February 2000


By George Mandel and Howard Rosenfeld

A rule that has curtailed the use of defined benefit plans as a viable option for the small, closely held business owner has been repealed effective for plan years beginning in 2000. This rule, set forth in IRC section 415(e) (sometimes referred to as the 1.0 rule), imposed a set of limits on individuals that participated in both a defined benefit and a defined contribution plan. In a small, closely held business, an owner receiving the maximum benefit under either type of plan could not participate in the other plan. For example, a doctor who participated in a tax sheltered annuity (sponsored by a hospital) at the maximum level and wanted to make deductible contributions to a defined benefit plan sponsored by her own private practice could not do so through a defined benefit plan. In addition, benefits or contributions under all plans, including terminated plans, had to be taken into account, no matter how far in the past the plan was terminated.

Individuals Affected

For plan years beginning on or after January 1, 2000, the 1.0 rule is repealed and the limitations are no longer applicable. The effect of this repeal impacts individuals that fall into any of the following categories:

* Category A: Individuals that have old (terminated) defined benefit plans and are limited as to the amount of their distribution due to their participation in a defined contribution plan.
* Category B: Individuals that currently sponsor a defined benefit plan and also had or are currently participating in a defined contribution plan.
* Category C: Individuals that have not been able to participate in a defined benefit plan due to their participation in a defined contribution plan.
* Category D: Individuals that have not been able to participate in a defined contribution plan due to their participation in a defined benefit plan.

In order to qualify for additional benefits as a result of the repeal of IRC section 415(e), the following conditions must be met:

* The individual must complete one hour of service in the plan year that begins in 2000 or be entitled to compensation in 2000. In other words, a terminated employee can not benefit from the repeal.

* The individual must accrue a benefit or be entitled to an increase in benefits after January 1, 2000, without regard to the repeal of section 415(e).

Planning Scenarios

When applying these rules to the categories noted above, the following planning is possible:

For Category A individuals, a new defined benefit plan would have to be started. Assuming the defined benefit plan limitations were lower in the year the prior plan terminated, the new plan would provide benefits based on the difference between current benefit limitations and the limitations in effect at the time the plan terminated. The new plan would recognize cost of living adjustments, and any individual who received a distribution from the terminated plan would be entitled to an additional benefit funded over a shorter period of time.

Example. Joe Smith established a defined benefit plan in 1980 and terminated it in 1990. In 1986, due to funding rule changes, contributions to the defined benefit plan ceased and a profit-sharing plan was established.

In 1990, when the defined benefit plan was terminated, the limitation for annual pension benefits was $120,000. Because of the 1.0 rule, Smith was limited to a lump sum distribution of $750,000, which was the equivalent to an $80,000 pension, that portion of the maximum available to an employee Joe's age when the plan terminated.

The limitation for annual pension benefits from a defined benefit plan in 2000 is $135,000. Therefore, if a new defined benefit plan is established in 2000, Smith is entitled to an additional benefit of $10,000 at retirement age due to the fact that there have been cost of living increases since the original plan was terminated in 1990. Since this increase is not caused by the repeal of 415(e), Smith is permitted to establish a new defined benefit plan in 2000 and have it provide for a benefit of $55,000 [$135,000 ­ $80,000, which is a combination of the cost of living adjustments and the repeal of section 415(e)]. If Smith were over age 55, this could amount to a tax-deductible contribution in 2000 of as much as several hundred thousand dollars.

For Category B individuals, the current plan must be reviewed, and most likely amended, to take advantage of the repeal of 415(e). Since Category B involves an existing defined benefit plan, the issue is whether a distribution already occurred due to the attainment of the plan's normal retirement age. If so, the same rules apply as those under Category A. If not, however, the plan needs to be reviewed in terms of cost of living language as well as the benefit formula.

Example. Jane Doe has an average salary of $75,000. Because a profit-sharing plan existed prior to the establishment of a defined benefit plan, the defined benefit plan's benefit formula had to be set at 50% of average compensation, or $37,500. With the repeal of section 415(e), Doe would be entitled to the maximum benefit permitted under a defined benefit plan, 100% of her average compensation, or $75,000. Since the plan's formula only provided for a benefit of $37,500, the plan would have to be amended.

Category C individuals have not been able to participate in a defined benefit plan due to the fact that they had always contributed to preexisting defined contribution plans at the maximum level. Since there is no prior defined benefit plan, a new defined benefit plan can be established in the year 2000, and a benefit can be funded, completely ignoring the accumulation of the defined contribution account balance.

Example. Dr. Jones has had a money purchase/profit-sharing plan since 1980. His accumulation in the plan is $2 million. He has been contributing the maximum permitted, currently 25% of compensation up to $30,000 annually, for his entire period of employment. He is 55 years old.

On January 1, 2000, Dr. Jones can establish a defined benefit plan without regard to the $2 million already accumulated. His new annual tax deductible contribution will range from $100,000 to $150,000, while the $2 million accumulation continues to compound tax deferred. If Dr. Jones continues with his current arrangement, he will be adding $300,000 (plus earnings) to his accumulation over the next 10 years. If he starts a defined benefit plan, he will be permitted to add in excess of $1 million (plus earnings) to his account over the same period.

Category D individuals have been precluded from having a defined contribution plan due to the fact that they already received or are entitled to receive a maximum benefit from a defined benefit plan. Individuals in Category D will have the opportunity to have a new defined contribution plan in the year 2000.

Example. Dr. Johnson has an overfunded defined benefit plan. She has not been able to make contributions to the plan for the last several years. Effective January 1, 2000, Dr. Johnson can install a profit-sharing and/or a money purchase plan and contribute $30,000 annually.

The repeal of IRC section 415(e) offers virtually all successful business owners the opportunity to provide more for their retirement needs. *

George Mandel, CPA/ PFS, is president of George Mandel Associates, Inc., and a member of National Retirement Planning Associates Inc., in White Plains, N.Y. He is a past president of the NYSSCPA Westchester Chapter and past president of the Westchester Estate Planning Council.
Howard Rosenfeld is a member of the American Society of Actuaries, a member of the American Society of Pension Actuaries, and an enrolled actuary. He is president of the Rosenfeld/Tortu Retirement Planning Company and National Retirement Planning Actuaries, in White Plains, N.Y.

Sheldon M. Geller, Esq.
Geller & Wind, Ltd.

Michael D. Schulman, CPA
Schulman & Company

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