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Maximize sec. 401(k) plan with companion nonqualified plan.

Ever since Sec. 401 (k) plans gained popularity in the early 1980s, executives have tried to devise ways to make the maximum elective deferral allowed under law. (For 1996, this amount will be $9,500.) Because of the special actual deferral percentage (ADP) nondiscrimination calculation required to be done on employee elective deferrals, executives are often limited to a lesser amount. The ADP calculation limits the amount that the highly compensated group can put into the plan as an elective deferral to a multiple of the average amount actually deferred by nonhighly compensated employees (NCEs).

Many employers faced with limitations on highly compensated employees (HCEs) provide extensive employee education on the benefits of tax deferred savings and the advantages of early savings. If the education effort is successful, the increased NCE contribution rate will increase the amounts HCEs can contribute. Since the final tests are done on actual contributions for the current plan year, plan administrators are trying to hit a moving target when advising HCEs of the amounts they can defer.

Other employers are counting on pension simplification to help HCEs make the maximum contribution. However, the legislation passed in December 1995 and vetoed by President Clinton exacted a 3% minimum matching contribution from the employer in order to completely avoid the ADP testing. While satisfaction of the proposed safe harbor will allow all HCEs to contribute $9,500 (subject to individual annual addition limitations) without regard to the NCEs' participation, the 3% matching safe harbor might be costly, depending on the number of plan participants.

Without going the safe harbor route, the way to maximize the HCEs' contribution into the plan is to allow each HCE to defer whatever level he wishes, perform the ADP test after year-end, and refund the minimum amount necessary to pass the test. If the refund is distributed within the first 2 1/2 months after the tested plan year, it is treated as if it were never deferred, and is included in the HCE's taxable income in the same tax year as the deferrals. Refunding the excess amount leaves the executive without the desired tax deferral.

There is a planning method that preserves the executive's deferral on the excess amounts. In Letter Ruling 9530038, the IRS approved an arrangement under which an HCE could defer salary under a nonqualified plan and retain the amounts in that plan until the employer performs ADP testing to determine the maximum amount of additional elective contributions that could be made for that plan year under its qualified Sec. 401 (k) plan. Once the employer determines the maximum amount of additional elective contributions that can be made for the plan year, an appropriate amount of funds is transferred to the qualified Sec. 401 (k) plan from the nonqualified plan.

Under the arrangement, the employee can make a $9,500 deferral into a nonqualified plan. Assuming that the rules concerning constructive receipt and economic benefit are met, the employee will not be taxed on amounts paid into the nonqualified plan until distributions are made.

The terms of the nonqualified plan will provide that an amount equal to the maximum amount that could be contributed to the Sec. 401 (k) plan after the ADP test will be paid to the employee by January 31 after the close of the current plan year. If the employee would like that amount transferred to the Sec. 401 (k) plan instead of being paid directly to him, an election for the Sec. 401 (k) plan must be made at the same time as the nonqualified plan election.

These arrangements can also provide for matching contributions to be made into the nonqualified plan and then transferred to the Sec. 401 (k) plan, to the extent amounts are allowable after the actual contribution percentage (ACP) test on matching contributions is performed. No interest earned on amounts in the nonqualified plan can be transferred into the Sec. 401 (k) plan. Amounts in the nonqualified plan in excess of the amounts that can be accepted by the Sec. 401 (k) plan are left in the nonqualified plan and continue to reap the benefits of tax deferral.

Example: Executive Z makes a qualifying election to Plan A, a nonqualified plan, to defer $9,500. Under the provisions of A, an amount equal to the maximum amount that the employee could defer into the employer Sec. 401 (k) plan, Plan B, after the ADP test is performed, will be distributed to Z. Z makes an election at the same time as the election to A, to transfer the distributable amount from A into B instead. The ADP calculation on B concludes that Z could have a $5,000 deferral into the Sec. 401 (k) plan. Pursuant to Z's election, the $5,000 will be transferred to B instead of being distributed to him. The remaining $4,500 plus interest earned on the $9,500 will remain in A and is distributed in accordance with the plan provisions.
COPYRIGHT 1996 American Institute of CPA's
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Copyright 1996, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

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Author:Vines, Joan H.
Publication:The Tax Adviser
Date:Feb 1, 1996
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