Question: My husband quit his job and his 401(k) plan sent us a check without any explanation or options. The check had 20 percent taken out already. I called the 800 number to ask if we couldn't just reinvest it into an IRA and not have the 20 percent taken out. The gentleman I spoke with took some time to look things up, but ultimately came back to say they had already sent the money to the IRS and there was no way to get it back.

After speaking with our financial adviser, we decided to pay off some debt with the remainder rather than reinvesting it with him, although he warned us of the additional 10 percent we'd pay at tax time.

One month later, we got a letter from the 401(k) company informing us they made a mistake and we owed them more than half of the money they sent us. They said it was the part the company paid, and my husband was not vested yet when he quit, so we needed to send it back to them. We don't have this money anymore, and since a month passed before they even told us anything, what is your opinion of our options at this time?

TB: Wow what a story! Your husband should request a written explanation of the rules governing how long he had to stay with the employer to get the employer contribution. He probably wasn't there long enough to be eligible to receive this money, but you should be sure. If your husband should not have received this money, you have to make a tough decision.

Your husband's former employer was legally required to provide a written explanation of his options. They were negligent if they failed to do so. Apparently, the problem was further compounded by paying more than what should have been paid. The fact that you used the money to pay off debt rather than investing it will make it more difficult for you to repay it. These are all factors that might encourage you to ignore the request to return the extra money.

Then there are the other factors. Can you feel comfortable keeping money your husband should not have received? What action will the former employer take to recover the money? How much trouble will the person who goofed get into for making this mistake? Some of your options are to:

a. Work out a plan for returning the money.

b. Provide a written explanation why you are unable to repay this money and hope your husband's former employer is willing to forget it. If they are not, they may threaten to take legal action to recover the money. You will need to decide whether they are serious.

c. Totally ignore the request to return the money and see what further action they take.

Question: I once read about a ruling that if your employer was going to cash out (pay for unused) vacation time, you could have the amount deposited into your 401(k). This was about two to three years ago. Do you know about this, or is there anywhere to look for this information?

TB: It has been several years since this item hit the news. As I recall, the IRS released an announcement indicating that unused vacation pay could be deferred into a 401(k) plan. They subsequently reversed their position, when this possibility became a hot item that attracted too much attention, requiring higher-level officials at Treasury to get involved.

Question: How big does a company have to be to get a 401(k) plan? My corporation has only two employees.

TB: A business with only one employee may establish a 401(k), but there are better alternatives. Establishing and running a 401(k) is cost prohibitive for two employees. The typical set-up fee is $1,000 and the annual administrative fee will be at least $1,000. It is also very difficult to find an organization that is interested in handling a new 401(k) plan when there are only two employees and no existing assets.

There are several alternatives I recommend considering until your business grows and adds a number of additional employees. One possibility is a simplified employer plan (SEP). This type of plan is funded solely by employer contributions. The business may contribute whatever amount it wishes, ranging between $0 and 15 percent of each eligible employee's pay. A SEP can be established and maintained by working directly with a mutual-fund company. There aren't any installation or administrative fees. Contributions to the plan are exempt from all payroll taxes, which is a significant advantage if the participants earn less than the Social Security maximum wage base.

For example, a $10,000 employer contribution to a SEP is exempt from Social Security, Medicare, workers' compensation, and unemployment taxes. A $10,000 employee contribution to a 401(k) is subject to these taxes up to the applicable maximum compensation limits.

Another alternative is a SIMPLE IRA. This plan is funded primarily by employee contributions. Each employee may contribute a maximum of $6,000 and receive the applicable employer contribution. The owner and other highly compensated employees may contribute the maximum amount, regardless of how much the other employees contribute. The employer is required to contribute 1 percent of pay as a match for the first two years. The employer contribution must be increased to at least 2 percent of pay starting with the third year. An alternative at that point is to explore switching to a 401(k), if the 2 percent required employer contribution is more than the business can afford.

A SIMPLE IRA can also be established by working directly with a mutual company. There isn't a fee to establish or maintain the plan. These fee savings should more than pay for the employer contribution that must be made for your employee.

