New Pension Planning Options

By Jeffrey R. Clark and Joseph E. Godfrey III

The 2001 Economic Growth and Tax Relief Reconciliation Act has some big extras for those in the retirement plan market. These changes are the most comprehensive since the 1974 passage of the Employee Retirement Income Security Act (ERISA), which defined the current retirement plan system.

The pension reform provisions of the 2001 Tax Act may be the beginning of a new national strategy for retirement security that attempts to restore the three-legged stool of Social Security, employer-provided benefits, and personal savings.

The tax laws enacted throughout the 1980s and early 1990s de-emphasized the employer-provided system. The 401(k) plan, which consists primarily of personal savings (albeit on a pre-tax basis), replaced most pension plans. Yet, because of the provisions regarding discrimination and deductible limits, 401(k) plans became unworkable for small businesses.

The new bill actually achieves many of Congress’ stated goals:

Expanded Coverage

The 401(k) salary deferral limits rose to $11,000 in 2002 and climb in $1,000 increments annually to $15,000 in 2005. This increase is just a very small piece of what actually changed.

Defined contribution plans. Previously, a 401(k) cash and deferral feature had to fit under the 15% of payroll deduction limit for the sponsor. This made offering a 401(k) feature difficult for small business owners that wanted to maximize their own retirement savings. In 2002, the cash and deferral feature may be added to the employer’s profit-sharing and matching contributions. The employer’s deductible limit for all profit-sharing plans will be 25% of the payroll. The effect of the new rules is shown in Exhibit 1.

Government “matching.” For tax years starting after 2001 and before 2007, the new law provides nonrefundable tax credits for a portion of contributions made by low- and middle-income taxpayers (with some exceptions). The credit ranges between 0% and 50% of employees’ salary deferrals up to $2,000 (for a maximum credit of $1,000), depending upon adjusted gross income (AGI; see Exhibit 2). The credit is effectively “government matching” of contributions.

Although the AGI limits are generous, especially at the 10% and 20% levels, they may not be fully realized because the credit is not refundable.

For profit-sharing plans, there no longer is a penalty to add a 401(k) cash and deferral feature. The plan sponsor will have to evaluate the additional cost and time to add this feature. The increased ability to invest tax-deductible contributions should mitigate any modest increase in plan administration costs.

With the profit-sharing “budget” under IRC section 404 rising from 15% to 25% of eligible payroll, the old money purchase and target benefit plans are no longer necessary. A flexible traditional or age-weighted profit-sharing plan is now sufficient. Companies with two plans (typically a 10% money purchase and 15% profit-sharing) can merge everything into one profit-sharing plan in 2002. However, they must amend or terminate the old plans before the participants accrue a new benefit, often after as few as 501 hours of service. Consolidating two plans into one will also reduce administration costs.

Other Expansions

Compensation limit. For tax year 2001, the compensation limit was $170,000 of earned income or W-2 wages, and is $200,000 in 2002. This will allow highly compensated participants to make greater contributions without increasing the cost for other employees.

Contribution limit. The defined contribution limit under IRC section 415, which was 25% of pay, not to exceed $35,000 in 2002 became 100% of pay in 2002, not to exceed $40,000. The overall plan limit is still 25% of payroll. This will effectively limit single-person profit-sharing plans to no more than 25% of eligible salary.

Benefit limit. With the repeal of IRC section 415(e), fully effective in tax year 2000, defined benefit and section 412(i) “fully insured” plans have made a stunning comeback. IRC section 415(e) formerly mandated that companies develop ratios between their already existing defined contribution plans, both as to those plan contributions and limits, and then reduce the benefits available under any defined benefit plan. The 2001 Tax Act expanded the maximum defined benefit (i.e., the amount of annualized income that can be received in retirement) under IRC section 415(b) in two ways:

Defined benefit plans first define (determine) the benefit at a given retirement age. Then an actuary calculates the level annual contribution, at an assumed rate of interest, that will provide sufficient monies at retirement to purchase the promised benefit (or be rolled over into an IRA). Defined benefit contributions therefore have increased because employers can—

Exhibit 3 illustrates the impact of these increases for a 50-year-old earning at least $160,000 who establishes a plan for the maximum 100% defined benefit at age 62.

The combination of the increased salary, the higher benefit amounts, and the age 62 full, funding limit the golden era of defined benefit plans (the late ’70s and early ’80s). In this example, the contribution soars by 52.4%. Such plans save on current taxes and build wealth in an environment where the assets also have certain creditor protection.

