•
 If you suspect your tax rate will be higher at retirement, consider investing using Roth deferrals.
•
 In a declining market, take caution in determining the maximum loan amount.
 
•
 Plan strategies in a down market.
 
•
 No elected politician has suggested they would support removing the tax deferred status of 401(k) deferrals.

 
 
If you suspect your tax rate will be higher at retirement, consider investing using Roth deferrals.
Most analyses of the tax benefits of Roth contributions compare the results of a tax-deferred contribution to a plan versus the contribution of the same amount as a Roth contribution, less the tax payment required on the contribution. This results in the conclusion that there is no difference in the resulting savings of the participant if the tax rate at the time of the contribution is the same as the tax rate at the time the participant begins to take distributions. If the latter tax rate is higher, then the participant has more savings with Roth contributions. Conversely, the tax-deferred contributions result in greater savings if the tax rate at the time of distribution is lower.

The July/August 2008 issue of the Aon Forum looks at this issue differently. What if the participant has sufficient resources to maximize the contributions to the plan and pay the taxes on the Roth contributions from other funds? For example, a participant is permitted to make deferrals of up to $15,500 in 2008. If that deferral amount is a Roth contribution, then the participant must pay an additional $8,346 in federal taxes on the sum of the deferral and the tax amount, assuming a 35 percent tax rate. If the deferral is a traditional tax-deferred 401(k) contribution, the participant will have an additional $5,425 of income tax savings to invest personally.

In the tax-deferred scenario, if sufficient time passes for the deferral and the taxable investment to double, the plan account will be $31,000 and the outside investment will be $10,850. Applying a 35 percent tax rate to the plan account and a 15 percent capital gains rate to the taxable account leaves a net after-tax value of $30,186. If the deferral was a Roth contribution, however, the plan account balance after the same passage of time would be a tax-free $31,000. Thus, the Roth contribution has resulted in larger savings even assuming the same marginal tax rate at the time of contribution and distribution.

The article’s authors acknowledge that the $814 increase under the Roth scenario seems “relatively modest,” but they point out that they used the most favorable assumptions regarding the growth of the taxable account in the tax-deferred 401(k) deferral scenario. More realistic assumptions would include the payment of some tax each year on the income from the taxable account, which may be taxed at higher rates than the 15 percent long-term capital gains rate. State taxes could cause even more erosion in the appreciation of the taxable account in that scenario. The authors suggest that over a significant period of time, use of Roth contributions in this manner could result in very significant increases in the participant’s savings.

They also note that catch-up contributions are available when the participant reaches age 50. If the participant makes a Roth contribution of $20,500, it is the equivalent of a pre-tax deferral of $31,538, using a 35 percent tax rate. This makes the eventual savings growth using Roth contributions even more significant.
 
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In a declining market, take caution in determining the maximum loan amount.
One aspect of retirement plan investment losses is their impact on participant plan loans. Plan sponsors and their record-keepers sometimes fail to recognize that huge swings in market values impact a plan’s operation even when no distribution is involved. In particular, rapidly dropping values can serve to limit the maximum loan a participant may receive from a plan. With 5 or more percentage point declines on a single day, the date when a plan’s 50 percent loan limit is determined will affect the amount of the loan. We will ask, “What date should be used to measure the participant’s maximum loan amount, and what happens when the value on that date differs from the value at the date of the actual loan disbursement?” This is a straightforward question in a rising market, but has a complex answer in a declining market.

How should the plan properly respond to a participant’s request to take the maximum possible loan? Plans generally limit the amount of a participant’s loan to the lesser of $50,000 or 50 percent of the participant’s vested account. It is the 50 percent threshold that can be directly affected by a steep drop in the value of the participant’s account. Make a mistake here and you can have a prohibited transaction and a portion of the loan may be taxable to the participant: Mistakes are easy to make.

It becomes a practical problem when asked to give the participant the “maximum” loan using not the $50,000 limit but rather the 50 percent threshold. The problem occurs because the loan authorization calculation and the loan disbursement seldom occur on the same day. By the time the loan papers are signed and the loan is distributed, the account value may have changed from the calculation date. In the past, that change has generally been upward, either due to additional contributions or a rising market: Not so today.

There is no bright line guidance in meeting all regulatory requirements as to when the maximum loan percentage should be set. The IRS tends to use the “last valuation date and the DOL uses the date of distribution. The trend in the industry has generally been to calculate the limit at the time the loan request is prepared for delivery to the participant. IRS Guidance in Notice 82-22 refers to "a valuation of the participant's interest within the last twelve months may be used, provided it is the last valuation available." But that was before daily valued accounts, and this guidance is from the IRS, not the DOL.

