Contributing Unused Vacation to a 401(k) or HRA

• DOI: http://doi.org/10.1002/jcaf.22186
• Date: 01 July 2016
• Published date: 01 July 2016
• Author: Shirley Dennis‐Escoffier

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Published online in Wiley Online Library (wileyonlinelibrary.com).

DOI 10.1002/jcaf.22186

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Contributing Unused Vacation

to a 401(k) or HRA

Shirley Dennis-Escoffier

Employers usually handle

unused vacation time in one

of three ways: (1) the vacation

time is forfeited if not used

in the calendar year; (2) the

unused days are carried over

to the next year; or (3) the

employer pays the employee the

equivalent of the unused days

in cash. The problem with

forfeitures is that employees

are usually reluctant to forfeit

their vacation and may rush

to take their vacation time

at the end of the year, substan-

tially reducing the company’s

available workforce. Permit-

ting employees to carry the

vacation time over to the next

year may just postpone deal-

ing with the problem. Offering

cash is expensive for busi-

nesses because they effectively

pay double wages and double

payroll taxes for each day

that employees work rather

than taking a vacation. There

is another option that busi-

nesses may wish to consider.

In a recent ruling, the IRS

addressed the tax treatment of

contributing the cash equiva-

lent of unused vacation time

to a 401(k) retirement plan or

a retiree health reimbursement

account (HRA). This is a valu-

able cost-effective option that

can help employees prepare for

their retirement.

401(K) PLANS AND HRAS

A 401(k) plan is a type of

qualified deferred compensa-

tion plan that permits employ-

ees to save for retirement on a

tax-favored basis. A 401(k) plan

is also known as a “cash or

deferred arrangement” because

it allows employees to choose

between receiving a certain

amount of their compensation

in cash or having the employer

pay that amount on the

employee’s behalf into a quali-

fied trust deferring the receipt

of compensation. Contribu-

tions made at the election of an

employee are commonly known

as elective deferrals or pre-tax

elective contributions because

they are not subject to income

tax until distributed from the

plan. However, these deferred

wages are subject to Social

Security and Medicare taxes.

The dollar amount that an

employee may elect to defer

through a 401(k) plan is lim-

ited. For 2016, the maximum

amount is $18,000 plus an addi-

tional catch-up contribution of

$6,000 for individuals who are

age 50 or older. Employers can

also choose to make a matching

contribution or a nonelective

contribution on behalf of each

participant. A 401(k) plan is

also subject to nondiscrimina-

tion requirements to ensure

that higher-paid employees

do not defer amounts that

are significantly more than

amounts deferred by lower-

paid employees. Essentially,

under these nondiscrimination

tests, the group average of the

individual percentages of non–

highly compensated participat-

ing employees sets the passing

limit for the group average of

the individual percentages for

highly compensated employees.

In a typical 401(k) plan,

employers require employees to

enroll in the plan by making an

affirmative contribution elec-

tion to participate in the plan.

Some employees, however,

delay making that contribution

election because they believe

they cannot afford to forgo

some of their salary or wages.

Most employers design their

plans so that an employee who