2 Increased contribution limits. Make-up contributions for older individuals. Increased portability of benefits. New tax credits. Reduced regulatory burdens. These are just some of the positive changes to be found in the recently enacted Economic Growth and Tax Relief Reconciliation Act of 2001 ( EGTRRA ). The new law will have a significant impact on employers who offer retirement plans, as well as retirement savers. In this brochure, we summarize the provisions of the new law and how they will affect you. Because many of the provisions take effect in 2002, you ll want to become familiar with them now. Of course, before applying the new law s changes to your specific situation, you should obtain professional advice. Qualified Plan Contribution and Benefit Limits The new law eases restrictions that apply to contributions and benefits under tax-qualified retirement plans and to the amount of compensation that may be taken into account in determining contributions and benefits. Overall Limits for Defined Contribution Plans. The tax law limits the maximum amount of annual additions (generally, employer and employee contributions and any allocated forfeitures) to a participating employee s account under a qualified defined contribution plan (a 401(k) or profit sharing plan, for instance). The 2001 limit is the lesser of (1) 25% of compensation (as defined by law) or (2) $35,000. The $35,000 amount was to have been indexed for inflation, in minimum $5,000 increments. The new law increases the percentage limit to 100% for years beginning after The new law also raises the dollar limit to $40,000 and lowers the minimum inflationindexing increment to $1,000, also for years beginning after Overall Limits for Defined Benefit Plans. The maximum annual benefit that may be funded under a defined benefit pension plan is limited. For years ending on or before December 31, 2001, the limit is generally the lesser of (1) 100% of the high three-year average of compensation or (2) $140,000. The dollar limit is reduced if pension Copyright 2001 by NPI.
3 2 3 benefits begin before and increased if benefits begin after the participant attains the Social Security retirement age (currently, age 65). Under the new law, the dollar limit increases to $160,000 for years ending after December 31, The adjustment for benefit commencement before the Social Security retirement age is amended so that a reduction occurs if benefits start before age 62 and an increase occurs if benefits begin after age 65. Salary Reduction Limits. The big news for many employees is that the new law increases the amount participants may defer under a salary reduction plan, such as a 401(k) plan, 403(b) arrangement, salary reduction Simplified Employee Pension (SAR-SEP), SIMPLE retirement plan, or 457 deferred compensation plan. The new limits are shown on the accompanying table. 401(k)/403(b)/ Year SAR-SEP SIMPLE $11,000 $7,000 $11, $12,000 $8,000 $12, $13,000 $9,000 $13, $14,000 $10,000 $14, $15,000 $10,000 $15,000 (adjusted) All limits are adjusted for inflation after being fully phased in. The new law also revises the 457 plan contribution limits for years beginning after 2001 by increasing the percentage limit (currently 33¹/ ³ % of compensation) to 100% and amending the special final three years limit so it will be twice the otherwise applicable dollar limit in the last three years before retirement. Other 457 plan changes are included in the law as well. Salary Reduction Catch-Up Contributions. The new law provides for special catch-up contributions for older individuals who may not have had the opportunity to save for retirement in earlier years. In the case of 401(k) plans, 403(b) annuities, SIMPLE plans, SAR-SEPs, and 457 plans, an individual who has reached age 50 by the end of the plan year and who has already made the maximum allowable elective deferral to the plan for the year may make an additional pre-tax catchup contribution if the plan so provides. The maximum catch-up contribution is the lesser of (1) an applicable dollar amount (see table) or (2) the participant s compensation less any other elective deferrals for the year. Year 401(k)/403(b)/SAR-SEP/457 SIMPLE 2002 $1,000 $ $2,000 $1, $3,000 $1, $4,000 $2, and after $5,000 $2,500 Amounts will be adjusted for inflation in 2007 and after. Example: Ed, who is over 50, participates in a 401(k) plan at work. The plan provides for the maximum catch-up contributions. In 2002, Ed earns $30,000. Under the terms of the plan, Ed can contribute up to 15% of pay to the plan, and he contributes the full $4,500. In this case, Ed can contribute an additional $1,000 as a catch-up contribution. An employer is permitted but not required to make matching contributions with respect to catch-up contributions. Catch-up contributions are not subject to any other contribution limits or to the otherwise applicable nondiscrimination rules. Compensation Limit. The tax law caps the annual compensation that can be taken into account in determining contributions and benefits under tax-qualified plans. In 2001, the limit is $170,000. The new law increases the compensation cap to $200,000 for years beginning after 2001, to be indexed for increases in the cost of living in minimum $5,000 (instead of $10,000) increments. Plan Loans In general, tax-qualified plans are permitted to make loans to participants. However, the tax law s prohibited transaction rules have prevented sole proprietors, more-than-10% partners, and more-than-5% stockholders of S corporations
