The Experts

Ted's Table

September 25, 2001

My 401(k) contributions are limited when I run up against the highly compensated employee (HCE) rules. Can I negotiate with my employer for lower pay in return for an employer contribution? ... Two of my friends have dramatically different contribution limits. Why? ... I was laid off but have a 401(k) loan outstanding ı can my payback period be extended? ... What are the drawbacks of constant selling and buying of funds in my 401(k) plan?

Q: I am an engineer employed on contract through several job shops. The industry standard for 401(k) plans is to allow employee contributions from day one, but no employer match. My pay rate is such that I usually max out my contributions in six to eight months, then I have no tax-advantaged contribution options.

On assignments longer than one year, I also risk running afoul of the highly compensated employee (HCE) rules, resulting in either a partial refund of contributions or a sharp reduction in contribution percentage (if I remain with the same employer).

Is there anything in the rules that would preclude negotiating with my employer (prior to hire) for a lower pay rate in exchange for an employer contribution (e.g., $1/hr for all hours worked)? If this is feasible, do you have any advice on how to sell it to an employer?

TB: Your situation does raise some interesting issues. First, there is the potential of being restricted because you are a highly compensated employee. This shouldn't impact your contributions prior to either the second or third calendar year that you are employed with the same employer.

The compensation limit for HCE purposes is $85,000 for 2001. Assume you started with a new employer this year and you earn more than $85,000. This will not impact your contributions this year because you go back to the prior year to determine which employees are HCEs for 2001 testing purposes. (Your contributions will be impacted in a second or later consecutive year that you are with the same employer.) It will be necessary in this situation to begin restricting your contributions during 2002, if you are still with the same employer, because you will be included in the HCE group when the 2002 year is tested. But, if you earn less than $85,000 with that employer during 2001, your contributions won't have to be restricted until, possibly, the 2003 plan year, if that is the first year after the one in which you earn more than the applicable HCE limit.

You also asked about having your employer reduce your pay scale and contribute this additional amount to a retirement plan. Technically, any such contributions are elective deferrals, which are subject to the $10,500 maximum limit; therefore, they must be counted toward this limit. Each employer must also operate its plan in a manner that satisfies all the applicable laws and regulations. This requires a certain amount of benefit uniformity. Generally all employees must be given similar benefits which would preclude giving you a special deal.

Special deals are possible if the employer offers a non-qualified plan. These plans must be limited to a select group of management or highly paid employees. Because of the nature of your employment, you may not fit into this category. In addition, non-qualified plans aren't as attractive to the employer, which is another reason why they are usually offered to only senior executives.

Another possibility would be to work for your job shop as an independent contractor. You would then be able to establish your own retirement plan and contribute a much larger amount. You would, however, have to pay both the employee and employer portion of the FICA taxes and you would not be eligible for any employer benefits such as medical, workmen's compensation, unemployment, etc. As a result, this usually isn't a good deal.

You most likely will have to continue doing what you have been doing — contribute as much as you are permitted into the 401(k) and then look for the best alternatives outside the plan. These should include contributing to a Roth IRA, provided you meet the income limits, and investing some after-tax income in mutual funds or other securities.

Q: I have a friend who can only contribute 4 percent to his 401(k), and I have another friend who is allowed to put in 22 percent.

Why do percentage contribution limits vary so greatly from company to company? How do employers go about choosing the maximum limit?

TB: It seems to me that you are observing situations affected by the highly compensated employee (HCE) rules. That's the conclusion I'm reaching based on such a wide disparity in contribution rates. The law requires that 401(k) plans be subject to what are known as discrimination tests. These tests ensure that the plan is offered equally to all employees. One of the ways to measure this is by comparing the contribution rates of highly paid employees to those of non-highly compensated employees (non-HCE). If the HCEs are contributing too much, the plan will be considered out of compliance and the employer either will have to refund the excess contributions to the HCEs or bring up the contributions of all the other employees with a gift contribution. Most employers refund the money. This testing arrangement causes it to be in the best interest of HCEs to get the word out to the lower paid employees to participate.

I suspect that the friend who can contribute only 4 percent is likely an HCE. The amount these employees may contribute is tied directly to the average percentage of pay that the other eligible employees contribute to the 401(k) plan. This friend is probably a participant in a plan where the non-HCEs contribute an average of only 2 percent of pay. This is typical for a plan with many lower-paid employees such as in the hospitality industry or low-tech manufacturing.

Your friend who is able to contribute 22 percent probably isn't an HCE. Non-HCEs can contribute the maximum amount permitted by law regardless of how much other employees contribute. By the way, the gap between these two groups, HCEs and non-HCEs, will get even bigger next year due to the recent changes in the law. Currently the combined employee/employer maximum contribution limit is 25 percent of pay. This will increase to 100 percent of pay next year. So, non-HCEs at the company where your friend is limited to only 4 percent will be able to contribute as much as 100 percent, less employer contributions, whereas your friend will still be limited to around 4 percent.

While the government provides guidelines for maximum contribution rates, employers are given the latitude to impose more restrictive contribution limits. Some allow the most generous rates because they need to, to compete with other employers for worker talent. Others have more restrictive contribution rates so that they can keep their plans from failing their discrimination tests. The choice of a contribution limit depends on the employer's situation and the market it operates in.

Q: When you leave a job and have an outstanding 401(k) loan, all the literature I have seen says that you have to repay the loan in 60 to 90 days. If you are laid off, can your employer elect to continue to carry your loan as part of a severance package or is the 60- to 90-day time period mandated by the government's 401(k) regulations? Even though it is expensive for the employer to continue to service the loan, do they have any leeway in extending the payback period legally?

TB: Employers are required to administer plan loans within the terms of the plan document. The document provisions must also satisfy all legal requirements. In most instances, employers require loans to be repaid via payroll deduction because other forms of payment such as personal checks are cumbersome to administer and expensive to process.

A repayment period of up to one year may be granted before a default occurs during periods of absence from work, if the plan document so permits, but the loan must still be repaid in its entirety within the original time period if you return to work.

One of the issues at question in your situation is whether the layoff is temporary or permanent. If it is likely to be temporary, you should ask your employer to amend the plan so you have the maximum flexibility that is permitted by law. If your layoff is likely to be permanent, which must be the case since you expect to get severance pay, you will have to repay the entire balance to avoid a taxable distribution. Loan payments can be deducted from severance pay but your employer may not want to do this because you are no longer an active employee.

Q: What are the drawbacks of constant selling and buying of funds in my 401(k) plan? Suppose I want to hold shares of fund A for six months, and then sell those to purchase shares of fund B. In turn, I hold those shares for three months, and then sell those to buy shares of fund C.

As far as taxes go, I believe that any interest is taxed as income upon withdrawals. I know there may be some limit to the number of times I can redirect holdings within a 401(k) plan. What fees will I incur?

TB: The biggest drawback is the fact that such a strategy is contrary to what you should be doing with your plan — investing for the long term. Studies have shown that trying to time the market through constant selling and buying will give you horrible results. All investment professionals recommend picking funds and sticking with them for longer periods of time.

According to government regulations, you may do as much buying and selling as you want with your 401(k) without any tax problems. All gains are tax-sheltered regardless of how long you hold a particular investment. You are correct that only distributions from the plan are taxable. Just as gains within the plan are not taxable, losses you may incur don't produce any tax benefits, as would be the case outside the plan.

The specific rules and costs associated with changing funds are governed by the administrative rules for your plan. Some mutual fund companies have also placed limits on trading activity to control the level of short-term flows of money from fund to fund. You have to check with your plan representatives to get the specific details concerning fees and restrictions on transactions for your 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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