Source: Tax Management Memorandum > 2006 > 02/20/2006 > MEMORANDUM > Employee Contributions Under Defined Contribution Plans — Design and Operational Considerations

47 Tax Management Memorandum 75

Employee Contributions Under Defined Contribution Plans — Design and Operational Considerations 

by Stephen R. Kern1
 McNees Wallace &  Nurick LLC
 Harrisburg, PA

1 The author wishes to gratefully acknowledge the assistance of Jonathan I. Grossman, Esq., in the preparation of this memorandum.

Major References: 

I.R.C. § 401(k).

INTRODUCTION 

Defined contribution plans continue to be the preferred qualified retirement plan vehicle among U.S. employers, with nearly 60 million private sector employees participating in plans holding approximately $2.5 trillion in assets.2 A study prepared by the Employee Benefit Research Institute (EBRI) showed that plan participation by heads of families in defined benefit plans decreased from 59.3% in 1992 to 38.4% in 2001.3 During that same period, participation by heads of families in defined contribution plans increased from 57.8% in 1992 to 78.7% in 2001.4 Today there are three times as many employees participating in defined contribution plans as defined benefit plans.5 In addition, beginning with the advent of the 401(k) plan in 1978,6 a continually larger percentage of defined contribution plan assets are attributable to employee contributions. In 2000, for example, employees represented the source of approximately 60% of contributions to defined contribution plans.7
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2 Mitchell et al., Turning Workers into Savers? Incentives, Liquidity, and Choice in 401(k) Plan Design 1 (Pension Research Council, Working Paper No. 2005-18, 2005).

3 Copeland, Retirement Plan Participation and Asset Allocation, EBRI Notes, Jan. 2004, at 1.

4 Id.

5 Mitchell et al., Turning Workers into Savers? Incentives, Liquidity, and Choice in 401(k) Plan Design 1, 33 (Pension Research Council, Working Paper No. 2005-18, 2005).

6 Revenue Act of 1978, P.L. 95-600.

7 News Dash, PlanSponsor.com, Sept. 13, 2005.

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The primary reasons for the migration towards defined contribution plans are cost and simplified design and administration. The maintenance of a defined contribution plan does not require the payment of PBGC premiums, the production of actuarial reports or the preparation of employee communications that attempt to effectively describe a “lifetime benefit.”The burden of investment performance (particularly in recent years) and its potential impact on required contributions also is a driving force. The combination of the “fixed cost” aspect of a defined contribution plan in conjunction with the ability for such a plan to be primarily, if not exclusively, funded through participant contributions is especially attractive to employers from a financial perspective.

Employers should not, however, be deceived by the apparent design and administrative simplicity and the reduced risk commonly associated with defined contribution plans. There are many considerations that must be addressed (and pitfalls avoided) with respect to the establishment and maintenance of a defined contribution plan that incorporates an employee contribution feature. This memorandum will explore some of the various design, administrative, and fiduciary issues associated with what has become America's most popular retirement plan design.8
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8 Sixty-four percent of employers responding to a Hewitt Associates, Inc. survey said they considered their 401(k) plan to be their primary retirement plan.

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EMPLOYEE CONTRIBUTIONS — CHARACTERIZATION AND LIMITATIONS 

Employers may offer plan participants the opportunity to contribute to a plan on an after-tax and/or a pre-tax basis. Between 1981 and 1987, participants also had the ability to make “qualified voluntary employee contributions” to plans on a tax-deductible basis.9 Pre-tax elective deferrals allow participants to reduce their federal taxable income while at the same time contributing to their retirement on a tax-deferred basis. These contributions are, however, subject to the contribution limitations set forth in § 402(g)10 (as increased by the catch-up contribution limitations set forth in § 414(v)) as well as the fairly stringent distribution limitations set forth in § 401(k).11 After-tax contributions, while not as efficient from a federal income tax perspective, potentially afford participants greater freedom with respect to both contribution limitations and in-service access to the funds.12
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9 1954 Code § 72(o)(5).

10 Unless otherwise noted, all section references are to the Internal Revenue Code of 1986, as amended, and the regulations promulgated thereunder.

11 1954 Code § 401(k)(2)(B)(i).

12 This greater degree of flexibility must be stated in the plan document.

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Beginning in 2006,13 a new employee contribution design option may be incorporated into an employer's 401(k) plan.14 Specifically, § 402A15 permits a 401(k) plan to include a “qualified Roth contribution program” that permits participants to designate some or all of their elective deferrals as Roth contributions to the plan. A Roth contribution is defined as an elective deferral that presently is includible in gross income.16
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13 Economic Growth and Tax Relief Reconciliation Act of 2001, P.L. 107-16, § 901.