4 4 5 but not stockholder-employees of regular C corporations from taking participant loans. For years starting after 2001, the new law modifies the prohibited transaction rules to allow plans to make participant loans to all the above owner-employees. Thus, plan loans will be available to these owner-employees in the same way they are to regular corporation stockholder-employees. Moreover, the IRS will waive penalties for prohibited loans to owneremployees made before 2002 if the loans would have been allowed had the new law s change been in effect throughout the period of the loans. Top Heavy Rules Additional qualification requirements apply to a plan that is considered top heavy generally defined as a plan having more than 60% of its assets or accrued benefits held for key employees. In general, the additional requirements include (1) faster vesting for participants who are not key employees and (2) minimum employer contributions for non-key employees. For 2001 plan years, 401(k) plan matching contributions may count toward the minimum contributions only if the employer forgoes using the matching contributions for purposes of the special nondiscrimination tests applicable to 401(k) plans. The pre-egtrra definition of key employee includes: an officer earning more than half the defined benefit plan dollar limit ($70,000 for 2001), a more-than-5% owner of the employer, a more-than-1% owner earning over $150,000, and the ten employees holding the largest ownership interests in the employer if they each earn more than $35,000 (in 2001) for the year. Key employee status and top heavy status are generally determined for a plan year as of the last day of the prior plan year (the determination year). A lookback rule includes in the key employee group those who were key employees during any of the four years prior to the determination year. In addition, all plan distributions in the determination year and the four preceding years must be added back to the balances of employees for the top heavy determination. Effective for years beginning after 2001, EGTRRA makes several changes to the top heavy rules: The definition of key employee is modified to remove the top-ten ownership category and to increase the compensation needed to be included in the officer category to more than $130,000 (to be adjusted for inflation in $5,000 minimum increments). Matching contributions can count toward satisfying top heavy minimum contributions without losing the ability to include them in the 401(k) plan nondiscrimination tests. A 401(k) plan that satisfies the tax law s design-based nondiscrimination safe harbor and makes matching contributions that satisfy the safe harbor rules will not be considered top heavy. The four-year lookback period is eliminated in determining key employee status. Only the determination year will be considered. Except for in-service distributions, the add back for distributions includes only the determination year and not the preceding four years. An individual s accrued benefit or account balance will no longer be counted in the top heavy determination if the individual has not performed services for the employer in the determination year. These changes will greatly reduce the number of plans that will be considered top heavy in the future and will make it easier for those plans that are top heavy to satisfy the minimum contribution rule. Deduction Limits Employer contributions to a tax-qualified plan are deductible within limits. For example, contributions to a profit sharing or stock bonus plan have generally been limited to 15% of the total compensation of covered employees, net of any employee elective deferrals to the plan. For purposes of the deduction limits, employee elective deferrals to a 401(k) plan have been treated as employer contributions and, thus, have been subject to the general deduction limits. The new law significantly affects the deduction limits, for years starting after Elective deferrals will no longer be considered employer contributions for purposes of the
5 6 7 deduction limits. And the definition of total employee compensation for deduction purposes will include elective deferrals. Moreover, the deduction limit for profit sharing and stock bonus plans will increase from 15% to 25% of compensation. Example: Corporation, which sponsors a tax-qualified profit sharing plan, pays $900,000 in total compensation to covered employees in Therefore, for 2001, Corporation may make a deductible profit sharing contribution of up to $135,000 (15% of $900,000). If Corporation pays the same $900,000 of compensation in 2002, it may deduct a contribution of up to $225,000 (25% of $900,000). Vesting of Employer Matching Contributions While employee contributions to a tax-qualified plan are immediately 100% vested (nonforfeitable), employer contributions including matching contributions may vest over longer periods. Plans which are not top heavy currently must use one of two minimum vesting schedules (five-year cliff or seven-year graded) or provide for more generous vesting of employer contributions. The new law provides that matching contributions must become vested more quickly using one of the minimum vesting schedules now required for top heavy plans. Therefore, for plan years starting