The Treasury Department and the IRS issued guidance on September 5, 2009 that is intended to facilitate retirement savings in the workplace by allowing unused vacation and sick leave to be converted into retirement savings and by expanding opportunities for employers to add automatic contribution arrangements to their 401(k) plans and SIMPLE IRA plans.

Specifically, the new retirement savings initiatives:

  • Permit 401(k) and profit sharing plans to allow contributions based on the dollar equivalent of unused vacation and sick leave, either on an annual basis or at termination of employment;
  • Allow default 401(k) contribution percentages in automatic 401(k) contribution arrangements to increase annually based on the rate of increase in an employee's eligible pay or on dates other than the first day of the plan year;
  • Allow employers to add automatic salary reduction contribution arrangements to their SIMPLE IRA plans and provide sample plan amendments to do so.

These initiatives are described in greater detail below.

Paid Time Off Contributions to 401(k) and Profit Sharing Plans

Two new Revenue Rulings, Rev. Rul. 2009-31 and Rev. Rul. 2009-32 (which may be found at http://www.irs.gov/pub/irs-drop/rr-09-31.pdf and http://www.irs.gov/pub/irs-drop/rr-09-31.pdf) illustrate several scenarios in which 401(k) and profit sharing plans can accept contributions based on an employee's accrued but unused vacation or sick leave. While cash-outs of unused leave are taxable to the employee when paid, plan contributions made in lieu of a cash-out are not taxed to the employee until they are distributed from the plan.

  • Assumptions. The Revenue Ruling scenarios all use the following assumptions: (a) the employer is a C-Corporation; (b) the plan year is the calendar year; (c) all employees are eligible to participate in the employer's paid time off ("PTO") plan on substantially the same terms and conditions; (d) the employer's PTO plan is a bona fide sick or vacation leave plan, exempt from the requirements of Section 409A of the Internal Revenue Code, and an employee may take paid leave without regard to whether the leave is due to illness or incapacity; (e) payments for paid leave (whether used or unused) are made from the employer's general assets: and (f) the dollar equivalent of unused paid leave (the "Unused Leave Value") is the number of hours of paid leave times the employee's hourly rate of pay as of the last day of the year for which the leave was granted (or as of the employee's termination of employment, as applicable).
  • Scenario 1: Annual Nonelective Profit Sharing Contribution of Unused Leave
    • How it works. Under the employer's PTO plan, no unused leave for a year may be carried over into the next year. The Unused Leave Value as of the last day of the year will be contributed to the profit sharing plan for that year as a nonelective profit sharing contribution. That, together with other contributions made on behalf of the employee, cannot exceed the maximum contribution limit for the year ($49,000 in 2009). Any Unused Leave Value that cannot be contributed to the profit sharing plan (because of the limit) will be paid to the employee by February 28 of the following year.
    • Nondiscrimination testing. Unless eligibility for this contribution is restricted to nonhighly compensated employees, the contribution (along with any other nonelective profit sharing contributions) would be subject to general nondiscrimination testing.
  • Scenario 2: Annual 401(k) Contribution of Unused Leave
    • How it works. Under the employer's PTO plan, unused leave up to a specified limit (the carryover limit) may be carried over and used in the following year. The employee may make a timely election to have all or any part of any Unused Leave Value in excess of the carryover limit (the "Excess Leave Value") contributed to the 401(k) plan as a 401(k) contribution. If no election is made, or to the extent to Excess Leave Value (together with other 401(k) contributions) exceeds the maximum annual contribution limit for 401(k) contributions ($16,500 in 2009) or for total contributions ($49,000 in 2009), the Excess Leave Value will be paid directly to the employee on February 1 of the following year.
    • Nondiscrimination testing. If an employee makes a timely 401(k) contribution election as to all or part of the Excess Leave Value, the portion of the Excess Leave Value that is contributed to the 401(k) plan will be treated as a 401(k) contribution for the year in which the contribution is made (i.e., the year following the year in which the paid leave was granted) and will be subject to applicable nondiscrimination testing, the maximum annual contribution limit for 401(k) contributions ($16,500 in 2009) and the maximum aggregate limit on contributions ($49,000 in 2009) for that year
  • Scenario 3: Nonelective Profit Sharing Contribution of Unused Leave at Termination of Employment
    • How it works. Under the employer's PTO plan, unused leave up to a specified limit may be carried over and used in the following year. The Unused Leave Value as of the employee's termination of employment will be contributed to the profit sharing plan as of the first day of the second payroll period beginning after the employee's termination of employment as a nonelective profit sharing contribution. To the extent that the Unused Leave Value (together with other contributions made on behalf of employee) exceeds the maximum contribution limit for the year ($49,000 in 2009), it will be paid to the employee within 60 days after the employee's termination of employment.
    • Nondiscrimination testing and plan qualification.
      • Unless eligibility for this contribution is restricted to nonhighly compensated employees, the contribution would be subject to general nondiscrimination testing.
      • If the employee terminates late in the year, so that the allocation date of the contribution (the first day of the second payroll period beginning after the employee's termination of employment) is in the following plan year, care must be taken that the contribution in the later year does not exceed 100% of the compensation of the (former) employee in the first 2-1/2 months of the later year, so as not to violate the maximum aggregate contribution limits. If the employee otherwise receives no (or very little) compensation (excluding severance pay) in the later year, then only a portion of the Unused Leave Value may be contributed to the plan. This can best be illustrated by example.