14 The inclusion of this design feature is optional, not mandatory. It also may be incorporated into a 403(b) plan.

15 As added by Economic Growth and Tax Relief Reconciliation Act of 2001, P.L. 107-16, § 617(a).

16 § 402A(c)(1).

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The Roth 401(k) feature is similar to a Roth IRA in that contributions are made to the plan on an after-tax basis and subsequently are distributed tax-free (including earnings). Unlike the Roth IRA,17 however, there is no income limitation with respect to participants who choose to utilize the Roth 401(k) feature. Roth 401(k) contributions essentially will be treated the same as 401(k) elective deferrals. Specifically, the Roth 401(k) contributions will be subject to the same dollar limitations,18 nondiscrimination rules, and distribution rules as traditional 401(k) elective deferrals.19
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17 § 408A(c)(3).

18 The dollar limitation set forth in § 402(g) applies to all elective deferrals combined. § 402(g).

19 Roth 401(k)contributions are subject to the additional limitation that they may not be distributed during the “nonexclusion period.” The nonexclusion period generally is defined as the five-year taxable period beginning with the first taxable year for which the participant made a designated Roth contribution to the plan. See § 402A(d)(2)(B).

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The inclusion of a Roth 401(k) feature may result in an increase in administrative expenses. Plan documents, summary plan descriptions, and administrative forms all will have to be revised. In addition, the plan's record keeper will be required to establish separate accounts for Roth contributions and 401(k) elective deferrals.

Most importantly, however, may be the potential impact on employee communications that may be required by the inclusion of a Roth 401(k) feature. Each participant will have to decide whether and to what extent the Roth 401(k) feature is advantageous from a personal financial perspective. Plan sponsors need to be sensitive as to the type of information and advice that they may properly provide to employees with respect to these matters.20
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20 See Interpretive Bulletin 96-1, 23 BPR 1540 (Dept. of Labor) (June 17, 1996).

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In addition to the characterization of employee contributions, plan sponsors also should be sensitive to the limitations that the plan document imposes on employee contributions to the plan, in that these limits may be well below the current statutory limitations. Traditionally, employers established limitations on employee contributions to correspond to the employer limitation on deductible contributions. Accordingly, many plans limited elective deferrals to no more than 15% of compensation. As a result of significant increases in both the deduction limit under § 404 and the limitation on allocations to individual accounts under § 415,21 to the extent that they have not already done so, plan sponsors should consider increasing the plan limits so as to allow participants to maximize their deferral opportunities.22
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21 The deduction limitation under § 404 was increased from 15% of compensation to 25% of compensation and 401(k) elective deferrals are not taken into account for purposes of determining the limitation. The Economic Growth and Tax Relief Reconciliation Act increased the § 415 limitation from the lesser of 25%of compensation or $30,000 to the lesser of 100% compensation or $40,000. These changes became effective in 2001.

22 Employee 401(k) elective deferrals and/or Roth contributions remain subject to the dollar limitations set forth in § 402(g).

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TRUST REQUIREMENT 

Regulations issued by the U.S. Department of Labor (DOL)govern when a participant's contributions to a qualified retirement plan constitute “plan assets.” This characterization is important because plan assets must be held in trust. The failure to timely deposit employee contributions in the trust may result in the imposition of penalties upon the sponsoring employer. The pertinent DOL regulations provide that employee contributions become plan assets as of the earliest date on which such contributions can reasonably be segregated from the employer's general assets.23 The regulations go on to establish a deposit deadline of no later than the fifteenth business day of the month following the month in which the contributions would have otherwise been payable to the participant in cash.24
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23 29 CFR § 2510.3-102(a).

24 29 CFR § 2510.3-102(b).

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It appears that the DOL has taken the position in recent years that the deposit deadline set forth in the regulations is not a safe harbor (as many employers have assumed).25 Rather, the DOL's position is that contributions must be deposited into the trust as soon as they may be segregated.26 In recent investigations, the DOL apparently has adopted a presumption that employee contributions by a small employer must be contributed to the trust within seven days of the payroll date.27
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25 Purdue, DOL Audit of 401(k) Deposits, 8 Pension and Benefits Week, Mar. 4, 2002, at 51.

26 Id. at 1.

27 Id. at 2.

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If the DOL challenges the timing of the trust deposits, the employer will have to prove that the employee contributions could not have been segregated more quickly. Where an employer is unsuccessful in substantiating its position, the DOL may require the employer to contribute earnings that were deemed to have been lost during the period starting on the day the DOL finds that the funds should have been deposited until the date the deposits to the trust actually were made.