after 2001, employer matches must generally become nonforfeitable under a three-year cliff vesting schedule (100% vesting after three years of service) or a six-year graded schedule (with 20% a year vesting beginning with the employee s second year of service). Thus, an employer with both matching and other employer contributions may have to apply different vesting schedules to different contribution types. Plans that already have faster vesting schedules will not be affected by this change. Roth Contribution Program Effective for tax years starting after 2005, 401(k) and 403(b) plan sponsors may include a Roth contribution program, similar to a Roth IRA, in their plans. With this program, participants may choose to have all or part of their elective deferrals treated as designated Roth contributions. Unlike pre-tax elective deferrals, designated Roth contributions will not be excluded from a participant s income in the year contributed. However, if all requirements are met, the plan earnings on those contributions will not be taxed on distribution. The annual dollar limit on designated Roth contributions will be the annual limit on elective deferrals, reduced by any elective deferrals that are not designated Roth contributions. So, since the 2006 limit on elective deferrals is $15,000, a qualifying participant who makes $5,000 of 401(k) pre-tax deferrals will be able to elect to make up to $10,000 of designated Roth contributions. Distributions from a Roth contribution program are tax free if made after a five-taxable-year period generally starting with the year for which the participant made the first designated Roth contribution. The distribution must also be: (1) made on or after the date the participant turns age 59½; (2) made to a beneficiary (or the estate) of a deceased participant; or (3) attributable to the participant s being disabled. The special purpose distributions allowed from Roth IRAs (i.e., for first-time homebuyer expenses) are not allowed from Roth contribution programs. Plans will be required to maintain separate accounts and recordkeeping for the designated Roth contributions and related earnings. Designated Roth contributions will be treated the same as any other elective deferral for purposes of the tax law s nonforfeitability requirements, distribution restrictions, and the special nondiscrimination requirements applicable to 401(k) plans. A participant may roll over designated Roth contributions only to another designated Roth contributions account or to a Roth IRA. Pension Portability Rollovers. The tax law contains numerous rules that apply when rolling over eligible distributions from one taxfavored retirement plan to another with the purpose of retaining the tax-favored treatment of the money distributed. Depending on the types of plans involved, the existing rules vary considerably.
6 8 9 For example, a recipient of an eligible distribution from a tax-qualified plan may roll it over (within 60 days after the date of receipt) to another tax-qualified plan or a traditional IRA without incurring tax. A distribution from a 403(b) annuity, though, may be rolled over only to another 403(b) program or an IRA. Distributions from a 457 deferred compensation plan may not be rolled over, but may be transferred directly to another 457 plan. Starting with distributions made after 2001, the new law expands the rollover options. The intent is to provide further incentives for individuals to keep distributed retirement benefits in tax-favored accounts and provide more flexibility as to where money can be rolled over. The new law provides that eligible rollover distributions from tax-qualified plans, 403(b) annuities, and governmental 457 plans generally may be rolled over to any of the other types of plans (and IRAs) that accept such rollovers. Note that these plans are not required to accept rollovers. Other new rollover provisions taking effect for post-2001 distributions: Taxable IRA amounts may be rolled over into a taxqualified plan, 403(b) annuity, or 457 plan. A surviving spouse who participates in her/his own tax-qualified plan, 403(b) annuity program, or 457 plan may roll over distributions from a deceased spouse s plan to the survivor s own plan, if that plan accepts such rollovers. After-tax employee contributions to a tax-qualified plan, which under existing law cannot be rolled over to another plan, may be rolled over to another qualified plan or traditional IRA. The IRS has the authority to extend the 60-day rollover period where failure to comply is due to casualty, disaster, or other events beyond the reasonable control of the taxpayer. Anti-Cutback Rules. When a participant s plan benefits are transferred to another plan, the receiving plan has been required to preserve all of the forms of distribution available under the transferring plan. For years beginning after 2001, the new law provides that the receiving plan will not be required to keep the same forms of distribution in a transfer situation, if certain requirements are met. Among the requirements: a single-sum distribution must be available from the receiving plan. Repeal of Same Desk Rule. In general, the same desk rule provides that a distribution from a 401(k), 403(b), or 457 plan to a terminated employee is prohibited if the employee continues performing the same functions for a successor employer, because the employee hasn t