The Experts

Ted's Table

July 31, 2001

I was laid off six months shy of vesting in my 401(k) plan. I lost $20,000 in matching contributions. Can I get that money back? ... Are there any factors that make it mandatory to roll money from a previous employer's 401(k) to a current employer's plan? ... Will the "top-heavy" limits on 401(k) contributions apply to the catch-up provisions in the new tax law? ... I have investments in a former employer's 401(k) plan. How can I cash out the company stock and leave the rest?

Q: In 1998 I was laid off after working at a job for three years and six months. I contributed the maximum to the 401(k) plan during those years. The company also matched my contributions and placed profit-sharing money into my account.

I was surprised to find that there was a four-year vesting schedule to gain ownership of my company's contributions. By being forced out when I was, I lost nearly $20,000 in company contributions. Do I have any recourse to recover this money?

TB: It is legally permissible for an employer to say that all employer contributions will be forfeited whenever an employee leaves the company, either voluntarily or involuntarily, before completing four years of service, in your case. This vesting method is known as cliff vesting because you go from 0 percent to 100 percent vested in a single shot. Current laws allow employers using a cliff-vesting schedule to take as long as five years to vest their contributions. Employers can use a shorter time period as well.

While some employers use cliff vesting, others use a graduated vesting schedule where 20 percent vests each year beginning after one, two or three years, reaching 100 percent after five, six or seven years. Either method satisfies legal requirements.

By the way, the tax bill signed into law earlier this year shortens both vesting schedules. The maximum time allowed for a cliff-vesting schedule will shorten to three years from five. Graduated vesting will have to be completed in a maximum of six, rather than seven years. These rules take effect Jan. 1, 2002.

The only potential recourse you may have is to claim that you were part of a "partial termination" of the plan. You have a potential right to claim the benefit you lost, under this area of the law, if the number of plan participants at your company declined by more than 20 percent within the plan year.

Employers must fully vest their contributions to employees who lose their jobs due to a partial termination. This provision is included in the law to provide additional protection to participants when a company closes a plant or business unit or when there are large workforce reductions. The specific regulations regarding what is a partial termination are sufficiently broad to give the IRS greater enforcement flexibility.

I recommend writing to the person who is designated as the plan administrator requesting payment of the forfeited amount due to a partial termination, if the reduction in the number of plan participants exceeds 20 percent. The name of the plan administrator is listed in the summary plan description.

Q: As administrator for our company's 401(k) program, I am sometimes asked by new employees whether they should roll over a balance from a previous employer or allow the previous account to remain open. I realize there is no easy answer, but are there certain factors that make a rollover mandatory?

TB: Rolling over money from one plan to another is an option rather than a requirement. I normally advise employees not to leave money in a former employer's plan because they lose both control and clout. The former employer has the right to change the investments at any time without the approval of participants. The former employer may also be acquired, which is also likely to lead to a forced move to different investments.

Former employees have less clout than active employees do. The longer someone is away from a former employer, the weaker the ties. This can, unfortunately, make it more difficult to get money out of the plan. The people involved with the plan at the former employer usually have more pressing duties than dealing with former employees. The problem becomes even more severe when companies are sold, restructured, etc.

That said, some plans automatically cash out employees who have a balance of $5,000 or less, unless those employees choose to roll over their money to an IRA or a new employer's plan. The new tax bill contains language allowing employers to automatically roll balances between $1,000 and $5,000 into a default IRA in the former employee's name, starting Jan. 1, 2002, for employees who don't request a rollover to a new employer's plan. This provision was added to the law because legislators worried that many people were cashing out of their retirement plans when they changed jobs.

Q: Will the "top-heavy" limitations on 401(k) contributions apply to the catch-up provisions of the new law, which will let me contribute an extra $1,000 next year? If I'm not able to contribute the new maximum of $11,000 because not enough lower-paid employees participate, will I also be unable to contribute the extra $1,000 that I am allowed by virtue of being over 50?

