Plan sponsors have been searching for alternatives to offset the loss of tax deductions since the enactment of the $150,000 compensation cap.
The alternatives include adding a money purchase plan, or age-weighting and cross-testing profit-sharing plans, or non-qualified plans. But each has its drawbacks.
Money purchase plans, because they are considered pension plans, commit the employer to contributing the same percentage to all employees on an ongoing basis. What's more, the employer is saddled with the administrative costs of yet another plan.
Age-weighting and cross-testing normally work only if the highly compensated employees are older than the rest of the employees. Even in the best cases, they would still add administrative costs and invite possible scrutiny from the Internal Revenue Service, Department of Labor and Pension Benefit Guaranty Corp.
Many plan sponsors - approximately two-thirds of all employers affected by the cap, according to a recent survey by Hewitt Associates - have turned to non-qualified plans. Although there are some interesting designs, the IRS has been looking very closely at these designs.
So, given this potentially costly and uncertain climate, there are a number of other existing plan design concepts employers might wish to explore.
One is the use of pre-1987 credit carryforwards. If a plan sponsor had a profit-sharing plan before 1987 and failed to deduct the maximum 15% for any years, the sponsor would have accumulated credits for those years. The credit accumulation was stopped in 1987, but the credits may be used in subsequent years and enable the employer to actually contribute and deduct up to 25% of that year's covered compensation. There is no limit on how far back an employer can go or on how much could be accumulated, and there is no limit on how far into the future the credits can be used.
But if an employer does not wish to contribute the full 25%, it could contribute, let's say, 20%. The employer actually would be increasing its deduction, and there would be remaining credit to carry forward to another year.
This alternative would not require any plan amendments nor any administrative costs. The employer need only review its corporate returns prior to 1987, add up the total credits and use as needed.
Employers might also explore integrating the plan with Social Security to keep the deduction the same and allocate a greater amount to the highly compensated people. This would allow those employees who earn more than the Social Security wage base ($61,200) to receive a greater allocated share of the contribution than those employees below the wage base.
Another myth that has been dispelled is that in a 401(k) plan, those employees earning more than $150,000 are the ones who would be most adversely affected. Actually, it is the midrange highly compensated employee who is affected the most. For example, let's say we have two highly compensated employees, one earning $300,000 (capped at $235,840 for 1993) and the other earning $70,000. In 1993, if both wished to defer the maximum of $8,994, this would represent 3.81% of the $300,000 employee's income and 12.85% of the $70,000 employee's income, or an average of 8.33%. In order to pass the ADP test, the ADP for the non-highly compensated employees would have to be 6.33%.
In 1994 when we apply the $150,000 cap and the new deferral limit of $9,240, this would represent 6.16% of the $300,000 employee's income and 13.2% of the $70,000 employee's income, raising the average to 9.68%. If the non-highly compensated average remains at 6.33%, the employer would fail the ADP test and money would have to be returned. Again, the $70,000 employee would be adversely affected because when money is returned to correct an ADP test, it is based on the employee who defers the highest percentage of income, not the employee who earns the most.
This same example remains in effect for 1995 because, with the advent of GATT - the General Agreement on Tariffs and Trades - the $9,420 deferred limit has been frozen for 1995. In subsequent years the limit will increase in increments of $500. The overall limit of $30,000 for deferred contribution plans, which was scheduled to be adjusted for the first time since 1984, will remain the same for 1995. It ultimately will be adjusted in $5,000 increments.
Is there anything that can be done before returning the money? The first and easiest way to help meet the ADP test would be to try to encourage non-highly compensated employees to defer more money and bring the average up. Another option might be to increase the company match to encourage greater deferrals by these employees.
If employers can't encourage greater deferrals by the non-highly compensated employees, they might consider making qualified non-elective contributions, or QNECs. These contributions, made by the employer for non-highly compensated employees, must be 100% vested and subject to the age 591/2 withdrawal restriction. Once these contributions are made, the employer may used them to help satisfy the ADP test.
Another less costly alternative would be to make a "targeted" QNEC. This would allow the employer to rank all non-highly compensated employees by annualized (not testing) compensation. The employer would then make contributions up to pre-determined levels for the lowest ranked employee and continue up the ranking until sufficient dollars were allocated to bring the average above the required level.
Both of the QNEC alternatives must be provided for in the plan or the plan must be amended to provide for them. These options are extremely attractive if the employer has discretionary funds available and wishes to make additional contributions to the plan. Of course, they must realize these contributions are 100% vested immediately.
The bottom line to all of this is that there are creative ways of enabling highly compensated employees to maintain a higher level of deferral without causing reporting and tax consequences, yet still adhering to the $150,000 compensation cap. As usual, many of these plan design issues stem from interpretations of the laws and regulations. Therefore, plan sponsors should seek sound legal and tax advice on how these creative ideas can best be used relative to their own plans and circumstances.
But with the right set of circumstances and the proper interpretations, a plan sponsor's life with the $150,000 compensation cap can be much more rewarding - for employer and employee alike.
E. Thomas Foster Jr. is an assistant vice president at Aetna Life Insurance & Annuity Co., Hartford, Conn.