Article: Reconsidering the Company Retirement Plan

June 2007

Reconsidering the company retirement plan

Rules regarding 401(k) or other salary-reduction plans are constantly changing, and business owners who offer these retirement plans will want to consider important developments

Most businesses today offer employees some form of qualified retirement plan. The most common version is the elective deferral plan, such as a 401(k), in which each eligible employee has the ability to carve off, in a pre-tax manner, some portion of compensation for investment into a retirement plan. But the rules regarding these 401(k) or other salary-reduction plans are constantly changing, and this year is no exception. Business owners who offer these retirement plans will want to consider important developments.

New vesting rules. “Vesting” refers to the rules under which an employee has full or partial rights to the plan account if they depart from employment. Previously, the vesting rules differed between employer funding accomplished as a match to employee contributions versus employer funding done as a general contribution. Matching funding has been required to vest under one of two schedules (either 100% after three years of participation or on a graded schedule ranging from years two through six). On the other hand, employer general funding vested slower, either at 100% after five years or on a graded schedule running from participation years three through seven.

But for retirement plan years beginning after 2006, all employer funding, whether matching or general funding, must use one of the more rapid schedules that previously applied to matching funds only.

This should cause a reconsideration of the vesting designation in the business retirement plan. Essentially, there are now only two choices: 100% vesting after three years of participation, or 20% per year graded vesting ranging from the second to sixth years. Some businesses that previously used the “cliff” approach of 100% vesting after five years may be better served by converting to the graded schedule.

Roth 401(k) feature. Another plan amendment, in this case optional, that can be made to a salary-reduction 401(k) plan is to add a Roth feature. If an employer amends the 401(k) plan to allow Roth contributions, each participant has the flexibility of electing either tax-deductible salary reductions as in the past or, alternatively, treating the salary-reduction funding as a non-deductible Roth account. The attraction of the Roth account is that those non-deductible investments not only build in a tax-free manner but remain tax-free when withdrawn during retirement years.

Unlike Roth IRA funding, there are no restrictions preventing upper-income filers from funding a Roth 401(k). In addition, the dollar amounts are based on the full 401(k) maximum, i.e., $15,500 for any participant in the 401(k) plan and a $20,500 limit for those who have reached age 50 by year-end for the year 2007.

In the 2006 Pension Protection Act, Congress made this Roth feature a permanent part of the tax law. Any amounts that an employee designates as Roth funding must be maintained separately in the plan records, so that at retirement the employee’s pre-tax traditional funds and post-tax Roth funds are separately identifiable. Any employer matching on a Roth 401(k) contribution continues to be treated as a pre-tax contribution.

While there is somewhat more administration with the Roth option added to a 401(k) plan, the evidence suggests an increasing number of employers are adopting this feature. The primary interest in using the Roth choice seems to be coming from younger workers in lower tax brackets. These employees are not as interested in the tax deductibility of a traditional 401(k) and also have a longer period of time for the compounding of a Roth account to produce greater tax-free amounts. If you wish to explore the Roth feature for your business, we can provide further information.

401(k) automatic enrollment. Most 401(k) plans, as elective deferral arrangements, allow employees to decide how much, if any, of their compensation they wish to salary-reduce as their investment into the retirement plan. Many employees never quite get around to starting those salary deferrals, sometimes due to uncertainty about the investment decision or how much they can afford to save, or perhaps the obstacle of the enrollment paperwork.

To overcome these obstacles, Congress is providing an incentive to employers to adopt the “automatic enrollment” approach to employee participation. The 401(k) plan is amended to provide that each new participant automatically has a specified percentage of compensation set aside into the retirement plan, with the funds invested in a diversified mix of funds. The employee has the opportunity to electively decline participation or adjust the funding percentage, but the objective is to get the ball rolling automatically and overcome the investment inertia.

To encourage this, employers who adopt an automatic enrollment feature will be relieved of the various discriminatory tests (e.g., ADP and ACP testing), and are also not subject to the top-heavy contribution rules. To receive these advantages, however, the automatic enrollment feature must meet specified minimums:

3% of participant compensation during the first year,
4% during the second,
5% during the third, and
6% of compensation during all subsequent years.

In addition, there is an employer match requirement, which must be at least 100% of the first 1% of employee deferrals, plus 50% of remaining employee elective deferrals from 1% to 6% of an individual’s compensation. Alternatively, an employer can do an across-the-board 3%-of-compensation contribution, which must cover all employees, even those declining to continue elective deferrals. Vesting is shortened from the normal 100% at three years to a 100%-at-two-years rule for employer contributions. Finally, each participant must be given a written notice at the beginning of each plan year, informing them of their rights to decline the automatic elective feature.

For employers interested in this approach, implementation becomes available for tax years beginning after 2007.

Based in Mesa, Arizona, and serving closely held businesses in the East Valley, the Phoenix area and throughout Arizona, Schmidt Westergard & Company, PLLC, is an independent full-service tax, audit, accounting and business advisory firm focusing on the middle market.