Email to a Friend

New Tax Legislation Affecting Pension Plans
May 2001

The Economic Growth and Tax Relief Reconciliation Act of 2001 passed both houses of Congress on May 26, 2001, and is expected to be signed by the President by June 5, 2001. This memorandum summarizes many of the significant changes under the new law that apply to 401(k) and other pension plans. Note that the changes cease to be effective after 2010 unless extended by Congress.

1. Increased Retirement Plan Dollar Limits Beginning in 2002. The new law increases the following annual plan limits:

(a) The elective deferral limit for 401(k) plans, 403(b) plans, and 457 plans is increased to $11,000 in calendar year 2002, $12,000 in 2003, $13,000 in 2004, $14,000 in 2005, and $15,000 in 2006, with cost-of-living increases in $500 multiples thereafter;

(b) The dollar limit under IRC §415 on annual additions under defined contribution plans is increased from $35,000 to $40,000 for plan years beginning after 2001, with cost-of-living increases in $1,000 multiples thereafter;

(c) The dollar limit under IRC §415 on the annual benefit payable under defined benefit plans is increased from $140,000 to $160,000 for plan years ending after 2001, with cost-of-living increases in $5,000 multiples thereafter;

(d) The plan compensation dollar limit is increased from $170,000 to $200,000 for plan years beginning after 2001, with cost-of-living increases in $5,000 multiples thereafter; and

(e) The elective deferral limit for SIMPLE-IRAs and SIMPLE 401(k) plans is $7,000 for calendar year 2002, $8,000 for 2003, $9,000 for 2004, and $10,000 for 2005, with cost-of-living adjustments in $300 multiples thereafter.

(f) Also, individuals who are eligible under a tax-exempt employer's 457 plan do not have to coordinate the contribution limit under the 457 plan with the contribution limit under IRC §402(g) (pertaining to elective deferrals under 401(k) and 403(b) plans), starting in calendar year 2002.

2. Increased Plan Deduction Limits for Employers Beginning in 2002. Deduction limits for profit sharing plans and stock bonus plans are significantly increased through a combination of three changes for tax years beginning after 2001:

(a) The 15% limit under IRC §404(a)(3) is increased to 25% of total participant compensation;

(b) 401(k) deferrals are separately deductible without regard to the 25% limit and do not count against the 25% limit applicable to employer contributions (e.g., matching contributions, nonelective contributions); and

(c) Participant compensation used to calculate the 25% limit described in (a) is based on IRC §415 compensation, which means it is "grossed up" for salary reduction contributions made by participants under 401(k) plans, cafeteria plans, etc.

3. Catch-up Contributions for Individuals Age 50 and Older Starting in 2002. Starting in the year in which an individual reaches age 50, a plan may allow the individual to make an annual "catch-up" contribution. The change is effective starting in 2002. The catch-up contribution may be provided under a qualified 401(k) plan, a 403(b) plan, a 457 plan maintained by a governmental entity, a SIMPLE-IRA plan or a SIMPLE-401(k) plan. The maximum catch-up contribution for qualified plans, 403(b) plans, and 457 plans is $1,000 in 2002, $2,000 in 2003, $3,000 in 2004, $4,000 in 2005, and $5,000 in 2006. The maximum catch-up contributions for SIMPLE-IRAs and SIMPLE-401(k) plans is $500 in 2002, $1,000 in 2003, $1,500 in 2004, $2,000 in 2005, and $2,500 in 206. The 2006 limit is subject to cost-of-living adjustments in $500 multiples starting in 2007. The catch-up contribution does not count against the IRC §402(g) limit (pertaining to maximum salary reduction contribution deferrals under 401(k) and 403(b) plans), the IRC §415 limit (as increased by the provisions of the new law), the IRC §457(b) limit, the SIMPLE limits under IRC §408(p) and IRC §401(k)(11), the SEP limits under IRC §402(h), the deduction limit under IRC §404, nor the plan's limit on elective deferrals (e.g., if a 401(k) plan's normal limit on elective deferrals is 10% of compensation, the catch-up contribution would be in addition to the maximum deferrals permitted under the plan's normal limit). Catch-up contributions will not cause a plan to fail the ADP and ACP tests under 401(k) plans, the IRC §401(a)(4) nondiscrimination test on the amount of contributions or benefits provided by the employer, or the coverage tests under IRC §410(b).