The failure to timely deposit employee contributions into a trust constitutes a prohibited transaction.28 An employer that participates in a prohibited transaction must file IRS Form 5330 and pay an excise tax equal to 15% of the “amount involved.”29 A Form 5330 must be filed by the last day of the seventh month after the end of the employer's tax year. If an employer does not correct a prohibited transaction (i.e., deposit the funds in trust), the IRS may assess an additional excise tax of 100% of the amount involved.30 An employer also is required to notify the IRS of any delinquent employee contributions to a plan on Form 5500.31
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28 § 4975(c)(1)(B).

29 § 4975(a).

30 § 4975(b).

31 Form 5500, Schedule H, Part IV 4(a), available at http://www.irs.gov/formspubs/lists/0,,id=97817,00.html.

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TAX IMPLICATIONS AND IMPACT ON OTHER BENEFITS 

While employee elective deferrals to a 401(k) plan are not currently subject to federal income tax, the contributions may be subject to taxation in local jurisdictions. In addition, 401(k) elective deferrals are considered wages for Pennsylvania personal income tax purposes.32 Elective contributions are also considered wages under both the Federal Insurance Contributions Act (FICA) and the Federal Unemployment Tax Act (FUTA).33 As a result of being subject to FICA and FUTA taxes, however, a participant's social security or unemployment benefits will not be reduced as a result of his election to reduce his compensation by contributing to the plan.
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32 72 Pa. Stat. § 7303(a)(ii)(E).

33 § 3121(v)(1)(A).

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As was discussed above, employee contributions to a qualified retirement plan must be deposited in trust. Section 3121(v) provides that the contributions are considered wages at the time they are deposited in the trust.34 Accordingly, since these amounts are subject to employment taxes, the taxes must be withheld from other compensation if the entire amount of the contribution is to be deposited in the trust.35
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34 See 358 T.M., Cash or Deferred Arrangements.

35 Id.

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COVERAGE AND NONDISCRIMINATION TESTING 

A 401(k) feature must satisfy certain coverage and nondiscrimination requirements set forth in the Code in order to retain its qualified status.36 Specifically, the coverage test set forth in § 410(b) and the nondiscrimination test set forth in § 401(k)(3)(A)(ii) must be met. For purposes of applying the tests set forth in § 410(b), all employees who are eligible to participate in the 401(k) feature must be treated as having benefited under the plan, whether or not they actually elect to make elective deferrals.37
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36 § 401(k)(3)(A).

37 § 410(b)(6)(E).

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For purposes of applying the coverage and nondiscrimination tests, the portion of the plan that consists of elective deferrals under a 401(k) feature and the portion consisting of employee after-tax and employer matching contributions are treated as separate plans from the other portions of the plan. Accordingly, a plan that provides for elective deferrals, matching contributions and other employer contributions (such as profit sharing) would be treated as three separate plans.38
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38 Regs. § 1.410(b)-7(c)(1).

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Section 401(k)(3)(A) provides that the 401(k) feature must pass one of the average deferral percentage (ADP) tests set forth in § 401(k)(3)(A)(ii). Specifically, the 401(k) feature must satisfy the 1.25 ADP test or the 2.0 ADP test. The 1.25 test is satisfied if the actual deferral percentage for the HCE's is not more than 1.25 times the ADP for all other eligible employees.39 The 2.0 test is satisfied if the ADP for highly compensated employees is not more than twice the ADP for all other employees and if the excess of the percentages is not more than two percentage points.40
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39 § 401(k)(3)(A)(ii)(I).

40 § 401(k)(3)(A)(ii)(II).

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The ADP for highly compensated employees is determined by taking the actual deferral ratio for each of those employees (the percentage of the employee's compensation represented by elective contributions)and averaging those individual ratios for all eligible highly compensated employees.41 With respect to the ADP for nonhighly compensated employees, it is determined based upon the elective contributions and compensation for the prior plan year.42 An employer may, however, elect to compute the ADP for nonhighly compensated employees based upon current year data instead of prior year data.43 Except under certain circumstances, however, the election to use the current year method cannot be revoked without the approval of the Secretary of the Treasury.44
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41 § 401(k)(3)(B).

42 § 401(k)(3)(A)(ii).

43 § 401(k)(3)(A).

44 Id.

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While relatively simplistic on their face, the ADP tests require the compilation of significant amounts of data as well as a number of computations. Specifically, in order to conduct the tests, the following steps must be taken:45
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45 For a more detailed description of the operation of the ADP tests, see 358 T.M., Cash or Deferred Arrangements.

