The Experts

Ask the Expert

By: Ted Benna Creator of the first 401(k) plan

September 5, 2002

This Week, Ted Tackles:
My wife and I have an S corporation. Can I pay myself income from it and put it into a 401(k) plan? ı Once I get my company's full matching contribution, should I stop contributing to the 401(k) and save in other accounts? ı When must my employer deposit my contributions to the plan, and when must the money be invested? ı Will my company include my bonus when determining whether I'm highly compensated? If so, how do I control my 401(k) contributions so I don't get a refund?

Q: My wife and I have our rental property in an S corporation. I was considering taking a salary of $15,000 and funding a 401(k) with $11,000 of it. Would this be allowed?

TB: A key issue for your situation, and similar situations, is whether your income is considered passive investment income or income earned for services performed. Contributions can be made to any retirement plan including a 401(k) when you have earned income.

You should discuss with your accountant what level of compensation would be appropriate for the services you perform. You may then make a pre-tax contribution to a 401(k) equal to 100 percent of this amount, up to the $11,000 maximum, less Social Security taxes that must be deducted. The employer may also contribute up to an additional 25 percent of the W-2 income as a profit-sharing contribution.

Assume your accountant tells you that $10,000 is the maximum amount he recommends taking as W-2 income. The amount remaining after Social Security taxes are deducted will be about $9,200. You can contribute this amount pre-tax to your 401(k) plan.

Your firm may also contribute up to $2,500 (25 percent of $10,000) as a profit-sharing contribution. Combining your salary deferral and the profit-sharing contribution, your total 401(k) contribution could be $11,700.

The key will be what amount your accountant thinks is reasonable W-2 income.

Q: My company matches 100 percent of the first $1,000 I contribute to the 401(k) plan, and 50 percent of the next $1,000, for a total of $1,500 annually. Once I max this out, should I stop contributing to the 401(k) and increase contributions to other savings vehicles, such as a mutual fund?

TB: In conversations with 401(k) participants ranging in age from their 20s to their 60s, I have learned that the most valuable benefit of the plan is the saving that occurs through payroll deduction. This is the only way that most employees can meet their desired savings goals.

Most employees lack the necessary discipline to save a fixed amount each pay period outside a 401(k) and to sustain the applicable savings rate over a long period without tapping these funds. Hence, the first question you need to ask yourself is this: Will you be able to maintain your savings rate outside the 401(k) and keep your hands off this money?

Other forms of saving will probably not give you the same tax advantage that you get with the 401(k). You will likely have to pay income taxes before you invest, unless your adjusted gross income is low enough that you can make tax-deductible contributions to a traditional IRA.

I prefer making the maximum contributions that are permitted in pre-tax savings accounts before saving after-tax because this is a faster way to accumulate an adequate nest egg. For example, at a 27 percent tax rate, if you earn $10,000, only $7,300 is left after-tax to invest. I prefer investing the entire $10,000 through the 401(k) plan even though I will have to pay tax later. I know some argue that saving in after-tax accounts is a better strategy because investment gains will be taxed at the (usually lower) capital gains rate rather than the regular income tax rate. But again, I stress that you need a lot of discipline to maintain your savings rate and leave the money alone when you invest it yourself in a taxable account outside a 401(k).

Another issue to think about is the fact that the amount of taxable income you receive in retirement will impact the taxes you pay on Social Security benefits. Some financial planning professionals say to "invest outside the 401(k)" so you'll have less taxable income when you receive Social Security benefits. This also is a valid issue to consider, but my response is "When do you plan to retire?"

If you plan to retire during your 50s, for example, your entire income must come from sources other than Social Security. (The earliest age you may begin receiving Social Security benefits is 62.) Drawing heavily on your 401(k) during this period will substantially reduce the Social Security tax issue.

A final point is that all the long-term projections that financial professionals run involve many assumptions, including the future of Social Security and future tax rates. By contrast, there's no uncertainty about the current tax break that you get when you put money into a 401(k).

Here are two related questions:

Q: Is there a regulation stating by what date a 401(k) contribution must be invested (i.e. so many days after being deducted from a paycheck)? My wife's plan doesn't seem to contribute in a timely fashion, and her account does not reflect contributions made each paycheck. From what she has discovered, it appears that her company is not providing the money to the 401(k) administrator on a regular basis. Is this possible and legal?

Q: Is there any legally prescribed time limit by which the 401(k) contributions taken out of my paycheck must be deposited into my 401(k) account? I've been checking the transaction history of my 401(k) account and I've noticed that on some occasions it's taken over a month. It doesn't seem proper that the company should be sitting on my money for so long before it gets into my account.

TB: There are two separate issues here.

When your employer must put amounts that are deducted from your pay into the plan. This is governed by Department of Labor (DOL) regulations that state the contributions must be transferred from the employer into the plan account as soon as possible after these amounts are determined, but no later than 15 business days after the month during which the contributions were deducted. Some employers deposit contributions after each pay period, but many employers deposit the contributions into the plan once a month -- usually during the first week after the month ends. For example, all contributions for the month of July would be deposited during the first week of August. Depending on the applicable payroll dates, the deposit date could be a month or more after the deduction from an employee's paycheck.
When the money must be invested per your instructions. Believe it or not, in this case there actually isn't any deadline. The DOL regulations apply only to getting the money into the plan account. It could sit in a money market or other account for an indefinite period before it is invested in the specific funds you have picked. One reason for a delay might be data issues that must be resolved before the money can be invested. However, if your employer takes an unreasonably long time to invest the money once it's in the account, this could be a breach of fiduciary responsibility. Your employer might have to make good on any investment gains you missed while the money was sitting waiting to be invested.

Q: Is the highly compensated employee rule applied to the income reported to the IRS on Form W-2, including base salary and bonus? If so, how do I, as an employee, control the maximum amount of contributions I make so I don't get hit with a penalty, and do I even need to worry about this?

TB: Total compensation, including salary, bonuses and most other forms of compensation, is what is used to determine which employees are highly compensated for the purposes of nondiscrimination testing. A way to avoid this problem is to earn less than the amount needed to throw you into this category. This limit is $90,000 earned during 2002. The worst situation is to earn just a few dollars more than this limit. So if you have any control over your compensation, either stay under this level or earn enough over $90,000 to be meaningful.

You don't have to worry about a penalty, per se, because if your employer's plan fails the non-discrimination tests it must find a way to fix this. That is commonly accomplished by refunding excess contributions to the highly compensated employees (HCE). But, there are other remedies.

If your concern is avoiding a refund, you should check with your employer as to what level of contribution would likely let you avoid one. Some employers run a test projecting contributions at mid-year and warn their HCEs if it looks like their contributions are in danger of being refunded. Others don't.

You should check with your employer to see if it does and, if so, check back several times throughout the year to see if you can increase or reduce your contributions.

Ted Benna, creator of the first 401(k) retirement savings plan, answers intriguing questions twice a month. With over 40 years of experience as an employee benefits consultant, Ted is a nationally recognized expert on benefits issues. He has authored three books, Helping Employees Achieve Retirement Income Security, Escaping the Coming Retirement Crisis, and Tips for Successfully Managing Your 401(k), 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.