Can Employers Allow Employees to Contribute Unused Paid Time Off to the Company’s 401(k) Plan?

Due to travel and other restrictions, many employees did not have the opportunity to use their annual paid time off. But even after most COVID restrictions have lapsed, the fact remains that many employees simply cannot or do not use their PTO on an annual basis.

Given many employers have a “use it or lose it” PTO policy, employers should consider other ways to allow employees to benefit from PTO even if such employees are unable to “use” PTO in its traditional sense. One option for employers to consider is amending their 401(k) plans to allow employees to contribute the dollar equivalent of unused PTO to the plan.

Is this legal?

The short answer is: YES, as long as certain requirements are met.

Revenue Ruling 2009-31 (“Rev. Rul. 2009-31”) addresses the issue of whether certain amendments to an existing qualified profit-sharing plan either requiring or permitting certain annual contributions of the dollar equivalent of unused PTO cause the plan to fail to meet the requirements of Internal Revenue Code (“IRC”) Section 401(a) and, if applicable, IRC Section 401(k).

Revenue Ruling 2009-32 (“Rev. Rul. 2009-32) addresses the issue of whether certain amendments to an existing qualified profit-sharing plan either requiring or permitting certain annual contributions of the dollar equivalent of unused PTO at a participant’s termination of employment cause the plan to fail to meet the requirements of IRC Section 401(a) and, if applicable, IRC Section 401(k).

The companion Revenue Rulings go into considerable technical detail. In short, Rev. Rul. 2009-31 addresses two situations where employers maintain a sick and vacation leave PTO plan that is available to all active employees on substantially the same terms and conditions. The PTO plans qualify as bona fide sick and vacation leave plans for purposes of IRC Section 409A and Section 1.409A- 1(a)(5) of the Income Tax Regulations. Under the PTO plans, participants may take paid leave without regard to whether the leave is due to illness or incapacity.

Rev. Rul. 2009-32 provides guidance on the same issues described in Rev. Rul. 2009-31 in four situations but in the context of unused PTO for terminated employees.

The issues addressed in Revenue Rulings 2009-31 and 2009-32 are:

• Whether the amendment to a profit-sharing plan requiring or permitting certain contributions of the dollar equivalent of unused PTO would cause the plan to fail to meet the requirements of IRC Section 401(a), and, if applicable, Section 401(k); and
• When a participant is required to recognize in gross income contributions of PTO to the plan and payments of PTO to the participant.

Under the facts presented in both Revenue Rulings, each of the employers maintain a profit-sharing plan that includes a 401(k) feature that, prior to the amendments permitting the dollar equivalent of unused PTO to be contributed to the plans, meets the requirements of IRC Section 401(a) and IRC Section 401(k). The plans have a calendar plan year and limitation year, and the contribution of the dollar equivalent of unused paid time off (when combined with other plan contributions and annual additions) does not exceed the limitations of IRC Section 415(c) (dealing with the maximum contributions on behalf of a participant under a defined contribution plan) or the limitations of IRC Section 401(a)(30) (dealing with the limitations on elective deferrals). In addition, the contributions to the plans are made timely by the employers and qualify as a deduction on the employers’ tax return for the applicable taxable year.

In Rev. Rul. 2009-31, the IRS concluded that the requested amendments in both employer situations would not cause the employers’ 401(k) plans to violate applicable law. Likewise, in Rev. Rul. 2009-32, the IRS concluded that the requested plan amendments in all four employer situations would not cause the employers’ 401(k) plans to violate applicable law.

Additionally, the IRS determined that assuming the applicable qualification requirements are satisfied, a participant does not include in gross income contributions of the dollar equivalent of unused PTO to the profit-sharing plan in accordance with IRC Section 402(a) until distributions are made to the participant from the plan and does not include in gross income an amount paid for the dollar equivalent of unused PTO that is not contributed to the profit-sharing plan until the taxable year in which the amount is paid to the participant.

Application of Revenue Rulings to a Specific Plan

It is very important to note that the IRS carefully analyzed all details in each of the situations addressed in Rev. Rul. 2009-31 and Rev. Rul. 2009-32 in order to determine that the requested amendments would not violate applicable law.

Accordingly, if an employer wants to consider amending its 401(k) plan to allow employees to contribute the dollar equivalent of unused PTO to the plan, the specific plan provisions should be reviewed by legal counsel to: (1) determine that amendment is possible; and (2) if possible, amend the plan so that it is compliant with all applicable law.

Timing of the 401(k) Plan Amendment

Based on the Revenue Rulings, if an employer decides to amend its 401(k) plan and the applicable PTO plan to provide that a participant may reduce all or part of the dollar equivalent of any unused vacation pay that may not be carried over to the following year, and have that amount contributed by the employer to the 401(k) plan and allocated to the participant’s account as of a set pay period in a particular year, to the extent that the contribution (in combination with prior annual additions) does not exceed the applicable limitations under Section 415(c) and to the extent that the contributions (in combination with prior elective deferrals) do not exceed the applicable limitation under Section 401(a)(30) — then the plan needs to be amended on or before December 31 of the year prior to the year in which the amendment takes effect.

Contributions of the dollar equivalent of PTO must be in addition to other contributions under the 401(k) plan and treated as elective contributions. The dollar equivalent of any unused PTO that is not contributed to the 401(k) plan under the applicable PTO plan must be paid to the participant by a set date in the year in which the amendment takes effect.

Timing of the 401(k) Plan Contributions

Under the applicable Revenue Rulings, the timing of the contributions may be determined by the employer, as long as the specific timing is set forth in the 401(k) plan and PTO amendments adopted on or before December 31 of the year prior to the year in which the amendments take effect, and the contributions are made during the applicable plan year.

Key Considerations

Permitting employees to contribute unused paid time off (“PTO”) to their employer’s 401(k) plan is a great employee benefits strategy.

As mentioned above, if an employer wants to consider amending its 401(k) plan to allow employees to contribute the dollar equivalent of unused PTO to the plan, the specific plan provisions should be reviewed by legal counsel to: (1) determine that amendment is possible; and (2) if possible, amend the plan so that it is compliant with all applicable law.

The plan must be amended on or before December 31 of the year prior to the year in which the amendment takes effect. The timing of the contributions may be determined by the employer, as long as the specific timing is set forth in the 401(k) plan and PTO amendments adopted on or before December 31.

For additional information, please contact Emily Langdon at elangdon@fraserstryker.com.