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• The employees who are eligible for the cash or deferred arrangement must be identified;

• The highly compensated employees among that group must be identified;

• The actual deferral ratio must be computed for each HCE;

• The individual deferral ratios must be averaged to determined the ADP for the HCE; and

• The second, third, and fourth steps must be repeated with respect to the nonhighly compensated employees.

There are a number of methods that an employer may utilize in an effort to comply with the ADP tests, such as limiting deferrals and tracking contributions during the year.46 If the plan is unable to satisfy the 1.25 or 2.0 ADP test, the regulations require that corrective action must be taken in order for the plan to retain its qualified status.47 Generally, if the plan fails the tests, the plan must either distribute the excess contributions (plus earnings) or, if the plan allows employee after-tax contributions, it may recharacterize the excess contributions as after-tax contributions.48
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46 See 358 T.M., Cash or Deferred Arrangements.

47 Regs. § 1.401(k)-2(b)(1).

48 The recharacterized amounts will be subject to the nondiscrimination tests set forth in § 414(m) of the Code.

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Under § 401(k)(8), the plan is not treated as having failed the ADP test if, by the end of the following plan year, the excess contributions (and income or earnings) are distributed to the highly compensated employees. These distributions are exempt from the 10% penalty on early distributions set forth in § 72(t), as well as any participant or spousal consent requirements.49 It is important to note, however, that if the excess contributions are not distributed within two-and-a-half months after the close of the plan year, a 10% excise tax is imposed upon the employer. It also is important to note that if excess contributions have to be recharacterized or distributed, the matching contributions attributable to those contributions must be forfeited.
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49 Regs. § 1.401(k)-2(b)(vii)(A).

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In order to avoid ADP testing entirely, the sponsoring employer may adopt a “design-based safe harbor” as set forth in § 401(k)(12). The design-based safe harbor is satisfied if the employer makes certain nonforfeitable matching or nonelective contributions to the plan and satisfies a participant notice requirement.

The matching contribution requirement is satisfied if matching contributions made on behalf of each nonhighly compensated employee equal 100% of the employee's elective contributions up to 3% of compensation and 50% of the employee's elective contributions between 3% and 5% of compensation.50 The requirement also may be satisfied by utilizing a different matching formula so long as the rate of match does not increase as the employee's level of elective contributions increases, and the total matching contributions at each level of elective contributions is at least equal to the contributions that would have been made under the formula set forth in the Code.51 Employers choosing to utilize the safe harbor matching formula may elect out of the safe harbor prospectively and revert back to ADP testing if the employees are notified of the change.52
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50 § 401(k)(12)(B)(i).

51 § 401(k)(12)(B)(iii).

52 Regs. § 1.401(k)-3(g)(1)(iv).

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An alternative to utilizing the matching contribution formula is for the sponsoring employer to make nonelective contributions on behalf of each eligible nonhighly compensated employee equal to at least 3%of the employee's compensation, without regard to whether the employee makes elective deferral contributions under the plan.53 An employer may also choose to use the matching contribution method in one year and the nonelective contribution method in another. There are no restrictions on employer's ability to do this so long as the plan permits the change to occur.54
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53 § 401(k)(12)(C).

54 See 358 T.M., Cash or Deferred Arrangements.

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The final requirement of the design based safe harbor is the employee notice requirement. Specifically, within a reasonable period before the beginning of any plan year, each employee must be given notice of his rights and obligations under the plan that is written in a manner to be calculated to be understood by the average eligible employee.55 The notice will be timely if it has provided at least 30 days and no more than 90 days before the beginning of the plan year.56
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55 § 401(k)(12)(D).

56 Regs. § 1.401(k)-3(d)(3)(ii).

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ENCOURAGING EMPLOYEE PARTICIPATION 

As is illustrated by the description of the operation of the ADP test, the amount that highly compensated employees may contribute to a 401(k) plan is determined by the average deferral percentages of the nonhighly compensated participants.57 While nonqualified deferred compensation plans are often made available to executives as a means to supplement the limited qualified retirement benefit, those arrangements do not offer the security and tax-advantaged distribution options available under a qualified plan.
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57 Code § § 402(g) and 401(a)(17), respectively, also limit the amount of contributions that may be made by highly compensated employees.

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In addition, many, if not most, employers want to actively encourage their employees to take advantage of the tax-favored vehicle that is being made available to them for retirement savings. According to a Hewett Associates study, nearly 30% of eligible employees do not participate in their company-sponsored 401(k) plans.58 Participation rates generally are the lowest among lower income employees.59 In addition, only 46% of eligible employees under the age of 30 participate in those plans.60
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58 Employees Still Eschewing 401(k), The Business Journal (Youngstown Publishing Co., Youngstown, OH) (Aug. 30, 2005), available at  www.business-journal.com/SBSC401KplansNo.asp.

