Pre-year end salary deferral issue

[chris]

Employer's 401(k) plan provides for age/service req's of 21 and one year with participation retroactive to first day of plan year. Plan year is a calendar year. Compensation is taken into account for all purposes for the entire plan year. Plan allows e/ee's to defer up to 7% of compensation. If an employee has not been deferring but now wants to max out his/her $10,600 deferral limit, can he/she elect to defer the entire final paycheck to be cut 12/31 if that paycheck is less than or equal to $10,600? The e/ee makes well above 170,000. From a reporting perspective the W-2 would of course reflect deferrals equal to the $10,600 limit. Any comments or suggestions appreciated....

[Tom Poje]

one, the limit is only 10,500 not 10,600!

This one may hinge on exactly what the document says or the enrollment forms say. sometimes they say

7% per payroll period maxium, or the form says enter a value, maximum of 7%. At that point, I think there is little you can do. especially since it is obvious you didnt let anyone else do this and the person involved is an HCE

[Guest pineapple]

In addition to Tom's points, you need to check the document to see what the modification/election period(s) are. Usually plans provide that participants can make/modify their elections on a semi-annual, quarterly, or monthly basis. Unless the document states that participants can make an election at any time, the participant is out of luck.

[jaemmons]

Why doesn't anyone else have a problem with the retroactive entry on pretax deferrals??? Retroactive entry on pretax deferrals only runs in favor of HCE's, since they are the ones who can most likely defer into the plan at the end of the year. Once these employees become eligible, how does the employer make up for the deferrals that could have been deferred from compensation since the beginning of the year? If they don't have enough comp, do they contribute a QNEC for the period they would have been able to defer?

Example: EE becomes eligible (meets both age 21/1yr) on December 1st. Since you have retroactive entry on deferrals, comp from 1/1 thru 12/1 is now eligible for deferral, but these pay periods have already passed.

If the ee earns $30k and wants to put away the 7% based upon the 30k. This is $2,100, but they only have two pays left (assuming biweekly payperiods) or roughly $2,300. How can this ee afford to defer the max without suffering a hardship? Seems to me that if someone is not able to defer the 7% of their entire comp because they became eligible too late in the year, that the er has a cutback issue, unless they make up the difference with a QNEC. Thoughts????

[Tom Poje]

There is no problem with retroactive entry dates, its just you can't defer on that money. But if my last paycheck was $10,000

(ha ha ha) ok, if your last paycheck was 10,000, and assuming you can change deferral election at anytime, and assuming your plan allows you to defer any amount as long as you dont exceed 7% for the year, you should be ok.

well, no, you still cant defer 100%, it would be 100% after FICA taxes are taken out.

personally, 3 days before the end of the year, an HCE involved, etc, the whole thing smells, especially like trouble.

[david rigby]

I'm not sure this EE is an HCE. From the original facts, I inferred that the EE was hired in the current year. Unless the EE is also a 5% owner, then he will not be an HCE until next year.

Have I missed something?

[Tom Poje]

good point, the original post doesn't say.

it just says the individual wasn't deferring.

I took it to mean the ee was hired last year, became eligible this year. e.g. could have been hired 2/1, completes 1 year and then retro enters at 1/1/

could be an hce, could be nhce.

[jaemmons]

You're still missing my point. How is someone going to be able to max out at the 7%, when they don't have enough salary left? How isn't it a potential problem with a lower paid employee not being able to afford the "catch up" from their prior compensation?? Aside from any potential cutback issues, you will need to test the current availability of this feature to ensure that it doesn't favor your highly paid employees. What if you have 2 employees become eligible on December 1 and 1 is an nhce and the other an HCE. The HCE is the only one who can actually afford to defer the maximum 7% from his/her remaining paychecks. I would think you would now have a problem, not only with a cutback in benefits, since the nhce cannot afford to maximize his/her deferrals, but you have a discrimination issue with the retroactive entry dates because the only new participant who can receive a full benefit on the pretax source is the HCE, unless the er is going to kick in a QNEC for the nhce to make up for the shortfall.

[Guest pineapple]

Sorry to disagree with you Jaemmons, but there is no discrimination issue here whatsoever. All employees (hce & nhce) are given the opportunity to defer up to 7% of compensation. Whether or not the employee can actually afford to defer the entire amount in December is irrelevent. (Should an hce not be able to defer because a nhce doesn't have any disposable income?!)

[Guest SteveR]

I have to agree with Pineapple that retroactive entry dates for 401k plans is not inherently discriminatory. However, it generally would not be considered good plan design if, in fact, we are trying to give all participants the maximum opportunity to defer income.

Secondly, the concept of the accelerated year end deferral is generally not a problem given that the plan document does not speak directly about "per payroll" limitations. Personally, I feel cost averaging probably works better over the long term than dumping your money in all at once. This year may be an exception.

[Kirk Maldonado]

I disagree with SteveR about dollar cost averaging.

Whether it makes sense or not depends on (1) whether the market is rising or falling and (2) whether you are talking about accelerating or decelerating the investments (meaning whether the lump sum investment would be at the beginning or end of the period).

For examle, if you have a $1,000,000 lump sum cash rollover into an IRA, holding it in cash and investing it in equities in increments over a 12 month period is not a smart move in a rising stock market.

I simply don't believe you can generalize.

[Jon Chambers]

In fact, in 1979, Constantinides proved mathematically that Dollar Cost Averaging (DCA) produced inferior expected investment results relative to investing as a lump sum at the start of the period. Numerous other academic studies reached the same conclusion, using both a theoretical approach and real world studies comparing DCA to lump sums.

Kirk is right that you can't generalize. However, we can generally state that there are three types of investment markets--rising markets, falling markets and flat markets. Lump sum is better in rising markets, DCA better in falling (although not investing at all would be better yet), and the two approaches generate roughly equivalent results. Rising markets are more common than falling markets, and gains tend to be larger than losses (if this weren't true, stocks would have negative expected returns, and noone would invest in them). Although this is an oversimplification of the pro lump-sum argument, (Constantinides proof compared a series of small bets to one large bet, and proved that the cumulative impact of the small bets was equal to the large bet, hence the greater expected return from the large bet outweighed the risk reduction from the small bets), I think it illustrates why DCA can't reasonably be expected to work.

Investment theory notwithstanding, DCA continues to be touted as a preferred approach by most of the major investment providers.