truly separated from service. The new law eliminates this rule for distributions after December 31, 2001, by providing that distributions may be made from the plan of the original employer where the original employment relationship has been terminated (even if severance has occurred before that date). Example: Ellen sells her Internet programming firm to another company. Her employees continue to perform all the same job functions for the new company as they did before the sale. Under the prior law s same desk rule, Ellen s 401(k) plan generally could not make distributions to her former employees. Since the new law allows distributions as long as employees sever employment with the former employer, Ellen s plan can make distributions to the former employees. A plan, however, may provide that certain specified types of severance from employment do not constitute distributable events. Involuntary Cash-Out. Under current law, a former employee may be forced to take plan benefits if the nonforfeitable value of the benefits does not exceed $5,000. In determining whether a benefit exceeds the limit, rollovers from another retirement plan or conduit IRA have been counted as part of the employee s account balance. For distributions after 2001, a plan sponsor no longer needs to count rollovers (and related earnings) in applying the $5,000 limit. The implication for employers: More former participants will be able to be cashed out of a plan than under current law.
7 10 11 Automatic Rollover of Certain Cash-Out Distributions. With respect to the above cash-out rule, EGTRRA makes a direct rollover the default option for involuntary distributions that exceed $1,000 and that are eligible rollover distributions. A distribution must generally be transferred to a plan sponsor-designated IRA, unless the participant affirmatively elects to have the distribution placed in another IRA or to receive it directly. However, this provision will not go into effect until the Department of Labor finalizes regulations on appropriate investment alternatives for the rollover amounts (not more than three years after enactment). Tax Credits for Individuals and Employers To encourage individuals to save adequately for retirement and to provide smaller employers incentives to establish retirement plans for their employees, the new law introduces two tax credits. Credit for Low- and Middle-Income Savers. For tax years starting after 2001 and before 2007, the new law provides a nonrefundable tax credit (i.e., a direct offset against tax) for a portion of contributions made to qualifying retirement accounts by eligible individuals age 18 or older (except full-time students or dependents claimed on another s return). Qualifying contributions include elective contributions to 401(k), 403(b), and 457 plans, SIMPLE and salary reduction Simplified Employee Pension (SAR-SEP) plans, and contributions to traditional or Roth IRAs, as well as voluntary after-tax contributions to tax-qualified plans. The credit is allowed in addition to any deduction or exclusion that otherwise applies to the contribution. The maximum annual contribution eligible for the credit is $2,000. The credit percentage rate ranges from 0% to 50% and depends on the adjusted gross income (AGI) of the taxpayer (see the accompanying table). Credit Joint Filer Head of Single/ Rate AGI Household AGI Other AGI 50% $0-30,000 $0-22,500 $0-15,000 20% $30,001-32,500 $22,501-24,375 $15,001-16,250 10% $32,501-50,000 $24,376-37,500 $16,251-25,000 0% Over $50,000 Over $37,500 Over $25,000 Example: John is married, files a joint return, and has a joint AGI of $32,000. He defers $1,500 of his income to his employer s 401(k) plan in He does not have to include that money in his gross income for tax purposes. Plus, John can take a credit against his federal income tax for 20% of his contribution, or $300. The amount of contribution eligible for the credit is generally reduced by taxable distributions from a qualifying plan (or any distributions from a Roth IRA) received by the taxpayer or a spouse during the current tax year, the two years before the year the credit is being claimed, or during the period after the end of the current year and before the due date of the taxpayer s return for the year. Small Business Credit for Plan Expenses. The new law allows a nonrefundable credit for 50% of the administrative and retirement education expenses of certain small businesses that adopt a new tax-qualified defined benefit or defined contribution plan, SIMPLE plan, or SEP. The credit is available for expenses paid or incurred in tax years starting after 2001 and applies to the first $1,000 of qualifying expenses of the plan in each of its first three plan years. Therefore, there is a maximum credit of $500 a year for three years. To be eligible, an employer must not have had, in the preceding year, more than 100 employees with compensation in excess of $5,000 each. In addition, the plan must be established after 2001, and it must cover at least one nonhighly compensated employee. A plan is considered new if, during the three-year period immediately before the first year the credit is available, the employer sponsored no qualified retirement plan for the employees covered by the new plan. An employer claiming the credit is not allowed a business expense deduction for the 50% of the expenses for which the credit is claimed.
