Question: Can an existing 401(k) plan
add a safe-harbor three percent nonelective contribution in year 2000?
TB: An employer who wants
to avoid the hassle and expense of nondiscrimination testing each year may set up what's
known as a "safe-harbor" 401(k) plan. Under such a plan, the employer has to pay
a certain amount of money into the account for the nonhighly compensated employees. There
are various formulas for calculating the amount. Some employers might find this option
expensive, especially since these contributions would have to be fully vested from the
word go.
The IRS answered your question when it released Notice 2000-3, on January 6, 2000. It
released this notice to encourage broader usage of the 401(k) safe harbor. One of the
challenges with the safe harbor is that the employer must notify its employees within a
"reasonable period" prior to the beginning of the plan year that it is switching
to the new type of plan. Notice 2000-3 gave plan sponsors until May 1, 2000 to provide
notice to employees, if they adopted the safe-harbor design before June 2, 2000. Both of
these dates have already passed so you have missed the safe-harbor opportunity for 2000 if
you haven't taken these steps.
Regarding the three percent employer nonelective contribution, an employer may wait until
as late as December 1 of the applicable year to decide to adopt this safe harbor. This
gives employers the flexibility to wait until close to the end of the year before making
this decision. However, employers who want to use this approach are required to inform
employees before the beginning of the year that it might be used, and that the employees
will be notified at least 30 days before the end of the plan year when the safe harbor
will be used. You should have issued such a notice to your employees prior to May 1, 2000,
the extended notice deadline for 2000, in order to use the nonelective contribution
approach for 2000. This notice only needs to be distributed to your employees. It doesn't
have to be filed with the IRS.
You should issue such a notice prior to the beginning of each future year if you want to
establish the opportunity to use the nonelective contribution. You must then make a
decision prior to December 1 of the applicable year and inform the employees of your
decision. The reason for this notice is to make certain all employees who are impacted by
this decision have an opportunity to take advantage of the safe-harbor arrangement.
Question: What are the different legal
processes a mid- to large-sized company has to go through to set up a 401(k) plan?
TB: The primary legal requirement is
to adopt a plan document, which contains the rules that will govern the plan. You must
resolve all the plan design issues, such as eligibility, vesting, the level of employer
contributions, etc., before the plan document can be prepared. The easiest way to create a
plan document is to use an IRS preapproved prototype.
You must prepare and distribute to eligible employees a summary plan description (SPD),
which tells them how the plan works. You're also required to obtain a fidelity bond from
an insurance company, which protects the plan from dishonesty on the part of those who
have control of the plan assets.
The above are the key legal requirements, but you also must make a number of decisions
regarding the operation of the plan. These include things such as:
1. How will the contributions be invested?
2. Who will maintain the participant accounts and provide other administrative/compliance
services?
3. How will the plan be communicated to employees?
You will also have to establish the administrative procedures and forms that will be
necessary to operate the plan. The entire process normally is led by the organization that
is selected to manage the plan. As a result, you should either select the organization
that will manage the plan early in the process, or retain the services of an independent
retirement-planning consultant who will help you design the plan and select your provider.
I strongly recommend using a consultant or seeking help from your counterpart at another
company who has a 401(k) plan so you can benefit from their experience. Otherwise, you
will have to learn as you go, which frequently leads to some bad decisions when a company
establishes its first plan.
Question: My employer has decided to
add an option whereby employees can invest their money into a family of funds. However,
they limited it to four funds, which parallel our existing funds. The primary difference
is that the "family" option lets you change up to four times per month, while
our existing funds only let us switch once a year. Private money managers manage the
existing funds, and my employer pays the fees. With the "family" we will be
subjected to whatever the funds' expense ratio is. The funds have similar objectives, with
one exception, and that one has performed better than our existing, privately managed
funds.
TB: The funds that have been selected
by your employer give you an advantage if your employer pays all the fees. The fact that
you can switch from fund to fund only once per year is a disadvantage, but it isn't that
big a deal. As you probably know, the most important thing over the long term is the total
return, net of investment expenses. This should be the primary reason for deciding which
funds to use.
Question: I take issue with your answer
to the question on June 6 about employers changing investment funds, in which you point
out the contradictions that exist in a 401(k) plan. The employee directs the investment
and is told he or she is responsible for the results. But, it's the employer's plan and
the employer is the one that selects the funds. In the Pension and Welfare Benefits
Administration publication "A Look at 401(k) Fees," the Department of Labor
states that "... plan sponsors must ... monitor investment alternatives and service
providers once selected to see that they continue to be appropriate choices."
