SALARY SAVINGS PLANS IN GENERAL

A salary savings plan, as it is called here (there is no single accepted term for these plans), is a plan under which employees are given a choice, or election, to receive a part of their compensation in cash or to contribute it to a qualified plan or similar arrangement under which the amount contributed to the plan is not subject to income taxation in the year in which it is contributed. Instead, income tax on the contributions and investment earnings on those contributions is deferred until actual withdrawals are made by the employee. Amounts contributed by the employee under such an arrangement are sometimes referred to as elective deferrals.

In the last decade, such plans have become extremely popular with employers and employees as a result of the trends, as well as specific advantages of the salary savings approach such as the following:

• No annual funding commitment for the employer except to the extent that the plan requires a matching or formula contribution

• Initial cost to the employer is minimized because elective deferral amounts come out of existing cash payroll

• No long-term liability for employer

• Benefits have high portability to employee—fast vesting, annual or more frequent account valuation, easy for employee to understand how much has accumulated

• Employee has option to save at desired level (or not to save at all)

• Apparent administrative simplicity (although complex plans with directed investment may be as costly to administer as a defined benefit plan)

Many salary savings plans make use of directed investment provisions (where the employee chooses the investments for his or her account, usually among a family of mutual funds), so that the employee's choices regarding savings programs are further enhanced.

The trend toward this type of qualified benefit is not without its disadvantages. Overall, the movement from the traditional pension plan to profit-sharing and salary savings approaches, however inevitable, probably results in a reduction in potential retirement income for employees, although employees who change jobs frequently (an increasing category of employees) may do better with the newer types of arrangement, as long as they do not dissipate their account accumulations before retirement. Many mobile workers, however, tend to spend distributions from profit-sharing or salary savings plans when they change jobs, particularly if the distribution is relatively small. Another emerging problem, in the case of plans using directed investment provisions, is that employees tend not to make good investment allocations in their plan accounts and, overall, may earn less on their money than if the employer chose the investments. Employees who do well with salary savings plans tend to be people who would save wisely and well for retirement even without the plan, thus raising questions as to the social utility of these plans. These problems, along with already well-known demographic problems with Social Security, threaten to haunt American society in the early 21st century as the baby boomers retire. Some time soon, we will have to better address, both individually and as a society, the issue of retirement income adequacy.

Among the general public, the best-known salary savings plan is the 401(k) plan, which is basically a qualified profit-sharing plan with an elective deferral feature. In addition, there are several other plan types (SIMPLEs, 403(b) tax-deferred annuity plans, and Section 457 plans) that, although not qualified plans, provide elective deferrals and have much the same income tax and other consequences for the participants. These plans are discussed together because of their practical similarity, but the student must be careful to note that they all have different rules and all are different from qualified plans.

SAVINGS PLANS | Profit-Sharing and Similar Plans

Almost any qualified plan can have a provision for employee contributions to supplement the plan fund or benefit. A plan that is designed particularly to exploit the possibility of employee contributions is often referred to as a savings plan or thrift plan. The term savings plan will be used here to describe a plan featuring employee after-tax contributions.

Design of Savings Plans

A savings plan is a defined-contribution plan so that employees can have separate accounts. Usually, qualified savings plans are designed as profit-sharing plans (rather than money-purchase pension plans) because only a profit-sharing plan permits account withdrawals during employment, and this is an important feature of the plan if the plan is to be described to employees as a savings medium. Thus, a savings plan can generally be described as a contributory profit-sharing plan.

The typical savings plan features employee contributions matched by the employer. Plan participation is voluntary; employees elect to contribute a chosen percentage of their compensation up to a maximum percentage specified in the plan. The employer then makes a matching contribution to the plan. The matching may be dollar for dollar, or the employer may put in some multiple or submultiple of the employee contribution rate. For example, typically a plan might permit an employee to contribute annually any whole percentage of compensation from 1 to 6 percent. The plan might then provide that the employer contributes at the rate of half the chosen employee percentage; thus, if the employee elects to contribute 4 percent of compensation, the employer would contribute an additional 2 percent.

If the plan's maximum contribution level is too high, there is a possibility of discrimination because only higher-paid employees could be in a position to contribute to the plan, and only they would receive full employer matching contributions. To prevent this type of discrimination, there is a specific numerical test applicable to after-tax employee contributions. Under this test [Code Section 401(m)], a plan is not deemed discriminatory for a plan year if, for highly compensated employees, the total of employee contributions (both matched and voluntary) plus employer matching contributions does not exceed certain numerical limits similar to those applicable to Section 401(k) plans. Administration of the Section 401(m) limits can be complex and costly.

Apart from the features relating to employee contributions, savings plans generally follow the rules for profit-sharing plans described earlier. In designing a savings plan, emphasis is usually put on features relating to the objective of providing a savings medium for employees. Thus, a savings plan usually has generous provisions for vesting, employee withdrawal of funds, plan loans, and investment flexibility.

Advantages and Disadvantages of Savings Plans

Savings plans have been very popular in the past and continue to be so, despite the advent of other types of plans, such as Section 401(k) plans, that provide greater tax leverage. Some older savings plans have been converted to add a 401(k) feature while retaining the provision for additional after-tax contributions by employees. Like all qualified plans, a savings plan provides a tax-deferred savings medium because earnings in the plan fund are not taxable until the employee's account is distributed.

A savings plan usually does not maximize the potential tax deduction available for plan contributions, because it involves after-tax contributions by the employee—contributions that are not deducted or excluded for federal income or Social Security tax purposes. A greater degree of tax deductibility can be provided with other types of plans, such as regular profit-sharing plans or Section 401(k) plans. However, some of these plans may require a greater employer outlay for the plan itself (although not necessarily for the overall compensation package). These other plans may also entail greater restrictions on the funds, which may make them a less attractive savings medium from the employee's standpoint.