8 12 13 Example: Joe s Garage, Inc., which employs 15 people, sets up a SIMPLE 401(k) plan in In 2002, the company spends $1,100 to set up and administer the plan, and it spends $500 to administer the plan in each of the next two years. Joe s Garage may claim a tax credit of $500 in 2002 and $250 a year in 2003 and If Joe s Garage claims the credit, it may deduct the remaining plan costs as a business expense. Employer-Provided Retirement Advice Certain employer-provided fringe benefits are excluded from an employee s income. Before EGTRRA, there was no specific exclusion for employer-provided retirement planning services, although they may possibly qualify as excludable educational assistance or a fringe benefit. For tax years starting after 2001, the new law specifically excludes from income all qualified retirement planning services provided to an employee and the employee s spouse by an employer maintaining a qualified employer plan. Qualified services include advice and information about the particular employer s plan, retirement income planning in general, and how the employer s plan fits into the individual s overall retirement income plan. The exclusion won t apply to highly compensated individuals unless the services are available to other employees on substantially the same terms. Miscellaneous Changes Several provisions in the new law reduce the administrative and regulatory burdens placed on the plan sponsor and administrator, while others impose stricter requirements. Plan Valuations. Under existing regulations, a defined benefit pension plan s valuation date for a plan year generally must be within the plan year to which the valuation refers or within the month prior to the beginning of that year. For plan years beginning after 2001, the new law provides that a fully funded defined benefit plan may instead elect to use any valuation date within the immediately preceding plan year. Other Defined Benefit Changes. The new law also: (1) phases out the current liability full funding limit so that, for plan years beginning after 2003, the limit will be completely repealed; (2) allows state and local government employees to use funds from 403(b) or 457 plans to purchase service credits under their defined benefit plans; (3) repeals (effective for tax years beginning after 2001) the 100%-of-compensation defined benefit plan contribution limit for multiemployer plans; and (4) provides that the existing 10% excise tax on nondeductible contributions to qualified plans will not apply to any contributions made to a defined benefit plan up to the accrued liability full funding limit, for tax years beginning after ESOP Dividends. In general, an employer sponsoring an Employee Stock Ownership Plan may currently deduct dividends paid on employer stock held in the ESOP, but only if the dividends are paid out to the participants in cash (or used to repay ESOP loans). Under the new law, the employer may also deduct dividends where participants can elect to receive the dividends in cash or leave them in the plan for reinvestment in employer securities, effective for tax years beginning after S Corporation ESOP. The new law clarifies the prohibited transaction excise tax treatment when an ESOP holds S corporation stock under specified conditions. Multiple Use Test Repealed. When testing for 401(k) plan nondiscrimination, plans are subject to the Actual Deferral Percentage and Actual Contribution Percentage tests. Some plans have had to satisfy a third test, called the multiple use or aggregate limit test. The new law repeals the multiple use test for years beginning after Notice of Reduction in Benefits. Under the existing pension law, defined benefit and money purchase pension plans must notify participants if a plan amendment will reduce future benefits. In response to recent publicity surrounding conversion of pension plans to cash balance plans, the new legislation mandates that defined benefit plans (except certain government or church plans) notify participants in writing if a plan amendment, adopted on or after June 7, 2001, will cause the future benefit accrual rate
9 14 15 to be reduced, including any elimination or reduction of an early retirement benefit or retirement-type subsidy. Generally, the notice must be provided within a reasonable time before the plan amendment takes effect. Failure of an employer to comply with the new rules could lead to an excise tax of $100 a day per omitted participant. Hardship Withdrawals and Deferral Suspension. When a participant takes a hardship withdrawal under the safe harbor rules, plans have had to suspend elective deferrals for 12 months. The new law directs the IRS to shorten the suspension period to six months, effective for years beginning after User Fees. Existing law generally imposes an IRS user fee on an entity that requests a determination letter that a written retirement plan maintained by the entity meets the taxqualification requirements. Under the new law, the IRS user fee for