Some Treasury and IRS officials think the much-heralded 401(k) salary-reduction plan–the country’s fastest-growing employee benefit–deprives the government of too much tax revenue. As a result, the plan is facing elimination or some tight restrictions.
Under a 401(k) employees can choose to have part of their pay diverted to a special account. The amount going into the fund isn’t taxed, and earnings on it accumulate tax-free. Withdrawal rules are similar to those covering IRAs, but so-called hardship withdrawals–which the IRS has never clearly defined–are usually permitted by the employer, without penalty, for such needs as buying a home, paying college tuition or defraying extraordinary medical costs.
Last year the IRS began drawing up rules that are expected to severely limit 401k withdrawal, according to Edward Davey, a vice-president at Johnson & Higgins, an insurance brokerage and benefits consulting firm. And as part of its tax-simplification package, the Treasury Department has proposed eliminating the 401(k) altogether.
While Congress is deciding whether to kill or modify the plan, the IRS may issue regulations that would limit withdrawals. One idea kicking around is to impose a 10% excise tax on early withdrawals.
All that, Davey says, is part of “the government’s philosophical shift from encouraging employer-sponsored plans to emphasizing personal savings vehicles such as IRAs.” Meanwhile, some companies, including Ernst & Whinney, one of the Big Eight accounting firms, have notified employees recently that they plan to begin a 401(k) later this year.
New wrinkles in retiring
If a person really needs the money in the 401k account and can convince a committee of fellow employees that it is a good reason (buying a house, paying educational expense, repairing a car required for transportation to work, and payment of medical bills are examples of good reasons), then the money can be withdrawn with no penalty. If a person withdraws funds from an IRA account, a 10 percent penalty is charged. Taxes that have been avoided are due from either account, however, during the year of withdrawal.
The 401k plan resembles an IRA in other respects besides the obligation to pay taxes for early withdrawal. The money that funds the 401k contribution limits, for the most part, comes from the employee’s paycheck. The employee elects to save a portion of his or her salary each payday, and the amount saved is deducted before taxes are calculated on the remainder. Thus, the amount saved and the interest on the savings enter the employee’s 401k account untaxed. This avoidance of current taxes allows the same snowballing of savings that permits IRA accounts to grow so quickly. Because the employee actually receives a reduced salary, another name for these 401k plans is OSRP, or Optional Salary Reduction Plan.
The people who invented the rules for OSRP were very clever. They knew that the people who probably would not elect to save for their own retirement were the very ones who ought to: those younger, lower paid staff members who need every cent to live on. They also knew that the people who would benefit the most financially would be the older, higher paid owners and employees who have few other legitimate tax avoidance schemes this good. So the designers of the plan included the rule that a reasonable ratio of savings had to exist between the higher and lower salaried staff members. A common way to assure this “reasonableness” is to state in your plan that the total weekly savings of the top third highest paid staff members won’t exceed by more than 2-1/2 times the total weekly savings of the lower paid two thirds of the staff. (List all employees by descending order of salary, draw a line under one third of the names down from the top to determine who is in each group.)
The firm’s ownes will want to encourage all staff members to participate in the plan, so that the higher paid employees can shelter substantial sums. Some bosses even “bribe” employees to join by matching a portion of the employee’s savings with a contribution from the firm, usually in the order of 3 to 5 percent of the person’s salary, for those who take full advantage of the matching offer. Of course, the matching contribution must be offered to all employees, high paid and low paid alike. The matching funds are a tax-deductible business expense, just like paychecks.
A pleasurable experience awaits the person who decides to install a 401k plan. The IRS will cooperate with any employer who wishes to install any retirement plan and do everything possible to assist employers in receiving quick approval. In the old days, making a submittal to the IRS for their approval (granting qualified tax status) of a retirement plan was like putting a message in a bottle and throwing it into the ocean. Now it’s possible to get IRS approval for a 401k plan within a week or two, and if there is a problem with the text that you submit, some IRS employee who calls you “Sir” will come by your office and help you with the language, if you wish. Le roi le veut.
Tax plan imperils popular employee savings program
Many employees had participated in 401(k) plans with the idea of using the money before retirement. If this portion of the tax reform proposal is passed, “people would have to think twice” before participating in these plans, said Frederick W. Rumack, director of tax and legal services at New York’s Buck Consultants.
Mr. Rumack, for one, thinks that this part of the tax package will not be passed. “It’s probably not going to happen,” he said, noting that so many corporations have adopted these plans that they may lobby Congress to keep them. And “it’s possible they would lobby hard,” he said.