59 Id.

60 Id.

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One means of “encouraging” employee participation is the use of automatic enrollment feature, which often is referred to as a “negative election.” An automatic enrollment feature essentially reverses the employee's decision-making process with respect to contributing to the plan. Rather than deciding whether to participate, the employee must affirmatively decide whether not to participate in the plan. The employer simply establishes a default contribution rate and default asset allocations, and the decision lies with the employee as to whether or not to modify those selections.

Automatic enrollment has been shown to significantly increase employee participation rates. In a study conducted by EBRI and the Investment Company Institute,61 66% of eligible workers at year-end 2000 were participants in 401(k) plans, while immediately after adding an automatic enrollment feature to the model, the participation rate rose to 92% of eligible employees.62 The study also shows that the impact of the automatic enrollment feature was strongest among the lower income workers.63
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61 Holden &  VanDerhei, The Influence of Automatic Enrollment, Catch-Up, and IRA Contributions on 401(k) Accumulations at Retirement, EBRI Issue Brief No. 283 (July 2005).

62 Id.

63 Id.

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Rev. Rul. 2000-864 sets forth the criteria that must be met in order for an employer to automatically reduce an employee's compensation and have that amount contributed as an elective deferral to a 401(k) plan. The revenue ruling emphasizes that the employer must adequately notify the employee of the effect of the compensation reduction election and of the employee's right to elect that no such compensation reduction be made. The revenue ruling utilizes two examples to demonstrate the use of an automatic enrollment feature. Both of the examples assume an automatic compensation reduction of 3%. Utilization of this figure led some employers to believe that perhaps the IRS considered an automatic 3% reduction to be the maximum amount permissible. In a General Information Letter,65 however, the IRS stated that an amount in excess of 3% was permissible so long as the notice requirement was satisfied.66
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64 2000-1 C.B. 617.

65 IRS Gen. Information Ltr. to J. Mark Iwry (Mar. 17, 2003).

66 Id.

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There are two issues relating to the operation of an automatic enrollment feature that require additional guidance in order for employers to feel more comfortable utilizing the option. These issues relate to the investment of automatic contributions and the coordination with state wage withholding laws. With respect to investments, absent guidance similar to that issued by the DOL with respect to the investment of funds contributed to an IRA pursuant to § 401(a)(31),67 plan fiduciaries may be hesitant to utilize appropriate asset allocation models for automatic contributions.68 Most default investment options are still low-yielding, short-term investment vehicles, even though age-based, lifestyle and balanced default investment option usage is on the rise.69
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67 29 CFR § 2550.404a-2.

68 Buckles, Guiding Light, Investment Advisor.com (Nov. 2005), available at http://www.investmentadvisor.com/issues/2005_12/features/5669-1.html.

69 Id.

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With respect to state law, many states require an employee's written authorization prior to the withholding of any wages.70 This requirement does not, of course, coincide with the theory behind automatic enrollment. Accordingly, coordination with or preemption of state law will be necessary in order to ensure the efficient operation of automatic enrollments in certain states.
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70 Id.

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The concept of automatic 401(k) enrollment has attracted the attention of Congress. During the 109th Congress, six pieces of automatic enrollment legislation were introduced.71 Interestingly, each piece of legislation sets the initial automatic enrollment compensation percentage at 3%. Each piece of legislation also, however, provides for automatic escalators ranging from 1-2% per year. Each proposal also provides for nondiscrimination safe harbor matching or nonelective contributions and addresses the issues of state wage withholding law preemption and default investments.72
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71 American Benefits Council, Automatic Enrollment Legislation Introduced in the 109th Congress (Oct., 31, 2005), available at http://benefitslink.com/search/results.php?startNumber=null& 
 datasource=MYDB& textQuery=Automatic+Enrollment+Legisla-
 tion+Introduced.

72 Id.

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A much more common design feature that is utilized to encourage employee participation is the use of employer matching contributions. Over 92% of 401(k) plan sponsors offer some type of company match or other contribution to their plans.73 It has been suggested that, outside of individual factors such as age and income, an employer match is one of the two most important determinants of whether an employee will participate in the plan.74 The existence of an employer match has been shown to increase the participant contribution rate by nearly 1% of earnings.75 A survey conducted by the Investment Company Institute showed that 80% of nonparticipants said they would be somewhat or very likely to participate in their 401(k) plan if their employer would provide or increase the company match.76
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73 Profit Sharing Council of America, 47th Annual Survey of Profit Sharing and 401(k) Plans Reflecting 2003 Plan Year Experience, cited in DC Solutions, Why Match?: How Employer Matching Contributions Can Ignite Participant Savings (Arnerich Massena Education 2005), available at http://www.kp401K.com/newletters/DC0505/insight.htm.

