Ted's Table

TB: An employer who wants to avoid the hassle and expense of nondiscrimination testing each year may set up what's known as a "safe-harbor" 401(k) plan. Under such a plan, the employer has to pay a certain amount of money into the account for the nonhighly compensated employees. There are various formulas for calculating the amount. Some employers might find this option expensive, especially since these contributions would have to be fully vested from the word go.

The IRS answered your question when it released Notice 2000-3, on January 6, 2000. It released this notice to encourage broader usage of the 401(k) safe harbor. One of the challenges with the safe harbor is that the employer must notify its employees within a "reasonable period" prior to the beginning of the plan year that it is switching to the new type of plan. Notice 2000-3 gave plan sponsors until May 1, 2000 to provide notice to employees, if they adopted the safe-harbor design before June 2, 2000. Both of these dates have already passed so you have missed the safe-harbor opportunity for 2000 if you haven't taken these steps.

Regarding the three percent employer nonelective contribution, an employer may wait until as late as December 1 of the applicable year to decide to adopt this safe harbor. This gives employers the flexibility to wait until close to the end of the year before making this decision. However, employers who want to use this approach are required to inform employees before the beginning of the year that it might be used, and that the employees will be notified at least 30 days before the end of the plan year when the safe harbor will be used. You should have issued such a notice to your employees prior to May 1, 2000, the extended notice deadline for 2000, in order to use the nonelective contribution approach for 2000. This notice only needs to be distributed to your employees. It doesn't have to be filed with the IRS.

You should issue such a notice prior to the beginning of each future year if you want to establish the opportunity to use the nonelective contribution. You must then make a decision prior to December 1 of the applicable year and inform the employees of your decision. The reason for this notice is to make certain all employees who are impacted by this decision have an opportunity to take advantage of the safe-harbor arrangement.

TB: The primary legal requirement is to adopt a plan document, which contains the rules that will govern the plan. You must resolve all the plan design issues, such as eligibility, vesting, the level of employer contributions, etc., before the plan document can be prepared. The easiest way to create a plan document is to use an IRS preapproved prototype.

You must prepare and distribute to eligible employees a summary plan description (SPD), which tells them how the plan works. You're also required to obtain a fidelity bond from an insurance company, which protects the plan from dishonesty on the part of those who have control of the plan assets.

The above are the key legal requirements, but you also must make a number of decisions regarding the operation of the plan. These include things such as:

1. How will the contributions be invested?

2. Who will maintain the participant accounts and provide other administrative/compliance services?

3. How will the plan be communicated to employees?

You will also have to establish the administrative procedures and forms that will be necessary to operate the plan. The entire process normally is led by the organization that is selected to manage the plan. As a result, you should either select the organization that will manage the plan early in the process, or retain the services of an independent retirement-planning consultant who will help you design the plan and select your provider.

I strongly recommend using a consultant or seeking help from your counterpart at another company who has a 401(k) plan so you can benefit from their experience. Otherwise, you will have to learn as you go, which frequently leads to some bad decisions when a company establishes its first plan.

TB: The funds that have been selected by your employer give you an advantage if your employer pays all the fees. The fact that you can switch from fund to fund only once per year is a disadvantage, but it isn't that big a deal. As you probably know, the most important thing over the long term is the total return, net of investment expenses. This should be the primary reason for deciding which funds to use.

TB: You're correct that the plan sponsor is responsible to monitor the investment funds and should replace an "underperforming" fund or a fund that drifts from its mandate.

This is great in theory, but it's difficult to execute when employers pick brand-name funds rather than generic funds by asset class. When brand-name funds are used, it's impossible to move from one fund to another without participants knowing that a change has occurred. Changing a fund, regardless of the reason, is a contradiction to the message most employers give the employees.

Most employees are told they must assume the responsibility for selecting the funds where they will invest their money and the results. Participants who are constantly given this message are shocked when the employer, without any employee involvement, changes a fund. This frequently occurs when a business is sold regardless of whether the funds are brand name or generic.

Moving an employee's money out of a brand-name fund for the reasons you mentioned also involves some significant risk. I'll use Fidelity Magellan as an example. Plans that use this fund should have dropped it a couple of years ago for bad performance and straying from its mandate. Employers that did so created some major employee ill will when Magellan rebounded and outperformed the traditional benchmarks. There is a reasonably good chance that when a fund is replaced the new fund will underperform the replaced fund during the following six to 12 months. This is a strong possibility, regardless of what professional assistance is used to evaluate the various funds and make this decision. Most employers that I am aware of simply added additional funds in this particular asset class, rather than forcing participants to sell their Magellan shares. Some professionals I know condemned these employers for not having the courage to "do the right thing" by forcing participants out of Magellan.