We have received reports that the DOL has pursued a prohibited transaction investigation where this loan problem occurred with a plan of 500 participants. This plan measured the maximum amount of the loan at the date the loan papers were prepared. The DOL said it should have used the date of disbursement. The value of the participant’s account on that date was lower than the date that the loan was requested and, as a result, exceeded the 50 percent threshold. The DOL stated that this required that the transaction be reported on Form 5330 and an excise tax be paid on the $250 excess portion of the loan. Needless to say, the legal and administration fees to address the action far exceed the amount of the transaction.

The DOL and the IRS have two differing agenda to measure the 50 percent limit. The DOL prohibited transaction regulations under DOL Reg. §2550.408b-1(f) condition an exemption from a prohibited transaction for a plan loan only when the plan loan is adequately secured. The regulations specify that no more than 50 percent of the participant’s vested benefit may be considered by the plan as security for a participant loan. The DOL has stated that the 50 percent limit is not affected by account losses after the origination of the loan, but our discussion is what happens before the loan is actually disbursed.

For the IRS, the 50 percent limit is an income tax consideration. If a plan permits participant loans, loans below that 50% level (not to exceed $50,000) avoid being a treated as a deemed distribution and thus are not taxable to the participant if all of the plan loan requirements are met. Under IRC §72(p)(2)(A), a participant generally may receive a nontaxable loan up to the lesser of 50 percent of his vested benefit, or $50,000. The Code does allow for plans to be written to allow loans in excess of the 50 percent limit as long as the loan does not exceed $10,000, and adequate collateral is provided. Few plans allow the $10,000 exception. There are also certain loan exemptions for those impacted by Hurricane Katrina, Rita or Wilma that raise the limit to 100,000 and 100 percent, but these can be discussed at another time. Where a participant loan exceeds the 50 percent limit, the excess is taxed as a taxable “deemed” distribution.

What is a practical solution? Some administrators limit the maximum loan to a percentage lower than the 50 percent threshold so that investment losses won’t cause the percentage limit to be exceeded on the date of the loan disbursement. We had seen those reductions to 45 or 40 percent of the participants vested benefit. But in today’s market that may not be enough. Others recalculate the loan on the date of distribution and lower the loan amount. These generally tie the loan authorization to the endorsement of the loan disbursement check.
 
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Plan strategies in a down market.
We tossed around the idea of finding something beneficial in the market’s steep decline. It is a tough goal, but we came up with two planning strategies that might prove useful for some employer’s plans. Here they are: First, for some employers this may be an opportunity to help keep a plan close to becoming top heavy from reaching the 60 percent threshold that triggers a top heavy minimum contribution. Second, the drop in market values may help soften the blow of terminating an executive compensation plan before it becomes fully subject to IRC §409A.

Almost all small employer plans become top heavy sooner or later. That occurs when the accounts of the key employees make up 60 percent or more of the plan’s total account balances.

As planning strategy to delay or prevent top heavy status for a plan not yet there, here is our thought. Plans with in-service distributions (e.g., distributions can be requested after age 59 ½, or in a pension plan, at or after normal retirement age) might consider asking certain key employees to take a distribution while the market is down. The participants can roll over those distributions rolled to an IRA. Only the amount of the in-service distribution would be included in top-heavy calculations of the next five years, but not the appreciation after that date. Distributions from the plan during the one-year period ending on the determination date must be counted when determining whether the required aggregation group is top-heavy. However, if distribution, such as this in-service distribution, was made for a reason other than severance from employment, death, or disability, then this look-back period is the five-year period ending on the determination date. When the market comes back -- as we all hope -- and the non-key accounts in the plan increase in value, then future top heavy calculations would not include the appreciated value of the key employees’ assets that were distributed. That could help delay the date when the 60 percent threshold is met. Additionally, after five years the amount of the in-service distribution would be excluded as an asset of the key employees in performing the top heavy test. Nor would it be included if that key employee terminates employment because the look back period in that event is one year.

