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Don't Kill Your 401(k)

New rules allow small businesses to suspend--rather than terminate--their plans.

Is the recession making it difficult to fork over your company's 401(k) contribution to your employees? If so, you're not alone. The Pension Rights Center's running list of companies that have changed or temporarily suspended their 401(k) contributions since last summer has reached 300. Yet, the list is dominated by large employers such as American Express and Xerox.

Until the Internal Revenue Service issued new rules in May, companies with safe harbor 401(k) plans--which are most often used by businesses with fewer than 250 employees--were not allowed to suspend their non-elective contributions.

"Companies on the financial edge, who could not afford to make the required contribution, had only one alternative: terminate the plan," says David Wray, president of the Profit Sharing/401(k) Council of America. "In these times, it is better that companies maintain their plans, even if the company cannot contribute."

After hearing about small business owners who were closing their 401(k) plans altogether, leaving employees with fees for withdrawing past contributions and with no mechanism for continued retirement savings, the IRS reconsidered and issued new proposed rules in May. The new rules, which are already effective but still open for comment, allow mid-year suspension of employer contributions as an alternative to terminating the plan.

"We went into our 401(k) plan with the best of intentions, but doing business now is challenging at all levels," says Marty McGreevy, whose company, Cyclonix, Inc., employs 32 people and contributes the federally mandated 3 percent of each salary to their 401(k) plans. "It's really interesting that [the IRS] is now giving small businesses [another] option to look at."

Understanding the New Rules
If you're interested in taking a look at this new option, it's important to first understand how a safe-harbor 401(k) plan works. Basically, it means that the employer--usually the owner of a small business--is able to save more aggressively for his own personal retirement than he could with a conventional 401(k) plan. That's because the sponsor of a safe-harbor plan is not subject to the non-discriminatory testing required in companies with traditional 401(k)s, which serves to ensure that no top employees are being unfairly overcompensated.

To maintain safe-harbor status, an employer is required to contribute at least 3 percent of each employee's salary. Your company must decide on an annual basis whether or not to maintain safe-harbor status, and once that decision is made--usually in the fall of the previous year--you are required to make that contribution during the following year.

"The economy looked very different in September and October [2008] than it did in February and March [2009]," says Stephen Dobrow, president of Burlingame, Calif.-based Primark Benefits, who testified about the issue before the House Small Business Committee earlier this year. "All of a sudden, clients were declaring bankruptcy, business was slowing down and many small businesses that had committed to the safe-harbor plan last year were stuck."

But the new rules proposed by the IRS allow companies that have already committed to the safe-harbor 401(k) to get out of their commitment, as long as they can meet certain criteria.

"The employer must be able to certify they are experiencing an economic hardship," says Alan Vorchheimer, principal of New York-based Buck Consultants, a human resources consulting firm. That includes proving:

  • That the employer is operating at an economic loss.
  • There is substantial unemployment or underemployment in the employer's trade or business and in the industry concerned.
  • The sales and profits of the industry concerned are depressed or declining.
  • It is reasonable to expect that the plan will continue only if the non-elective contributions are reduced or suspended.

If the criteria are met, the plan must be amended and employees must be notified, according to the IRS. The revised plan must not be effective until at least 30 days after notifying employees of the change, so they have a reasonable opportunity to change their 401(k) elections. And once a business owner chooses to suspend contributions, his 401(k) plan is no longer considered a safe-harbor plan for that year, meaning he will be subject to non-discrimination testing for the year, Dobrow says.

"There are a bunch of technical rules, so you should contact your retirement plan provider to make sure you meet the criteria and help you amend the plan," Dobrow says.

But just because you halt 401(k) contributions this year (or next year), there's no reason you can't start them back again in 2010 (or 2011). "The decision of whether to be safe harbor or not is an annual decision," Dobrow says. "So if business is picking up, you can always start back if you decide before the beginning of the next year."

Spreading the Benefits
So who will benefit from the new rules? At a recent meeting of about 250 employee benefits professionals, at least 80 percent said they had at least one client who could benefit from suspending contributions to a safe harbor 401(k), Dobrow says. A handful of Dobrow's own clients have already implemented the new rules to suspend their contributions for the rest of the year, and Vorchheimer predicts the rules will have more of an impact in 2010 if the economic downturn continues.

"The new ruling will benefit only a small number of companies, but for those it will benefit, it will be very helpful," Wray adds.

While employers will get to keep their cash in a tough business environment, they aren't the only ones who will benefit. By keeping 401(k)s open, their employees will also fare better, as they'll still be able to contribute their own money and avoid penalties involved in cashing out a closed 401(k).

Nancy Mann Jackson is a freelance writer who writes frequently about small business issues. Reach her at www.nancyjackson.com .

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