4. Increase in of 25% Annual Additions Limit for Defined Contribution Plans; and Elimination of Maximum Exclusion Allowance for 403(b) Plans Starting in 2002. The new law increases the annual additions limit under IRC §415(c)(1)(A) from 25% to 100% of compensation. Thus, for plan limitation years beginning after 2001, the annual additions limit is 100% of compensation for participants who earn less than $40,000, and the limit is $40,000 for participants who earn $40,000 or more. Corresponding amendments are made to 403(b) plan limits and 457 plan limits. For 403(b) plans, the maximum exclusion allowance under IRC §403(b)(2) is repealed, effective January 1, 2002, substituting the IRC §415 limit. For 457 plans, the 33-1/3% limit under prior law is replaced by a 100% of compensation limit, to coordinate with the IRC §415 limit that is applicable to qualified plans and 403(b) plans.

5. Higher Benefit Limits for Early Retirement. Under the new law, the dollar limit under IRC §415(b)(1)(A) pertaining to defined benefit plans is not reduced for early retirement in the case of benefits that commence at or after age 62. This change is effective starting in limitation years that end in 2002 or later. A reduction to the dollar limit will apply only to benefit commencement before age 62 (rather than before social security retirement age as under prior law) and the increase in the dollar limit will apply to benefit commencement after age 65 (rather than after social security retirement age). As a result, higher benefits will be available for those retiring in their 50s and 60s.

6. Portability of Benefits. Starting in 2002, the new law significantly expands the portability of benefits:

(a) Distributions from qualified plans, 403(b) plans, and governmental 457 plans may be rolled into any of such plans, or into IRAs (e.g., a qualified plan distribution could be rolled over into a 403(b) custodial account, or vice versa); and

(b) Pre-tax distributions from IRAs (i.e., distributions from traditional IRAs that are not treated as a return of basis under the IRC §72 rules) are eligible for rollover into qualified plans, 403(b) plans, or 457 plans.

7. Automatic Rollovers for Involuntary Distributions. If a plan makes an involuntary distribution of more than $1,000, and the employee does not affirmatively elect to receive cash or to make a direct rollover, the default method of payment must be a direct rollover to an IRA. The Secretary of Labor must issue regulations that will prescribe safe harbors with respect to investments in the default IRA. This default rollover rule does not take effect until the Secretary of Labor issues those regulations.

8. Changes to Top Heavy Rules in 2002. The new law makes some significant changes to the top heavy rules for plan years beginning in 2002 or later:

(a) Matching contributions will count toward satisfying the employer's top heavy minimum contribution liability even if also counted in the ACP nondiscrimination test;

(b) The 5-year testing period for determining key employees is modified to a 1-year testing period (i.e., the data for the four prior years are irrelevant);

(c) The compensation requirement for the officer test (pertaining to the identification of key employees) is increased to $130,000 (subject to cost-of-living adjustments) in $5,000 multiples, starting in 2003;

(d) The top ten owner test is eliminated from the definition of key employee;

(e) A1-year lookback, rather than a 5-year lookback, applies for adding back distributions made after a separation from service or termination of the plan, when determining whether a plan is top-heavy;

(f) Safe harbor 401(k) plans that offer a matching contribution that satisfies the requirements of IRC §401(m)(11) are exempt from the top-heavy rules; and

(g) Top-heavy minimum accruals are not required under a defined benefit plan for any plan year that the plan is frozen.

9. Multiple Use Test Repealed in 2002. The special "multiple use" test applicable to 401(k) plans is repealed for plan years beginning in 2002 and later. Due to this repeal, the full 2% disparity level may be used in both the ADP test and the ACP test.

10. Faster Vesting for Matching Contributions Under Non-Top-Heavy Plans Beginning in 2002. A plan that is not top-heavy must apply a vesting schedule that is at least as favorable as the top-heavy vesting schedules for matching contributions that are made in plan years that begin in 2002 or later. The top-heavy schedules require 100% vesting after a participant has three years of service (known as "3-year cliff vesting") or 100% vesting after six years of service, provided that the participant's vesting percentage is no less than 20% after two years of service, 40% after three years of service, 60% after four years of service, and 80% after five years of service ("6-year graded vesting").

11. Plan Loan Rules. The new law eliminates the current prohibition on making plan loans to owners of an unincorporated employer (e.g., sole proprietorship, partnership, LLC or S corporation) for plan years beginning after 2001.

