Retirement Plans: Coming Attractions of 401(k) Plans

The 401(k) plan has become the most widely used retirement plan among companies throughout the country. For construction companies looking to adopt a new qualified plan or to supplement an existing one, the 401(k) is a viable alternative. In addition, management of a construction company may want to modify an existing 401(k) in light of recent tax law developments.

Background: The name for the 401(k) plan derives from the tax code section authorizing its use. With a 401(k), participating employees may elect to defer a portion of salary on a pretax basis. The funds can compound in each participant’s account without any current tax liability. Upon retirement, distributions of contributions are taxed at ordinary income rates.

To sweeten the pot, the employer may provide matching contributions. For instance, the employer may include contributions equal to 3% of compensation up to a set amount.

The plan must meet various nondiscrimination rules to ensure favorable tax treatment. In addition, the tax law imposes an annual dollar limit on contributions. For example, for the 2007 tax year the limit is generally $15,500 ($20,500 for a participant age 50 or over).
Note: These figures remain unchanged for 2008.

Under the Pension Protection Act of 2006, various enhancements to a company’s 401(k) plan may be available. Consider the following features:

*Automatic-enrollment plans: The Act liberalizes several tax rules affecting automatic-enrollment 401(k) plans. Such a plan automatically includes employees as participants unless they affirmatively opt out of participation. The arrangement tends to increase overall participation, which, in turn, may avoid nondiscrimination problems and otherwise benefit higher-paid employees.

*Investment advice: A 401(k) plan provider is now permitted to offer personalized investment advice to participants. Generally, any fees received for these services (e.g., commissions) cannot be based on the investment options selected by the participants. Also, while personalized advice can be provided to account holders, the 401(k) provider cannot advise employers about which funds and investments to include in the plan.

*Hardship withdrawals: Regulations issued in 2007 expand the tax rules for hardship withdrawals to include “primary beneficiaries” under a 401(k) plan. A primary beneficiary is someone who has been named as a beneficiary of the plan and has an unconditional right to all or part of the plan participant’s account balance upon the participant’s death.

*Nonspouse beneficiaries: An individual may roll a deceased spouse’s interest in a 401(k) plan into an IRA. Subsequently, the normal rules for distributions apply. The Act extends this flexibility to nonspouse beneficiaries.

401(k) plan to Roth IRA rollovers: After 2007, participants will be able to directly roll over funds from a 401(k) plan to a Roth IRA, assuming other technical requirements are met. Currently, funds must be transferred to a traditional IRA and then the IRA must be converted into a Roth IRA.

Roth 401(k) plans: This feature enables participants to combine certain features of a Roth IRA, such as tax-free distributions after a five-year holding period, with elements of a 401(k). The tax code provision authorizing Roth 401(k) plans has been extended through 2010.

Military reservists: Employees who are called to active military duty are now allowed to take penalty-free withdrawals from a 401(k). The new law gives reservists up to two years after their service to recontribute amounts without paying tax on the distributions.

Bottom line: Either a plain-vanilla 401(k) plan or an enhanced version using one or more of these features may be appropriate for a construction firm. Consult with a professional benefits adviser.

December 2007