74 Munnell et al., What Determines 401(k)Participation and Contributions?, Social Security Administration Perspective, available at www.ssa.gov/policy/doc/ssb/v64n3p64.html, cited in DC Solutions, Why Match?: How Employer Matching Contributions Can Ignite Participant Savings (Arnerich Massena Education 2005), available at http://www.kp401K.com/newletters/DC0505/insight.htm.

75 Munnell &  Sunden, Suspending the Employer 401(k) Match (Center for Retirement Research, Boston College)June, 2003, No. 12, cited in DC Solutions, Why Match?:How Employer Matching Contributions Can Ignite Participant Savings (Arnerich Massena Education 2005), available at http://www.kp401K.com/newletters/DC0505/insight.htm.

76 401(k) Plan Participants; Characteristics, Contributions, and Monthly Activity (Investment Company Institute) Spring 2000 cited in DC Solutions, Why Match?: How Employer Matching Contributions Can Ignite Participant Savings (Arnerich Massena Education 2005), available at http://www.kp401K.com/newletters/DC0505/insight.htm.

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Interestingly, while the presence of a match may increase participation, the actual size of the match does not appear to have much of an impact. Larger matches actually have been found to have an inverse impact on contributions because participants do not have to contribute as much of their own money to reach predetermined retirement goals.77 On the other hand, the “structure”of the match can have a significant impact on the level of contributions. For example, “front-end loading” a matching contribution may have the effect of encouraging participants who would not contribute at all to at least contribute some minimum percentage in order to get the matching contribution.
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77 Munnell &  Sunden, Suspending the Employer 401(k) Match (Center for Retirement Research, Boston College) June, 2003, No. 12, cited in DC Solutions, Why Match?: How Employer Matching Contributions Can Ignite Participant Savings (Arnerich Massena Education 2005), available at http://www.kp401K.com/newletters/DC0505/insight.htm.

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It also has been shown that “spreading”the match can have the effect of increasing the participation rate. For example, while a matching contribution of 100% of contributions up to 3% of compensation, and 50% of contributions up to 6% of compensation will produce the same amount of matching contributions, the second structure encourages higher contribution rates from participants in order to take advantage of the full match.78 Research indicates that participants will, in fact, increase their contributions to reach the maximum match level offered under the plan.79
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78 D.C. Solutions, Why Match?: How Employer Matching Contributions Can Ignite Participant Savings (Arnerich Massena Education 2005), available at http://www.kp401K.com/newletters/DC0505/insight.htm.

79 Holden &  VanDerhei, Contribution Behavior of 401(k) Plan Participants, 71 Investment Company Institute Prospective, No. 4 (Oct. 2001).

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Another plan design feature that is utilized to encourage employee participation is permitting in-service access to employee contributions.80 Because of the restrictions placed on distributions of 401(k) elective deferrals by § 401(k),81 liberal access to employee contributions is not permissible. Accordingly, access to employee contributions is limited to loans, hardship withdrawals and distributions following the attainment of age 591/2 .
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80 Access to funds has been demonstrated to be the second of the two most important determinants of employee participation. See Munnell et al., What Determines 401(k) Participation and Contributions?, Social Security Administration Perspective, available at www.ssa.gov/policy/doc/ssb/v64n3p64.html, cited in DC Solutions, Why Match?: How Employer Matching Contributions Can Ignite Participant Savings (Arnerich Massena Education 2005), available at http://www.kp401K.com/newletters/DC0505/insight.htm.

81 § 401(k)(2)(B)(i).

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It is important to recognize that providing access to employee contributions necessarily will increase the administrative expenses associated with the plan's operation. In addition, providing access to employee contributions is somewhat counterproductive to the notion of characterizing the plan as a retirement vehicle since it will afford immediate access to funds that are intended to be utilized upon retirement. Accordingly, a plan's sponsor should weigh these factors against the likely increase in the participation rate associated with in-service withdrawals.

In order to avoid being characterized as a prohibited transaction, plan loans must meet the requirements set forth in the pertinent DOL regulations.82 In addition, ERISA also requires that the plan sponsor adopt a loan policy to govern the administration of plan loans.83 The policy must address issues such as the frequency with which loans will be permitted, circumstances pursuant to which they will be offered, the establishment of an interest rate, and methods for repayment.
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82 29 CFR § 2550.408b-1.

