Conversion of unused vacation days into retirement plan contributions.

• Author: Daum, Timothy A.

The Wall Street Journal article, "Value of Unused Vacation Days Can Now Be Added to 401 (k)s" (12/10/96), based on Letter Ruling (TAM) 9635002, has generated a great deal of interest on the concept of converting vacation days into qualified retirement plan contributions. However, much of this excitement may be unwarranted.

The taxpayer in the TAM simply wanted to know whether vacation days converted to cash equivalents and contributed to its qualified retirement plan on behalf of its employees were subject to FICA taxation. The IRS concluded that the amounts contributed were not. subject to FICA taxation, as they were nonelective employer contributions rather than contributions pursuant to a cash or deferred election (Sec. 401(k) contribution); the employees did not have the option of receiving their accrued vacation days in the form of cash. An employee cannot have a cash or deferred election (as defined under Sec. 401(k)) unless he has the option of receiving benefits in cash.

The ruling generated excitement in the business community. Many thought it might be a way of saving on FICA taxes or a way around the 11i9,500 limit on Sec. 401(k) contributions in Sec. 402(g). While it is true that the amounts contributed are not subject to FICA taxes or the $9,500 limit on Sec. 401(k) contributions, there are many other issues that severely limit the feasibility of implementing a program to convert unused vacation days into retirement plan contributions.

Employers are not permitted to contribute unused vacation pay to their retirement plans on behalf of highly compensated employees (HCEs), unless the complex (and often costly) compliance test in Sec. 401(a)(4) is performed on an annual basis and shows that the effect of the additional nonelective contributions is nondiscriminatory. Many (if not most) retirement plans will fail this compliance test; significantly more HCEs than non-HCEs have unused vacation days or there are one or more HCEs with a greater number of unused...