12. Tax Credits for Certain Voluntary Contributions and Plan-Related Expenses Beginning in 2002. The new law adds new nonrefundable tax credits for certain contributions and plan-related expenses. New IRC §25B allows individuals who meet certain adjusted gross income (AGI) limits to claim a partial income tax credit for their salary reduction contributions. These limits generally are $50,000 of AGI if married, filing jointly, and $25,000 of AGI if single. The credit may pertain to 401(k) contributions, 403(b) contributions, 457(b) contributions (if the employer is a government), and voluntary after-tax employee contributions. The maximum amount of contributions eligible for the credit is $2,000 per year, and the credit equals a specified percentage (ranging from 10% to 50%) of such contributions, based on the individual's AGI. The credit is first available for contributions made in 2002. The new law also adds IRC §45E, which allows a small employer a credit of up to 50% of "qualified start up costs." Start up costs include expenses incurred in the establishment or administration of the plan, and expenses attributable to retirement-related education of the employer's employees. The plan must cover at least one person who is not a highly compensated employee. The provision is designed to promote the establishment of plans by small employers (generally 100 or fewer employees in prior year with compensation of $5,000 or more). The credit is available only for the first three years of the plan's existence, and any amount which the employer claims as a credit is not deductible.

13. Roth 401(k) or 403(b) Option Starting in 2006. The new law permits a 401(k) plan or 403(b) plan to allow a participant to designate all or part of his future elective deferrals as a Roth contribution beginning in 2006. An elective deferral that is designated as a Roth contribution would not be excludable from gross income when contributed. Separate accounting for the Roth contributions (and attributable earnings) would have to be maintained. Qualified distributions from Roth accounts would be tax-free, like qualified distributions from Roth IRAs.

14. Hardship Withdrawals. Treasury regulations currently require a 401(k) plan to suspend a participant's right to make elective deferrals or after-tax employee contributions for a period of one year following a hardship withdrawal if the plan is subject to the "safe harbor" hardship rules. The new law requires the Treasury to reduce the mandatory suspension period to six months for hardship withdrawals that occur after December 31, 2001. Also, prior law treats a hardship withdrawal of 401(k) contributions as ineligible for rollover, so that the mandatory withholding rule does not apply to such withdrawals. The new law applies this treatment to all hardship withdrawals, not just to those attributable to 401(k) contributions. This eliminates the need for the plan administrator to determine what portion of the hardship withdrawal is attributable to 401(k) contributions in order to administer the rollover and withholding rules.

15. "Same Desk" Rule Eliminated for 401(k) Plans Beginning in 2002. The reference to "separation from service" is replaced by "severance from employment" in IRC §401(k)(2), thereby eliminating the "same desk" rule problem in business acquisitions for distributions made after 2001. So long as the buyer is not maintaining the seller's plan with respect to the transferred employees, post 2001 distribution from the seller's 401(k) plan or 403(b) will be permitted to the transferred employees.

16. Provisions Encouraging Funding of Defined Benefit Plans. The new law repeals the current liability funding limit under IRC §412(c)(7) for plan years beginning in 2004 and later, with an increase in the funding limit for 2002 and 2003 before the limit is fully repealed. The new law also allows employers to make fully deductible contributions equal to the unfunded current liability, without regard to whether the plan has 100 or more participants, but if the plan has 100 or fewer participants, the liability attributable to benefit increases for highly compensated employees within the last 2 years is disregarded to compute the special deduction limit. When a defined benefit plan is terminated, the amount needed to make the plan sufficient for benefit liabilities is substituted for unfunded current liability to determine the deduction limit for the employer.

17. Modifications to ERISA 204(h) Notice Requirements. Under current law, ERISA §204(h) requires an employer to provide 15 days advance notice to participants when a defined benefit or money purchase pension plan is amended to substantially reduce the future rate of benefit accrual. The new law amends ERISA §204(h) to prescribe more specific notice requirements, to change the 15-day notice rule to a "reasonable period" before the effective date of the amendment, and to allow the notice to be provided before the amendment is actually adopted by the employer. Failure to provide the notice no longer results in a continuation of the pre-amendment formula, except under "egregious failures." Instead, violation of the 15-day advance notice requirement results in an excise tax of $100 per day per individual who has not received the notice. There are waivers of the excise tax for certain failures where the employer has exercised "reasonable diligence." These modifications apply to amendments that take effect after the date of enactment of the new law, although the period for providing the notice will not end earlier than 3 months after the enactment date.

18. Restrictions on S Corporation ESOPs. The new law prohibits, and imposes excise taxes on, allocations (both within and outside the ESOP) of employer securities to certain "disqualified persons" who are participants in an ESOP maintained by an S corporation. The effective date of these restrictions for S corporation ESOPs in existence on March 14, 2001, is the first plan year beginning after 2004. For an S corporation ESOP established after March 14, 2001, the effective date is plan years ending after March 14, 2001. In addition, if a corporation that maintained an ESOP as of March 14, 2001, was not an S corporation on that date, the nonallocation rules become effective as of the first plan year ending March 14, 2001, so that any change to an S corporation after March 14, 2001, immediately subjects the plan to the nonallocation rules.