83 Id.

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Although loans afford plan participants with an access to funds that they may require, it is important to realize that there is a significant tax disadvantage associated with plan loans. Specifically, while the loan itself is received tax-free and also provides the participant with an opportunity to pay interest to his own account in the plan, the loan repayment will be made with after-tax dollars. Accordingly, since those funds also will be taxable upon their distribution from the plan, those amounts are essentially subject to double taxation.

Hardship distributions represent the only permissible means for distributing elective deferrals prior to a participant's attainment of age 591/2 . In order to qualify as a hardship, the distribution must be made on account of an immediate and heavy financial need of the employee and the distribution may not exceed the amount necessary to satisfy the financial need.84 Earnings attributable to employee elective deferrals may not be distributed on account of hardship and hardship withdrawals of elective deferrals are not eligible rollover distributions.85
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84 Regs. § 1.401(k)-1(d)(3)(i).

85 § 402(c)(4)(C).

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In determining whether an employee has an immediate and heavy financial need, the employer must take into account all the relevant facts and circumstances and the decision must be based upon objective nondiscriminatory standards.86 An employer may adopt the “safe harbors” set forth in the pertinent regulations, which limit the availability of hardships to six specific events.87 With respect to the satisfaction of financial need requirement, the regulations provide that a distribution is not necessary to satisfy the need to the extent that the amount to be distributed in excess of the amount required to relieve the need.88 The distribution may, however, include amounts necessary to pay all applicable taxes or penalties. A distribution will not be seen as necessary to satisfy a financial need to the extent that it may be relieved from other resources reasonably available to the employee, including the cessation of elective contributions under the plan or by other distributions or loans from any of the qualified plans maintained by the employer.89
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86 Regs. § 401(k)-1(d)(3).

87 Id.

88 Id.

89 Id.

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INVESTMENT OF PLAN ASSETS 

One of the most important issues associated with the operation of a 401(k) plan (or any qualified retirement plan) is the identification of the individual(s) or entity that is going to be responsible for the investment of plan assets. Section 404(a)(1) of ERISA requires that plan fiduciaries discharge their duties by diversifying the investments of the plan so as to minimize the risk of large loses, unless under the circumstances, it clearly is not prudent to do so and by defraying reasonable expenses of administering the plan. Today, many 401(k) sponsors permit participants to direct the investment of some or all of the assets allocated to their accounts (especially elective deferrals). Participant involvement may range from the utilization of self-directed brokerage accounts to selecting from among a menu of employer selected investment options.

If an employer is considering permitting participant directed investment, the employer must determine whether to operate the plan in compliance with the requirements set forth in ERISA § 404(c). It is important to remember that compliance with ERISA § 404(c) will not insulate the plan's fiduciaries with respect to any liability relating to their selection of the investment options from which participants may select. Rather, § 404(c) only provides the fiduciaries with protection with respect to the participants’ investment decisions from among a selection of otherwise prudent investments.

The pertinent DOL regulations contain approximately 25 requirements for ERISA § 404(c) compliance.90 Basically, in order to comply with ERISA § 404(c), the following conditions must be met:
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90 Scheidt &  Wolf, Current Considerations and New Challenges for ERISA Section 404(c) Compliance, The Bureau of National Affairs, Inc., 2004.

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• The plan must allow the participants to direct the investment of their accounts within a broad range of investment alternatives;

• The plan must allow the participants to change their investment allocations as frequently as appropriate based upon the volatility of the investment alternatives; and

• Plan fiduciaries must provide specific disclosures and sufficient investment information to participants.91

The type and number of investment vehicles that will be made available under the plan is critically important. According to the Profit Sharing/401(k) Council of America, company retirement plans had an average of 17 investment options in 2003, up from an average of 10 options in 1998.92 A study by Columbia University indicates, however, that the more investment options are offered, the less likely the employees were to sign up for the 401(k) plan.93 The study concluded that the highest participation rates were found among plans with less than 10 investment options.94
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92 Why A Wealth of Choices in 401(k) May Not Be Good, Post-Gazette.com (Business News).

93 Id.

94 Id.

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With respect to the type of investment options that will be made available, a critical decision involves whether to include company stock as an investment option. According to Sheena Iyengar, a management professor at Columbia Business School, if company stock is made available as an investment option, as the number of investment options increase, employees are more likely to put money into the company stock.95 This is a concern because, contrary to the beliefs (or wished) of many employers, company stock usually represents one of the most risky investment options offered by a plan. In addition, in today's post-Enron environment, the DOL views investments in employer stock with a heightened level of scrutiny and lawsuits against plan fiduciaries with respect to company stock performance have become more prevalent. A recent Third Circuit decision also has liberalized the rules pursuant to which affected participants may bring actions against plan fiduciaries.96
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95 Id.

