Maximize sec. 401(k) plan with companion nonqualified plan.

• Author: Vines, Joan H.

Ever since Sec. 401 (k) plans gained popularity in the early 1980s, executives have tried to devise ways to make the maximum elective deferral allowed under law. (For 1996, this amount will be $9,500.) Because of the special actual deferral percentage (ADP) nondiscrimination calculation required to be done on employee elective deferrals, executives are often limited to a lesser amount. The ADP calculation limits the amount that the highly compensated group can put into the plan as an elective deferral to a multiple of the average amount actually deferred by nonhighly compensated employees (NCEs).

Many employers faced with limitations on highly compensated employees (HCEs) provide extensive employee education on the benefits of tax deferred savings and the advantages of early savings. If the education effort is successful, the increased NCE contribution rate will increase the amounts HCEs can contribute. Since the final tests are done on actual contributions for the current plan year, plan administrators are trying to hit a moving target when advising HCEs of the amounts they can defer.

Other employers are counting on pension simplification to help HCEs make the maximum contribution. However, the legislation passed in December 1995 and vetoed by President Clinton exacted a 3% minimum matching contribution from the employer in order to completely avoid the ADP testing. While satisfaction of the proposed safe harbor will allow all HCEs to contribute $9,500 (subject to individual annual addition limitations) without regard to the NCEs' participation, the 3% matching safe harbor might be costly, depending on the number of plan participants.

Without going the safe harbor route, the way to maximize the HCEs' contribution into the plan is to allow each HCE to defer whatever level he wishes, perform the ADP test after year-end, and refund the minimum amount necessary to pass the test. If the refund is distributed within the first 2 1/2 months after the tested plan year, it is treated as if it were never deferred, and is included in the HCE's taxable income in the same tax year as the deferrals. Refunding the excess amount leaves the executive without the desired tax deferral.

There is a planning method that preserves the executive's deferral on the excess amounts. In Letter Ruling 9530038, the IRS approved an arrangement under which an HCE could defer salary under a nonqualified plan and retain the amounts in that plan until the employer performs...