Example: Assume that an employee terminates employment on December 31, 2009 and that the employee's Unused Leave Value on that date is $1,000. Assuming that the employee does not receive any other compensation from the employer in 2010, the maximum amount that may be contributed to the profit sharing plan on behalf of the employee for 2010 is $500, determined as follows: First, $500 in Unused Leave Value must be paid to the employee during the first 2-1/2 months of 2010 (i.e., cashed out) so that the contribution (the remaining $500) will not exceed 100% of the compensation ($500) received by the employee in 2010.

Note that severance pay, if any, that is received in 2010 is not treated as compensation for this purpose. Thus, even if the employee received additional severance pay in 2010, the maximum Unused Leave Value that may be contributed on behalf of the employee in this example would be $500.

  • Scenario 4: 401(k) Contribution of Unused Leave at Termination of Employment
    • How it works. The facts are the same as Scenario 3 except that the employee's Unused Leave Value at termination of employment will be paid directly to the employee on the first day of the second payroll period beginning after the employee's termination of employment unless the employee makes a timely election to have all or part of the Unused Leave Value contributed to the 401(k) plan as a 401(k) contribution.
    • Nondiscrimination testing and plan qualification.
      • If an employee makes a timely 401(k) contribution election as to all or part of the Unused Leave Value (i.e., before the first day of the second payroll period beginning after the employee's termination of employment), the portion of the Unused Leave Value that is contributed to the 401(k) plan will be treated as a 401(k) contribution for the year in which the contribution is made (i.e., the year that includes the first day of the second payroll period beginning after the employee's termination of employment) and will be subject to applicable nondiscrimination testing requirements, the maximum annual contribution limit for 401(k) contributions ($16,500 in 2009) and the maximum aggregate limit on contributions ($49,000 in 2009) for that year.
      • In contrast to Scenario 3, if the contribution is made in the plan year following the plan year in which the employee terminates employment, the employee may be able to contribute up to 100% of the Unused Leave Value to the 401(k) plan. Because the contribution is considered a 401(k) contribution, it will also be treated as compensation for purposes of applying the maximum aggregate contribution requirements. The contribution would still be subject to nondiscrimination testing and the maximum 401(k) contribution limits ($16,500 in 2009).  

Expanded Automatic Contribution Opportunities

Background. A 401(k) plan may include an automatic contribution arrangement under which, unless an eligible employee elects otherwise, the employee will be deemed to have elected a 401(k) contribution in a percentage of pay designated by default, which may be increased annually until the employee reaches the maximum default percentage permitted under the plan.

The new IRS guidance allows some new variations on the annual increases in the default 401(k) contribution percentage.

