Question: Can an employer include an independent contractor in its 401(k)?

TB: No. A 401(k) plan is established by an employer for the benefit of its employees. Employees who make pretax contributions actually authorize the employer to reduce their pay and to contribute the amount of the salary reduction into a 401(k).

An independent contractor is paid a fee, rather than compensation, for services rendered. As a result, there isn't an employment relationship which would permit the employer to reduce the salary and contribute this amount to the plan. "The employer must withhold taxes and issue a W-2, rather than a 1099, when there is an employer/employee relationship."

Question: My husband was notified that he isn't eligible to contribute to his employer's qualified 401(k) plan at all in 2001 because he made more than $85,000 in 2000. He is only eligible to contribute to the employer's nonqualified retirement plan. My understanding of the law is that because of his income, his contribution percentage must be limited. Is it legal for his employer to cut him off entirely from the qualified plan? There is another factor here, my husband's base salary is only $45,000 and the rest is variable pay. His employer only deducts from his base pay for the qualified 401(k). So, why is he considered a highly compensated employee in the first place? Do we have any legal recourse here?

TB: In all likelihood your husband was excluded from contributing because his employer's plan either failed or was in danger of failing its discrimination test. The IRS requires that 401(k) plans be tested to ensure they are offered equally to all employees. Otherwise, only the highly compensated employees would likely take advantage of them.

The first step in applying this section of the law is to determine which employees are highly compensated. The determination of who is a highly compensated employee is based solely on an employee's gross wages and/or stock ownership. Employees who earn more than $85,000 or own 5 percent or more of company stock are included in the highly compensated category, even if they are not eligible for the plan. The fact that your husband's plan permits contributions only from base pay is not relevant. This is the way the law is written.

An employer can exclude any employees it wishes from the plan as long as those that are eligible meet the legal standards. Excluding highly compensated employees fits within the permissible legal standards for exclusion; however, totally excluding the highly compensated employees is unusual. The more common practice is to limit their contributions to whatever amount will work.

I have personally recommended excluding highly compensated employees in several instances where participation of the nonhighly paid employees was very low or where there were some other unusual situations. What your husband's employer is doing is legal but I can't comment on their logic without knowing all the applicable facts. In instances where I have recommended excluding highly compensated employees, I have also recommended that the employer offer a nonqualified plan with significantly better benefits than the 401(k) plan. Hopefully that has happened in this situation.

TB: To answer your first three questions, the employer is permitted to withdraw from the plan contributions that have been made in error within one year after the contribution has been made. The employer doesn't have to give you any detailed accounting beyond what you normally get. This, however, shouldn't stop those of you who have been contributing to the plan from asking your employer for a detailed summary showing when the contributions were made to your accounts because you are not convinced the error occurred. The maximum amount your employer should take back is the current value of the excess contribution but only up to the actual amount of the excess contribution at the time it was made. In other words, the withdrawal should be adjusted for any losses, but any gain should be left in the plan.

Concerning your fourth question, your employer may not be acting within the law. Department of Labor (DOL) rules require your employer to deposit your deferrals as soon as possible after your paycheck is issued and, in any case, no later than 15 days after the end of the calendar month in which the deferral occurred. The primary hammer you have to help you is threatening to report your employer to the DOL for failing to make deposits to the plan within the legally permissible time period. You should consider informing your employer that you will request help from the DOL if you don't receive satisfactory evidence that the extra contribution was made before the money is taken back.

Concerning your last question, when you can withdraw money from your plan without paying the early withdrawal penalty, you can do it if:

1. You are over age 59ý;
2. You leave your employer (including taking early retirement at age 55);
3. You incur a hardship, such as complete disability, you die, you are in debt for medical expenses exceeding 7.5 percent of your adjusted gross income, you are required by court order to give the money to a spouse or child, or you are separated from service and have set up a payment schedule to take substantially equal payments over the course of your life expectancy; or
4. Your plan permits loans.

Regarding the ability to move this money into an IRA: You can easily roll withdrawals taken after you reach age 59ý or if you take early retirement. Likewise, you can easily roll the money if you leave your employer. You wouldn't have to pay a penalty on these moves.

You can't, however, roll a hardship withdrawal over. The amount will be fully taxable and the 10 percent early distribution penalty will apply if you are under age 59ý. A loan must be repaid. If you default on the loan, it will be considered a withdrawal and you will have to pay taxes and the penalty.

Your last question is common among employees frustrated with their plan. The law is designed so that you keep this money for your retirement. That's why it's so hard to get the money out. If you are really that unhappy with the plan and want to stay at your job, providing you are younger than 59ý, you could take the money and pay the penalties. Or, you would have to leave your job. I'm not endorsing either of these options, I'm just letting you know about them.

Getting help to make sure the plan is operated within the law may be the best solution to preserve your job and your savings.

Ted Benna, creator of the first 401(k) retirement savings plan, will answer your most intriguing questions every Tuesday. With over 30 years of experience as an employee benefits consultant, Ted is a nationally recognized expert on benefits issues. He has authored two books, Helping Employees Achieve Retirement Income Security and Escaping the Coming Retirement Crisis, and is President of the 401(k) Association. Ted is a frequent speaker at meetings of 401(k) plan sponsors and participants. His articles and comments have appeared in numerous publications, including The New York Times and The Wall Street Journal.

Read Ted Benna's Biography

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The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.

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