Converting Unused Leave to Retirement Plan Contributions
Robert A. (Rob) Browning, Friday, November 20, 2009 | Filed under: 401(k) Plans, Fringe Benefits, Qualified Retirement Plans
In September of this year, the IRS issued official guidance on how employers may convert unused leave under a bona fide sick leave, vacation leave, or paid-time-off (“PTO”) program into contributions to a qualified, defined contribution plan (such as a profit sharing or 401(k) plan). Revenue Rulings 2009-31 and 2009-32 provide a virtual “roadmap” for how the value of unused leave (that might otherwise be forfeited each year or paid out in cash on termination of employment) may be used as a basis for making additional employer contributions, or in some cases, employee elective deferrals, to such a plan.
Overview of the Rulings
Revenue Ruling 2009-31 addresses the annual conversion of unused leave, while Revenue Ruling 2009-32 addresses the conversion of unused leave upon termination of employment. Both rulings address two alternative scenarios: (i) where amounts that might otherwise be forfeited under the PTO program are instead converted into nonelective employer contributions to a qualified plan, and (ii) where amounts that might otherwise be paid in cash under the PTO program are instead converted, at an employee’s election, into additional “pre-tax deferrals” to a 401(k) plan. The ruling that addresses the conversion of unused leave on termination of employment also addresses employees who terminate late in the year, and whose “leave conversion” contributions are therefore made the following year.
Annual Leave Conversion Elections
With respect to annual leave conversions, the ruling contemplates (in one scenario) that an employer has a PTO program that credits up to 240 hours of PTO per year (based on years of service), but does not allow for carryover of unused leave. Instead, any unused leave is simply forfeited at year end. In that scenario, the IRS ruled that the employer may amend its PTO program (and its qualified retirement plan) to provide that the value of any unused PTO (that would otherwise be forfeited) will instead be converted into an employer nonelective contribution to the qualified plan.
Because such an employer contribution would not be the same percentage of pay for all employees, any non-governmental plan will be required to perform additional testing (referred to as the “401(a)(4) general nondiscrimination test”) to ensure that the leave conversion contributions do not discriminate in favor of highly compensated employees (“HCEs”). In addition, if the contribution would cause any employee to exceed the Section 415 limit on “annual additions” to a participant’s account (which is $49,000 for both 2009 and 2010), the excess must be paid in cash, rather than contributed to the plan.
In the alternative scenario, the PTO plan does allow employees to carry over a limited number of PTO hours, but provides that any unused hours in excess of the carryover limit will be paid to the employee in cash, during February of the following year. In this scenario, the IRS ruled that the employer may allow employees to elect, no later than December 31, to convert all or a portion of the unused leave that cannot be carried over (the portion that would otherwise be paid out in cash in the following year) into an “employee pre-tax deferral” to the plan. Because the cash would not have been payable until the following year, any amount the employee elects to convert will also count as a deferral for the following year.
Thus, if at the end of 2009, an employee has 100 hours of unused leave, but the PTO policy allows only 40 hours to be carried over (and provides for the other 60 to be “cashed out” in the following year), the employee may elect to convert all or a portion of the value of that 60 hours into an “employee contribution” to the plan. This amount will count against the $16,500 limit on the employee’s 401(k) deferrals for the 2010 calendar year.
Leave Conversion Elections on Termination of Employment
The final two scenarios involve a situation in which an employee terminates late in the year, and the leave cashout (and consequently the conversion to employer or employee contributions) occurs in the following year, when the participant has no other compensation. Ordinarily, this could pose a problem because the alternative Section 415 limit on annual additions is 100% of a participant’s “compensation.” However, so long as the employer has amended the plan, as permitted under the final Section 415 regulations, to include in the definition of “compensation” any leave cash-outs that are paid within 2 1/2 months after termination of employment (or by the end of the plan year of termination, if later), the leave conversion contributions will not cause the Section 415 limit to be exceeded, even though the participant receives no other “compensation” from the employer in that year.
Proceed With Caution
Plan sponsors contemplating any type of leave conversion arrangement should proceed with caution, as there are a number of potential pitfalls. First, the employer must make sure that the PTO program qualifies as a “bona fide” sick, vacation or other leave arrangement, and is therefore exempt from the constraints imposed by Code Section 409A. The PTO program should also not include any cash-out or “buy-back” provisions that would implicate the IRS rules regarding constructive receipt.
In addition, sponsors should make sure that any leave conversion contributions do not cause their retirement plans to lose their tax-qualified status. This could happen if the contributions cause a participant’s annual additions to exceed the Section 415 limit. Any private (i.e., non-governmental) employer will also want to ensure that nonelective leave conversion contributions do not cause the plan to fail the Section 401(a)(4) nondiscrimination test. This may effectively require that HCEs be excluded from the leave conversion feature. Finally, an employer will want to make sure that any “elective” contributions are properly counted against the $16,500 limit on 401(k) deferrals for the appropriate year, and that any deferral elections are made in a timely manner.
For all of these reasons, we strongly advise that sponsors work with experienced benefits counsel when designing a program to convert unused leave into retirement plan contributions.
The second ruling addresses four different scenarios involving the conversion of unused leave on termination of employment. In the first scenario, the PTO program provides for unused PTO to be paid out in cash within 60 days of termination of employment. The IRS ruled that, in this situation, the employer could amend the PTO plan (and the qualified plan) to provide that, instead of paying out the unused PTO in cash, the value of the unused PTO would be contributed to the plan as an employer nonelective contribution. The only portion to be paid in cash would be the amount, if any, that would cause the plan to exceed the $49,000 limit on annual additions.
Alternatively, the employer could amend the PTO plan (and the qualified plan) to provide that employees could elect, prior to termination, to convert a portion of their leave cash-out amount into an employee pre-tax contribution to the plan. This contribution would count against the employee’s $16,500 limit on 401(k) deferrals for the year in which it is credited to the qualified plan.
The concept of converting the value of unused leave into a contribution to a qualified retirement plan is not entirely new. The IRS has previously issued private letter rulings to several individual plan sponsors (mostly governmental employers, who need not deal with the Tax Code’s nondiscrimination rules) with respect to specific leave conversion arrangements. However, the Obama Administration pushed for the issuance of these revenue rulings – which may be relied upon by all plan sponsors –as part of a larger effort to promote retirement savings.