401(k) Plans: Approach With Caution

401(k) plans allow employees to put away a portion of their earnings for retirement and avoid taxation until the money is withdrawn. But the problems associated with the plans outnumber the advantages.

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Two years ago, Timothy B. Sullivan didn't know much about 401(k) plans, and why should he? A vice-president of the L. G. Balfour Co., a jewelry manufacturer in Attleboro, Mass., he did not make a habit of reading the Internal Revenue Service Code, which is where 401(k)s are described. But then references to the plans started to crop up in some of the trade journals.

His interest was piqued, and he began to read whatever he could on the subject. 401(k) plans, he learned, are similar to Individual Retirement Accounts. Employees put away a portion of their earnings in a retirement plan, and the federal government excludes that amount (plus any interest, dividends, and capital gains that accumulate) from current taxation.

What separates 401(k)s from IRAs, Sullivan discovered, is the way the IRS treats the money deposited. Dollars placed in an IRA are tax deductible, while funds set aside in a 401(k) are considered "deferred compensation" and aren't reported to the IRS as income. For example, a worker earning $30,000 a year and depositing 5% of his salary in a 401(k) plan, would pay income taxes on wages of $28,500, which is his total income ($30,000) minus the $1,500 contributed to the 401(k). For an employee earning $20,000 annually and putting back 5%, or $1,000, in a 401(k), the amount subject to taxation would be $19,000.

The idea of deferring a portion of one's income taxes until retirement appealed to Sullivan, so he called a couple of pension consultants.

"Should L. G. Balfour offer a 401(k) plan to its employees?" he asked.

No, the consultants responded. Not yet. They explained that the IRS was not expected to issue final regulations governing 401(k)s until sometime in 1983, and although temporary rules were in place, the consultants advised against operating under them -- it was too risky.

But Sullivan wasn't convinced: "I thought 401(k)s sounded like the greatest thing since iced tea." So he brought in another consultant, Meidinger Inc., headquartered in Louisville.

Meidinger's job was to find out if Balfour could meet tough discrimination rules that are part of the IRS Code and specify that no group of employees (in most cases, those at the top end of the pay scale) may benefit disproportionately from a 401(k) plan. "From our projections, it became clear that Balfour would neet the discrimination test," recalls Larry Jessoe, a Meidinger vice-president based in Boston.

Sullivan was delighted. Within six months, the Balfour Employee Tax-Sheltered Savings Plan was in place and more than 900 of the company's 1,300 eligible employees had signed on.

It is easy to see why so many of Balfour's employees agreed so quickly to participate in a 401(k) plan. Says John Ehrenberg, president of BHP Inc., a Chicago company that established a 401(k) plan for its employees earlier this year, "Everybody wants to save money on taxes."

And tax deferral is what 401(k)s are all about. Approved by Congress in 1978, the plans allow workers to postpone income taxes on a portion of their earnings, but they also enable companies to avoid paying certain payroll taxes, such as unemployment insurance and workers' compensation, on the amounts employees set aside. What is more, the plans permit corporations to expand their existing benefits packages without affecting some other retirement programs, such as IRAs.

But there are problems with the plans, principally, the lack of federal regulations governing them, the tough standards for withdrawals from the plans, the complex discrimination requirements, and the impact of 401(k)s on existing profit-sharing plans. Consequently, small businesses should think twice before jumping on the 401(k) bandwagon.

The biggest problem, consultants agree, is the lack of federal regulations. Without them, many of the details of plan administration remain unsettled, a fact that makes companies with existing 401(k) plans nervous. "Sure, we're concerned," says BHP's Ehrenberg. "But it's in the government's interest to have healthy retirement plans as alternatives to government programs."

A similar point is made by Jill Mervin of Organization Resources Inc. in New York, who adds, optimistically, "Our theory is that even if the final rules are up in the air, there's going to have to be some mechanism to grandfather in what's in existence now."

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