The other planning idea, or rather opportunity to turn a lemon into lemonade, relates to a new law, IRC §409A, that is affecting executive compensation plans. We understand that this idea is being used by benefit attorneys attempting to bring a nonqualified deferred compensation plan into compliance with the new requirements of IRC §409A. Those requirements apply to plans beginning in 2005. The written plan must be in compliance by Dec. 31, 2008, regardless of the employer’s fiscal year. In many cases, rather than trying to conform an existing deferred compensation plan to the new laws, attorneys are recommending that the plan be terminated and the benefits distributed . Where the value of that distribution is based on stock values – as with many rabbi trusts – the financial impact of such a distribution is less, because less is being distributed. At the same time that cash that is being distributed can be reinvested at what everyone hopes is the bottom of the market. The regulations provide limited relief from the rules preventing changes in the time and form of payments where a nonqualified deferred compensation arrangement is terminated. The IRS regulations permit a service recipient to terminate and liquidate a NQDC plan in three situations: (1) when the service recipient has declared bankruptcy, (2) when the service recipient has participated in certain change in control events, or (3) at the service recipient's discretion, all subject to certain restrictions and limitations. A plan can be terminated and liquidated, with distribution accelerated, if (a) the termination and liquidation does not occur proximate to a downturn in the financial health of the employer, (b) all arrangements of the same type (under the plan aggregation rules) are terminated with respect to all participants, (c) no payments other than those otherwise payable under the terms of the plan absent a termination of the plan are made within 12 months of the termination (Reg § 1.409A-3(j)(4)(ix)(C)(3)), (d) all termination and other payments are made more than 12 and within 24 months of termination of the arrangement (Reg § 1.409A-3(j)(4)(ix)(C)(4)), and (e) the employer does not adopt a new arrangement that would be aggregated with any terminated arrangement for a period of three years following termination.
 
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No elected politician has suggested they would support removing the tax deferred status of 401(k) deferrals.
There has not been a single day in the past two weeks where my e-mail inbox did not include a new article or editorial discussing how the government is plotting to remove the tax deferral for contributing into a 401(k) account as well as outright seizing your account balances. There is a major problem with each of these stories though, they are not true. Not a single elected or appointed federal government representative has come out in favor of the proposal, but yet, the story persists that the government is actively moving forward with its nefarious plans to steal your money.

The controversy started at a House Committee Meeting on Education and Labor. At the hearing, Teresa Ghilarducci, an economics professor at the New School for Research and Author of When I'm Sixty-Four: The Plot Against Pensions and the Plan to Save Them, put forth a plan which would remove the tax deferred status of 401(k) plans, thus bringing an additional 80 billion dollars in federal revenues. Ghilarducci proposed that “Congress let workers trade their 401(k) and 401(k) - type plan assets (perhaps valued at mid-August prices) for a Guaranteed Retirement Account composed of government bonds (earning a 3% return, adjusted for inflation). When the worker collects Social Security, the Guaranteed Retirement Account will pay an inflation adjusted annuity, based on the accumulated funds.”

Clearly, while one can debate the wisdom and efficacy of Ghilarducci’s plan, it is clear that there was no mention of a forceful taking of one’s retirement account or institution of mandatory socialism as suggested by the Wall Street Journal and James Pehokoukis of US News and World Report, to name two. Pehokoukis, using the editorial dodge of asking a question to imply ulterior motives to another, asked “the American government would never do something as, well, socialist as seize private pension funds, right? … [E]ven Uncle Sam isn’t that stupid, but some Democrats might try something almost as loopy: kill 401(k) plans.”

George Miller, being the Chairman of the Education and Labor Committee, has come under attack in these articles as the chief democrat supporting Ghilarducci’s plan. Unfortunately, Chairman Miller has made no statements in support of Ghilarducci’s plan, and recently chastised the Wall Street Journal stating “The Wall Street Journal is needlessly creating fear among Americans rightly worried about their retirement security by misrepresenting my efforts to strengthen workers' retirement savings - attacks that have no basis in fact. I do not support 'abolishing' 401(k)s, moving these plans, or changing their tax status, plain and simple.”

While anyone who has ever followed Congress knows, politicians’ positions on issues can change on a dime, but if one were to take the time to digest all of the information available about Ms. Ghilarducci’s plan, it would be easy to determine that the plan has little support, and your 401(k) accounts are presently safe from a predatory government. Now, if only I were comforted by the actions of the “efficient” free market.
 
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  Note: Occasionally, articles we feel would be of interest to our E-newsletter readers will be presented that previously appeared in other compilations of writings by Greg Matthews who is the Editor for the 401(k) Advisor, a monthly newsletter from Aspen Law & Business. The newsletter may be ordered at www.aspenpublishers.com or by calling 1-800-638-8437.
 
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