lients may be asking about the new “catch-up” pension and IRA contributions allowed under the latest tax act. CPAs should be aware of these new provisions to educate themselves and instruct clients properly.
Many employers offer plans in which workers set aside some of their salary for retirement. A “salary reduction” arrangement allows an employee to elect to have the employer pay a portion of salary to an employee plan. These “elective deferrals” are excludable from the employee’s income if certain requirements are met.
The maximum annual elective deferral per individual in 2001 in a qualified cash or deferred arrangement (CODA) (IRC section 401(k)), tax-sheltered annuity (section 403(b)) or simplified employee pension (SEP) plan (section 408(k)) is $10,500 (indexed annually for inflation). The 2001 maximum for a savings incentive match plan for employees (SIMPLE) (section 408(p)) is $6,500 (indexed annually for inflation).
Employees of a state (including a political subdivision, agency or instrumentality) or a tax-exempt organization are not deemed to have constructively received compensation deferred under an eligible deferred compensation plan (section 457(a)). For these employees, the 2001 deferral limit is the lesser of $8,500 or 33 1/3% of compensation. Under a special catch-up rule, a section 457 plan can provide that, for one or more of the participant’s last three years before retirement, the otherwise applicable limit is increased to the lesser of (1) $15,000 or (2) the sum of the otherwise applicable limit for the year, plus the amount by which the limit in prior participation years exceeded deferrals for that year.
The Economic Growth and Tax Relief Reconciliation Act of 2001 ( EGTRRA ) added section 414(v), raising—for individuals at least age 50 before the end of the plan year—the limits on elective deferrals for section 401(k) qualified CODA plans, 403(b) tax-sheltered annuities, 408(k) SEPs, 408(p) SIMPLEs and 457 state or local government plans.
This provision is particularly intended to aid women nearing retirement age who may be behind in saving for retirement due to career interruptions.
Under the new law, the additional amount of elective contributions is the lesser of the (1) “applicable dollar amount” or (2) participant’s compensation for the year, reduced by any other elective deferrals for the year.
The “applicable dollar amount” varies, depending on plan type:
For plans other than SIMPLE plans under sections 401(k)(11) or 408(p), the applicable dollar amount is $1,000 for 2002, $2,000 for 2003, $3,000 for 2004, $4,000 for 2005 and $5,000 for 2006 and thereafter.
For section 401(k)(11) or 408(p) SIMPLE plans, the applicable dollar amount is $500 for 2002, $1,000 for 2003, $1,500 for 2004, and $2,000 for 2005. This amount rises to $2,500 for 2006 and thereafter.
Both the $5,000 and $2,500 amounts applicable starting in 2006 will be indexed for inflation starting in 2007 and continue thereafter.
Only “eligible participants” can make these additional contributions, defined as participants who have attained age 50 before the close of the plan year and for whom no other elective deferrals may be made to the plan for the year because of any limit or restriction in section 414(v)(3) (for example, the annual limit on elective deferrals) or any comparable plan limit or restriction.
Example 1. D is 53 and participates in a section 401(k) plan; her compensation will be $42,000 in 2003. In the absence of the new law, D’s maximum annual deferral limit for 2003 would be $12,600. Under the plan terms, her maximum annual deferral limit is 10% of compensation ($4,200). However, under the EGTRRA , D can make an additional $2,000 contribution. Thus, D can contribute up to $6,200 for 2003 ($4,200 under the plan, plus a $2,000 catch-up contribution).
Example 2. In 2006, J is a 60-year-old highly compensated employee who participates in a section 401(k) plan. In the absence of the new law, his maximum annual deferral limit would be $15,000. After application of the special nondiscrimination rules applicable to section 401(k) plans, the maximum annual deferral that J can make for 2006 will be $8,000. However, under the catch-up provision, J can make an additional $5,000 contribution.
For a section 457 plan, the catch-up rule does not apply to a participant’s last three years before retirement. In those years, the applicable dollar limit is doubled (as provided in section 457(b)(3)).
Catch-up contributions are not subject to, and are not taken into account in applying, any contribution limits to other plan contributions or benefits.
An employer will not fail the section 401(a)(4) nondiscrimination rules if the plan allows all eligible plan participants to elect catch-up contributions. However, for this purpose, all plans maintained by related employers will be treated as one plan if the employers are treated as a single employer for purposes of (1) section 414(b) (corporate members of a controlled group), (2) section 414(c) (trades or businesses under common control), (3) section 414(m) (affiliated service groups) or (4) section 414(o) (regulations preventing the avoidance of any employee benefit requirement dealing with separate organizations, employee leasing or other arrangements); see new section 414(v)(4).
According to the EGTRRA Conference Report, an employer can match catch-up contributions. Any such matching contributions are subject to the usual rules.
The new law also provides “catch-up” provisions for clients otherwise eligible to contribute to a traditional and/or Roth IRA. Under section 219(b)(5)(B), the contribution limit for taxpayers age 50 and over at the end of the tax year will be $3,500 for 2002–2004, $4,500 for 2005, $5,000 for 2006 and 2007 and $6,000 for 2008 and thereafter.
Under EGTRRA Section 631(b), the new provisions apply to contributions in tax years beginning after 2001. All EGTRRA provisions, unless extended, cease to apply to tax years beginning after 2010.
The new provisions are good news indeed for employees—if covered by an employee plan or if they contribute to an IRA—who will be at least age 50 by the end of 2002.
—Lesli S. Laffie, JD, LLM