Favorable Retirement Plan Changes Enacted in 2001 Tax Legislation
Employment & Labor Law Alert
December 21, 2001
The Economic Growth and Tax Relief Reconciliation Act of 2001 (the “2001 Act”) contains many changes to the rules for tax-qualified retirement plans that are beneficial to employers and employees. The article discusses some of the most important changes.
1. Increases in Benefit and Contribution Limits
Defined Benefit Plans. Under pre-2001 law, the maximum annual benefit payable at retirement was the lesser of 100% of average compensation for the three highest years, and $140,000. The $140,000 was indexed for inflation in $5,000 increments. The maximum benefit was reduced if payments began before the “social security retirement age” (currently, age 65), and increased if benefits began after age 65. Plans of government and tax-exempt employers had a floor of $75,000 on the reduction of benefits beginning at or after age 55.
Under the 2001 Act, the maximum annual benefit is 100% of average compensation for the three highest years, and $160,000 indexed for inflation in $5000 increments. The maximum amount is reduced for benefits beginning before age 62, and increased for benefits beginning after age 65. The floor for plans of government and tax-exempt employers is eliminated.
Defined Contribution Plans. Under pre-2001 law, the maximum annual addition for a participant was the lesser of 25% of compensation, and $35,000. Annual additions are the sum of employer contributions, employee contributions, and forfeitures under all defined contribution plans of the same employer. Inflation adjustments were made in increments of $5,000.
Under the 2001 Act, beginning in 2002, the maximum contribution is 100 percent of compensation, and $40,000. The $40,000 limit is indexed for inflation in increments of $1,000.
Compensation Limit. Under pre-2001 law, the maximum annual compensation taken into account for determining contributions and benefits, applying deduction limits, and non-discrimination testing, was $170,000. Indexing for inflation was in increments of $10,000.
Under the 2001 Act, beginning in 2002, the maximum compensation taken into account is $200,000. This limit is indexed for inflation in $5,000 increments.
Elective Salary Deferral Limits. Under pre-2001 law, a taxpayer could exclude from gross income elective salary deferrals to a qualified cash or deferred arrangement (“401(k) plan”), a tax-sheltered annuity (“403(b) annuity”), and a salary reduction simplified employee pension plan (“SARSEP”), as long as the deferrals did not exceed $10,500. The maximum amount of deferrals that could be made to a SIMPLE plan and excluded from gross income was $6,500. These limits were indexed for inflation in $500 increments.
Under the 2001 Act, the maximum amount of elective salary deferrals cannot exceed an “applicable dollar amount,” which is $11,000 for 2002, with increases of $1,000 annually until it reaches $15,000 in 2006. After 2006, the deferral limit will be indexed for inflation in $500 increments. The maximum amount of elective deferrals for SIMPLE plans is limited to a different “applicable dollar amount,” which is $7,000 in 2002, with annual increases of $1,000 until 2005. This amount will also be indexed for inflation in $500 increments.
Section 457 plans. Under pre-2001 law, the maximum annual elective salary deferral under a deferred compensation plan of a state or local government or a tax-exempt organization (a “Section 457 plan”) was the lesser of 33 1/3% of compensation, and $8,500. The limit was indexed for inflation in $500 increments. The law also provided that for one or more of the participant’s last three taxable years, the limit was increased to the lesser of $15,000, and the sum of the otherwise applicable limit plus the amount by which the limit of previous years exceeded actual deferrals for those years.
Under the 2001 Act, the maximum annual elective salary deferral is the lesser of 100% compensation, and an “applicable dollar amount” of $11,000 in 2002, which increases by $1,000 annually until 2006 when the applicable dollar amount is $15,000. After 2006, the dollar amount will be indexed for inflation in $500 increments. The new law provides that for one or more of the participant’s last three taxable years the limit is increased to the lesser of twice the applicable dollar amount then in effect, and the sum of the otherwise applicable limit plus the amount by which the limit of previous years exceeded actual deferrals for those years.
