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Avoiding 401(k) traps.



Since their creation under Internal Revenue Code The Internal Revenue Code is the body of law that codifies all federal tax laws, including income, estate, gift, excise, alcohol, tobacco, and employment taxes. These laws constitute title 26 of the U.S. Code (26 U.S.C.A. § 1 et seq.  section 401(k), cash or deferred arrangements (CODAs) have become the most popular type of retirement benefit plan for companies of all sizes. Many employers adopt 401(k) salary deferral deferral - Waiting for quiet on the Ethernet.  plans to supplement their company-funded pension plans with employee-funded pretax pre·tax  
adj.
Existing before tax deductions: pretax income.

pretax adj [profit] → vor (Abzug der) Steuern 
 retirement savings. Many employees who no longer can deduct individual retirement account (IRA Ira, in the Bible
Ira (ī`rə), in the Bible.

1 Chief officer of David.

2,

3 Two of David's guard.
IRA, abbreviation
IRA.
) contributions due to income restrictions are able to replace them with deductible elective deferrals to CODAs.

During the 1980s CODA (1) A distributed file system developed at Carnegie Mellon University in the late 1980s. Evolving from the Andrews File System, Coda is noted for its ability to withstand network failures. See AFS.

(2) A software company based in the U.K.
 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 Having reference to things that happened in the past, prior to the occurrence of the act in question.

A retroactive or retrospective law is one that takes away or impairs vested rights acquired under existing laws, creates new obligations, imposes new duties, or attaches a
 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 omnibus: see bus.  Budget Reconciliation Act of 1989 as well as all the previously proposed regulations, temporary and final regulations, IRS An abbreviation for the Internal Revenue Service, a federal agency charged with the responsibility of administering and enforcing internal revenue laws.  notices and revenue procedures Revenue procedures are published statements of the Internal Revenue Service practices and procedures. Revenue procedures are published in the Internal Revenue Bulletin. . Finalized See finalization.  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 (Internet Relay Chat) Computer conferencing on the Internet. There are hundreds of IRC channels on numerous subjects that are hosted on IRC servers around the world. After joining a channel, your messages are broadcast to everyone listening to that channel.  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 The 1986 Tax Reform Act introduced the General Nondiscrimination rules which applied to qualified pension plans and 403(b) plans that for private sector employers. It did not allow such pension plans to discriminate in favor of highly compensated employees.  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.

CONTRIBUTION LIMITS

Annual additions to qualified defined-contribution plans Defined-Contribution Plan

A retirement plan wherein a certain amount or percentage of money is set aside each year for the benefit of the employee. There are restrictions as to when and how you can withdraw these funds without penalties.
 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 dis·qual·i·fi·ca·tion  
n.
1. The act of disqualifying or the condition of having been disqualified.

2. Something that disqualifies: illness as a disqualification for enlistment in the army.
. 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 Profit-Sharing Plan

A plan that gives employees a share in the profits of the company. Each employee receives into an account, a percentage of those profits based on their earnings. Also known as "deferred profit-sharing plan" or "DPSP".
 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 dis·qual·i·fy  
tr.v. dis·qual·i·fied, dis·qual·i·fy·ing, dis·qual·i·fies
1.
a. To render unqualified or unfit.

b. To declare unqualified or ineligible.

2.
 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 (1) (Automatic Data Processing) Synonymous with data processing (DP), electronic data processing (EDP) and information processing.

(2) (Automatic Data Processing, Inc., Roseland, NJ, www.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 Matching Contribution

A type of contribution an employer chooses to make to his or her employee's employer-sponsored retirement plan. The contribution is based on elective deferral contributions made by the employee.
 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 (Associate Computing Professional) The award for successful completion of an examination in computers offered by the ICCP. It is geared to newcomers in the computing field. For more information, visit www.iccp.org.

ACP - Algebra of Communicating Processes
) 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 Taxable year

The 12-month period an individual uses to report income for income tax purposes. For most individuals, their tax year is the calendar year.
 can result in a 10% penalty on the excess amount.

Rather than implement corrective distributions, employers may make qualified nonelective contributions Nonelective Contribution

A type of contribution an employer chooses to make to each of his or her eligible employee's employer-sponsored retirement plan. The contribution is not based on salary reduction contributions made by the employee.
. 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 IMPEDIMENTS, contracts. Legal objections to the making of a contract. Impediments which relate to the person are those of minority, want of reason, coverture, and the like; they are sometimes called disabilities. Vide Incapacity.
     2.
 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 spou·sal  
adj.
1. Of or relating to marriage; nuptial.

2. Of or relating to a spouse.

n.
Marriage; nuptials. Often used in the plural.
 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 Discrimination testing is a technique employed in sensory analysis to determine whether there is a detectable difference among two or more products. The test uses a trained panel to discriminate from one product to another. , 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 Tax-sheltered annuity

A type of retirement plan under Section 403(b) of the Internal Revenue Code that permits employees of public educational organizations or tax-exempt organizations to make before-tax contributions via a salary reduction agreement to a tax-sheltered retirement
.

408(k). A simplified salary-reduction employee pension.

Nondiscrimination non·dis·crim·i·na·tion  
n.
1. Absence of discrimination.

2. The practice or policy of refraining from discrimination.



non
 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 non·de·duct·i·ble  
adj.
Not deductible, especially for income-tax purposes.

Adj. 1. nondeductible - not allowable as a deduction
deductible - acceptable as a deduction (especially as a tax deduction)
 voluntary contributions are used instead of elective contributions.

EXECUTIVE SUMMARY

* 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 The Employee Retirement Income Security Act of 1974 (ERISA), 29 U.S.C.A. § 1001 et seq. (1974), is a federal law that sets minimum standards for most voluntarily established Pension and health plans in private industry to provide protection for individuals enrolled in these plans.  this definition does not necessarily apply.

JAMES L. KIDDER, CPA (Computer Press Association, Landing, NJ) An earlier membership organization founded in 1983 that promoted excellence in computer journalism. Its annual awards honored outstanding examples in print, broadcast and electronic media. The CPA disbanded in 2000. , CPC (1) (Central Processing Complex) An IBM mainframe that has two or more central processors (CPs) that share memory. It is the collection of processors, memory and I/O subsystems manufactured with a single serial number, typically all contained in one cabinet. , is a senior employee benefit consultant with Fringe Benefits fringe benefits,
n.pl the benefits, other than wages or salary, provided by an employer for employees (e.g., health insurance, vacation time, disability income).
 Designs, Inc., Des Moines, Iowa “Des Moines” redirects here. For other uses, see Des Moines (disambiguation).
Des Moines (pronounced /dɪˈmɔɪn/ in English,
. 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.
COPYRIGHT 1993 American Institute of CPA's
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1993, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

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Author:Kidder, James L.
Publication:Journal of Accountancy
Date:Sep 1, 1993
Words:2147
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