New Tax Bill Includes Pension Reform

On June 7, 2001, President Bush signed into law the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). Along with the (eventual) elimination of the estate tax and the largest tax reductions in twenty years, this bill also included some significant changes to pension and employee benefits rules. These changes will be of interest to any employer who sponsors a qualified retirement plan.

The changes generally fall into three areas: First, increases in the limits on contributions and benefits available from qualified plans; Second, simplification and liberalization of certain technical rules which govern plan administration; and finally, miscellaneous provisions including new required disclosures to participants about plan changes. The following is a brief summary of some of the more important changes.

Increase in Contribution and Benefit Limits

Increase in Deductible Contribution Limits

The 15% limitation on deductible contributions to profit sharing and stock bonus plans has been increased to 25%. In addition, employee 401(k) deferrals are no longer subject to the limit.

Defined Contribution Plan Limit

Currently, each participant in a defined contribution plan cannot receive a contribution which is more than $35,000 or 25% of compensation, whichever is less. That limit has been increased to $40,000 or 100% of compensation. The $40,000 limit is indexed for inflation in $5,000 increments.

Defined Benefit Plan Limit

The maximum benefit limitation for a defined benefit plan (currently $140,000 per year) is increased to $160,000. This limit will be indexed for inflation in $5,000 increments.

Section 401(k)/403(b) Elective Deferrals

The annual limit on elective deferrals to 401(k) and 403(b) plans is increased from the current $10,500 to $11,000. It will then increase by $1,000 annually until it reaches $15,000 in 2006. After that, the limit will be indexed for inflation in $500 increments beginning in 2007.

Catch-up Contributions

Plan participants age 50 and older will be allowed to make an additional "catch-up" contribution to a 401(k), 403(b) or 457(b) plan. The maximum catch-up contribution will be $1,000 in 2002. The limit will increase each year by $1,000 until it reaches $5,000 in 2006. It will then be indexed for inflation in $500 increments beginning in 2007. This catch-up contribution is not restricted by any other contribution limits and is not subject to non-discrimination rules.

Annual Compensation Limit

The annual limit on includable compensation is increased from the current $170,000 to $200,000. It will then be indexed in $5,000 increments.

Section 457(b) Plans

The limit on elective deferrals to Section 457(b) plans, currently set at $8,500, will increase to $11,000 in 2002 and will be subject to $1,000 annual increases thereafter until it reaches $15,000 in 2006. Maximum deferrals under Section 457(b) no longer need to be coordinated with deferrals made to 401(k), 403(b), SEP or SIMPLE plans during the year.

Tax Credit for Employee Contributions

A temporary nonrefundable tax credit is available for low income individuals who make contributions to a 401(k), 403(b), 457(b) or an IRA. The credit ranges between 10% and 50% of the contribution up to a maximum contribution of $2,000. The credit is generally available for single taxpayers with adjusted gross income of $25,000 or less, or married taxpayers with adjusted gross income of less than $50,000.

IRAs

The maximum annual IRA contribution (either a traditional IRA or a Roth IRA) is increased from $2,000 to $3,000 beginning in 2002. It increases to $4,000 in 2005 and to $5,000 in 2008. After that, the limit is indexed for inflation in $500 increments.

Simplification and Liberalization of Pension Rules

Rollover Distributions

Eligible rollover distributions now can be made from any combination of 401(a) qualified plans, 403(b) plans, state and local government 457(b) plans or IRAs. After-tax contributions now can be included in eligible rollover distributions. A surviving spouse who receives a distribution from a deceased employee's qualified plan on death will be able to roll it over into his or her own employer's plan, if that plan permits it.

Involuntary Cash-Outs

A plan sponsor will now be required to automatically rollover an involuntary cash-out of more than $1,000 to an IRA unless a participant makes an election to receive it in cash.

Vesting

Employer matching contributions must now vest under a three-year cliff vesting schedule or a six-year graduated vesting schedule (the current five-year cliff and seven-year graduated schedules continue to apply to other employer contributions).

Same Desk Rule

This rule, which restricts an employee's right to receive a distribution of 401(k) accounts when a company is sold, has essentially been eliminated.

Top Heavy Rules

The definition of "key employee" for the purpose of determining a plan's top heavy status has been greatly simplified. The five-year "look back" period used for determining top heavy status has been reduced to one year.

Multiple Use Test

The dreaded "multiple use test" which applies to 401(k) and matching contributions has been eliminated. However, the Average Deferral Percentage (ADP) and Average Contribution Percentage (ACP) tests remain in effect.

Plan Loans

The restriction on plan loans for self-employed individuals, partners and subchapter S owners has been eliminated.

Miscellaneous Changes

Notice of Future Benefit Reductions

Currently, Section 204(h) of ERISA requires an advance notice to participants when a pension plan reduces or eliminates benefit accruals. Under the new law, a pension plan with more than 100 participants will now be required to provide a more detailed notice to each participant. The bill also now imposes a $100 per individual, per day, penalty tax if the notice is not provided (up to a maximum of $500,000). This provision is effective for all amendments taking effect on or after June 7, 2001.

Effective Dates and Expiration Dates

Generally, the pension changes made by EGTRRA take effect for plan years beginning in 2002. As with the other provisions of EGTRRA, they "sunset" after December 31, 2010, unless extended by Congress.

Planning Opportunities

These changes provide some interesting planning opportunities for employers and employees. Those who want to maximize deductible contributions will generally find that they are able to contribute a larger amount to their qualified plans.