IRS Ruling Addresses Elections to Contribute Unused Vacation to...

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IRS Ruling Addresses Elections to Contribute Unused Vacation to Retiree HRA or 401(k) Plan

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The IRS has issued a private letter ruling affirming the favorable tax treatment of a collectively bargained arrangement allowing employees to contribute the value of unused vacation days to their employer’s 401(k) plan, a retiree health reimbursement arrangement (HRA), or a combination of the two. Vacation benefits offered by the employer requesting the ruling are earned annually and cannot carry over from year to year. At the end of each vacation year, the value of unused vacation up to 21 days is forfeited, and the value of any additional days is paid out as regular wages. Pursuant to a collective bargaining agreement, the employer proposed to amend its retiree HRA and 401(k) plan to allow employees to irrevocably elect to contribute the value that would otherwise be forfeited each year to one or both plans. If an employee did not make the election before the year in which the vacation was earned, the entire amount would go to the 401(k) plan. Amounts exceeding certain annual limits for 401(k) plans, however, would always go into the HRA.

The private letter ruling reviews relevant Code provisions and concludes that amounts contributed to the 401(k) plan will not be considered employee pre-tax contributions subject to the Code § 402(g) deferral limit. The ruling explains that, while employees will be permitted to choose where the value of their unused vacation goes, the choice will be between two nontaxable options. Because the amounts will not be paid in cash or applied toward a taxable benefit, the elections will not create a cash or deferred arrangement. The ruling also reviews the 2002 IRS guidance establishing the requirements for an HRA and concludes that employees’ coverage and benefits under the retiree HRA will be excludable from gross income. Even if employees elect to contribute their vacation, the contributions will still be paid solely by the employer, and the benefits will be used only to reimburse eligible medical expenses during retirement.

Comment: Prior IRS rulings have looked favorably on the automatic and mandatory contribution of unused vacation into another plan—and a recent ruling allowed employees to choose which of two retiree medical plans would get the contribution. However, the choice between an HRA and a 401(k) plan is a new twist. Employers intrigued by this idea, though, should proceed with caution. Private letter rulings apply only to the taxpayers that request them and can depend greatly on the facts. In this case, contributions of unused vacation to the 401(k) plan benefited from a nondiscrimination exception for plans maintained pursuant to collective bargaining agreements. The nondiscrimination rules could be an obstacle in other situations and for other plans (including HRAs), depending on the design. 

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Last Modified:2/5/2016 1:14:33 PM

Last Modified By: Kevin_Murphy

Type: INFO

Level: Advanced

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