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.