Dual sec. 401(k) plan/nonqualified deferred compensation plan arrangement.

More and more, employers are looking to provide key management with nonqualified deferred compensation arrangements to offset restrictions on the limits that apply to qualified retirement plans. In Letter Ruling 9530038, the IRS approved a coordinated Sec. 401(k) plan/nonqualified plan design that holds some promise for executives interested in combining these two methods of compensation deferral.

Under the facts of Letter Ruling 9530038, an employee (who was a member of a select group of management or highly compensated employees) entered into a salary reduction agreement by December 31 of the calendar year preceding the year the compensation to which the deferral election related was earned. The election specified that a percentage of compensation otherwise payable to the employee was to be deferred under a nonqualified deferred compensation arrangement. As soon as practicable after the close of the deferral year, the employer would perform a preliminary actual deferral percentage (ADP) test under Sec. 401(k) (3) and a preliminary actual contribution percentage (ACP) test under Sec. 401(m) on the employer's qualified Sec. 401(k) plan. The purpose for running these tests on a preliminary basis was to determine the maximum amount of the employee's salary deferral that could be contributed to the Sec. 401(k) plan without exceeding the applicable limitations. After conducting the preliminary tests (but in no event later than March 15 of the year following the Sec. 401(k)'s plan year), the lesser of the amount deferred under the nonqualified plan or the amount that could be contributed on the employee's behalf under the Sec. 401(k) plan without exceeding the applicable limits was contributed to the Sec. 401(k) plan. The election to have these amounts contributed to the Sec. 401(k) plan must have been made prior to the beginning of the plan year to which the deferrals relate. Any amounts originally deferred to the nonqualified deferred compensation plan that could not be contributed to the Sec. 401(k) plan because of the limitations could either be immediately distributed (coincident with the contribution of deferred amounts into the Sec. 401(k) plan), or could continue to be deferred under the nonqualified arrangement.

The determination of whether these "excess" amounts could be distributed or continue to be deferred would be based on the employee's irrevocable election, made prior to the beginning of the plan year to which the election related.

There appear to be at least two advantages to such a dual plan design. First, by holding off on making the Sec. 401(k) plan contribution until after performing preliminary ADP and ACP tests, the employee can be assured that excess amounts will not be contributed to the Sec. 401(k) plan (and thus not distributed into current taxable income). Second, the arrangement allows the employee to defer under a nonqualified arrangement exactly that amount he would otherwise defer under the qualified plan if it were not for the statutory limits.

Such an arrangement may also be detrimental to employees, however. Since contributions to the Sec. 401(k) plan would not occur until after the close of its plan year, the employee would lose out on a year's worth of tax-deferred growth on the earnings associated with this contribution; and by waiting until after the close of the Sec. 401(k) plan ear to make his Sec. 401(k) contribution, the employee may "give up" all or a portion of his share of die ADP for highly compensated employees. That is, highly compensated employees who do not participate in the nonqualified arrangement may not be as restricted in their ability to defer compensation into the Sec. 401(k) plan as they might otherwise be, because of the lack of participation by those covered by the nonqualified plan until after the close of the Sec. 401(k) plan year.

It should be noted that Letter Rulling 9530038 considered a modified plan design that was originally the subject of Letter Ruling 9317037. The primary difference between the plan design addressed in Letter Ruling 9530038 and the original plan design is that originally the employee could wait until after the preliminary ADP and ACP tests were performed before electing to contribute all or a portion of his nonqualified plan deferrals into the qualified Sec. 401(k) plan. Letter Ruling 9317037 was revoked by Letter Ruling 9414051, however; the Service became concerned that the ruling did not adequately address the constructive receipt issue relative to this post-year-end election.