewer regulations and reporting requirements than with defined-benefit plans.
Organizations that offer 403(b) plans are not likely to see a greater benefit with a 401(k). In fact, the new legislation allows participants in 403(b) plans to change their deferral elections to meet rules applicable to 401(k) plans, further reducing any differences between the two.
A 401(k) plan's effect on existing retirement plans
When you establish a qualified 401(k) plan, it is prudent to review and, if necessary, amend other existing retirement plans to protect their benefits. For example, if the 401(k) plan involves salary reduction, redefine the term compensation in other retirement plans as "compensation before any voluntary reductions under the 401(k) plan." Otherwise, participants may be penalized for contributing to the 401(k), since salary-based employer contributions or benefits under other retirement plans or welfare plans may be smaller if employees maximize their deferral election.
The establishment and use of a 401(k) plan may reduce an employee's ability to contribute to a 403(b) plan or 457(b) plan. The $9,500 401(k) elective deferral unit is reduced by deferrals to a 403(b) plan and any contribution to a 401(k) or 457(b) plan. In fact, the combination of a 401(k) plan and 457(b) plan reduces the 401(k) limit to $7,500 (as adjusted for inflation), the 457(b) limit.
Some employers have converted contributions under other contributory retirement plans, including defined-benefit plans, so that mandatory employee contributions are a salary reduction election under the 401(k) plan instead of after-tax deductions.
A good choice
It is a well-deserved coup for associations to regain 401(k) plans as a benefit option. Consider the pros and cons for your staff and consult with your accountant, lawyer, and a plan administrator about how the regulations apply to your association.
RELATED ARTICLE: More New Pension-Related
Legislation
In addition to affecting 401(k) plans, the Small Business Job Protection Act of 1996 legislated other significant changes to pension and employee benefit accounts. Among other actions, the new law
* brings the salary-reduction rules for 403(b) tax-sheltered annuities in line with the rules for 401(k) plans, retroactive to tax years beginning after December 31, 1995, and
* creates SIMPLE (Savings Incentive Match Plan) 401(k) and individual retirement account plans for businesses with 100 or fewer employees. (Although SIMPLE 401(k) plans are not subject to the special 401(k) nondiscrimination rules or top-heavy rules, they do limit annual employee and employer contributions.)
Effective August 20, 1996, the new law also restricts the requirements to use General Agreement on Tariffs and Trade (GATT) interest and mortality rates to compute maximum limits on benefits for early retirement under defined-benefit plans.
Beginning with plan years after December 31, 1996, the act
* simplifies the definition of highly compensated employees;
* amends minimum participation rules for defined-benefit plans and repeals current minimum-participation rules for defined-contribution plans;
* no longer requires that plan participants who are still working when they reach age 70 1/2 begin receiving distributions; and
* suspends the 15 percent excise tax on "excess distributions" (more than $155,000 per year or lump sums greater than $775,000).
For plan years beginning after December 31, 1998, the law makes safe-harbor nondiscrimination rules available for 401(k) plans for purposes of computing the Average Deferral Percentage Test and the Average Contribution Percentage Test.
For plan years beginning after December 31, 1999, the act repeals five-year forward averaging for lump sum distributions for tax-qualified plans for distributions occurring after December 31, 1999.
RELATED ARTICLE: Evaluating 401(k) Vendors
BY JOSEPH W. VALLETTA
Follow these six steps to select the best 401(k) provider for your association.
Step 1: Know the 401(k) marketplace. There are more than 200 full-service mutual fund, bank, and insurance providers; 3,000-plus asset managers; and 1,500 or more administrators who offer 401(k) plan services. In your role as a fiduciary, understanding the different types of solutions available to your organization is essential. Useful reference information is available from the Profit Sharing 401(k) Council of America, Chicago, (312) 441-8550; the 401(k) Provider Directory, Baltimore, (800) 462-0628; and the ASAE Services Corp., Washington, D.C., (202) 626-2835.
Step 2: Organize the search process. A 401(k) provider search can last from two to five months, and many roadblocks can spring up along the way. Therefore, it is important to spend time planning the search process. In the planning stages, 1) set goals and objectives, 2) create a time line that includes the request for proposal response deadline as well as meetings and visits to the finalists' facilities, and 3) decide who from your organization is going to be involved in the selection process.
Step 3: Develop a request for proposal. A request for proposal is a questionnaire designed to efficiently gather information on potential vendors. An RFP should be easy to understand and evaluate. To help accomplish this goal, divide your RFP into five sections: 1) organizational information, 2) record keeping and administration, 3) investments, 4) communication, and 5) price. It is customary to allow the vendor four weeks to respond to an RFP.
Step 4: Evaluate the request for proposal. Once the responses start rolling in, your challenge becomes evaluating and differentiating the vendors' services. Having the vendors' answers presorted by record keeping, investment, and communication issues helps facilitate the evaluation process. To help analyze a large amount of information in an organized way, use "the four P's" - people, process, performance, and price - to evaluate the responses.
* People. To identify an organization's capabilities and how its personnel's abilities are used to benefit you, find out who does what, what their qualifications are, and how long they have been doing it.
* Process. Identify the organization's ability to successfully and consistently carry out its assigned tasks. Understanding how the company is organized and what kind of technology and process it employs will help you accomplish this goal.
* Performance. Identify how successful the vendor's people and processes have been. One way to do this is to talk with the vendor's current and former clients.
* Price. Use a standardized fee worksheet to identify and list all fees. Then use this fee information to compare costs across vendors.
Step 5: Narrow the field. Based on the RFP responses, identify the most qualified vendors, typically two to four, and set up interview meetings. Give each vendor approximately two hours to present its services and answer questions. During the interview, look for consistency between each vendor's presentation and RFP responses.
Next, if feasible, set up a meeting to tour the vendor's record keeping and participant service center facilities. Examining the vendor's technology, people, and facilities will help you understand the company's capabilities and commitment to the 401(k) plan business.
Step 6: Select the best vendor. After going through steps 15, you'll be prepared to select the vendor who has survived the rigors of your evaluation and research. Remember, there is no one best vendor for all plans, but it is possible to follow this six-step approach and find the vendor who best fits your association's needs.
Joseph W. Valletta is a principal of HR Investment Consultants, an investment consulting firm in Baltimore, Maryland. He is a chartered financial analyst and is co-publisher of the 401(k) Provider Directory, a comprehensive guide to the fees and services of 401(k) plan vendors. Web site: www.401ksearch.com.
RELATED ARTICLE: Find Out About 401(k) Plans
For associations interested in establishing 401(k) plans for their employees, ASAE offers retirement program services through JZA, Inc., Bethesda, Maryland. For free information about establishing a 401(k) or other retirement program for association employees, call JZA, (301) 664-9464.
ASAE has also teamed up with the Chicago-based American Buying Retirement Services, Inc., for associations interested in providing 401(k) plan and supplemental retirement programs to their members. For a free brochure, call the ASAE Services Corp., (202) 626-2835, or American Buying Retirement Services, (800) 495-4050.
Brian D. McQuade is a senior partner in McQuade & Drolet, P.L.L.C., certified public accountants and consultants. Dan Brandenburg is a shareholder in the law firm Sanders, Schnabel, Brandenburg and Zimmerman, P.C. Both firms are in Washington, D.C.
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| Title Annotation: | includes related articles |
|---|---|
| Author: | Valletta, Joseph W. |
| Publication: | Association Management |
| Date: | Feb 1, 1997 |
| Words: | 2806 |
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