The tax reform package comes at the same time that a major survey has released findings concerning these plans as well as other defined contribution plans. The survey found that larger companies were more likely to adopt a salary-reduction 401k plan than smaller ones. But smaller companies contributed more to profit-sharing plans than the larger firms.
The 1984 Profit Sharing Survey — its 27th edition — was conducted by the Lincolnshire, Ill.-based actuarial consulting firm of Hewitt Associates in conjunction with the Profit Sharing Council of America. The survey is based on 1983 developments.
The firm conducted surveys on employer contributions, investment performance, asset management, costs, turnover, and other features of profit-sharing plans.
Twenty percent of the plans invest in employer stock. But in those plans, the employer’s stock represents less than 50% of total plan assets.
Balanced funds and guaranteed investment contracts have the largest percentage of assets at companies with less than $10 million in plan assets.
In 39% of the plans, the employee makes the investment fund selection for those funds contributed by the employer. For employee contributions, the employee makes the decision in 57% of the 401k limits.
The survey also found that banks no longer manage the largest percentage of aggregate assets, as they did in 1982. Bank managers had 19.9% of all profit-sharing plans, insurance companies had 25.1%, investment advisors had 30.3% and 23% of all plans were managed by the companies themselves.
Banks dominated in the group of profit-sharing plans with assets between of $6 million and $10 million and in the group with assets of between $400,000 and $1 million
The Senate bill is much more drastic. It axes the entire IRA deduction if your company covers you with a retirement plan. Interest on the money you’ve already saved in an IRA would continue to accumulate tax-free until withdrawal, but starting in 1987, any contributions would not be deductible.
But the House and Senate fail to realize that for an engineer, being covered by a retirement plan and being vested in that plan are not the same thing. The key word here is “covered.’ Plenty of engineers work for companies with pension plans, but few work long enough to pocket any of those dollars. Many engineers leave their employer–or get shown the door–long before they can meet vesting requirements in corporate pension plans. In fact, some studies indicate that 50% of all engineers do not reach their five-year anniversary with an employer. Thus, even though the tax reform bill reduces vesting to five years, plenty of engineers still leave the company before they qualify for pension benefits.
Apparently Congress has a short memory. Back in 1978 dedicated IEEE volunteers, led by institute ex-president John Guarrera, filled the halls of Congress with horror stories–case histories of engineers who worked 14 years or more for an employer and were laid off only months before they were vested. The cries were heard, and in 1982 Individual Retirement Accounts became legal.
But what Uncle Sam giveth, he can taketh away.
Maybe senators don’t have to worry about retirement: If they are not re-elected, they can return to cushy jobs in their old law firms. Nobody suggests they are obsolete at 32, overqualified at 45, or over-the-hill at 50.
Engineers are not so lucky. Their jobs depend as much on technology as they do on political whim. Aerospace and defense hiring is now just as chancy as it was back in 1978, when the IEEE fought its case in Congress. Just two months ago, following the Challenger disaster, Lockheed’s Space Operations Division in Orlando pink-slipped about 500 engineers and scientists, with more layoffs expected. At NASA, officials predict that some 1100 space jobs are headed for a crash.
Even the commercial electronics industry is volatile. Despite its reputation for stability, Tektronix announced it will lay off 2000 employees–10% of its work force– between now and August.
IEEE’s original goal, portable pensions, was never reached. Opposition from the Department of the Treasury was enormous; too many potentially taxable dollars would get away. But losing IRAs will set the struggle back nearly a decade.
STAND YOUR GROUND–AGAIN
Engineers–our nation’s technical backbone–were not afraid to tell Congress what they didn’t like about tax laws back in 1978. Senators and representatives need some reminding. I suggest you remind your senator today that being “covered’ by an employer-sponsored pension plan does not guarantee any money at retirement. Maybe you could also remind them that engineers know how to pull the lever on election day. Call the IEEE’s Washington office, (202) 785-0017, to find out who represents you in Congress and where to write.
Of course, there’s that old saw about engineers never getting involved in politics, never making phone calls, never moving a pencil across a sheet of paper. Employers, Uncle Sam, and the tax man can stick it to them, and they won’t complain.
All that’s okay, but next time the IEEE gets off its duff and tries to regain some of the ground that will be lost when the IRA dies, think of the terrific horror stories it can relate to Congress–maybe even yours.