On June 7, 2001, the Economic Growth and Tax Relief Reconciliation Act of 2001 (“EGTRRA”) was signed into law. In general, changes made by EGTRRA increase the amounts that employers may contribute to 401(k) plans, ESOPs and other defined contribution plans. EGTRRA also speeds up vesting of matching contributions and simplifies the rules for “top-heavy” plans. The new provisions begin to go into effect in 2002, but many of the changes are phased in over several years. This issue of “We thought you should know…” presents some highlights of the new retirement plan rules, along with an illustration of the planning opportunities that EGTRRA offers and a chart that compares the previous rules with EGTRRA changes.

Increases in Benefit, Contribution and Deduction Limits

  • Annual Compensation. The maximum annual compensation of a participant that may be used to calculate contributions and benefits under a qualified retirement plan is increased to $200,000 from $170,000. This limit amount will be indexed for cost-of-living increases in $5,000 increments. Effective: Plan years beginning after 2001.
  • Individual Benefit and Contribution Limits. The dollar limit on “annual additions” to a participant’s account in a profit sharing, 401(k) or other defined contribution plan is increased from $35,000 to $40,000 in 2002. The alternative limit of 25% of compensation is increased to 100%. For defined benefit plans, the dollar limit on accruals will be $160,000 in 2002. Effective: Limitation years beginning after 2001.
  • Elective Deferrals. The annual limit on salary deferrals to a 401(k) plan is increased from the current limit of $10,500 to $11,000 in 2002. The limit will increase by $1,000 in each of the next four years, reaching $15,000 in 2006. This increase also applies to salary deferrals to tax-deferred annuity plans (403(b) plans) and government deferred compensation plans (457 plans). Effective: 2002.
  • Contribution Deduction Limits. The limit on an employer’s deduction for contributions to a profit sharing or stock bonus plan is increased from 15% to 25% of participants’ aggregate compensation. 401(k) deferrals are not counted for purposes of the deduction limits. However, 401(k) deferrals will be included for purposes of calculating the compensation on which this limit is based. The deduction limit for money purchase pension plans remains at 25%. Effective: Taxable years beginning after 2001.

401(k) Plans

  • Catch-up Contributions. Participants who are 50 and older may make catch-up deferral contributions of up to $1,000 in 2002, increasing by $1,000 per year to $5,000 in 2006 (or, if less, the amount of the participant’s annual compensation reduced by his or her other deferrals). These contributions do not count against the dollar limit on deferrals ($11,000 in 2002) and are not counted towards the limit on annual additions to a defined contribution plan. The regular limit on tax deductions for contributions to a defined contribution plan does not apply to catch-ups, nor does any limit on deferrals otherwise imposed by the terms of the plan. In addition, catch-up contributions are not taken into account in performing the annual 401(k) discrimination test (the “ADP test”). The catch-up rules also apply to 403(b) and 457 plans. Effective: Taxable years beginning after 2001.
  • Faster Vesting for Matching Contributions. Matching contributions are subject to more rapid vesting. These contributions must be 100% vested after three years (“three-year cliff vesting”) or must vest at a rate of at least 20% per year beginning after two years of service (“six-year graded vesting”). Effective: Plan years beginning after 2001.
  • Prohibition on “Multiple Use” Repealed. Plans may now rely on the “alternative limit” (lesser of 200% or 2 percentage points difference) in discrimination testing of contribution rates for both deferral contributions, and matching and after-tax contributions. Effective: 2002.
  • “Same Desk” Rule Repealed. If a company is acquired by or merged into another, the acquired company’s plan may now distribute benefits to participants who continue to work at the same job after the merger or acquisition. Effective: For distributions after 2001.
  • Hardship Rules Liberalized. 401(k) plans that provide for suspension of a participant’s deferrals after a hardship withdrawal may shorten the suspension period from 12 to six months. Effective: 2002.
  • Roth Contributions to 401(k) Plan. 401(k) plans may permit employees to make after-tax “Roth” contributions, which will be treated as salary deferrals. These contributions are included in taxable income when made. Neither the Roth contributions nor attributable earnings will be subject to tax in the year they are distributed. Effective: Taxable years beginning after 2005.