TB: For starters, I should mention that given the context of your question, your use of the term "top heavy" is inaccurate. You are referring to the wrong section of the law. This is a common mistake even among professionals, including accountants and attorneys, who aren't regularly involved with this area of the law. "Top heavy" is a specifically defined term that may apply to any retirement plan. A plan is top heavy whenever more than 60 percent of the money in the plan belongs to "key" employees. There are special compliance issues for top-heavy plans, including a minimum required employer contribution.

The provision of the law that prevents you from being able to contribute the maximum amount ($10,500 in 2001 and $11,000 in 2002) is a special discrimination test that applies to 401(k) plans, known as the ADP test. This test ties the amount that highly compensated employees may contribute to the plan to the average percentage of pay that the nonhighly compensated employees contribute.

Good news — the new catch-up contributions are not subject to the ADP test. For the benefit of other readers let me briefly explain what these contributions are about. Contained in the tax bill are provisions allowing 401(k) plan participants who are over age 50 to contribute an additional $1,000 a year in 2002, above the maximum annual contribution limit. This limit will rise by $1,000 a year to $5,000 in 2006. Further increases will be indexed to inflation starting in 2007, and will be made in $500 increments. (Editor's note: On Aug. 14, this Web site will publish a feature article explaining catch- up contributions in depth.)

Catch-up contributions are a big plus, particularly for those highly compensated workers who earn between $85,000 and $125,000. These individuals typically are not permitted to contribute more than 5 percent to 7 percent of pay, which frequently is much less than the maximum permitted dollar amount. The catch-up contributions will become even more useful to these employees when the maximum amount increases to $5,000.

Q: I was recently laid off. My former employer's 401(k) plan is currently maintained by Vanguard, but had been transferred from T. Rowe Price, so my investments are a mix of funds from both. I also have money invested in the company stock fund.

I like my current mix of funds, with the exception of the company stock fund. I like the fact that I don't have transaction fees with my current situation. I am still unemployed and will need the cash to carry me through paying my daughter's school tuition and expenses while I continue to look for work. Ideally, I want to keep the money in everything but the company stock fund.

How can I do this? If I cash the stock fund out, I will still have more than $5,000 left. I think I want to avoid a rollover of the entire amount to an IRA because then I will have to pay additional fees on transactions, even though I gain investment flexibility.

TB: If I'm reading your question correctly, it sounds like your goal is to sell the company stock and to use the proceeds, plus possibly some of the other money, for some immediate needs. You want to move the remaining balance to an IRA with the same investments you have now, but you don't want to pay any transaction fees.

I recommend completing the paperwork at T. Rowe Price and Vanguard to do a rollover of the mutual fund shares you want to retain directly to IRAs at these fund companies. Opening the IRAs with them will likely keep your fees lower than what you might get by going to a regular brokerage firm where you may have to pay additional commission fees. Have the employer stock and any other cash you need distributed to you. Have any remaining fund shares transferred to the IRAs. You will of course have to sell shares of one or more of your mutual funds to get any additional cash that you will need beyond what you can net from the company stock.

I don't think either T. Rowe Price or Vanguard will charge a transaction fee for the rollovers, but you should check with them first. You will have to pay them a commission to sell the shares of company stock, if you have those distributed in certificate form from the plan. The mandatory tax withholding doesn't apply to company stock that is distributed to you in certificate form but it will apply to any cash you withdraw. Regardless of the taxes that are withheld, you have to plan for the actual tax that will be payable on this distribution when you file your taxes. Depending on your tax bracket, it is likely to be higher than the automatic 20 percent withholding.

An alternative is to have the 401(k) plan sell the shares of stock and distribute the cash to you if the plan gives you this option. The 20 percent mandatory tax withholding will apply to the total distribution you receive in this instance.

By the way, you should also be aware you might have to pay a 10 percent early withdrawal penalty on withdrawals from your 401(k) account, if applicable.

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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