These changes enhance the economic benefit of qualified retirement plans and encourage more employees to participate in them. Employees can save more during their earning years and receive more once they retire.
2. Elective Deferrals Will Not Affect Employer Plan Contribution Limits
Under prior law, employee elective salary deferral contributions to a 401(k) plan were treated as employer contributions and, as a result, were subject to the limitation on deductible employer contributions. The maximum deductible employer contribution was the greater of 15 percent of the compensation paid or accrued to participants during the taxable year, and the amount the employer must contribute to a SIMPLE 401(k) plan.
Under the 2001 Act, beginning in 2002, the maximum deductible employer contribution to a 401(k) plan is the greater of 25 percent of compensation, and the amount the employer must contribute to a SIMPLE 401(k) plan.
These changes should make 401(k) plans more attractive to employers because they can make larger contributions without risking the loss of their deduction.
3. Individuals Over Age 50 Can Make Elective Deferrals in Excess of Otherwise Applicable Limits.
Under pre-2001 law, the rules regarding elective salary deferrals applied to all employees regardless of age.
Under the 2001 Act, beginning in 2002, employees who have reached age 50 can make additional elective salary deferrals to employer-sponsored retirement plans. To be eligible, participants must have reached the age 50 before the close of the plan year, and are unable to make other elective deferrals because of other limitations.
The maximum amount of additional elective salary deferrals is the lesser of the “applicable dollar amount,” which is $1000 in 2002 (increasing by $1,000 annually until the applicable amount is $5,000 in 2006), and the excess of the participant’s compensation over any other deferrals for the year. The “applicable dollar amount” for a SIMPLE 401(k) plan and a SIMPLE IRA is $500 for 2002, increasing by $500 annually until the applicable amount is $2,500 in 2006. After 2006 the applicable amounts will be indexed for inflation in $500 increments.
The amount of additional elective deferrals is not affected by nor does it affect other contribution limits. Additional elective deferrals are not subject to the nondiscrimination rules, except that all eligible employees must be allowed to make additional elective deferrals.
Additional elective deferrals may not be made to government or Section 457 plans.
These changes will make it easier for older employees to save more as they near retirement.
4. Faster Vesting Schedule for Employer Matching Contributions
Under pre-2001 law, a qualified plan had to use one of the following vesting schedules: 100 percent vesting for employer contributions on the completion of five years of service, or 100 percent vesting on the completion of seven years of service, with 20 percent vesting after three years, and 20 percent additional annual vesting thereafter.
Under the 2001 Act, there is a faster vesting schedule for employer matching contributions. Beginning in 2002, the plan must provide for the vesting of these contributions at 100 percent on the completion of three years of service, or 100 percent vesting on the completion of six years of service, with 20 percent vesting after two years, and 20 percent additional annual vesting thereafter.
These changes should make 401(k) plans more attractive to employees, because they can accumulate greater retirement savings in a shorter period.
5. Additional Categories of Owner-Employees Will Be Exempt From Prohibited Transaction Rules on Plan Loans
Under pre-2001 law, loans from qualified plans to owner-employees were prohibited transactions. An “owner-employee” included a sole proprietor, a partner who owned more than 10 percent of either the capital interest or profits interest, an employee-officer of a subchapter S corporation who owned more than 5 percent of the stock, and the owner of an IRA. Family members of these persons were also subject to the prohibition.
Under the 2001 Act, beginning in 2002, “owner-employee” means only a participant or beneficiary of an IRA, and an employer or association of employees that establishes an IRA.
This change aligns the treatment of most “owner-employees.” For example, the sole shareholder of a C corporation was exempt from the prohibited transaction rule, but not a sole proprietor. This is no longer the case.
The 2001 Act contains many beneficial changes. Depending on the specific language of an employer’s plan, these changes can require amendments to the plan to implement the changes. Employers requiring an evaluation and amendment of their plans should contact any attorney in Gibbons’ Tax Department or Employment and Labor Law Department.