Avoiding 401(k) traps.
During the 1980s CODA plans underwent numerous refinements and clarifications of the rules as the Treasury Department and pension professionals gained experience with their implementation. The Treasury and the Internal Revenue Service were especially concerned with the potential for discrimination in favor of highly compensated employees (for definitions of terms used in this article, see the glossary on page 44).
Final comprehensive CODA regulations were released on August 15, 1991, but their interpretations are still evolving. While amendments required to bring 401(k) plans into compliance must be made by the end of a plan year, beginning in 1994 the resulting changes will be retroactive to the August 15, 1991, release date.
The regulations encompass changes under the Tax Reform Act of 1986, the Technical and Miscellaneous Revenue Act of 1988, the Omnibus Budget Reconciliation Act of 1989 as well as all the previously proposed regulations, temporary and final regulations, IRS notices and revenue procedures. Finalized CODA regulations contain some substantive changes that affect numerous participants and employers. CPAs working in this area should be aware of the regulations' complexities; even minor errors or omissions can lead to penalties, tax liabilities or plan disqualifications.
The key changes affect the following regulations: IRC sections 401(k)--the CODA regulations, 401(m)--matching contributions, 401(a)(30)--disqualification for exceeding limits, 402(g)--dollar limits on elective deferrals and 4979-excise taxes on excess contributions. The general nondiscrimination regulations for qualified plans under IRC section 401(a)(4) and for "permitted disparities" under IRC section 401(l) also are affected. Summaries of these changes appear below.
Annual additions to qualified defined-contribution plans for an individual participant are limited to the lesser of $30,000 or 25% of pay under IRC section 415. Annual additions include all elective deferrals, company contributions, allocated forfeitures and voluntary contributions to all defined-contribution plans of the same or related employers in which an employee participates. Exceeding these limits can lead to plan disqualification. Since 401(k) plans are defined-contribution plans, these limits apply. However, the regulations now make it possible to distribute or return elective contributions from a 401(k) plan to comply with the annual addition limit.
Employer deductions for 401(k) plan contributions (elective and company combined) are limited to 15% of the aggregate pay of all eligible employees because such plans are not profit-sharing plans but, rather, "arrangements" within profit-sharing plans. (There are some exceptions.)
Under IRC section 402(g), the maximum dollar amount a participant may elect to defer to a 401(k) plan is $8,994 for 1993; the sum is indexed annually. This limit includes all qualified deferrals to all 401(k), 403(b) and 408(k) plans in which an employee elects to participate.
Under IRC section 401(a)(30), a plan is disqualified if elective deferrals of the same or related employers exceed the dollar limit. The new regulations do, however, provide relief from disqualification if a timely corrective distribution is made to the participant. Excess deferrals do not cause plan disqualification when they are made to plans of two or more unrelated employers if they are corrected.
Amounts distributed to highly compensated employees to reduce their elective deferrals to the dollar limit are counted for average deferral percentage (ADP) test purposes (for a definition of "highly compensated employees," see the sidebar on page 46, "Defining the Highly Compensated"). Distributions to others do not. Therefore, highly compensated participants and employers must monitor deferrals carefully to avoid failing the ADP test. If one highly compensated employee defers an excess amount, the amount other highly compensated employees can defer can in turn be restricted.
STIFFER PARTNERSHIP RULES
Business partners face an additional limitation because of the way they can control their businesses. For example, matching contributions to a plan for a partner's benefit are considered CODA contributions under the regulations if the partners directly or indirectly allow their contributions to vary. As a result, matching contributions for partners must be counted toward the $8,994 limit and are subject to the other 401(k) restrictions. The Treasury and the IRS say they did not intend for this to be the case, but they did not address the partnership taxation issues immediately because of their complexity.
Some contributions are not treated as CODAs but are subject to the regular discrimination tests under IRC section 401(a)(4). For example, a partner may make a one-time, irrevocable election of a specified percentage or amount of pay to be contributed by the employer throughout his or her employment. Many partnerships make ordinary discretionary profit-sharing contributions instead of matching contributions to their 401(k) plans, enabling partners and employees to achieve their contribution objectives. Such contributions must be allocated in a nondiscriminatory manner to eligible participants.
The regulations require any excesses, once determined, to be corrected--by withdrawing or reclassifying them--using a specified leveling method. Excess contributions are defined as the amounts contributed by highly compensated employees in excess of the amounts allowable under the ADP test. Excess aggregate contributions are those above amounts allowable under the average contribution percentage (ACP) test. Deferrals are reduced for the highly compensated employee with the greatest percentage deferral until the test is passed or that employee's percentage equals the next highest highly compensated employee's percentage. If the test still is not met, the process is repeated until the test is satisfied.
Most plan sponsors have adopted a policy of performing ADP and ACP tests several months before their plan's yearend to detect and correct deferral problems early. Failure to correct the excesses within 2 1/2 months after the end of the taxable year can result in a 10% penalty on the excess amount.
Rather than implement corrective distributions, employers may make qualified nonelective contributions. As long as such contributions are subject to the CODA rules and restrictions, they may be counted for ADP test purposes. While this method avoids the distribution and tax liability for the participants, it may cost an employer more.
