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Is this legal?


joel
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Rather than paying retiring employees in cash, as is the current practice, for their accumulated sick and vacation days and other compensatory time Pinellas County of Florida is about to establish a 401(a) plan for the express purpose of sheltering these amounts from income tax. The employee will not have the option of receiving a cash payment. Is this permitted?

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  • 2 weeks later...

Just saw this post....Very interesting... There are two separate tax issues:

1. Can employer establish a qualified plan based on compensation deferred and never included in taxation?

2. Can the there be a tax free transfer of the sick pay and vacation days to the plan? I always thought that the amounts deferred under sick pay and vacation pay had to be included in compensation and there was an IRS ruling that prohibited tax free transfers of accrued compensation to a deferred compensation plan unless statutorily permitted. (e.g., an employee cannot make a tax free transfer of amounts deferred under a qualified plan to a 125 plan to pay retiree health insurance.) I queston how the funds could be transferred without the employees' consent-- my understanding of these plans is that they are subject to collective bargaining or state law and employer cannot take away rights to fufnds since employees are paid in cash for accrued sick and vacation days upon termination of employment.

More Interesting question-- could the deal be structured so that employees agreed to forefit their accrued sick and vacation pay in return for receiving an equal amount of contributions to the 401(a) plan. Is this taxable as property payable for services under IRC 61 under an economic benefit doctrine?

mjb

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Contribution can be limited to annual 415 limit and payment can be made in installments. There may be IRS authority for transfer- Under IRS reg. 1.457-4(d) an employee can contribute up to $11,000 in accumulated sick or vacation plan to a 457 plan maintained by a govt employer. Funds can be withdrawn before termination of employment.

This proposal may have application to 403(B) plans maintained by NP employers where employees accumulate sick pay/vacation pay. Excess vacation pay/sick pay can be contributed to 403(B) plan as employer contribution to 403(B) plan with no fica tax up to 415 limit. Alternatively emplyee could elect to recevie the vacation pay /sick pay as wages and contribute it as a 403(B) SR contribution subject only to FICA tax and separate 402(g) limit .

mjb

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Guest Adrian Nenu

Hi,

I work for Pinellas County, which is the plan Joel is referring to.

Pinellas County has implemented a 401a plan to avoid paying 7.65% in FICA tax by depositing a departing employee's sick, compensatory and vacation time in the 401a instead of paying it out on the last check. This amount can be quite significant; up to $ 40,000 can be contributed to the 401a account.

This plan will be mandatory for a designated group of employees and eventually for all departing employees. Right now, only employees 55 and over are subject to the mandatory 401a participation when they depart/retire.

The plan is managed by Bencor and the investments are offered by Valic - all variable and one fixed annuity. Bencor and my employer are pushing this plan very hard at meetings with employees.

My question is: Is it legal to force everyone or a specific age group of employees to contribute to this plan?

I am very skeptical of the legality of this plan...and the majority of employees do not wish to participate regardless of any claimed tax benefits.

Thank you for your help and best wishes!

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First of all there is a beneficial result to employees because otherwise taxable wages are converted into pension contributions with the following impact : no 7.65 % fica withholding and the opportunity to accumulate interest on the funds tax free. The funds should be available to employees at any time after severance of employment from the county and employees over 55 have no 10% penalty tax to pay on withdrawals. I guess the question is whether it is better to have 100% deferral or pay withholding tax of 21.65% on the payments.

As far as legality it is matter of state law as to whether your employer can transfer the vacation/sick pay to a retirement plan without the consent of the employees as well as any collective bargaining agreement between the county and a union representing the employees. The real question is who is going to pay for the cost of establishing and operating this plan? the county or the employees.

mjb

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Guest Adrian Nenu

Thank you for your help!

The cost of this plan will be shouldered by the employees in the form of 2%-3% annualized annuity expenses and probably additional administrative expenses.

Employees over 55 can cash out without a penalty and save 7.65% in FICA tax they do not have to pay.