96 See In Re Schering-Plough Corp. ERISA Litigation, 420 F.3d 231 (3d Cir. 2005).

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Plan sponsors also must be sensitive to the information that they provide to plan participants with respect to the plans investment options. Many, if not most, plan participants may lack the requisite knowledge to make prudent investment decisions, especially with respect to diversification and asset allocation. Accordingly, the participants often look to their employer for advice as to how to invest the funds that are allocated to their accounts. It is imperative that the plan sponsor and/or the plan's fiduciaries do not go so far as to be viewed as providing investment advice to the plan's participants. In DOL Interpretive Bulletin 96-1, the DOL provides guidance as to the type of information that may be provided to plan participants without “crossing the line” into the realm of providing investment advice.97
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97 Interpretive Bulletin 96-1, 23 BPR 1540, (Dept. of Labor) (June 17, 1996).

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Plan sponsors and fiduciaries also must be sensitive to the fees and costs associated with the plan's operation and its investment vehicles. ERISA considers any compensation paid to a service provider to be a prohibited transaction unless the compensation is reasonable. Accordingly, plan fiduciaries who allow a plan to pay more than reasonable compensation may be held personally liable for the difference.98 In addition, as is clearly illustrated in Joint Publication recently issued by the DOL and the Securities Exchange Commission entitled, “Selecting and Monitoring Pension Consultants,”plan fiduciaries now are required to closely monitor the actions of third party consultants and must be particularly sensitive to potential conflicts of interest.
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98 Reish Luftman Reicher &  Cohen, ERISA Report for Plan Sponsors (July 2005), available at http://www.reish.com.

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SPECIAL CONSIDERATIONS FOR TAX-EXEMPT EMPLOYERS 

Employers that are exempt from federal taxation pursuant to § 501(c)(3) should consider the relative advantages and disadvantages associated with maintaining a 401(k) plan versus a 403(b) plan. The Small Business Job Protection Act of 199699 eliminated the prohibition set forth in the Tax Reform Act of 1986100 on most tax-exempt employers maintaining 401(k) plans.101
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99 P.L. 104-188.

100 P.L. 99-514.

101 Governmental entities are still prohibited from maintaining 401(k) plans.

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The principal advantage of a 401(k) plan is greater flexibility with respect to investments. A 403(b) plan must be invested in either annuity contracts or mutual funds.102 On the other hand, there are no restrictions(other than issues relating to fiduciary prudence) on the investment options that may be offered under a 401(k) plan.
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102 § 403(b)(1)(A), (7).

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There are, however, certain disadvantages associated with a 401(k) plan. Perhaps most important is the application of ERISA. Many 403(b) plans are exempt from ERISA. This exemption applies where an employer makes no contributions to the plan, limits its involvement with respect to plan administration and affords employees a reasonable choice of funding media.103 There is, however, no corresponding exemption with respect to 401(k) plans.
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103 29 CFR § 2510.3-2(f).

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As was discussed earlier, employee contributions to a 401(k) plan are subject to certain nondiscrimination tests. These nondiscrimination requirements are not applicable to 403(b) plans. Section 403(b) plans are also exempt from the top-heavy rule set forth in § 416.104
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104 Regs. § 1.416-1, Q& A T-29 and Q& A G-1.

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Regardless of which type of plan a 501(c)(3) organization selects to accommodate employee contributions, it should also consider the adoption of § 457(b) plan. Effective in 2002, EGTRRA105 eliminated the coordination between § 457(b)plan deferrals and 401(k) or 403(b) deferrals. Accordingly, it is possible for an employee of a 501(c)(3) organization to contribute the maximum amount of elective deferrals ($15,000 in 2006) to each plan. This is especially true if a 403(b) plan is utilized in conjunction with a 457(b) plan because, as is discussed above, there are no nondiscrimination requirements applicable to employee contributions to a 403(b) plan.
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105 Economic Growth and Tax Relief Reconciliation Act of 2001, P.L. 107-16, § 615(a).

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CONCLUSION 

The design and maintenance of a retirement plan that permits employee contributions may appear deceptively simple at first glance. A closer look, however, reveals that employers and plan fiduciaries are faced with a myriad of challenging issues, including encouraging employee participation and coping with nondiscrimination testing, selecting investment vehicles, investment advisors, and other third party service providers, and monitoring investment and administrative expenses. Prudent employers and fiduciaries need to be mindful of these issues and when designing and operating the plan.

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91 Id.

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