Contributing unused sick leave or paid time off to a 401(k) plan

[Guest Mark Porter]

I had an HR director tell me she had read that there was a proposal to allow employers to contribute unused PTO (paid time off) and/or sick leave to a 401k. I think it's a great idea but I have read nothing of this and can see some compliance issues. Just wanted to make sure I hadn't missed something.

[Tom Poje]

I think this one goes back at least 5 years.

I don't recall the major problem that might exist, possibly it was a BRF issue, whether it was effectively available to all rather than just HCEs, but I dont recall.

If you type in unused vacation time on the search you will come up with a number of possible discussions

This is from 401(k) Q & A

Question 25: Is it true that the IRS is allowing participants to defer accrued but unused vacation time into 401(k) plans, tax-free?

Answer: Basically yes, but any plan sponsors considering such a feature should exercise caution. In IRS Technical Advice Memorandum 9635002 (Nov. 9, 1995), the employer maintained a use-it-or-lose-it vacation policy (i.e., employees forfeited any accrued but unused vacation time at the end of a calendar year). The employer proposed a procedure to the IRS whereby employees with more than two weeks of unused vacation could elect to have the dollar value of any excess vacation time contributed to the employer's 401(k) plan.

The IRS ruled that such a procedure would not trigger a taxable event to employees at the time of contribution, although their elections did not constitute cash or deferred arrangements under the 401(k) plan (because they had no opportunity to receive the unused vacation time in cash). Instead, the IRS characterized the contribution as a nonelective employer contribution. The IRS also confirmed that such contributions were not constructively received by employees or subject to FICA taxes at the time of contribution.

While the outcome of the IRS ruling has excited some participants and service providers, the IRS did not address potentially troublesome nondiscrimination implications. For example, it is likely that highly compensated employees would use a vacation time contribution procedure more than nonhighly compensated employees (note that any contributions would be treated as employer contributions on behalf of individual participants). Thus, a plan sponsor contemplating vacation time contributions to a 401(k) plan should ensure that its service providers have thoroughly analyzed applicable nondiscrimination tests, including those under Code Section 401(a)(4).