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CCH® PENSION — 09/25/09

Guidance issued allowing unused paid time off to be contributed to 401(k) plans

The IRS has issued guidance that allows 401(k) plans to be amended to permit or require certain contributions of the dollar equivalent of participants' unused paid time off (PTO), in accordance with the governing nondiscrimination requirements and contribution limits. Two general situations are addressed: the contribution of unused PTO at the end of the year that would otherwise be forfeited and the contribution of unused PTO at the time of participants' termination of employment that would be distributed to the participants.

Annual contributions of unused PTO

A 401(k) plan may be amended to accept contributions of the dollar equivalent of unused PTO that would be forfeited at the end of the year (either because no carryover of PTO is allowed or because only limited carryover amounts are permitted). The amount contributed cannot exceed the limitations of Code Sec. 415(c) (in combination with any prior annual additions) and is subject to the distribution rules applicable to other contributions to the 401(k) plan (i.e., the tax on premature distributions under Code Sec. 72(t)). If amounts of unused PTO money are contributed automatically, they are treated as nonelective contributions. Because of the variable nature of the contributions being made, plans that have adopted the design-based safe harbor rules under Code Sec. 401(a)(4) will generally not satisfy a design-based safe harbor and will need to perform discrimination testing.

The IRS also permits contributions of unused PTO to 401(k) plans where participants may elect to receive cash or contribute some or all of the unused PTO to the plans. These elective contributions must not exceed the applicable limitations of Code Sec. 401(a)(30) and Code Sec. 415(c).

Contributions of unused PTO upon participants' termination of employment

The IRS came to the same conclusion when a 401(k) plan is amended to permit or require contributions of the dollar equivalent of unused PTO that would be distributed upon a participant's termination of employment. In all of the situations discussed by the IRS, the PTO programs allow participants to carryover unused paid time off to the following year up to a specified limit.

Timing is important. The date of termination and the subsequent contribution to the plan determine the limitation year and the tax year. In the situations involving a participant's termination of employment, the unused PTO money is paid out within 60 days of termination under the terms of the PTO program. In one situation, the employee terminates on October 1, 2009, and the unused PTO money is contributed to the 401(k) plan on October 19, 2009. The contribution, for purposes of the nondiscrimination rules under Code Sec. 401(a)(4), applies to the 2009 limitation year. The situation becomes more complicated when the employee terminates near the end of the year, such as December 28, 2009. If unused PTO money is contributed in January 2010, it applies to the 2010 limitation year.

Code Sec. 415 limits. The Code Sec. 415(c) limit of 100% of compensation has to be carefully watched if a nonelective contribution is made in conjunction with a payment of cash. For example, assume the unused PTO money totals $300. With a nonelective contribution, any forfeiture paid in cash is considered to be compensation, but the 401(k) nonelective contribution is not counted as compensation. Therefore, if $100 is distributed as cash and $200 is contributed to the 401(k) plan in 2010, the Code Sec. 415(c) 100% of compensation limit is exceeded. The cash distribution can be no more than 50% of the total unused PTO money that is distributed. With elective contributions, the total unused PTO money is counted as compensation, which means that the Code Sec. 415(c) limits are not violated.

Tax consequences

Participants are not required to include in gross income contributions of the dollar equivalent of the unused PTO until distributions are made to the participants from the plans. In addition, the dollar equivalent amounts of unused PTO that are not contributed to the plans are not included in the participants' gross income until the taxable year in which the amounts are paid to the participants.

PTO program

Finally, the amendment of the PTO program does not cause it to fail to qualify as a bona fide sick and vacation leave plan under Code Sec. 409A.

For more information on this and related topics, consult the CCH Pension Plan Guide, CCH Employee Benefits Management, and Spencer's Benefits Reports.

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