Some corporate plan sponsors are considering allowing participants to reinvest ESOP dividends into their 401(k) plans.
These "401(k) switchbacks" are being pitched by employee benefit consultants and accounting firms as a kicker to established employee stock ownership plan dividend pass-through programs. They encourage employees to keep the assets in the retirement system and defer taxes on the income.
So far, the Internal Revenue Service has issued at least six positive private letter rulings this year on the subject.
Section 404(c) of the tax code for years has allowed companies to deduct from their income taxes cash dividends on ESOP shares paid directly to plan participants, or paid to the ESOP and distributed within 90 days to employees. That way, the participant has the tax liability.
Now, however, some companies are converting the company stock portion of their 401(k) plans into unleveraged ESOPs, often known as KSOPs.
Under the switchback model, employees are allowed to choose whether they want to reinvest the dividends paid on the company stock back into the KSOP on a tax-deferred basis, or take a taxable cash payment.
If the employee elects to reinvest the dividends, the employee's contribution to the 401(k) generally is reduced by the amount of the dividend.
The advantage of the switchback is dividends are kept in the retirement system, rather than distributed to employees in cash payments, as in traditional ESOP dividend pass-throughs, said Linda P. Holleman, senior vice president at Godwins Booke & Dickenson in Winston-Salem, N.C.
In addition, because of the extra cash available, many employees don't have to take loans on their 401(k) balances, said Duncan Harwood, a principal with Buck Consultants Inc. in Kansas City, Mo., and head of its national ESOP consulting practice.
Bill Wilson, a partner in the Washington office of Deloitte & Touche, said companies plan to use the 401(k) switchback to motivate employees and help them save more for retirement. For example, an employee can often afford to increase the amount of salary deferred into the 401(k) by the amount of the dividends paid, enhancing the effects of long-term compounding.
Other companies are sharing the tax savings they gain by increasing employer contributions.
The switchback also can enhance diversification, assuming the employee may direct the investment of the dividends, even if the original company contribution was in company stock.
"I think the ability for employees to diversify out of company stock with a 401(k) switchback can really be persuasive for many human resources professionals who worry that company stock contributions may be too high for many of their employees' retirement accounts," Mr. Harwood noted.
Companies likely to benefit most from the tax savings of a dividend pass-through would:
Have a large amount of company stock in the defined contribution plan;
Pay high dividends;
Expect taxable income to exceed the expected dividend payment to the qualified plan; and
Have or are willing to implement an ESOP or KSOP plan.
The concept is not new, said Michael Keeling, president of the ESOP Association, Washington. "The ability to do this kind of thing.....has been available since 1984," he said.
"Whenever you have a new, little wrinkle like this that someone figures out, it sounds sexy, but it's not something that's going to turn the world upside down."
But Corey Rosen, executive director of the National Center for Employee Ownership in Oakland, Calif., said: "I think the number of plans taking advantage of the dividend pass-through and the switchback will grow in the future."
Frank Roquet, a consultant and attorney at Hewitt Associates L.L.C., Lincolnshire, Ill., agreed the number of plans taking advantage of switchbacks could grow. But he noted the plan design "is not for everybody."
"The company philosophy needs to center on the fact that company stock is important and that the company match should be made in stock. But I think many companies may be attracted by the ability to maximize their possible deductions."
Mr. Roquet said many corporate executives are hesitant to implement the switchback. "They're waiting to see how the early pioneers get on with the program before they follow. I think there's something of a 'this is too good to be true' mentality at work out there now."
Mr. Roquet has worked with two large corporate employers this year to set up ESOP pass-through programs with 401(k) switchbacks but said he could not identify those companies.
Buck's Mr. Harwood has worked with about a dozen corporations to develop similar programs. Mr. Harwood said his firm is getting inquiries all the time about the switchback concept, partly because corporations are being pushed by their accounting firms and partly because plan sponsors are talking about the idea among themselves.
"I think a lot of companies began to wonder why they weren't taking advantage of lower taxes. And for those that were paying cash dividends to employees, they began to worry about the leakage of dividends from the retirement system and the subsequent loss of compounding over the years of those dividend assets," said Mr. Harwood.
The switchback concept is still at "its very front edge," 's Mr. Wilson said.
"The story really remains to be written. It depends on how employees react to the idea. Communicating the switchback may be complicated. If employees are lukewarm about it, they may not redirect what dividends they can back to the 401(k) plan, negating the principle.
"And if they aren't investing in the plan and getting company stock contributions, the tax savings to the company may not be significant enough and the company may modify or eliminate the plan altogether."