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June 2001

Highlights of the Qualified Retirment Plan Provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001 (the 'Act')

By J. Michael Bermensolo, Sheldon M. Geller, Walter Pettus, Geller Group Ltd

The Act makes extensive changes to the rules relating to qualified retirement plans, most of which take effect in 2002. Plan sponsors need to review the new provisions including increased contribution and benefits limits, 401(k) elective deferral limits, deductibility limits and compensation limits.

I. Contribution and Benefit Limits

401(k) Contribution Dollar Limit will be increased from $10,500 to $15,000, beginning with a $500 increase to $11,000 in 2002. The limit increases $1,000 for each of the next four years, to $15,000 in 2006.
Defined Contribution Annual Addition Limit will be increased from $35,000 in 2001 to the lesser of $40,000 or 100% of compensation, effective in 2002. The annual addition dollar limit (generally employer and employee contributions and forfeitures) was $30,000 in 2000. Defined contribution plans include 401(k) and profit sharing plans.
Defined Benefit Annual Limit will be increased from $140,000 to $160,000 for limitation years ending after December 31, 2001, and the dollar limit need only be actuarily reduced for benefits commencing before age 62 (rather than the Social Security retirement age).
Compensation Limit will be increased from $170,000 to $200,000, effective in 2002.
"Catch-up" Contributions may 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 non-discrimination test.
Profit Sharing/401(k) Plan Deduction Limit for employer contributions increases from 15% of compensation to 25% of compensation, effective for tax years beginning after December 31, 2001.
Employee 401(k) Elective Deferrals will be deductible in addition to the employer contribution 25% deduction limit, effective for tax years beginning after December 31, 2001.
Compensation for deduction purposes will no longer be reduced for employee elective deferrals made to a 401(k) plan or to a cafeteria plan, effective for tax yeas beginning after December 31, 2001.
IRA Accounts Under Defined Contribution Plans, effective in 2003, permit participants to make IRA contributions to a separate account maintained under a qualified plan.
Individual Retirement Account Contribution Limits for deductible IRA contributions will increase to $3,000 per year for 2002-2004, $4,000 for 2005-2007 and $5,000 for 2008.

II. 401(k) Plans

Multiple Use Test applicable to 401(k) plans with matching employer contributions is repealed, effective in 2002.
"Same Desk Rule" is repealed and replaced with a "severance from employment" standard, effective in 2002.
The Hardship Distribution IRS Safe Harbor will 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 are now permissible for owner-employees ("S" corporation shareholders, partners, LLC members and sole proprietors), effective in 2002.
Roth "IRAs" Under 401(k) Plans may permit participants to elect a tax treatment providing for after-tax contributions and tax-free distributions, effective in 2006.
A Tax Credit for low income savers of up to $1,000 of contributions to 401(k) plans, in addition to the tax deduction, effective in 2002.

III. Top Heavy Plans

Key Employee status will be based on the determination year without regard to the four year look-back period applicable under present law.
"Officer" category of "Key Employee" will require minimum compensation of $130,000 (rather than the current $70,000) and the top 10 owner rule will be repealed.
Add-Back of Distributions made within five years of the determination date will be shortened to a one year add-back (except for in-service distributions).
401(k) Safe Harbor Plans, which consist solely of contributions which satisfy the design-based safe harbors for matching and/or non-elective 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 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.

IV. Rollover and Direct Transfers

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.
Pre-Tax and Post-Tax IRA Distributions are eligible for rollover into qualified plans.
After-tax 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 non-forfeitable accrued benefit equals or exceeds $5,000.
Involuntary Cash-Outs that exceed $1,000 and are eligible rollover distributions must be rolled over to an employer-designated IRA, unless the participant affirmatively elects cash or a different recipient for a direct transfer.

V. 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 determination letter applications submitted after December 31, 2000.
A Tax Credit equal to 50% of the administrative and retirement education expenses incurred in connection with a new plan of the first $1,000 for each of the first three plan years, for expenses paid or incurred in tax years beginning after December 31, 2001 for plans established after that date for small plan sponsors (i.e., 100 or fewer employees who had compensation in excess of $5,000 in the proceeding year).

VI. Compliance

The IRS will provide an extended amendment period for plan sponsors to amend their plans to comply with the Act. It appears that amendments to comply with the Act will not need to be adopted before the last day of the 2004 plan year. The delayed amendment date is conditioned upon the amendments being retroactively effective when adopted and in the interim, the plan is being operated in accordance with the new law.
The Act does not affect compliance with the changes in qualification made by "GUST", requiring 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). GUST includes 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.
All changes made by the Act will not apply to taxable, plan or limitation years beginning after December 31, 2010. Nevertheless, it appears that Congress will preserve many of the positive changes made by the Act.

VII. Observations

The IRA feature for eligible retirement plans would make it convenient for employees to save for retirement by making IRA contributions to their employer's qualified retirement plans directly from payroll.
An employer's need for a non-qualified plan is diminished as a result of the increased limits for compensation, contributions and benefits under qualified retirement plans.
Plan loans to sole proprietors, partners, LLC members and "S" corporation shareholders will be permissible, in the same manner as plan loans to participants who are not owner-employees.
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 to profit sharing plans will also apply to money purchase pension plans (including target benefit plans), effective in 2002. The amount of deductible employer contributions to money purchase pension plans (including target benefit plans) will be subject to not only the 25% of compensation limit, but also the amount needed to fund the plan's contribution formula (i.e., the minimum funding cost).
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. That is, the plan sponsor will not have to contribute for non-key employees who do not make 401(k) elective deferrals. This does not mean that an accompanying profit sharing contribution automatically satisfies the top-heavy rules, although the matching contributions will count toward otherwise satisfying the minimum contribution.
A rollover of after-tax contributions from a qualified plan to another qualified plan must be effected by a direct transfer.
An individual will be able to rollover amounts distributed from an IRA into an eligible retirement plan, even if the amounts in the IRA are not all attributable to contributions from a "conduit IRA".
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 also applies in determining benefits under qualified plans (in addition to applying 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, and the limit would have to be decreased because benefits were commencing before age 65. However, by delaying the receipt of benefits until 2002, the benefit limitation would increase to $160,000 and this limit would not decrease due to benefits commencing before age 65.
The provision providing for faster vesting applies only to employer matching contribution accounts and not to other employer contribution accounts. The minimum vesting schedules are shortened from a five year cliff to a three year cliff schedule, and from a seven year graded to a six year graded schedule. All other employer contribution accounts continue to be subject to the current alternative minimum vesting schedules (i.e., five year cliff and the seven year graded schedules).
Employers do not need to limit employee elective deferral contributions as a means of preventing loss of deductibility for any part of the employer contribution amount. For purposes of determining the amount of an employer's deduction for contributions, 401(k) elective deferrals are no longer deemed employer contributions and therefore are not subject to the employer deduction limit.
The special rule allowing for a deduction for amounts contributed up to 100% of a defined benefit plan's unfunded current liability should provide more plan sponsors with incentives 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). Small employers with no more than 100 employees receive this tax credit in each of the first three plan years for new plans. Plan sponsors need to claim deductions for the 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, including the other 50% of the first $1,000 in expenses for purposes of determining the credit.

Please feel free to telephone Michael Bermensolo, Walter Pettus or Sheldon Geller of our firm to discuss the extent to which these new provisions may affect your plan design. Many plan sponsors will want to take advantage of the increased qualified plan dollar limits and percentage figures to enhance their retirement plan programs. This memorandum is intended to provide accurate and authoritative information, but it does not constitute tax, legal, accounting or other professional advice.