Presuming you agree that ALL plans (defined benefit or defined contribution) should have
an investment policy statement, the IPS should define when a particular investment should
be put on a "watch list" or replaced due to bad performance, straying from its
mandate, etc. Why should a defined-contribution and/or 401(k) plan be different, even when
it's participant directed? Would you argue that participants should suffer bad performance
in a fund just because they made the initial choice?
Asset allocation should be based upon asset classes, not fund names.
TB: You're correct that the plan
sponsor is responsible to monitor the investment funds and should replace an
"underperforming" fund or a fund that drifts from its mandate.
This is great in theory, but it's difficult to execute when employers pick brand-name
funds rather than generic funds by asset class. When brand-name funds are used, it's
impossible to move from one fund to another without participants knowing that a change has
occurred. Changing a fund, regardless of the reason, is a contradiction to the message
most employers give the employees.
Most employees are told they must assume the responsibility for selecting the funds where
they will invest their money and the results. Participants who are constantly given this
message are shocked when the employer, without any employee involvement, changes a fund.
This frequently occurs when a business is sold regardless of whether the funds are brand
name or generic.
Moving an employee's money out of a brand-name fund for the reasons you mentioned also
involves some significant risk. I'll use Fidelity Magellan as an example. Plans that use
this fund should have dropped it a couple of years ago for bad performance and straying
from its mandate. Employers that did so created some major employee ill will when Magellan
rebounded and outperformed the traditional benchmarks. There is a reasonably good chance
that when a fund is replaced the new fund will underperform the replaced fund during the
following six to 12 months. This is a strong possibility, regardless of what professional
assistance is used to evaluate the various funds and make this decision. Most employers
that I am aware of simply added additional funds in this particular asset class, rather
than forcing participants to sell their Magellan shares. Some professionals I know
condemned these employers for not having the courage to "do the right thing" by
forcing participants out of Magellan.
I agree with you that using managers that are selected by the employer to manage a
particular asset class, which is then presented to participants in a generic form such as
a large-cap equity fund, avoids this problem. However, many participants push hard for
brand-name funds rather then the generic type. When it comes to fund selection, employers
are in a no-win situation, which is one of the reasons why employers are likely to cease
being investment gatekeepers during the next decade.
Question: My wife took a loan last year
to help pay for my living expenses while I was finishing college. We paid back part of it
but then her job was terminated. We stopped paying the loan back with her last paycheck in
March. There haven't been any adjustments to the account yet and we haven't changed
anything. I understand that you can make penalty-free withdrawals from an IRA for school
expenses. Does this hold true for 401(k)s? Also, can a 401(k) be tapped penalty-free for a
first house, like an IRA can?
TB: Withdrawals from a 401(k) for
education or first-home purchases don't receive any special tax breaks. Withdrawals for
these reasons are fully taxable and the 10 percent early distribution penalty applies if
the withdrawal occurs during active employment prior to age 59ý. The unpaid loan will be
fully taxable and the penalty tax will be imposed unless your wife is able to pay off the
loan.
Question: I plan on retiring at 59, six
months before turning 59ý. I intend to combine my retirement cash out with my 401(k),
roll it over into an IRA, and start drawing income from it. My financial advisor told me
that I had to wait one year before going back to work in the same industry
(telecommunications), or the IRS would view my rollover as a distribution and I would be
required to pay tax and penalties on the entire distribution. Is this correct?
TB: Tax-deferred rollovers into an
IRA are permitted even if you continue working. So, the fact that you will continue
working within the same industry after you roll money into an IRA won't disqualify the
rollover.
You apparently also want to start drawing an income from the IRA prior to age 59ý without
incurring the 10 percent penalty tax. Distributions prior to age 59ý must qualify under
Internal Revenue Code Section 72(t) in order to avoid the penalty tax. The distribution
must be structured as a series of substantially equal periodic payments, not less
frequently than annual, paid over your life expectancy or the joint life expectancy of you
and your beneficiary. Once these distributions begin, they must continue for five years or
until you reach age 59ý, whichever comes later.
I am not aware of any employment restrictions, but I have never claimed to be a Section
72(t) authority. It would, in fact, be very difficult for the IRS to monitor whether
someone has returned to work within the same industry, which is another reason why I doubt
that what you are being told is correct. I suggest asking your financial advisor to give
you a copy of the IRS ruling that supports his position.
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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