I agree with you that using managers that are selected by the employer to manage a particular asset class, which is then presented to participants in a generic form such as a large-cap equity fund, avoids this problem. However, many participants push hard for brand-name funds rather then the generic type. When it comes to fund selection, employers are in a no-win situation, which is one of the reasons why employers are likely to cease being investment gatekeepers during the next decade.

TB: Withdrawals from a 401(k) for education or first-home purchases don't receive any special tax breaks. Withdrawals for these reasons are fully taxable and the 10 percent early distribution penalty applies if the withdrawal occurs during active employment prior to age 59½. The unpaid loan will be fully taxable and the penalty tax will be imposed unless your wife is able to pay off the loan.

TB: Tax-deferred rollovers into an IRA are permitted even if you continue working. So, the fact that you will continue working within the same industry after you roll money into an IRA won't disqualify the rollover.

You apparently also want to start drawing an income from the IRA prior to age 59½ without incurring the 10 percent penalty tax. Distributions prior to age 59½ must qualify under Internal Revenue Code Section 72(t) in order to avoid the penalty tax. The distribution must be structured as a series of substantially equal periodic payments, not less frequently than annual, paid over your life expectancy or the joint life expectancy of you and your beneficiary. Once these distributions begin, they must continue for five years or until you reach age 59½, whichever comes later.

I am not aware of any employment restrictions, but I have never claimed to be a Section 72(t) authority. It would, in fact, be very difficult for the IRS to monitor whether someone has returned to work within the same industry, which is another reason why I doubt that what you are being told is correct. I suggest asking your financial advisor to give you a copy of the IRS ruling that supports his position.

Ted Benna, creator of the first 401(k) retirement savings plan, will answer your most intriguing questions every week. With over 30 years of experience as an employee benefits consultant, Ted is a nationally recognized expert on benefits issues. He has authored two books, Helping Employees Achieve Retirement Income Security and Escaping the Coming Retirement Crisis, and is President of the 401(k) Association. Ted is a frequent speaker at meetings of 401(k) plan sponsors and participants. His articles and comments have appeared in numerous publications, including The New York Times and The Wall Street Journal.

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.

Ted's Table

TB: An employer who wants to avoid the hassle and expense of nondiscrimination testing each year may set up what's known as a "safe-harbor" 401(k) plan. Under such a plan, the employer has to pay a certain amount of money into the account for the nonhighly compensated employees. There are various formulas for calculating the amount. Some employers might find this option expensive, especially since these contributions would have to be fully vested from the word go.

The IRS answered your question when it released Notice 2000-3, on January 6, 2000. It released this notice to encourage broader usage of the 401(k) safe harbor. One of the challenges with the safe harbor is that the employer must notify its employees within a "reasonable period" prior to the beginning of the plan year that it is switching to the new type of plan. Notice 2000-3 gave plan sponsors until May 1, 2000 to provide notice to employees, if they adopted the safe-harbor design before June 2, 2000. Both of these dates have already passed so you have missed the safe-harbor opportunity for 2000 if you haven't taken these steps.

Regarding the three percent employer nonelective contribution, an employer may wait until as late as December 1 of the applicable year to decide to adopt this safe harbor. This gives employers the flexibility to wait until close to the end of the year before making this decision. However, employers who want to use this approach are required to inform employees before the beginning of the year that it might be used, and that the employees will be notified at least 30 days before the end of the plan year when the safe harbor will be used. You should have issued such a notice to your employees prior to May 1, 2000, the extended notice deadline for 2000, in order to use the nonelective contribution approach for 2000. This notice only needs to be distributed to your employees. It doesn't have to be filed with the IRS.

You should issue such a notice prior to the beginning of each future year if you want to establish the opportunity to use the nonelective contribution. You must then make a decision prior to December 1 of the applicable year and inform the employees of your decision. The reason for this notice is to make certain all employees who are impacted by this decision have an opportunity to take advantage of the safe-harbor arrangement.

TB: The primary legal requirement is to adopt a plan document, which contains the rules that will govern the plan. You must resolve all the plan design issues, such as eligibility, vesting, the level of employer contributions, etc., before the plan document can be prepared. The easiest way to create a plan document is to use an IRS preapproved prototype.

You must prepare and distribute to eligible employees a summary plan description (SPD), which tells them how the plan works. You're also required to obtain a fidelity bond from an insurance company, which protects the plan from dishonesty on the part of those who have control of the plan assets.

