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Conversion of unused vacation days into retirement plan contributions.

The Wall Street Journal article, "Value of Unused Vacation Days Can Now Be Added to 401 (k)s" (12/10/96), based on Letter Ruling (TAM) 9635002, has generated a great deal of interest on the concept of converting vacation days into qualified retirement plan contributions. However, much of this excitement may be unwarranted.

The taxpayer in the TAM simply wanted to know whether vacation days converted to cash equivalents and contributed to its qualified retirement plan on behalf of its employees were subject to FICA taxation. The IRS concluded that the amounts contributed were not. subject to FICA taxation, as they were nonelective employer contributions rather than contributions pursuant to a cash or deferred election (Sec. 401(k) contribution); the employees did not have the option of receiving their accrued vacation days in the form of cash. An employee cannot have a cash or deferred election (as defined under Sec. 401(k)) unless he has the option of receiving benefits in cash.

The ruling generated excitement in the business community. Many thought it might be a way of saving on FICA taxes or a way around the 11i9,500 limit on Sec. 401(k) contributions in Sec. 402(g). While it is true that the amounts contributed are not subject to FICA taxes or the $9,500 limit on Sec. 401(k) contributions, there are many other issues that severely limit the feasibility of implementing a program to convert unused vacation days into retirement plan contributions.

Employers are not permitted to contribute unused vacation pay to their retirement plans on behalf of highly compensated employees (HCEs), unless the complex (and often costly) compliance test in Sec. 401(a)(4) is performed on an annual basis and shows that the effect of the additional nonelective contributions is nondiscriminatory. Many (if not most) retirement plans will fail this compliance test; significantly more HCEs than non-HCEs have unused vacation days or there are one or more HCEs with a greater number of unused vacation days than any of the non-HCEs. It may be possible to get the plan to pass the test using "cross testing" (testing the contributions on a benefits basis), but this would probably require significant additional expenses. That generally leaves the program available only to non-HCEs.

If an employer wants to use such a program for non-HCEs (and HCEs, if the compliance test under Sec. 401(a)(4) is met), both the employer and the employees will save on FICA taxes for amounts contributed to the retirement plan and the employees will benefit from the income tax deferral on the contribution. However, under such a program, the employees cannot be given the choice of receiving additional cash in lieu of taking vacation days. Instead, they must either use the days or have the employer automatically contribute the cash equivalent to the retirement plan. It may be difficult for an employer that currently offers employees the cash option to take that option away (even though it probably is better for the employees from a financial perspective). In addition, for those employers that currently forfeit unused vacation days and do not give employees the option to receive cash, contributing the cash equivalent of unused vacation days to a qualified retirement plan will result in increased costs instead of savings.

In summary, the ruling does not represent a new way of thinking by the IRS on FICA taxation of retirement plan contributions, nor does it create any new opportunities for plan design. The opportunity to adopt such a program has been available for years, but it simply is not feasible for the majority of employers that sponsor qualified retirement plans.

COPYRIGHT 1997 American Institute of CPA's
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Author:Daum, Timothy A.
Publication:The Tax Adviser
Date:Sep 1, 1997
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Next Article:Tax planning opportunities for distributions of employer securities from qualified retirement plans.

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