The Experts

Ted's Table

July 17, 2001

Our new plan year begins Dec. 31, 2001. Does this mean I have to wait a year longer to take advantage of some of the new 401(k) rules? ... If I default on my 401(k) loan, will it affect my credit rating? ... What are the most common reasons that the IRS and/or Department of Labor penalize an employer and/or disqualify a 401(k) plan? ... Hourly workers at my company contribute to the 401(k) based on their base pay, but have to limit their contributions if their total compensation makes them highly compensated employees. Shouldn't they be able to contribute based on their total compensation as well?

Question: For tax reasons my employer changed the 401(k) plan year-end date a few years ago to Dec. 30. I understand this means I won't be able to take advantage until 2003 of the new tax breaks that become effective Jan. 1, 2002. Is there anything I can do?

TB: Some changes in the new tax law are related to the calendar year and some are tied to the plan year, which in your case begins Dec. 31, 2001 rather than Jan. 1, 2002. The legislators put specific dates into the new law to try to clarify the effective dates of different provisions.

The maximum contribution limit (currently $10,500 and rising to $11,000 in 2002) is tied to the calendar year rather than the plan year so this one shouldn't be a problem for you.

The combined employee/employer contribution limit, which is currently equal to 25 percent of pay, is tied to the plan year because this is the period during which the plan must comply. This limit has been removed for plan years commencing Jan. 1, 2002 or later. This change will not be applicable for you until your employer's plan reaches the start of a new plan year on Dec. 31, 2002. That is why you may not be very happy about this unusual structure for your plan.

You could ask your employer to change the plan year to run from Jan. 1 through Dec. 31, but it may be reluctant to do so.

Question: I borrowed $50,000 from my 401(k) and still owe $32,000. If I default on the loan will this affect my credit rating? I understand I have to pay penalties and taxes. I'm buying a second house and want to put the $1,156 that I currently send every month to repay my 401(k) loan toward the principal of my 10-year mortgage.

TB: Defaulting on your plan loan won't affect your credit rating because this is a personal loan — in essence you are borrowing from yourself. As a result, your default won't be reported to the applicable credit agencies.

You will, of course, have to come up with the money needed to pay the tax on that money, which will be considered a distribution, including the 10 percent early withdrawal penalty if you are under age 59ı. Based on the numbers you gave, I'm estimating you may need $10,000 or so to pay the tax that will be due. You should continue to repay the loan if you don't have the tax money available.

Question: What are the most common reasons that the IRS and/or Department of Labor penalize an employer and/or disqualify a 401(k) plan? In other words, what are the worst 401(k) mistakes an employer can make?

TB: Is there anything you'd like to tell me?

Seriously, disqualifying a plan rarely happens. In fact, I have never seen a plan disqualified during my 40-plus years in this field. The penalties related to disqualification are so severe that this rarely happens. In addition, participants who are innocent parties bear the brunt of mistakes the employer made if this happens. The threat of disqualification, as punishment, is used primarily to scare employers into voluntary compliance with the law.

Disqualification is most likely to occur when the plan covers only, or primarily, highly compensated employees. The IRS' usual goal in dealing with larger plans with violations is to get the deficiencies corrected and to fine the employer rather than to disqualify the plan.

Nevertheless, it would be very foolish for an employer to intentionally violate the law, because an IRS or DOL agent can still make things very miserable. Your question about the worst mistake is like asking what is the worst sin you can commit. There isn't any score sheet that is used to rank mistakes — they are generally all bad.

A major thrust of the law and regulations is the issue of discrimination. The goals of this area of the law are to prevent highly compensated employees from receiving benefits that are more favorable than what is permitted and to ensure that employees who are nonhighly compensated receive the benefits they are supposed to get. As a result, you can count on an audit to focus on this area of compliance.

Otherwise, the IRS and DOL frequently change their priorities when they conduct audits. Two of the DOL's biggest bugaboos concern the timeliness of contributions to the plan and fees, particularly those paid from plan assets.

Question: My company considers both hourly and salaried employees as "highly compensated" when they reach $85,000 in total compensation. Hourly employees have to base their contributions on their base pay, and the contribution percentage is limited to 8 percent (instead of 16 percent) if their total compensation is $85,000 or greater. It seems like the hourly employees should be able to contribute a percentage of their total compensation. Is the plan making a mistake?

TB: The determination of who is highly compensated depends on total pay regardless of how the plan document defines compensation for contribution purposes. As a result, you are included in the highly paid group that must be restricted if you earn at least $85,000, even though only a portion of this amount is counted as plan compensation. This is the way the law is written.

However, the fact that your employer doesn't let you make contributions based on total pay is reducing the amount you may contribute to a lower level than what is legally required. For example, you should be able to contribute 8 percent of your total pay rather than just 8 percent of your base pay. Your employer may have limited your contributions to base pay because this reduces the amount of the employer-matching contribution. It is, however, legally permissible to permit employee contributions on total pay and to still restrict employer contributions to base pay. It would be advantageous for your employer to make this change because it would result in a better benefit for employees with no added cost to the employer. The one-time cost to amend the plan to make this change should be small and it could actually be included when other changes are being made to the plan.

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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