The IRS often puts a damper on ingenious incentive ideas that Benefits creates.  But not this time.

In a recent issue of What’s New in Benefits & Compensation, we made reference to a private letter ruling in which the feds gave a thumbs up to a rather creative strategy for boosting retirement savings. The ruling itself isn’t recent — it was from 2005 — but the plan design the ruling dealt with remains rather cutting edge in my opinion.

An employer asked about whether it was OK to offer an incentive plan that allowed employees to put their unused vacation pay into the 401(k) plan.

The firm had a use-it-or-lose-it paid-vacation policy. As a way to reduce absenteeism,  increase 401(k) participation and cut some of the firms’ payroll tax burden, Benefits suggested giving employees three options:

• put the value of remaining unused days into the retirement plan at the end of the year
• trade in days earlier in the year in exchange for increased 401(k) contributions, or
• use all vacation days in lieu of the added contributions.

Senior management liked the idea. But they were concerned the money could be considered a form of “compensation,” especially because people would earn compounding interest off the contributions.

Taking taxes out of the contributions would create hassles for Payroll, and likely annoy employees who choose that option over the vacation time.

To be on the safe side, the firm asked for the private letter ruling.

In its decision, the IRS said the plan wasn’t taxable.

But the agency also noted it’s very easy to cross the line of what it calls “constructive receipt” of income. In plain English, that means it’s taxable if employees have the option to receive cash or another taxable benefits in place of unused vacation.

In this case, a cash buy-back for unused days wasn’t one of employees’ choices. The plan in no way affected employees’ monetary compensation.

And there were no changes made to the monetary value of the vacation benefits themselves. People simply had a little more flexibility to their existing benefits.

While private letter rulings aren’t legal documents – and only apply to one case – they usually provide helpful suggestions for how the IRS would view similar policies.

Cite: IRS Private Letter Ruling No. 200511043.