Big Changes, Big Benefits

EXECUTIVE SUMMARY

THE ECONOMIC GROWTH AND TAX RELIEF RECONCILIATION Act made significant changes to pension and retirement planning. Maximum contributions to 401(k) plans jumped to $11,000 for 2002 and will increase $1,000 per year until 2006. Similar increases apply to 403(b) and 457 plans as well as SAR-SEPs. IRA contributions—both regular and Roth—increased to $3,000 and will rise to $5,000 by 2008. RETIREMENT PLANS ACROSS THE BOARD NOW ARE MORE portable. Investors can roll over most types of employer-sponsored plans into another plan or an IRA or roll over an IRA into an employer-sponsored qualified plan—if the plan permits such a move. Rollover extensions also now will be available under certain circumstances. COMPANIES NOW CAN CONTRIBUTE UP TO 25% of payroll to profit sharing, up from 15%. Retirement benefits for highly compensated employees in defined benefit plans increase to $160,000 payable as early as age 62, and will be indexed for inflation. 401(k) providers now are required to vest matching contributions faster, using one of two methods. CONGRESS MODIFIED THE TOP-HEAVY RULES THAT WERE onerous for many small companies. The act modifies the definition of key employee, narrowing the number of workers who will fall under it. Unless an executive owns 5% of the business, he or she now has to make at least $130,000 to be considered a key employee. BEGINNING THIS YEAR, EMPLOYEES WHO ARE 50 YEARS or older can make an additional $1,000 contribution to their 401(k), 403(b), SAR-SEP or 457 plan. This amount increases to $5,000 by 2006. These same workers will be able to contribute $500 extra to an IRA in 2002 as well, with another $500 increase in 2005.

GEORGE TAYLOR, EA, is chief pension consultant with ARIS Corp. of America, headquartered in State College, Pennsylvania. He also is past president of the American Society of Pension Actuaries and has served for many years on its government affairs committee. His e-mail address is georgt@uplink.net .

PAs who help clients with pension planning, take notice: Sweeping changes in the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) have transformed this discipline. Fortunately, most of the changes are beneficial. For instance, 401(k) participants now can contribute more money and plan participants can move money more freely between plans. Future benefits and contributions will be calculated more liberally. In addition, to encourage small businesses to offer retirement plans, increased benefits now are available to the company’s principals and officers.

The 2001 Economic Growth and Tax Relief
Reconciliation Act’s provisions give
employees more opportunities to save.

Nonetheless, despite the overall positive nature of the changes, the act still poses some pitfalls for the unwary. Many business and individual clients may need to adopt different strategies to get the most benefit from the new regulations and avoid the traps. (Of course, any pension planning CPAs do is complicated by the fact that, at least in theory, all of EGTRRA’s provisions will sunset in 2011. But in the meantime, due diligence requires amending and rewording client plans.) This article outlines some of EGTRRA’s key pension reforms. Although much of the law is easy to understand, with clear dictates for best practice, the author has included “CPA alerts” when extra care is required.

GOOD NEWS FOR THE RANK AND FILE

EGTRRA’s provisions give employees across the board more opportunities to save. Here are some of the important changes that can help to add more cash to the retirement pot.

Increased elective pension deferrals. Employees now can salt away more cash. Pretax contributions to 401(k) plans, previously limited to $10,500 annually, increased to $11,000 for 2002 and will increase $1,000 per year until 2006, when they reach $15,000—an increase of more than 40%. For the next five years until (or if) the act sunsets, the contribution ceiling will be indexed for inflation in $500 increments.

Similar increases apply to 403(b) plans offered to teachers and employees of nonprofits; 457 plans, found mostly in state and local governments; and SAR-SEPs, a salary-reduction type of Simplified Employee Pension.

With increased contribution limits to Simple IRAs, small business employees also will have a chance to contribute more to their retirement plans. Many such businesses use these plans because of their significantly reduced administrative requirements and fees. Previously, $6,000 was the most these employees could set aside on a pretax basis. Under the new law, the limit jumped to $7,000 in 2002 and will increase by $1,000 a year until 2005 when it tops out at $10,000. Thereafter, the contribution limit may rise, based on inflation, in $500 increments.