a determination letter is waived for a plan sponsor with 100 or fewer employees and at least one nonhighly compensated employee-participant. This waiver applies only for requests made after 2001 and within the first five plan years of the plan. Employees of Tax-Exempt Entities. The new law reinstates a rule that employees of a tax-exempt entity who are eligible to make elective deferrals under a 403(b) program may be excluded in applying the plan coverage requirements to a 401(k) plan under specific circumstances. Individual Retirement Account Changes For many people, an Individual Retirement Account is a key element of their retirement planning. IRAs come in two basic varieties: traditional and Roth. Total annual contributions (not counting rollover contributions) to all of an individual s IRAs have been capped at $2,000 or, if less, total compensation for the tax year. Contributions to a traditional IRA are income-tax deductible, subject to income-based limitations that apply when an individual (and/or a spouse) participates in a qualified retirement plan at work. Nondeductible contributions are also permitted. Any deductible contributions and all IRA earnings are taxable on distribution from a traditional IRA. With a Roth IRA, contributions are not deductible but earnings accumulate tax deferred and, if all tax law conditions are met, are tax free on distribution. Eligibility to contribute to a Roth IRA is phased out if a taxpayer s adjusted gross income exceeds prescribed limits. The new law makes several changes that will affect IRAs. Annual Contribution Limit. The new law increases the overall annual contribution limit for both types of IRAs, starting in Year Maximum IRA Contribution $3, $4, and after $5,000 (to be adjusted for inflation in $500 increments) Additional Catch-Up Contributions. Under the new law, individuals age 50 and older (as of the end of the tax year) may make catch-up contributions to IRAs, if otherwise eligible to contribute. An additional $500 a year (before application of the AGI phaseout limits) can be contributed for 2002 through Thus, for a 50-year-old contributing to a traditional or Roth IRA in 2002, the limit will be $3,500 (i.e., $3,000 regular limit plus $500). The catch-up amount increases to $1,000 per year for 2006 and later years. Deemed IRAs. Effective beginning with the 2003 plan year, an eligible retirement plan (i.e., a tax-qualified plan, 403(b) tax-sheltered annuity arrangement, or 457 plan) may allow employees to make voluntary contributions to a separate plan account or annuity that meets the requirements of a traditional IRA or Roth IRA. If a plan adopts this arrangement, the deemed IRA and any contributions to it are not subject to the tax law rules applicable to the eligible retirement plan (such as the qualified plan contribution limits), but instead are governed by the tax law rules for the type of IRA chosen. However, the fiduciary and exclusive benefit rules of the pension law (ERISA) would apply to the deemed IRA to the extent otherwise applicable to the plan. This means the deemed IRA contributions will be subject to ERISA s fiduciary investment standards, etc., but not the reporting, disclosure, and similar requirements of ERISA.
10 16 Remedial Amendments In general, written plan amendments to reflect law changes must be made by the filing due date of a plan sponsor s tax return for the year in which the change in the law goes into effect. Usually, though, legislation containing changes calling for plan amendments provides a remedial amendment period during which plan amendments can be made to reflect the changes. If a plan operates within the terms of the new requirements as they become effective, the plan will be in compliance even though the written plan amendments aren t made until the end of the remedial amendment period. Congress did not include a remedial amendment period in the law. However, the IRS has since indicated that a plan will have until the end of the 2005 plan year to adopt any necessary retroactive remedial EGTRRA amendments. The remedial amendment period is available only if required good faith EGTRRA amendments are adopted. These should generally be in place by the end of the plan year in which the provision is effective. Your Next Step Since many of the provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001 go into effect in 2002, plan sponsors and administrators will need to comply with the new rules almost immediately. Accordingly, it is important that you seek professional advice to find out how your plan will be affected and learn about any steps you need to take now. If we can be of assistance, let us know. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is provided with the understanding that it does not constitute legal, accounting, or other professional service. Before acting on any information in this publication, you should seek the advice of a benefits professional. PAB 10/01
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