  • Annual Increase in Default 401(k) Contributions May be Based on Compensation Increases. Notice 2009-65 (which may be found at the following web site http://www.irs.gov/pub/irs-drop/n-09-65.pdf) allows a 401(k) plan to increase the default 401(k) contribution percentage under an automatic contribution arrangement based in part on the percentage increase in an employee's compensation.

Example: A 401(k) plan provides an automatic contribution arrangement under which the initial default 401(k) contribution election is 1% of eligible pay. The employee's default 401(k) contribution percentage will increase each year by a percentage that is the greater of (i) 1% or (ii) 40% of the percentage increase in the employee's eligible base salary, until the employee is contributing 11% of eligible pay. Thus, if an employee's base salary increases by 5% in his first year of participation, the employee's default 401(k) contribution percentage would increase by 2 percentage points (i.e., 40% of 5%) to 3% of eligible pay in year two. In this way, employees with higher percentage pay increases will reach the maximum default 401(k) contribution percentage sooner than employees with lower percentage pay increases.

The 401(k) plan must provide the employee with an effective opportunity to make or change the default 401(k) contribution election (before the default election becomes effective and a default 401(k) contribution is made). In addition, the employee must receive adequate notice of his right to make, change or revoke his 401(k) contribution election or revoke the default 401(k) contribution.

If the increase in the default 401(k) contribution percentage under an automatic contribution arrangement is based partly on compensation increases, the arrangement will not be treated as a qualified automatic contribution arrangement (a "QACA")" exempt from nondiscrimination testing or an eligible automatic contribution arrangement (an "EACA"), under which an eligible employee may withdraw his or her default 401(k) contributions (without penalty) within 90 days after the first default 401(k) contribution is made.

  • Timing of Annual Increases in the Default 401(k) Contributions Under QACAs and EACAs. Notice 2009-65 also allows an automatic contribution arrangement that otherwise satisfies the requirements of a QACA or EACA to increase the default 401(k) contribution percentage annually on a date other than the first day of the plan year. This will allow 401(k) plans that are intended to meet the QACA and/or EACA requirements to increase employees' default 401(k) contribution percentages on the same day that annual pay increases become effective. The same date must be used for all eligible employees.

There is a wrinkle, however. If a QACA increases the default 401(k) contribution percentage on a date other than the first day of a plan year, it must increase the percentage to the new applicable minimum percentage for QACAs before the first day of the applicable plan year, as illustrated in the following example.

Example: Assume that an employee makes his or her first default 401(k) contribution of 3% under a QACA on March 1, 2009. Under the QACA requirements, that rate remains in effect until the last day of the following plan year (i.e., until December 31, 2010). If the plan year is the calendar year, and the increases in the default 401(k) contribution percentages are all made on a calendar year basis, the employee's default 401(k) contribution percentage must be increased to at least 4% for the plan year beginning on January 1, 2011. If, however, the plan increased the default 401(k) contribution percentage each April 1 rather than each January 1, the employee's default 401(k) contribution percentage must be increased to 4% on April 1, 2010 to ensure that it is at least 4% of pay for the entire plan year that begins on January 1, 2011.

  • Automatic Contribution Arrangements Under SIMPLE IRA Plans. Notice 2009-66 (which may be found at the following web site http://www.irs.gov/pub/irs-drop/n-09-66.pdf) allows an employer to implement automatic contribution arrangements under a SIMPLE IRA plan. Under the automatic contribution arrangement, the employer will make default salary reduction contributions for each employee who fails to make an affirmative contribution election (including an affirmative election not to contribute) under the SIMPLE IRA plan.

What is a SIMPLE IRA Plan? A SIMPLE IRA plan is a retirement arrangement maintained by an employer with no more than 100 employees under which each eligible employee may elect to have salary reduction contributions made to his individual retirement account or individual retirement annuity (a SIMPLE IRA). The employer must also make matching or nonelective contributions to each employee's SIMPLE IRA.

The automatic contribution arrangement under a SIMPLE IRA plan may also provide that each employee's default salary reduction contribution percentage will increase from time to time based on how long the employer has been making default salary reduction contributions for the employee (e.g., 1% increase each year) until the employee makes an affirmative contribution election or the employee reaches the highest maximum default 401(k) contribution percentage permitted under the plan.