In the early 1990s, the IRS issued a technical advice memorandum on how unused vacation or sick pay can be transferred to 401(k) plans. The IRS also issued a private-letter ruling providing further insight into this concept.
The practice, however, has not seen significant use by employers. During the current economic downturn and with IRS initiatives to provide tools to help employers and employees save for retirement, the IRS issued Revenue Ruling 2009-31 and Revenue Ruling 2009-32, which breathe new life into this planning idea.
Under Revenue Ruling 2009-31, an employer maintains a paid time-off (PTO) program combining vacation and sick leave pay. Two alternatives are discussed in this Revenue Ruling.
Under the first situation, an employer maintains a use-it-or-lose-it PTO program under which employees forfeit any unused PTO at the end of the calendar year. The employer amends its 401(k) plan to provide for a contribution equal to the value of unused PTO at the end of each calendar year.
The contribution is allocated as of Dec. 31, 2009, but is not actually contributed to the 401(k) plan until Feb. 28, 2010. In this scenario:
* The contribution is permissible and is treated as an employer nonelective contribution for 2010. Thus, the contribution is treated as an employer contribution and not an employee salary deferral contribution. Employees may still contribute up to the maximum amount of $16,500, plus a catch-up contribution of $5,500 for individuals who turn 50 in the applicable plan year.
* The contribution is subject to annual testing under Section 401(a)(4) of the Tax Code to ensure that it is not discriminatory in favor of highly compensated employees.
Although not addressed in the ruling, testing contributions can be expensive. If the employer only offered the PTO contribution to non-highly compensated employees, testing could be avoided, and the concept works without significant effort. Unfortunately, it's often highly compensated employees who end up with the greatest amount of unused PTO each year.
Under the second alternative, the PTO plan provided for a limited carryover and an automatic cash-out of unused PTO that exceeds the carryover allowance in the following February. For example, an employee may have four weeks of PTO time.
The maximum carryover may be one week. Any time not used in excess of one week is cashed out. In this situation the employer amended its 401(k) plan to permit employees to elect to receive the PTO cash-out or to contribute the PTO cash-out to the 401(k) plan in the following February. Under this scenario:
* The employee election is treated as a typical cash or deferred election under Section 401(k) of the code. Accordingly, any amounts that pour over to the 401(k) plan, as elected by an employee, will reduce the maximum amount an employee may contribute under Section 402(g) of the code. Thus, the $16,500 maximum contribution, plus the $5,500 catch-up contribution are reduced by the vacation pour-over.
* This alternative is not required to be tested under Section 401(a)(4) since employee elections occur and the amounts do not automatically pour over as an employer contribution.
Termination of employment
Revenue Ruling 2009-32 is similar to Revenue Ruling 2009-31, but addresses contributions of PTO time following a termination of employment. In this Revenue Ruling, both employer contributions automatically pour over to the 401(k) plan following a termination (in lieu of being forfeited).
A participant may elect to contribute PTO time to the 401(k), which would otherwise be cashed out. Similar to the prior ruling, automatic pour-overs to the 401(k) are treated as employer contributions, and employee elections are treated as amounts subject to the Section 401(k) limitations.
In neither rulings does the IRS confirm whether or not the concept will work with Section 403(b) plans, but this approach should work. The rulings are also based upon an employer being a "C" corporation. However, the concepts would also appear to work for partnership and "S" corporations. Nevertheless, IRS guidance would be welcome with regard to these open issues.
In the current economic climate, many employers are reviewing these Revenue Rulings. In lieu of cost-of-living increases, bonuses and other long-term incentive plans, employers may grant additional vacation time to employees.
Most employees will view additional PTO as a significant benefit. Employers who increase vacation time or already have rich vacation programs may consider implementing a vacation "pour over" program to help employees save for retirement and to provide a new benefit to employees.
Contributing Editor Frank Palmieri, CPA, JD, LL.M (Taxation) is a partner with the law firm of Palmieri & Eisenberg, with offices in Princeton, N.J. and Alexandria, VA. He is a national speaker and writer on employee benefits issues and is a fellow in the American College of Employee Benefits Counsel.
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