S Corporation Changes

  • Anti-abuse Rules for S Corporation ESOPs. An excise tax is imposed on an S corporation if share ownership through the ESOP is or becomes highly concentrated among one or more “disqualified persons” (and certain family members) who own shares in the corporation. If the provision is violated, an excise tax equal to 50% of the value of the shares allocated to, or the synthetic equity owned by, the disqualified person is imposed on the corporation. A disqualified person who receives a prohibited allocation is also taxed on the value of the shares allocated to his or her ESOP account. Effective: Generally, plan years ending on or after March 14, 2001. For an ESOP maintained by an S corporation before March 14, 2001, the new law is effective for plan years beginning after 2004.
  • Plan Loans for Owner-Employees. “Owner-employees” of an S corporation, a partner-ship or an unincorporated business may now receive loans from a plan on the same terms as other participants. Effective: January 1, 2002.

Rollovers and Portability

  • Rollover Options Expanded. Tax-deferred rollover treatment is now available for more types of distributions. Distributions from qualified retirement plans, 403(b) plans and 457 plans may be rolled into any of these plans or into an IRA. Distributions from a “contributory” IRA – that is, an IRA to which a taxpayer has made deductible contributions – may now be rolled over to a qualified plan, 403(b) plan or 457 plan. Additionally, after-tax contributions may be rolled over to an IRA or qualified plan or transferred to a qualified plan in a direct trustee-to-trustee transfer. Effective: Distributions after 2001.
  • Cash-out Rules. The portion of a participant’s account attributable to rollover contributions is not taken into account when determining the account balance for purposes of an involuntary cash-out. A plan may make a distribution without the participant’s consent if the account balance is $5,000 or less. Effective: Distributions after 2001.
  • Automatic Rollovers. For involuntary cash-outs of between $1,000 and $5,000, the plan sponsor must provide for an automatic rollover to an IRA, unless the participant makes a different election. Effective: Upon issuance of final IRS regulations.

Small Plans

  • Small Business Tax Credit. A tax credit for plan administrative and retirement education expenses is available to a “small employer” (an employer whose plan covers at least one non-highly compensated employee and who has 100 or fewer employees earning more than $5,000 each). The credit applies to 50% of the first $1,000 in expenses. Effective: For costs paid or incurred after 2001 for plans established after that year.
  • Determination Letter Fees. A small employer (as defined above) is not required to pay a user fee for a determination letter request, subject to certain time limits for the request. Effective: Requests made after 2001.

Miscellaneous Changes

  • Deduction for ESOP Dividend Reinvestment. An employer that maintains an ESOP may deduct dividends on the employer securities in a participant’s ESOP account if the participant is given the right to elect either to receive the dividends in cash or to reinvest the dividend in employer securities in the ESOP. Effective: Taxable years beginning after 2001.

Other Plan Changes

  • Top-Heavy Rules Liberalized. The rules used to determine whether a plan is top-heavy are simplified. (Top-heavy plans are those in which 60% or more of the assets are held for “key employees.”). A key employee is an employee who during the preceding year was (1) an officer with compensation in above $130,000 (indexed in $5,000 increments), (2) a five-percent owner, or (3) a one-percent owner with compensation above $150,000. Key employee status is determined based on the preceding year, rather than the preceding five years. In addition, matching contributions count toward the required 3% minimum top-heavy contribution. 401(k) plans that adopt the “safe harbor” plan design providing for minimum matching contributions are exempt from the top-heavy rules. Effective: 2002.
  • Notification of benefit reductions. Current rules requiring sponsors of pension plans to notify participants of amendments that reduce future benefit accruals in money purchase and defined benefit pension plans are changed and expanded. Notice of a reduction must be provided within a reasonable time before the effective date of the amendment (rather than the current 15 days). The penalty for failing to provide the notice is an excise tax of $100 per day, per individual, until the notice is provided. Effective: Amendments taking effect after June 7, 2001.

Plan Amendments and Determination Letters

On June 29, 2001, the IRS announced that plans must be amended by the end of the 2005 plan year to correct provisions that would cause the plan to be disqualified under EGTRRA. A plan sponsor that wishes to adopt permissive EGTRRA provisions – for example, the higher salary deferral limit – must adopt a “good faith EGTRRA amendment” before the end of the year in which the change is to be effective. To adopt the higher deferral limit as soon as possible, therefore, the sponsor of a calendar year plan must adopt a good faith amendment by December 31, 2002. The IRS will issue model good faith EGTRRA amendments before the end of August, 2001.

At present, the IRS will not consider EGTRRA when it issues determination letters. The passage of EGTRRA will have no effect on the deadline for adopting amendments to comply with GUST or filing amended plans for a favorable determination letter.

As illustrated by the attached example, EGTRRA offers employers the opportunity to make changes in their plans that will be helpful to employees and financially beneficial to employers. If you would like to discuss the EGTRRA provisions in more detail or to analyze the impact of EGTRRA on your plan, please don’t hesitate to contact us.

July, 2001