When to Put Your 401(k) Plan Out of Its Misery

Problems seem to come in bunches. In the past year I have seen several 401(k) that created expensive messes the employers that adopted them. In each instance the employer should never have set up the plan in the first place. These sad cases illustrate how a great plan like a 401(k) is not for every employer.

If you or your clients have a 401(k) plan, make sure it is doing what was intended. If the plan doesn't, and you can't fix it easily, give some thought to terminating it.

Background A 401(k) plan is nothing more than a profit sharing plan with a special feature. It permits employees to direct some of their pay into the plan on a pre-tax basis. Section 401(k) of the Code says that if the plan meets special rules, the amount put in by employees (called the "elective deferral") will not be taxed to them at that time. Section 401(k) simply overcomes the "constructive receipt of income" doctrine.

401(k) plans have exploded in popularity since 1986. A major financial industry has developed to sell and service 401(k) plans. Every bank, mutual fund, insurance company offers them. It seems that everybody with a briefcase has one inside to sell you. The 401(k) plan has evolved as the cornerstone of America's private sector retirement system. Employees now expect that an employer will have one.

However, that does not mean that a 401(k) plan is the best match in all circumstances. Perhaps because 401(k) plans are pushed so aggressively, the plans are adopted where they don't belong. Contrary to popular myth, a 401(k) is not always a wise choice for an employer.

Let me share with you a few of the messes with 401(k)s that I have handled this year. Maybe they can help you identify potential disasters with your clients.

Employer is Too Small A manufacturing company with a total of six employees was sold a 401(k) plan in 2001. There are two owners and four rank and file employees. The owners each make less than $50,000 per year. The rank and file make, on average, under $20,000 per year. The two owners each deferred about $2,000 per year. The rank and file put in zilch.

The owners were just informed by the 401(k) salesman (only 11 months after the year ended) that the plan is "top heavy" for 2002, so contributions are required for the rank and file. (Of the three rank and file employees in 2002, one is now in prison, one had been fired, and the one other quit. I am certain retirement security is not high on their list of personal career objectives). Why did the 401(k) salesman only tell them now about a deficiency in 2002? Answer from the salesman: the "top heavy" testing is "very complicated" and "takes time" to calculate.

And, what about 2003? Maybe that will be another problem, allows the salesman, as only the owners made deferrals into the plan again this year. You think they'll have to wait another year to find out?

There's another problem. The plan has never filed 5500s. The salesman never bothered to tell the owners about that small detail. Anyway, that's the company's CPA fault, says the salesman.

Finally, all the contributions, meager as they were, went into a mutual fund with heavy front end loads and a lousy track record.

Employer is Too Big The company has 90 rank and file employees and one owner. The owner makes huge money and the rank and file make slightly more than minimum wage. The owner is sold a 401(k) plan "to secure his personal financial future," says the 401(k) salesman. He expects to put in $40,000 per year for himself pre-tax and beans for the rank and file.

After the first year ends, the owner learns about ADP non-discrimination testing. He can defer less than $2,000. The owner, who is the only highly compensated employee, learns that if he doesn’t make any elective deferrals to the 401(k), at least he can save the cost of ADP testing. Make the best out of a bad deal.

Business at the company improves and it adds staff. The next year the company has more than one hundred employees. Bingo! Since the plan now covers more than one hundred employees, the Department of Labor requires an audited financial statement for the 5500. The cost of preparing and audited financial statement is greater than the total assets of the plan. The owner is infuriated and insists he will not pay for it.

The owner decides to terminate the plan. However, the financial services company which provided the plan won't process the termination paperwork unless the audited financial statement for the 5500 is prepared. The owner then also learns about the "back end" charges for terminating the plan and liquidating the investments.

Tax Exempt Employer A tax exempt employer with 20 employees wants to put in a plan. The employer cannot afford to contribute any money of its own, so funding will come only through employee elective deferrals.

The 401(k) salesman puts in a 401(k) plan because that is all he had in his briefcase. The employer is then stuck with administrative expenses for ADP discrimination testing, trustee's fees, 5500s, etc.

The employer was not advised about 403(b) plans. The employer could have put one in for free. As long as only employee deferrals go into the plan, and the employer contributes nothing, a 403(b) plan is exempt from ERISA and all its filing and non-discrimination tests.

Employer Short on Cash The employer is a small manufacturing company. There are three owners and about 25 rank and file employees. The company is struggling, so the owners figure out a quick short term loan arrangement. They "borrow" the employees’ elective deferrals and use them to pay the company bills. The "loan" would be paid back when times got better.

This scam went on for more than eighteen months. Interestingly, not one employee ever noticed from his 401(k) statements that what he had been deferring was not ending up in his account.

Eventually, the company’s CPA and the home office of the 401(k) company catch on. The owners are appalled that anyone thinks this is a big deal. They ask me for help. I advise them to hire a criminal attorney instead to represent them on the indictments that may follow.

The DOL and the local authorities will bring criminal charges against those who misappropriate employee elective deferrals. I have seen that happen when the amount is only a few thousand dollars.

Controlled Group and Affiliated Service Group Problems The employer is a corporation which has one owner and ten employees. The owner's financial advisor tells him about the advantages of a one-person 401(k) plan. The new tax laws permit one-person 401(k) plans large pre-tax contributions that were not available under the old laws.

So, the financial advisor has the owner adopt and contribute $40,000 to a 401(k) plan that covers only the owner. This is done by the owner taking a "consulting fee" from the business rather than taking his customary paycheck.

The problem is that the consulting "business" must be aggregated with the corporation as an affiliated service group. The plan is disqualified. The owner and the financial advisor are upset with me because of my hyper-technical reading of the tax laws.

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