Employees under 55 who cash out are subject to the 10% panalty in additon to income tax. They do however save the 7.65% on FICA tax. Our employer has promised to reinburse us the difference (2.35%) so that the employee breaks even.

As far as an investment, the Bencor/Valic plan is mediocre at best, but the account can be rolled over to an IRA with a much less expensive vendor (Vanguard). Becor/Valic says there is no redemption penalty during the first year after an account is activated. I want to see that in writing!

I spoke with Ms. Kandi Hicks Winters who heads the State of Florida 457 plan and she confirmed that the Pinellas County 401a plan structure and the mandatory participation is legal.

Thank you again and best wishes!

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Would investing trust money in annuity contracts with a 2-3% annual charge (plus other admin expenses?) be a breach of fiduciary duty under state law?

Isn't there a cheaper way to run this plan?

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IRC 401: If the charges are disclosed to the participants and the funds can be withdrawn in the first year without redemption charges I don't see what the violation could be. many state plans provide for similar charges in their plans. Remember participants are avoiding FICA tax n the payments.

mjb

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Guest Adrian Nenu

Investing trust funds in high expense investment products such as annuities is a breach of fiduciary duty on the part of the trustee. Such fees turn decent stock/bond investment returns with moderate risk into returns equivalent to CD/T-bills.

The Prudent Investor Rule considers index funds as prudent investments when trustees invest other people's money. The use high commission investment products is certainly against the best interests of the trust beneficiary.

Best wishes!

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Its not a question of whether cheaper is best but a question of what the customer gets for the charges. VAs usually have a mortality charge of 1.00-1.25% to guarantee the invested amounts principal) in the event the participant dies before benefits commence. There are also admin and mgt charges similar to mutual fund charges.

mjb

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Guest Adrian Nenu

The Mortality Insurance is like buying insurance against being hit by lightning - simply not worth the 1%-1.25% or so.

There is a study that calculated the value of the Mortality Insurance and the conclusion was that the coverage costs around 5-35 basis points, depending on the age of the investor. This means the chances of a payout are extremely low. The fees go into the pockets of the insurance companies.

Costs matter!

Best wishes!

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An employee who participates in the plan can make a withdrawal without redemption charges within 12 months after the transfer and since the funds will be withdrawable at any time (since the transfer occurs on account of severance from employment) I dont see what your objections is based on. Just rollover the funds to vanguard. No one is requiring that you pay the fees that you find objectionable.

mjb

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Guest Adrian Nenu

That's right, a rollover to Vanguard would solve the problem (easy for us to say it). But...

During the "presentation" of the 401a plan:

1. The rolover option was never revealed to the committee which was evaluating the 401a plan. I had to mention it.

2. The tax deferring benefits and FICA tax savings were repeated over and over with charts and graphs.

3. A prospectus of the 401a was not available and is still not available, even to the county administrators.

4. The fact that the investment options were variable annuities was not revealed to the committee. I doubt any of the committee members or administrators even know what variable annuities are, who are they suitable for or what is the average annual expense.

5. Plan expenses were never mentioned and were not available. I inquired with the Valic rep and was told they would be in the 2%-3% range. There was no firm response on the redemption penalty; hopefully, there will not be any.

6. The Human Resources/ Payroll staff and the Budget Director were strictly looking at the FICA tax savings for the county.

Does anyone think that people such as these understand the concept of how high fees affect account growth? No one on the committee questioned the 401a plan except me and the rest nodded in approval without a bit of thought. Bencor/Valic will have little trouble convincing these people and others like them to leave the account with Bencor/Valic.

Best wishes!

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  • 1 month later...
Guest Gordy

Has any light been shed on the legality of this issue? A local hospital is doing something similar with accrued vacation and sick pay. I don't understand how taxable compensation will be avoided or how a plan formula could be followed for allocation purposes. Also no one seems to know exactly what the 401 (a) plan is. Seems suspect.????

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