Ted's Table

TB: The rules regarding how employees are separated into the highly and nonhighly compensated groupings are somewhat complex. You must first begin by identifying the plan year that will be tested. In your case, this is the 2000 plan year. The highly compensated employees for the testing year 2000 must include all employees who own at least 5 percent of the company during either 1999 or 2000, and employees who earned more than $80,000 during 1999. An employee hired this year who doesn't own stock won't be a highly compensated employee, regardless of how much the employee earns this year. Certain family members of owners must also be included in the highly compensated group.

The employee you mentioned in your question doesn't have to be limited to the HCE percentage for 2000 if he isn't an owner or related to an owner. You mention that he wants to contribute 20 percent instead of 12 percent. He may do so, but the $10,500 pretax limit must still be applied. This limit must be reduced by any contributions he made to another 401(k) prior to joining your company.

This employee will become highly compensated if he earns $90,000 during 2000. This will push him into the HCE group when you do the year 2001 tests. You will need to restrict his contributions accordingly beginning January 1, 2001.

TB: What is best in my opinion depends upon the amount of other taxable income you have. If your taxable income is less than $5,000, a lump sum withdrawal using 10-year income averaging may make sense because the effective tax rate you will pay on the entire distribution will be at the 15 percent rate. I suspect this isn't the case since you say you won't need this money to provide an income at this time. I assume by this fact that your other taxable income is in the $25,000-plus range. If this is correct, the lump sum will be taxed at the 28 percent rate, or higher, if you take it now.

The money will benefit from tax-deferred growth if you leave it in the plan or roll it into an IRA. This is a plus, but if your taxable income remains at the present level or increases, you will ultimately pay a high level of taxes as you withdraw the money each year. Uncle Sam will ultimately get a big chunk of this money. The question boils down to do you want to pay the IRS now or later?

I don't recommend accepting the opinion of a financial advisor whose main interest may be investing the money you have left after paying the tax. You should have an independent tax professional do an analysis of the potential tax liability and net benefit results for both alternatives, if you haven't already done so.

TB: The same three methods of computing the minimum distribution apply to both 401(k) and IRAs. You need to follow the rules for distribution under Internal Revenue Code Section 401(a)(9). You need to find someone who has a copy of the code — check your local library or a law library. The interest rate must be reasonable. In the past, the IRS has accepted 120 percent of the 30-year Treasury Bond rate as a reasonable rate. A lower rate should also be acceptable if the money is invested at a lower rate. For example, if you have the money all invested in fixed income investments with a 5.5 percent annual return, using this rate should be reasonable.

TB: Your employer may legally change from one administrative organization to another at any time without the approval of participants. Participants are subject to the fee structure of the new provider, which may be higher or lower than the prior administrative firm. Most providers charge a loan administrative fee, so the fact that you did not have to pay such a fee during the past four years is a plus.

Your employer could, of course, pay this fee for those participants who had existing loans when the provider was changed. You may want to discuss this possibility with the person at your firm who handles your plan.

TB: If his plan permits it, your husband may withdraw the amount in his 401(k) that he has contributed to use to help buy a primary residence. You should check the summary plan document that was given to him when he enrolled in his 401(k) plan to see if these withdrawals are permitted.

The amount he withdraws will be taxable at your current tax rate, plus a 10 percent penalty tax will be imposed if he is under age 59½. Typically, this means that 35 percent to 45 percent of the amount withdrawn will be lost in taxes.

Let me suggest a strategy that could help you minimize the tax hit. You should buy the house and withdraw the money at the beginning of next year rather than the end of this year. The tax benefits (mortgage interest deduction) gained via home ownership during most of 2001 will more than offset the tax created by the 401(k) withdrawal. You won't gain this offsetting tax advantage if you purchase a home close to the end of the year.

TB: Yes, an employer may legally exclude a particular group of employees, such as they have done in this instance, if the group excluded is small compared to the total number of employees.