FEAR OF DISPARITY
Under regulations sections 1.401(a)(4)-9, plans may be restructured, to pass the discrimination tests, into separate components that still make up a single plan. As long as each component passes the coverage and discrimination tests, the plan as a whole remains qualified. The regulations, however, don't allow restructuring for IRC sections 401(k) and 401(m) for plan years beginning after January 1, 1992. The IRS believes restructuring CODA plans allows too much disparity in deferrals and contributions in favor of the highly compensated.
The Unemployment Compensation Amendments of 1992 eliminated many of the impediments to plan distribution rollovers. It also added a new twist to the distribution rules for 401(k) and other qualified plans. The act requires recipients of a plan distribution made after December 31, 1992, to make trust-to-trust transfers. Distributions made directly to participants are subject to 20% federal income tax withholding and, in some states, to state income tax withholding. Participants who receive distributions directly from their plans and personally roll them over within 60 days to other qualified trusts or IRAs may be entitled to have the amounts refunded when they file their tax returns. Individuals can avoid paying income tax and, when applicable, the 10% early-distribution penalty on the amount withheld if they use money from personal savings to roll over the total distribution (including the amount withheld). They therefore can't use the amounts withheld until they receive refunds after the end of the year.
Many pension practitioners are raising questions about this new withholding requirement. Distributions of excess deferrals under IRC section 402(g), amounts treated as distributed due to failure to repay loans and hardship distributions are not exempt as of this writing, which can impose a significant burden on employees who already are in difficulty. In addition, guidance is needed on numerous issues, including the necessity for spousal consent, the qualified status of a receiving plan if the transferring plan subsequently is disqualified and plan administrators' duties to provide notices and information.
The final regulations also prohibit aggregation of 401(k) plans with employee stock option plans for coverage and discrimination testing, family aggregation for purposes of discrimination, compensation and other issues.
There's little doubt 401(k) plans will remain the most widely accepted and appreciated type of retirement benefit plan. They offer flexibility for both employee and employer, ease of understanding and, in many cases, individual investment discretion. When a 401(k) plan is properly designed and administered, it can be an efficient and effective benefit. However, employers sponsoring or considering adopting 401(k) plans must be alert to the potential pitfalls and penalties associated with failure to comply with the regulations on a timely basis. Plan disqualification and failure to make timely corrections can have severe consequences in the form of taxes and penalties for participants and sponsors. GLOSSARY OF TERMS USED IN THIS ARTICLE
Related employers. Two or more employers under common ownership control. The rules for determining common control for purposes of qualified plans are defined in Internal Revenue Code sections 414(b) and 414(c) and generally are the same as the control group rules in IRC section 1563. The affiliated services group rules that require employees to be treated as employed by related employers are in IRC section 414(m).
403(b). A tax-sheltered annuity.
408(k). A simplified salary-reduction employee pension.
Nondiscrimination rules. IRC section 401(a)(4) rules prohibiting qualified plans from providing highly compensate individuals with benefits or contributions greater than those provided to employees who are not highly compensated. The regulations are very complex. A final revision is expected soon.
Average deferral percentage (ADP). The aggregate percentage of electively deferred pay for each participant, divided by the number of participants. Employees making no elective contributions are not counted in this computation.
Average contribution percentage (ACP). A percentage computed as ADP is, except matching contributions and nondeductible voluntary contributions are used instead of elective contributions.
* THE FASTEST GROWING type of pension plan is the 401(k) plan. Many employers are adopting such plans to supplement their company-funded pension plans with employee-funded pretax retirement savings. When such a plan is properly designed and administered, it can be an efficient and effective benefit.
* THE REGULATIONS WENT into effect in 1991 but their interpretations are still evolving. While amendments required to bring plans into compliance must be made by the end of a plan year, beginning in 1994 the resulting changes will be retroactive to the August 15, 1991, release date.
* UNDER THE CHANGED RULES, partners in a business face an additional limitation. Matching contributions to a plan for a partner's benefit are considered cash or deferred arrangement contributions under the final Treasury regulations if they directly or indirectly allow the partner to vary the amount of contributions.
* EMPLOYERS SPONSORING or considering 401(k) plans must be alert to the potential pitfalls and penalties associated with failure to comply with the regulations on a timely basis. Plan disqualification and failure to make timely corrections can have severe consequences in the form of taxes and penalties for participants an sponsors.
DEFINING THE HIGHLY COMPENSATED
Highly compensated employees for purposes of 401(k) and other pension and profit-sharing plans are defined in Internal Revenue Code section 414(q). In general, during the year, or the preceding year, such an employee
* Was at any time a 5% owner.
* Received compensation from the employer in excess of $96,368 (indexed).
* Was at any time an officer and received compensation greater than 50% of the defined-benefit dollar limit on benefits at the Social Security retirement age ($57,820, indexed).
* Is a family member of a 5% owner or a highly compensated employee who is one of the 10 most highly compensated employees.
Numerous rules and exceptions apply. IRC section 414(q) should be read carefully when determining who actually is a highly compensated employee. It also should be noted that in other areas of the tax code and in the Employee Retirement Income Security Act this definition does not necessarily apply.
JAMES L. KIDDER, CPA, CPC, is a senior employee benefit consultant with Fringe Benefits Designs, Inc., Des Moines, Iowa. A former member of the American Institute of CPAs relations with actuaries committee and the retirement committee and a past Journal of Accountancy editorial adviser, he is a past president of the Iowa Society of CPAs and a member of the American Society of Pension Actuaries.