How to solve employees' 401(k) problems.

The Omnibus Budget Reconciliation Act of 1993, among other things, reduces the amount of compensation that can be considered wages for qualified pension plan purposes. This can create problems for highly paid executives with 401(k) plans. Keith Tobias, CPA, executive vice-president of Compensation Resource Group, Inc., Menlo Park, California, describes one way to get around the problem.

The lower limit on the amount of compensation that can be considered wages for pension purposes-reduced to $150,000 for 1994 from $235,840--often produces a headache for highly paid employees (see "New Compensation Limit for Qualified Retirement Plans," JofA, Dec.93, page 24). Such a cut could

* Reduce the tax-deductible amount employees can deposit in their 401(k) plans.

* Cut the amount employers can match.

* If it turns out the employees have been depositing too much in their 401(k) plans, require them to return a portion of the deferred dollars, which must be included in taxable income.

There is an easy solution to this problem.

THE TWO-PLAN SOLUTION

One employer has developed a way to guarantee that 401(k) nondiscrimination tests--the actual deferral percentage (ADP) and actual contribution percentage (ACP)--are met each year while ensuring that its highly compensated executives maximize their contributions without the need for distributions at yearend. The taxpayer described in Internal Revenue Service private letter ruling 9317037 outlined how it set up two plans--plan A, a nonqualified deferred compensation (NQDC) plan, and plan B, a qualified 401(k) plan.

Under this procedure, highly compensated employees commit their pension money only into plan A during the plan year. At the end of the plan year, the company does its ADP and ACP testing, determines the amount the highly compensated employees could have put into the 401(k) plans and then transfers that amount from plan A to plan B. Any money left in plan A after the transfer remains deferred under the terms of plan A. What's more, the company can make its 401(k) matching contribution, if any, to plan A. This contribution also is eligible for the transfer. However, interest earnings credited to plan A may not be moved into plan B; they must remain in plan A.

Employers that maintain 401(k) plans as well as those considering such plans might use the two-plan approach. For companies with NQDC plans in place, all it takes is a simple amendment to provide for the rollover to the 401(k) plan.

Companies using this approach commonly may find that their highly compensated employees are more likely to defer income into a pension plan once it is offered without limitations.

THE RISK FACTOR

Of course, for an NQDC to comply with the tax code there must be a substantial risk of forfeiture. For example, if a sponsoring employer goes bankrupt, its employees could lose the money in the plan. However, since only one year's contribution is in an NQDC plan at any one time, the risk is minimized. To be sure, any deferrals in excess of the 401(k) plan limits that remain in the NQDC are subject to greater risks.

Less serious risks--for example, those imposed by a company's changing hands or its change of heart about offering such a benefit-can be reduced by choosing a rabbi trust or one of several conventional options that meet the requirements of the IRS. Companies considering NQDC plans certainly should review these security alternatives.

Warning flag raised by the IRS

The IRS said it was reviewing private letter ruling 9317037--the one cited in this article--due to concerns over potential constructive receipt in certain plan designs.

According to the IRS, a constructive receipt concern arises if an employee has control of the deferred compensation after a plan year ends and prior to transfer into a qualified plan. A plan providing such control over the deferred compensation is not in accordance with longstanding practices in nonqualified plan design.

A plan designed to make the rollover between the nonqualified plan and the qualified plan automatic--that is, such a rollover is irrevocably chosen prior to deferral--does not violate the constructive receipt doctrine, according to the IRS. Although the IRS position in this area appears clear, the best insurance for a company concerned about the IRS's position on an individual plan is to apply for a private letter ruling.

EXECUTIVE SUMMARY

* UNDER THE NEW TAX saw, highly paid executives with 401(k) plans may run into problems if they find their contributions are more than what is allowed. Their employers must return portions of their deferred contributions for inclusion in taxable income.

* ONE EMPLOYER found a way to guarantee that 401(k) nondiscrimination tests are met each year while ensuring that its highly compensated executives maximize their contributions without the need for distributions at yearend.

* A PRIVATE LETTER ruling issued by the Internal Revenue Service solves the problem by allowing the establishment of two plans--plan A, a nonqualified referred compensation (NQDC) plan, and plan B, a qualified 401(k) plan.

* DURING THE PLAN year, highly compensated employees commit to plan A. Then, immediately following the end of the plan year, the employer determines the amount the highly compensated could have put into the 401(k) and transfers that sum from plan a to plan B. Any money left in plan A after the transfer remains deferred under the terms of plan A.