Gayle M. Meadors, P.C.
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New Tax Law Makes Qualified Retirement Gayle M. Meadors, P.C.* A series of pension reforms was part of the massive tax legislation known as the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) signed by President Bush in June of 2001. These reforms are intended to make qualified retirement plans more attractive to current and future sponsors by increasing the dollar amounts that can be sheltered and by easing many administrative rules which were perceived as discouraging the formation of qualified retirement plans, especially by small employers. The following is a summary of the major pension reforms contained in EGTRRA. DEFINED CONTRIBUTION PLANS Examples: Profit-sharing plans, 401(k) plans, money purchase pension plans Increased Annual Contributions Presently the most a participant can have credited to his account in 2001 is $35,000 or 25% of pay, whichever is less. The $35,000 is indexed for inflation, but changes are made in $5,000 increments meaning many years may go by without an adjustment. For profit-sharing, 401(k) and money purchase plans . . . . the limit is [now] Starting in 2002 plan years, the limit is $40,000 or 100% of pay, whichever is less. The $40,000 is indexed for inflation and changes in $1,000 increments. This lower increment limit means the limit is likely to increase virtually every year. Increased Deduction Limit Presently, an employer can only deduct contributions not exceeding 15% of covered payroll for a defined contribution plan. There is one exception to this rule where if an employer sponsors both a profit-sharing plan and a money purchase plan, the deduction limit could be up to 25% of covered payroll. . . . the deduction limit for any defined contribution plan is increased to 25% Starting in 2002, the deduction limit for any defined contribution plan is increased to 25% of covered payroll. This means an employer will no longer have to maintain both a profit-sharing plan and a money purchase plan in order to make a deductible contribution equal to 25% of covered payroll. Change in Treatment of Salary Deferrals Presently amounts contributed by an employee under a 401(k) plan through salary reduction are treated like all other employer contributions and hence count towards the deduction limit. . . . an employer will no longer have to maintain both a profit-sharing plan and Starting in 2002, salary reduction contributions under 401(k) do not count towards the deduction limit. For example, an employer would be able to maintain a single profit-sharing plan with 401(k) features and contribute a full 25% of covered payroll contributions plus any salary reduction contributions. Change in Maximum Compensation Recognized by the Plan In 2001, a plan can only recognize up to $170,000 of a participant's compensation for plan purposes regardless of how much the participant earns in total. Starting in 2002, compensation up to $200,000 can be recognized. Such limit is indexed for inflation. Salary Reduction Contributions In 2001, the maximum salary reduction contribution that can be made to a 401(k) plan is $10,500. Starting in 2002, the limit is increased to $11,000 and the limit increases by $1,000 per year until $15,000 is reached in the Starting in 2002, the limit is increased to $11,000 and the limit increases by $1,000 per year until $15,000 is reached in the year 2006. For years after 2006, that limit will be increased to reflect inflation. Catch-up Contributions Presently, no special contributions can be made by older participants who are close to retirement [with the exception of 403(b) plans and 457 plans]. Such participants are subject to the same rules as everyone else. Starting in 2002, participants age 50 and older can make an additional contribution of up to $1000 with such limit increasing by $1,000 per year until it reaches $5,000 in 2006. After 2006, that limit will be increased to reflect inflation. The catchup contributions relate to the maximum amount a participant could otherwise make. For example, assume in 2002 a participant could not contribute the full $10,500 due to the nondiscrimination testing, but rather could contribute only $8,000. The new rules say that the $8,000 maximum permissible contribution could be increased by the catchup limit in effect for the year in question, in this case $1,000. . . . an employer would be able to . . . contribute a full 25% of covered payroll contributions plus any salary reduction contributions. Catchup contributions are elective on the part of employers, meaning a plan does not have to offer the participant the chance to make these contributions. However, if an employer chooses to offer catchup elections, they must be offered to all participants in all plans sponsored by the controlled group of employers. Because these catchup contributions are not subject to the regular nondiscrimination rules, they have to be accounted for separately in plan recordkeeping. As mentioned above, all salary reduction contributions including catchup contributions are exempt from the 25% of covered payroll deduction limit. Change in 401(k) Plan Testing Presently, if a 401(k) plan permits both salary reduction (pre-tax) contributions as well as after-tax participant contributions and/or employer matching contributions, both the 401(k) portion and the after-tax/matching portion could not take advantage of one prong of the nondiscrimination testing rules known as the alternative limitation test. Starting in 2002, all such contributions can be tested under the alternative limitation test. This means a costly extra nondiscrimination test can be avoided, and hence, administrative costs should be reduced. Accelerated Vesting for Presently, employer matching contributions must fully vest after five years or vest on a graded vesting schedule spread over the three to seven years of service period. Faster vesting (three-year cliff, six-year graded) is required if the plan is "top heavy" (see discussion). In 2002, matching contributions made in 2002 and thereafter must meet the top heavy schedule (i.e., three-year cliff or six-year graded) regardless of whether the plan is top heavy. DEFINED BENEFIT PLANS Change in Maximum Annual Presently, the maximum annual pension payable under a defined benefit plan is $140,000 (or if less, 100% of the participant's average compensation). This maximum is reduced if benefits are payable before the Social Security normal retirement age. Starting in 2002 . . . maximum annual pension payable increased to $160,000, . . . Starting in 2002, not only is the maximum annual pension payable increased to $160,000, but the reduction for early