Ted's Table

May 30, 2000

This Week, Ted Tackles: My employer inadvertently gave me more than my 401(k) balance after I retired. Do I have to pay it back? ý Why does my employer offer after-tax deferrals into my 401(k) plan? ý Is the 20% tax withholding required when stock is the only distribution from an ESOP? ý How can I set up a plan so highly compensated employees can get more money into it? ý How do I set up a 401(k) plan for temp employees? ý How is a lump-sum distribution defined?

TB: Your question is a most interesting one. Whoever made the mistake by overpaying you is probably in some hot water. This likely is an administrative employee at M&I Trust and Investment Management Co. The primary issue is whether you want to benefit at someone else's expense. Someone will have to make up this loss if you don't repay the amount that was paid in error. Your former employer could take legal action to recover this amount but they probably won't do so. Are you willing to retain money that has been paid to you in error?

Question: My plan offers an after-tax option for my deferrals. There is no company match on these funds. What advantage is there for me in using this feature? Why is my employer offering this option?

TB: Most employers that offer plans with after-tax contributions do so because their plans which pre-dated 401(k)s permitted this type of contribution. Employees who want unrestricted access to these funds prefer after-tax contributions. These contributions can be withdrawn at any time for any reason.

Pre-tax contributions may be withdrawn during active employment prior to age 59ý only for one of the IRS-approved reasons. The amount withdrawn is taxable, plus a 10% penalty tax is imposed. After-tax contributions may be a desirable alternative for savings in excess of the amount that is matched by the employer when an employee's goal is accumulating funds for a short-term need such as buying a home.

Question: Is the 20% mandatory withholding required on an Employee Stock Ownership Plan (ESOP) distribution if the only asset in the ESOP is qualified employer stock?

TB: The mandatory 20% withholding isn't required when qualified employer stock is the sole distribution from an ESOP. When a combination of stock and cash are distributed, the amount withheld shouldn't exceed the cash portion. For example, assume the total taxable distribution is $100,000 and only $10,000 of cash is distributed. The maximum amount to be withheld is $10,000.

Question: My employer sponsors a 401(k) plan. There are only a few highly compensated employees and the rest make considerably less (non-highly compensated). Is there any other type of plan we could set up for the highly compensated employees to put more money away and avoid the discrimination testing? We are a for-profit business, so I understand a 403(b) is not an option.

TB: You may want to consider a SIMPLE IRA or the 401(k) safe-harbor plan. The highly compensated employees can contribute $6,000 to a SIMPLE IRA regardless of the amount the other eligible employees contribute. This amount can be doubled if the spouses of the highly compensated employees also earn at least $7,000 per year. The required-minimum employer contribution is 1% of pay the first two years and then it has to be increased to at least 2% of pay.

The highly compensated employees can contribute the $10,500 maximum to a 401(k) safe-harbor plan. The employer must contribute at least 3% of pay. The highly compensated employees will receive this 3% contribution in addition to the $10,500 contribution. This isn't a bad deal in exchange for contributing 3% for the other eligible employees.

If you don't like these alternatives, you will have to accept the limits imposed by the standard 401(k). Consider adding an employer-matching contribution to encourage employee participation if you don't already do so. I recommend a match equal to 25 cents for each dollar an employee contributes, limited to the first 4% of pay that an employee contributes. The maximum cost will be equal to 1% of the pay of eligible employees.

You should also consider automatically enrolling new employees in the plan. This is commonly referred to as a negative election. The employee is automatically in the plan unless he or she tells you not to deduct contributions from his or her pay. This should increase the level of participation over time.

Question: Do you have any suggestions for establishing a 401(k) plan for a temporary staffing agency? Specifically, we want to set up a plan that just covers 12 full-time employees and allows us to exclude or do something different for our 250 temps. Most of these temps work over 1,000 hours a year. Any suggestions?

TB: It's difficult to make a 401(k) work well for most businesses that have lots of part-time employees who work more than 1,000 hours per year. Temporary staffing agencies fall into this category. A 401(k) plan must cover employees who work more than 1,000 hours per year who have been employed for at least 12 months. One alternative is to establish a plan without an employer contribution, which covers all employees who have completed at least one year of service and have reached age 21. This will give both the 12 full-time employees and the eligible, temporary staff members a plan to which they can contribute.

Generally, most of the eligible, temporary employees don't contribute to 401(k)s. This lack of participation affects only the full-time employees who are highly compensated. Highly compensated employees are defined as those who own at least 5% of the business and/or those who earn more than $85,000.

Assume there are two highly compensated employees at your agency. Establishing a 401(k) will give all other eligible employees the opportunity to contribute up to 25% of their pay, subject to the $10,500 maximum limit. The two highly compensated employees will be limited to probably somewhere around 3% to 4% of pay. This will be substantially less than what they would like to contribute but it probably is a better result for the business than having no plan.

You could also explore, with the help of a retirement-planning consultant, whether one of the more exotic employer-funded, defined-contribution plans will produce better results.

Question: Jim worked for a telecom company for 11 years. His 401(k) money was distributed between February 1999 and February 2000. The distributions total $120,000. These distributions represent 100% of Jim's 401(k) assets. He no longer works for that employer. Are these withdrawals considered a qualified lump-sum distribution? Why or why not?

TB: I'm not sure why you're asking this question. I'll start by assuming it relates to the special five-year income-averaging rule. That rule was used as a way to reduce the tax hit when an individual took a lump-sum distribution. This special tax treatment was repealed for plan years beginning after January 1, 2000. To qualify for this special tax treatment for tax years prior to January 1, 2000, the lump-sum distribution must have been paid to the recipient:

a. on account of the employee's death, or

b. after the employee attained age 59ý, or

c. on account of the employee's separation from service, or

d. if self-employed, after the employee becomes disabled, and

e. the employee must have been a participant for five or more taxable years prior to the taxable year of the distribution.

For favorable tax treatment, the recipient must elect to have the distribution treated as a lump sum, and such amounts must be received after the recipient reaches age 59ý. Each recipient is permitted only one such election. In addition, all plans of the same type maintained by the employer are treated as a single plan for this purpose.

The distributions to Jim must be measured against these requirements. The fact that part of the distribution occurred during 2000 creates an additional problem due to the change in the law. You should probably consult an ERISA attorney or consultant who is familiar with this area of the law. This person can examine all the facts to give you a specific answer.

Another issue is whether Jim is eligible to roll over the amount distributed to an IRA or another employer plan. The easiest way to answer this question is to list the types of distributions that may not be rolled over. These include the following:

a. payments, at least annually, for the life of the employee or the joint lives of the employee and his or her designated beneficiary, or

b. payments, at least annually, for a specific period of 10 years or more, or

c. amounts required to be distributed pursuant to minimum distribution rules, or

d. elective deferrals that are returned because of Internal Revenue Code Section 415 limitations (combined-employee/employer contributions cannot exceed 25% of pay), or

e. corrective distributions, and income on these amounts, caused by exceeding the 401(k) dollar limit or due to failing the ADP test which applies to the contributions of highly compensated employees, or

f. corrective distributions due to failing IR Code Section 401(m) for excess employer-matching contributions or employee after-tax contributions, and income on these amounts, or

g. defaulted participant loans that are deemed to be distributions, or

h. deductible dividends on employer securities under IR Code Section 404(k), and

i. deemed distributions of "P.S. 58" costs due to the ownership of life insurance in a plan account.

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.

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