Avoiding 401(k) Traps

Since their creation under Internal Revenue Code section 401(k), cash or deferred (CODAs) have become the most popular type of retirement benefit plan for companies of all sizes. Many employers adopt 401(k) salary deferral plans to supplement their company-funded pension plans with employee-funded pretax retirement savings. Many employees who no longer can deduct individual retirement account (IRA) contributions due to income restrictions are able to replace them with deductible elective deferrals to CODAs. During the 1980s CODA plans underwent numerous refinements and clarifications of the rules as the Treasury Department and pension professionals gained experience with their implementation. The Treasury and the Internal Revenue Service were especially concerned with the potential for discrimination in favor of highly compensated employees (for definitions of terms used in this article, see the glossary on page 44). Final comprehensive CODA regulations were released on August 15, 1991, but their interpretations are still evolving. While amendments required to bring 401(k) plans into compliance must be made by the end of a plan year, beginning in 1994 the resulting changes will be retroactive to the August 15, 1991, release date. The regulations encompass changes under the Tax Reform Act of 1986, the Technical and Miscellaneous Revenue Act of 1988, the Omnibus Budget Reconciliation Act of 1989 as well as all the previously proposed regulations, temporary and final regulations, IRS notices and revenue procedures. Finalized CODA regulations contain some substantive changes that affect numerous participants and employers. CPAs working in this area should be aware of the regulations' complexities; even minor errors or omissions can lead to penalties, tax liabilities or plan disqualifications. The key changes affect the following regulations: IRC sections 401(k)--the CODA regulations, 401(m)--matching contributions, 401(a)(30)--disqualification for exceeding limits, 402(g)--dollar limits on elective deferrals and 4979-excise taxes on excess contributions. The general nondiscrimination regulations for qualified plans under IRC section 401(a)(4) and for permitted disparities under IRC section 401(l) also are affected. Summaries of these changes appear below. CONTRIBUTION LIMITS Annual additions to qualified defined-contribution plans for an individual participant are limited to the lesser of $30,000 or 25% of pay under IRC section 415. Annual additions include all elective deferrals, company contributions, allocated forfeitures and voluntary contributions to all defined-contribution plans of the same or related employers in which an employee participates. Exceeding these limits can lead to plan disqualification. Since 401(k) plans are defined-contribution plans, these limits apply. However, the regulations now make it possible to distribute or return elective contributions from a 401(k) plan to comply with the annual addition limit. Employer deductions for 401(k) plan contributions (elective and company combined) are limited to 15% of the aggregate pay of all eligible employees because such plans are not profit-sharing plans but, rather, arrangements within profit-sharing plans. (There are some exceptions.) Under IRC section 402(g), the maximum dollar amount a participant may elect to defer to a 401(k) plan is $8,994 for 1993; the sum is indexed annually. This limit includes all qualified deferrals to all 401(k), 403(b) and 408(k) plans in which an employee elects to participate. Under IRC section 401(a)(30), a plan is disqualified if elective deferrals of the same or related employers exceed the dollar limit. The new regulations do, however, provide relief from disqualification if a timely corrective distribution is made to the participant. Excess deferrals do not cause plan disqualification when they are made to plans of two or more unrelated employers if they are corrected. …