Human Capital & Careers

Keeping 401(k) Contributions Alive

A recent IRS ruling enables funds to keep flowing into retirement accounts after employees are disabled.
David KatzNovember 2, 2000

Disability and retirement may not be concepts that prey on the brains of many denizens of the new economy, where youth rules and serious injuries are relatively few.

But a recent IRS ruling enabling a 401(k) plan to buy long-term disability insurance may put the spotlight on a problem Silicon Valley and dot-com companies didn’t know they had: The need to keep funds flowing into defined- contribution plans while an employee is out of work.

With 401(k) plans increasingly serving as the primary source of retirement income rather than merely supplementing a defined-benefit plan, the need to keep 401(k) funds building is becoming more important, notes John F. Woyke, a principal with Towers Perrin, the Valhalla, N.Y., employee benefits consulting and actuarial firm. While most of the firm’s corporate clients use 401(k)s as a supplement to other retirement benefits, he says, “for clients in the new economy it’s often the sole source of retirement income.”

Thus, private letter ruling 200031060, which the IRS made public in August, provides “a particular benefit for the dot-coms” and Silicon Valley companies, he says, noting that such firms “generally have no defined benefit plan at all and precious little disability insurance either.”

Woyke thinks CFOs and human resources professionals should take a good look at the possibility of adding LTD insurance to their companies’ 401(k) plans as a way to make sure contributions of employees continue even when they’re disabled. Noting that such coverage costs the employer nothing, he says, “adding this to your 401(k) will make it that much more flexible and desirable to employees.”

In its ruling, the IRS granted the request of a company that wanted to provide for the continuation of benefit accumulations in its 401(k) that wouldn’t occur if an employee became unable to work because of a disability. The employer proposed to let participants direct the plan to allocate a part of their salary-deferral contributions to buy LTD insurance through the plan. The insurance premium would be deducted from the participant’s plan account each month.

If a covered participant later became disabled, the plan would start receiving amounts from the insurer after a waiting period of a year. The amount flowing into the plan would be equal to 1/12 of the total of employee contributions and the employer’s matching and non-matching qualified contributions, based on the year before the year in which the disability began.

Agreeing with the employer, the IRS ruled, among other things, that covered participants would not be taxed on the cost of the insurance coverage and that amounts payable to the policy would not be taxable to participants when paid to the 401(k) plan. As is the case with other contributions to 401(k) s, distributions to participants of amounts received under the insurance policy would be fully taxable.

Joel Rich, a senior vice president with The Segal Co., a New York-based benefits consulting firm, said it makes sense for more employers to provide LTD coverage within their 401(k) plans. Since there tends to be a low frequency of disabilities among 401(k) participants, the risk “doesn’t get the attention it deserves,” he notes.

Providing such a benefit, however, places new fiduciary responsibilities on the shoulders of CFOs. One is to avoid buying coverage “from fly-by-night insurers” or brokers, Rich says. Another is to see that the coverage is explained to employees in the same way that any other investment option is explained. “Employees will need some help in understanding whether this is something they should be doing or not,” he says.

CFOs also need to determine how well the LTD coverage fits into the context of the company’s overall benefits concerns, making sure there are “no gaps or overlaps,” he says.

In the plan approved by the IRS, he notes, “no future increases in salary were taken into account.” For some employees, this might provide inadequate retirement funding, the consultant suggests. But for employees who have, in addition to a 401(k) plan a pension and regular LTD coverage, it might be excessive, he adds.