You should also be aware of the fact that a 3 percent minimum employer contribution is required when a 401(k) plan is "top heavy." This condition occurs when 60 percent or more of the plan assets belong to the owners and any other "key employees." A 401(k) plan that covers only two employees will usually be top heavy, unless the owners are not active employees of the business. This minimum employer contribution makes 401(k) plans undesirable for many employers that have less than five non-key employees.

Question: What is the national average of employee deferrals as a percentage of compensation?

TB: Many studies have been conducted measuring average employee-deferral rates; however, it is advisable to do a little digging to know what conclusions should be drawn from the results. The following are some of the things I would want to know about the survey:

a. Is it an average of all eligible employees, or just those who are contributing?

b. Have employees who are suspended due to hardship withdrawals included in the average?

c. Are employees of companies who do not have 401(k)-retirement plans included in the survey?

d. Are the survey results adjusted to reflect the maximum compensation and contribution limits? For example, a CEO who earned $14 million last year could make contributions from only the first $160,000 of compensation, and could only contribute $10,000. Was the CEO included by using 6.25 percent ($10,000 divided by $160,000) or 0.07 percent ($10,000 divided by $14 million)?

The surveys I have seen recently show an average contribution rate between 4.5 percent and 5 percent of pay. I have not dug into how the results were determined. Two good places to get survey results are: the Profit Sharing/401(k) Association online, or by telephone at (312) 441-8550; and Employee Benefit Research Institute online, or by telephone at (202) 659-0670.

Question: I'm retired and taking required minimum distributions from my 401(k). What are the disadvantages of rolling over my 401(k) into an IRA that is placed in my revocable living trust?

TB: The proceeds left in your IRA when you die will pass to your beneficiaries. These proceeds will be part of your taxable estate and will also be subject to income tax. If you are married and your estate is large enough to be taxable, estate-tax savings can be accomplished by using revocable and irrevocable trusts.

Distributions from your IRA to a trust may be taxable to the trust, rather than as additional income of the beneficiaries. Who will incur the income-tax liability depends upon how the trust is structured. There may be an income-tax advantage if the trust is taxable; however, this is not likely because trust tax rates are high. As a result, paying this money to the trust may result in higher income taxes than if the money went directly to the heirs.

There are also some non-tax reasons for naming a trust as your IRA beneficiary. I am currently helping my son and his wife with their estate planning. They have a three-month-old daughter. I have recommended establishing a revocable trust which will be named as the secondary beneficiary for their IRAs. These funds will pass directly into the trust to be managed by the trustee for her benefit in the event of both of their deaths. This arrangement enables the parents to select the trustee, indicate their investment preferences, and to specify when money will be distributed to their daughter.

You should consider getting help from a qualified, independent professional.

Question: I began to work for a company in November of 1998. The company has a 401(k) plan that requires you to be employed for one year before you are eligible to participate. However, in February of 1999, the company changed providers and held an open 401(k) enrollment. I enrolled and payroll-deducted contributions to the 401(k) started in March of 1999. The company does not match any percentage of the contribution. My payroll deductions for 1999 totaled $2,284.70.

In March of 2000, the employer determined that I had been an ineligible participant, because I had not worked for the company for one year when I started to contribute to my 401(k) in March of 1999. They returned my payroll contributions of $2,284.70, but did not give me the investment gains of $638.23. I believe that the $638.23 is my money, but they say that they do not have to return it to me. Who should get the gains?

TB: I agree with you that you should get the investment gains on this money. The biggest challenge is how to accomplish this. The rules for taking money out of a 401(k) plan are very strict, even when the contributions have been made in error.

Paying the gain directly from the plan to you does not fit any of the rules that permit distributions to be made from a 401(k) to active employees. Therefore, paying the money directly to you does not appear to be a legally permissible option.

The cleanest approach probably is to return the money you received from the plan to the employer as a contribution made in error. The employer can then pay to you your contribution, plus the gain ($2,922.93 in total), from a corporate account, or the like. The IRS only permits contributions that have been made in error to be returned to the employer. Since the investment gain is not a contribution that has been made in error, the 401(k) plan cannot pay this money to the employer so that they can give it to you.

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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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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