The CPA Journal

EMPLOYEE BENEFIT PLANS

Qualified Retirement Plans and the 2001 Tax Act

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

The 2001 Tax Act (Economic Growth and Tax Relief Reconciliation Act of 2001) makes extensive changes to qualified retirement plans, most of which take effect in 2002. Plan sponsors need to review the new provisions, which include increased contribution and benefits limits, 401(k) elective deferral limits, deductibility limits, and compensation limits. Many plan sponsors will want to take advantage of the increased qualified plan dollar and percentage limits to enlarge their retirement plan programs.

Contribution and Benefit Limits

The 2001 Tax Act contains a number of provisions regarding contribution and benefit limits for qualified plans. The 401(k) contribution dollar limit will increase from $10,500 to $15,000, beginning with a $500 increase in 2002. The limit increases $1,000 in each of the next four years, to $15,000 in 2006.

The defined contribution annual limit on additions will increase from $35,000 in 2001 to the lesser of $40,000 or 100% of compensation, effective in 2002. The annual dollar limit on additions (generally employer and employee contributions plus forfeitures) was $30,000 in 2000. Defined contribution plans include 401(k) and profit-sharing plans.

The defined benefit annual limit will increase from $140,000 to $160,000 for years ending after December 31, 2001, and the dollar limit need only be actuarially reduced for benefits commencing before age 62 (rather than the Social Security retirement age).

The maximum compensation for determining contributions and benefits under a retirement plan will increase from $170,000 to $200,000, effective in 2002.

“Catch-up” contributions may now be made by individuals age 50 and older in the amount of $1,000 in 2002, $2,000 in 2003, $3,000 in 2004, $4,000 in 2005, and $5,000 in 2006. These amounts are additional contributions above the normal limits that apply to 401(k) plans, and are not subject to the special nondiscrimination test.

The limit on deductions for an employer’s contributions to a stock bonus or profit-sharing plan increases from 15% to 25% after December 31, 2001.

Employee 401(k) elective deferrals will be deductible even where the employee participates in a stock bonus or profit-sharing plan, effective for tax years beginning after December 31, 2001.

For deduction purposes, compensation will no longer be reduced for employee elective deferrals made to a 401(k) plan or cafeteria plan, effective for tax years beginning after December 31, 2001.

IRA accounts under defined contribution plans will permit participants to make IRA contributions to a separate account maintained under a qualified plan, effective in 2003. IRA account contribution limits for deductible IRA contributions will increase to $3,000 per year in 2002–2004, $4,000 in 2005–2007, and $5,000 in 2008.

401(k) Plans

The 2001 Tax Act included a number of changes directed specifically toward 401(k) plans. The multiple-use test applicable to 401(k) plans with matching employer contributions will be repealed effective in 2002. The same-desk rule will also be repealed and replaced with a “severance from employment” standard, effective in 2002.

The hardship distribution IRS safe harbor will now require only a six-month suspension of participation (rather than a 12-month suspension).

Matching contribution accounts under non–top-heavy plans will be required to vest under a top-heavy vesting schedule (i.e., three-year cliff or six-year graded), effective for plan years beginning after December 31, 2001.

Participant loans from qualified plans will be permitted for owner-employees (S corporation shareholders, partners, LLC members, and sole proprietors), effective in 2002.

Effective in 2006, Roth IRAs under 401(k) plans may permit participants to elect a tax treatment providing for after-tax contributions and tax-free distributions.
Low-income savers will receive a tax credit of up to $1,000 for contributions to 401(k) plans, in addition to the usual tax deduction, effective in 2002.

Top-Heavy Plans

Several provisions of the 2001 Tax Act affect top-heavy qualified plans. Key employee status will now be based on the determination year without regard to the four-year look-back period applicable under present law. To qualify for the officer category, key employees must receive a minimum compensation of $130,000 (rather than the current $70,000); the top 10 owner rule is repealed.

The requirement that the add-back of distributions be made within five years of the determination date will be shortened to a one-year add-back period (except for in-service distributions). 401(k) safe harbor plans, which consist solely of contributions that satisfy the design-based safe harbors for matching or nonelective contributions, will be deemed to be non–top-heavy plans.

Matching contributions may be used to satisfy the top-heavy minimum contribution obligation for non–key employees and may also be treated as matching contributions for non-discrimination testing purposes. “Frozen” defined benefit plans will not be required to provide top-heavy minimum accruals for non-key employees.

Rollovers and Direct Transfers

Under the 2001 Tax Act, distributions from qualified plans may be rolled over into 403(b) plans, and distributions from 403(b) plans may be rolled over into qualified plans. Both pre- and posttax IRA distributions are eligible for rollover into qualified plans. Aftertax employee contributions may be included in an eligible rollover distribution to a qualified plan or an IRA.

Involuntary cash-outs will not take into account rollover contributions and allocable earnings in determining whether a participant’s nonforfeitable accrued benefit equals or exceeds $5,000. Involuntary cash-outs that are eligible rollover distributions in excess of $1,000 must be rolled over to an employer-designated IRA, unless the participant affirmatively elects cash or a different recipient for a direct transfer.