commencement applies only if benefits begin prior to age 62. Annual limits are increased for benefit commencement dates after age 65. Change in Maximum Compensation Recognized by the Plan In 2001, a plan can only recognize up to $170,000 of a participant's compensation for plan purposes regardless of how much the participant earns in total. Starting in 2002, compensation up to $200,000 can be recognized. Such limit is indexed for inflation. Change in Funding Limitations Presently, the maximum amount by which a defined benefit plan can be funded is limited to 160% of the current liability. Starting in 2002, that percentage increases to 165% in 2002, 170% in 2003, and it is totally repealed after 2003. CHANGES APPLICABLE TO ANY IRA Type Contributions Presently, a qualified retirement plan cannot accept deductible employee contributions. In other words, the only acceptable employee contributions at present are before-tax salary reduction contributions or after-tax contributions that are not deductible. Starting in 2003, a plan can allow a participant to make IRA-type contributions. Starting in 2006, such IRA contributions can include ROTH IRA contributions. Starting in 2003, a plan can allow a participant to make IRA-type contributions. Starting in 2006, such IRA contributions can include ROTH IRA contributions. Plan Loans and Owners Presently, a qualified retirement plan cannot make a loan to an owner-employee who is defined as a sole proprietor, more than 10% partner, or a more than 5% subchapter S corporation shareholder. In 2002, loans can be made to owner-employees on the same basis as all other employees. Tax credit for Low-Income Participants Presently, there is no income tax credit available for low-income participants. In 2002, loans can be made to owner-employees on the same basis as all In 2002, a tax credit of 50% of contributions up to $2,000 is available for contributions made to a 401(k) plan, 403(b) plan, SIMPLE IRA, regular IRA, or 457 plan. The credit starts to be phased out for gross income over $30,000 (jointly) until it disappears entirely for income above $50,000. Single limits are one-half of the joint limits. This credit expires in 2006. New Plans Presently, there is no particular incentive for an employer to sponsor a new plan. In 2002, a new small employer plan is eligible for a tax credit for certain administrative expenses. The plan must be new and must cover at least one nonhighly compensated employee. Fees for determination letters are also waived for small plans during the first 5 years of the plan's existence. Top Heavy Rule Simplification Presently, there are complicated rules for determining whether a plan is "top heavy" (i.e., more than 60% of benefits go to key employees). If a plan is top heavy, accelerated vesting and minimum contributions are required. In 2002, a new small employer plan is eligible for a tax credit for certain administrative expenses. In 2002, although the top heavy rules are not eliminated, they have been considerably simplified. All employer matching contributions will count towards the minimum contribution. A key employee will be determined by looking back one year as opposed to the current five years. The threshold for determining if an officer is a key employee increases from the current $70,000 to $130,000. The lookback period for distributions is reduced from five years to one year (except for in-service distributions where the lookback period remains five years). Liberalization of Rollovers Rules Presently, distributions from a retirement plan qualified under Internal Revenue Code Section 401(a) retirement plan can only be rolled over to another 401(a) plan or an IRA. Likewise, distributions from a 403(b) plan or a 457 plan can only be rolled over to another 403(b) or 457 plan or an IRA. After-tax contributions cannot be rolled over at all. In 2002, rollovers will be allowed from In 2002 rollovers will be allowed from any of these types of plans to any other. For example, a 401(k) plan could accept a rollover from a 403(b) plan. After-tax contributions can now be rolled over to another plan. Acceptance of rollovers continues to be a discretionary, not a mandatory, provision. 403(b) Annuities Presently, contributions under a Code Section 403(b) annuity are limited, in addition to limits similar to those for a Code Section 401(a) plan, to an amount known as the exclusion allowance. In 2002, the exclusion allowance limitation no longer applies. In general, all the benefit enhancements discussed elsewhere would be applicable to a 403(b) plan. Thus, for example, higher salary reduction contributions and the new catchup contributions would be available under a 403(b) plan. CONCLUSION This summary is intended to just be an overview of the new law. There are other changes that are beyond the scope of this article that may well have an effect on a particular employer's plan. Considerable thought needs to be given to these changes in the law, because many of the changes are discretionary, not mandatory. In some cases, failure to take action by means of a plan amendment may mean current law provisions continue in effect. In a major change from prior practice, the IRS has taken the position that all EGTRRA amendments must be formally adopted in the year they take effect. (Previously, plans were given several years before amendments reflecting new legislation had to be adopted.) To facilitate this process, the IRS issued model EGTRRA amendments on September 1, 2001 in Notice 2001-57. These model amendments are deemed to be a "good faith" attempt to comply with the requirements of EGTRRA. Additional changes in the form of final amendments will be required once the IRS issues regulations under EGTRRA. Since many employers will have to take action before the end of 2001, plan sponsors should consult their legal advisor on plan matters for advice on meeting these requirements. Even though final EGTRRA amendments will not be required until 2005, nothing in EGTRRA extends the deadline for complying with (1) the Uruguay Round Agreements Act, P.L. 103-465 (GATT); (2) the Uniformed Services Employment and Reemployment Rights Act of 1994, P.L. 103-353 (USERRA); (3) the Small Business Job Protection Act of 1996, P.L. 104-188 (SBJPA); (4) the Taxpayer Relief Act of 1997, P.L. 105-34 (TRA '97); and (5) the 1998 IRS Reform Act, P.L. 105-206, collectively referred to as GUST. GUST amendments must still be adopted by the end of the 2001 plan year except for prototype and volume submitter plans which have an extension into the 2002 plan year. n
*Attorney-at-Law, 20 S. Clark Street, 25th Floor, Chicago, IL 60603; |
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