Strengthened Pension Security

Many provisions will make traditional defined benefit plans even better in years to come:

Some other changes will mandate better communication of changes in plan benefits, especially regarding cash balance plan conversions.

Defined benefit plans, which are a good deal now, will become even better in 2006 when the current liability funding limit is fully phased out. One way to avoid the problem until then is to use an IRC section 412(i) “fully insured” defined benefit chassis that is not subject to the current liability limits.

A 412(i) plan is a special defined benefit plan that substitutes the actuarial guarantees of certain insurance and annuity contracts to satisfy the funding limits. Because insurance company policies are long-term contracts, they use lower guaranteed rates than the IRS mandates, the result being a far larger contribution in the initial plan years and a larger current tax deduction.

Both defined benefit and 412(i) plans can be more flexible in future years if the benefit needs to be adjusted or frozen should the current goal of maximum tax-deductible contributions be changed because of the heavy front-end cash funding that builds up asset values quickly. Also, the PBGC premiums, actuarial fees, and annual plan year compliance costs are generally lower because the retirement plan’s entire value tracks the insurance company’s contractual guarantees.

Miscellaneous Provisions

To further stimulate plan coverage, Congress has offered a nonrefundable tax credit to small businesses that establish their first retirement plan. It can be a SEP IRA, a Simple IRA, or any form of qualified plan. The credit is up to 50% of the first $1,000 of administration and education expenses (maximum $500 credit) for the first three plan years.

Congress also waived certain IRS user fees for favorable letter of determination requests filed after 2001 and during the first five plan years. This is very advantageous for small business owners that installed a non-prototype plan within the past few years, but did not want to pay for a favorable letter of determination. Most pension service firms, and some law firms, will help prepare this filing.

Eligible small businesses must have 100 or fewer employees. At least one non–highly compensated employee must be eligible to participate. Highly compensated employees are defined as those that earn $85,000 or more, are a greater than 5% owner, or a linear family member or spouse of such owner (even if they earn minimum wage).

Enhanced Fairness to Women

Many women will enter, leave, and re-enter the workforce when they have children. Many others may become caregivers for parents or other disabled family members. Current pension rules adversely affect their retirement security.

A host of changes may help women facing such a predicament:

It will be even easier to get more monies into qualified plans for baby boomers that have put off saving for retirement. The base plan document may need to be updated to allow for these provisions before a participant can use them.

Increased Portability

Moving monies between plans has often been a difficult endeavor. In addition, when an old plan was amended to a new design, the prior law required that all benefit options be maintained in the new one, even if they were not used.

The 2001 Tax Act generally established two types of money: qualified and non-qualified. The complex requirements for maintaining old benefit forms were eliminated. Qualified monies can now move freely between different plan types, from 403(b) to 401(k) or from 457 to IRA. This allows money to go into the most cost-effective and beneficial programs.

The January 2001 IRA distribution regulations must be coordinated with the new estate tax and new pension rules. It is never a good idea to leave money in an old 401(k) plan, and generally not advisable to roll money from an IRA into a company plan. When an owner of a 401(k) dies, it must be distributed to the beneficiary, generally within one year. If the beneficiary is a spouse, it can be rolled over into a spousal IRA, but if the beneficiary is a child or grandchildren, it cannot. This eliminates the potential benefit of providing heirs tax-sheltered growth on the IRA account while taking the required minimum distributions (RMD) over their lifetime—the so-called stretch IRA.

Reduced Regulatory Burdens

These provisions could lower record-keeping costs, add flexibility, and spur new plan creation. The new law removes the prohibition on the sponsor giving investment advice to participants. Under the old law, sponsors were not allowed to provide investment advice to the participants, although they could be held liable if the participant made bad investment decisions. If the sponsor paid fee-for-service planners to advise participants, then the fee would be imputed income to each participant who received the assistance. The new law allows the sponsor to provide actual advice and investment consultation services. This service, if paid for by the sponsor, will not cause imputed income to the participants after 2001. All participants must be eligible to receive this assistance, not just the highly compensated ones. This is a new area where CPAs can add value for their clients.

The 2001 Tax Act also includes: plan loans for S corporation and non-incorporated business owners, refinements to hardship withdrawal rules, repeal of the multiple-use test for 401(k) plans, and some other technical simplifications. Collectively, these miscellaneous provisions eliminate most of the obstacles to installing a new plan.

©2002 CPA Journal. Legal Notices