The above are the key legal requirements, but you also must make a number of decisions regarding the operation of the plan. These include things such as:

1. How will the contributions be invested?

2. Who will maintain the participant accounts and provide other administrative/compliance services?

3. How will the plan be communicated to employees?

You will also have to establish the administrative procedures and forms that will be necessary to operate the plan. The entire process normally is led by the organization that is selected to manage the plan. As a result, you should either select the organization that will manage the plan early in the process, or retain the services of an independent retirement-planning consultant who will help you design the plan and select your provider.

I strongly recommend using a consultant or seeking help from your counterpart at another company who has a 401(k) plan so you can benefit from their experience. Otherwise, you will have to learn as you go, which frequently leads to some bad decisions when a company establishes its first plan.

TB: The funds that have been selected by your employer give you an advantage if your employer pays all the fees. The fact that you can switch from fund to fund only once per year is a disadvantage, but it isn't that big a deal. As you probably know, the most important thing over the long term is the total return, net of investment expenses. This should be the primary reason for deciding which funds to use.

TB: You're correct that the plan sponsor is responsible to monitor the investment funds and should replace an "underperforming" fund or a fund that drifts from its mandate.

This is great in theory, but it's difficult to execute when employers pick brand-name funds rather than generic funds by asset class. When brand-name funds are used, it's impossible to move from one fund to another without participants knowing that a change has occurred. Changing a fund, regardless of the reason, is a contradiction to the message most employers give the employees.

Most employees are told they must assume the responsibility for selecting the funds where they will invest their money and the results. Participants who are constantly given this message are shocked when the employer, without any employee involvement, changes a fund. This frequently occurs when a business is sold regardless of whether the funds are brand name or generic.

Moving an employee's money out of a brand-name fund for the reasons you mentioned also involves some significant risk. I'll use Fidelity Magellan as an example. Plans that use this fund should have dropped it a couple of years ago for bad performance and straying from its mandate. Employers that did so created some major employee ill will when Magellan rebounded and outperformed the traditional benchmarks. There is a reasonably good chance that when a fund is replaced the new fund will underperform the replaced fund during the following six to 12 months. This is a strong possibility, regardless of what professional assistance is used to evaluate the various funds and make this decision. Most employers that I am aware of simply added additional funds in this particular asset class, rather than forcing participants to sell their Magellan shares. Some professionals I know condemned these employers for not having the courage to "do the right thing" by forcing participants out of Magellan.

I agree with you that using managers that are selected by the employer to manage a particular asset class, which is then presented to participants in a generic form such as a large-cap equity fund, avoids this problem. However, many participants push hard for brand-name funds rather then the generic type. When it comes to fund selection, employers are in a no-win situation, which is one of the reasons why employers are likely to cease being investment gatekeepers during the next decade.

TB: Withdrawals from a 401(k) for education or first-home purchases don't receive any special tax breaks. Withdrawals for these reasons are fully taxable and the 10 percent early distribution penalty applies if the withdrawal occurs during active employment prior to age 59½. The unpaid loan will be fully taxable and the penalty tax will be imposed unless your wife is able to pay off the loan.

TB: Tax-deferred rollovers into an IRA are permitted even if you continue working. So, the fact that you will continue working within the same industry after you roll money into an IRA won't disqualify the rollover.

You apparently also want to start drawing an income from the IRA prior to age 59½ without incurring the 10 percent penalty tax. Distributions prior to age 59½ must qualify under Internal Revenue Code Section 72(t) in order to avoid the penalty tax. The distribution must be structured as a series of substantially equal periodic payments, not less frequently than annual, paid over your life expectancy or the joint life expectancy of you and your beneficiary. Once these distributions begin, they must continue for five years or until you reach age 59½, whichever comes later.

I am not aware of any employment restrictions, but I have never claimed to be a Section 72(t) authority. It would, in fact, be very difficult for the IRS to monitor whether someone has returned to work within the same industry, which is another reason why I doubt that what you are being told is correct. I suggest asking your financial advisor to give you a copy of the IRS ruling that supports his position.

Ted Benna, creator of the first 401(k) retirement savings plan, will answer your most intriguing questions every week. With over 30 years of experience as an employee benefits consultant, Ted is a nationally recognized expert on benefits issues. He has authored two books, Helping Employees Achieve Retirement Income Security and Escaping the Coming Retirement Crisis, and is President of the 401(k) Association. Ted is a frequent speaker at meetings of 401(k) plan sponsors and participants. His articles and comments have appeared in numerous publications, including The New York Times and The Wall Street Journal.

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.