Plan Sponsor Costs

IRS user fees for determination letter requests will be waived for plan sponsors with 100 or fewer employees during the first five plan years, effective for requests submitted after December 31, 2000.

The IRS will offer a tax credit equal to 50% of the first $1,000 of: administrative and retirement education expenses incurred for each of the first three plan years of a new plan; expenses paid or incurred in tax years beginning after December 31, 2001; and costs incurred by small plan sponsors (i.e., 100 or fewer employees who had compensation in excess of $5,000 in the proceeding year) for a new plan established after December 31, 2001.

Compliance

The IRS will provide an extended amendment period for plan sponsors to amend their plans to comply with the 2001 Tax Act. Amendments will not need to be adopted before the last day of the 2004 plan year; the delayed amendment date is contingent upon the amendments being retroactively effective when adopted. In the interim, the plan should be operated in accordance with the new law.

The 2001 Tax Act does not affect compliance with the changes in qualification made by the General Agreements on Tariffs and Trade, the Uniformed Services Employment and Reemployment Rights Act of 1994, the Small Business Job Protection Act of 1996, the Taxpayer Relief Act of 1997, and the Internal Revenue Service Restructuring and Reform Act of 1998 (collectively known as GUST). This will require plan sponsors to amend and restate their plans prior to the end of the 2001 plan year (i.e., December 31, 2001, for calendar-year plans).

None of the changes made by the 2001 Tax Act will apply to taxable, plan, or limitation years beginning after December 31, 2010. It appears likely that Congress will act to preserve many of the act’s positive changes before this sunset date.

Observations

The 2001 Tax Act will have some significant implications for both employers and employees. The IRA feature makes it convenient for employees to save for retirement by making IRA contributions to their employer’s qualified plans directly from payroll. An employer’s need for a nonqualified plan is diminished because the act increases compensation, contribution, and benefit limits under qualified plans.

Plan loans to sole proprietors, partners, LLC members, and S corporation shareholders will be permitted in the same manner as plan loans to participants that are not owner-employees.

Under the 2001 Tax Act, elective 401(k) deferrals are not taken into account for purposes of determining the employer contribution deduction limits. Employees may be permitted to elect to defer greater 401(k) withholding amounts, and employers may make greater deductible-matching and profit-sharing contributions.

The 25% of compensation limit on deductible employer contributions applicable to money purchase plans will also apply to profit-sharing plans, effective in 2002.

A top-heavy 401(k) safe harbor plan that consists solely of elective deferrals and matching contributions will not be required to make any additional contributions for non–key employees; the plan sponsor will not have to contribute for non-key employees that do not make 401(k) elective deferrals. This does not mean that an accompanying profit-sharing contribution automatically satisfies the top-heavy rules; however, the matching contributions will count toward
otherwise satisfying the minimum contribution.

A rollover of aftertax contributions from a qualified plan to another qualified plan must be effected by a direct transfer. An individual will be able to roll over amounts distributed from an IRA into an eligible retirement plan, even if the funds are not all attributable to contributions from a conduit IRA.

Under the 2001 Tax Act, employers will not need to maintain a money purchase pension plan in addition to a profit-sharing plan in order to contribute and timely deduct an annual amount greater than 15% of eligible employee compensation.

The increased $200,000 compensation limit now applies in determining benefits under qualified plans (in addition to the employer deduction rules), thus enabling owner-employees to receive more favorable allocations.

A 63-year-old defined benefit pension plan participant commencing benefits in 2001 would have a benefit limit of $140,000; this limit would have to be decreased because the benefits commenced before age 65. By delaying receipt of benefits until 2002, however, the benefit limitation would increase to $160,000, and this limit would not decrease because the benefits commenced before age 65.

The 2001 Tax Act provision for shorter minimum vesting schedules—from a five-year cliff to a three-year cliff, from a seven-year graded to a six-year graded—applies only to employer-matching contribution accounts and not to other employer-contribution accounts. All other employer-contribution accounts continue to be subject to the current alternative minimum vesting schedules (i.e., five-year cliff and seven-year graded).

Employers no longer need to limit employee-elective deferral contributions in order to prevent loss of deductibility for any part of the employer contribution amount. 401(k) elective deferrals are no longer deemed employer contributions for the purposes of determining the amount of an employer’s deduction for contributions; therefore, they are not subject to the employer deduction limit.

A special rule allowing a deduction for an amount of up to 100% of a defined benefit plan’s unfunded current liability should provide more plan sponsors with the incentive to adequately fund their plans.

To avoid a double tax benefit, qualified costs are not deductible to the extent they are effectively offset by the tax credit (i.e., 50% of the costs up to $1,000). Employers with 100 or fewer employees receive this tax credit in each of the first three plan years for new plans. Plan sponsors must claim deductions for any remaining qualified costs that are ordinary and necessary business expenses and thus deductible on their federal income tax returns. The deductible plan-related costs include the expenses not offset by the credit, such as the other 50% of the first $1,000 in expenses.