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: The rules regarding how employees are separated into the highly and nonhighly compensated groupings are somewhat complex. You must first begin by identifying the plan year that will be tested. In your case, this is the 2000 plan year. The highly compensated employees for the testing year 2000 must include all employees who own at least 5 percent of the company during either 1999 or 2000, and employees who earned more than $80,000 during 1999. An employee hired this year who doesn't own stock won't be a highly compensated employee, regardless of how much the employee earns this year. Certain family members of owners must also be included in the highly compensated group.

The employee you mentioned in your question doesn't have to be limited to the HCE percentage for 2000 if he isn't an owner or related to an owner. You mention that he wants to contribute 20 percent instead of 12 percent. He may do so, but the $10,500 pretax limit must still be applied. This limit must be reduced by any contributions he made to another 401(k) prior to joining your company.

This employee will become highly compensated if he earns $90,000 during 2000. This will push him into the HCE group when you do the year 2001 tests. You will need to restrict his contributions accordingly beginning January 1, 2001.

TB: What is best in my opinion depends upon the amount of other taxable income you have. If your taxable income is less than $5,000, a lump sum withdrawal using 10-year income averaging may make sense because the effective tax rate you will pay on the entire distribution will be at the 15 percent rate. I suspect this isn't the case since you say you won't need this money to provide an income at this time. I assume by this fact that your other taxable income is in the $25,000-plus range. If this is correct, the lump sum will be taxed at the 28 percent rate, or higher, if you take it now.

The money will benefit from tax-deferred growth if you leave it in the plan or roll it into an IRA. This is a plus, but if your taxable income remains at the present level or increases, you will ultimately pay a high level of taxes as you withdraw the money each year. Uncle Sam will ultimately get a big chunk of this money. The question boils down to do you want to pay the IRS now or later?

I don't recommend accepting the opinion of a financial advisor whose main interest may be investing the money you have left after paying the tax. You should have an independent tax professional do an analysis of the potential tax liability and net benefit results for both alternatives, if you haven't already done so.

TB: The same three methods of computing the minimum distribution apply to both 401(k) and IRAs. You need to follow the rules for distribution under Internal Revenue Code Section 401(a)(9). You need to find someone who has a copy of the code — check your local library or a law library. The interest rate must be reasonable. In the past, the IRS has accepted 120 percent of the 30-year Treasury Bond rate as a reasonable rate. A lower rate should also be acceptable if the money is invested at a lower rate. For example, if you have the money all invested in fixed income investments with a 5.5 percent annual return, using this rate should be reasonable.

TB: Your employer may legally change from one administrative organization to another at any time without the approval of participants. Participants are subject to the fee structure of the new provider, which may be higher or lower than the prior administrative firm. Most providers charge a loan administrative fee, so the fact that you did not have to pay such a fee during the past four years is a plus.

Your employer could, of course, pay this fee for those participants who had existing loans when the provider was changed. You may want to discuss this possibility with the person at your firm who handles your plan.

TB: If his plan permits it, your husband may withdraw the amount in his 401(k) that he has contributed to use to help buy a primary residence. You should check the summary plan document that was given to him when he enrolled in his 401(k) plan to see if these withdrawals are permitted.

The amount he withdraws will be taxable at your current tax rate, plus a 10 percent penalty tax will be imposed if he is under age 59½. Typically, this means that 35 percent to 45 percent of the amount withdrawn will be lost in taxes.

Let me suggest a strategy that could help you minimize the tax hit. You should buy the house and withdraw the money at the beginning of next year rather than the end of this year. The tax benefits (mortgage interest deduction) gained via home ownership during most of 2001 will more than offset the tax created by the 401(k) withdrawal. You won't gain this offsetting tax advantage if you purchase a home close to the end of the year.

TB: Yes, an employer may legally exclude a particular group of employees, such as they have done in this instance, if the group excluded is small compared to the total number of employees.

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.