In addition Congress added special provisions to help lower-income savers. (Previously, there was no tax credit for investors in low-income brackets.) Those eligible must make $50,000 or less if married, or $25,000 or less if single. The lower an individual’s income, the higher the credit. For instance, taxpayers who file a joint tax return, with an adjustable gross income of less than $30,000, are eligible for a nonrefundable tax credit of 50% on up to $2,000 of contributions to an IRA, 401(k), 403(b), Simple, SEP or 457 plan. Joint filers with an AGI of between $30,000 and $32,500 can receive a 20% credit; those in the $32,500 to $50,000 range are eligible for a 10% credit. CPAs should keep in mind, however, this provision is in place only from 2002 to 2006. The income threshold for single filers is half that for joint filers.

Easier rollovers. Under prior law, employees had a difficult time moving money from one type of retirement savings plan to another, causing havoc for job switchers. Individuals who moved from the private to the public sector were unable to transfer their assets from a 401(k) plan to a 403(b) plan. Government workers who invested in 457 plans were in an even tighter bind because, by law, these investments could be rolled over only into another 457 plan—not even an IRA would suffice.

Fortunately, plan assets across the board are now much more portable. Investors can roll over most types of employer-sponsored plans into another plan or an IRA, or roll over an IRA into a qualified plan, if their employer’s plan permits such a move. In addition individuals generally will be able to move aftertax contributions from their pension plan into a traditional IRA. As a final boon, those who fail to roll over their funds within the prescribed 60-day period now may ask the IRS for an extension if their failure to comply is due to a disaster, casualty or other event that reasonably can be deemed to be beyond the taxpayer’s control.

Effective in 2003, the new law facilitates IRA contributions as “add-ons.” In other words, companies can amend their retirement plans to allow employees to make IRA contributions to their employer-sponsored plan. This has two potential benefits: Qualified plans usually have a smaller investment charge and, sometimes, no charge at all to the employee. (Why should anyone pay a bank to administer an IRA when an employer will do it for free?) Second, most employers offer a larger range of investments through their qualified plans than banks are able to offer through an individual IRA.

Roth pensions at work. CPAs already know the advantages of Roth IRAs—assets accrue and can be withdrawn tax-free. Starting in 2006 employees of participating employers will be able to invest in what amounts to a Roth 401(k) or a Roth 403(b). This will allow employees the best of both worlds: Although they won’t get tax breaks on the money they contribute, the funds will grow and can be withdrawn tax-free and also are eligible for employer matching contributions. If an employee retires or changes jobs, he or she can roll over these funds into a Roth IRA.
Under current law, individuals who earn more than $100,000 are ineligible to contribute to a Roth IRA. With the passage of EGTRRA, this compensation limit for Roth contributions to a qualified plan would appear not to apply. Thus it seems even those who earn over $100,000 can make such contributions.

EMPLOYER CHANGES

In addition to increased employee contribution levels, there are also changes on the employer level. Most important, employers now can be more generous. Companies can contribute up to 25% of payroll to profit-sharing plans, up from 15% before 2002.

In defined benefit plans, there is a substantial increase in the retirement benefits available to highly compensated employees. The previous limit of $135,000 increased to $160,000. In addition, starting in 2002, the limit will be indexed for inflation in $5,000 increments (rounded down to the nearest $5,000). Equally important, the reduction for benefits that start before Social Security retirement age has been eliminated for those over 62, providing significant increases in both benefits and deductible contributions for companies with defined benefit plans. In most circumstances, this provision will not produce cost increases for rank and file employees.

Faster employer vesting. As of January 2002 pension plan providers were required to vest matching contributions more quickly, choosing from one of two schedules. In the first, workers simply will become fully vested in three years instead of five. Under the second, workers are vested in 20% increments, starting with the second year of service, until the employee is fully vested after six years of service.

BIG CHANGES FOR OWNERS AND MANAGERS

One key change could provide bigger payouts for executives in both tax-favored defined benefit and defined contribution plans. Congress lifted some of the stringent limits that prevented effective funding of large pensions for certain individuals. For instance those earning over $170,000 previously were unable to fully benefit from their company’s pension plan since only the first $170,000 of compensation could be considered in computing benefits and contributions. Beginning in 2002, incomes up to $200,000 qualified. The rise in eligible salary will grow in tandem with increases in the consumer price index—in $5,000 annual increments (rounded down to the nearest $5,000).

This is also good news for Fortune 500 executives. Across corporate America, many companies have set up nonqualified plans for higher-paid executives whose full salaries were ineligible for funding through companywide qualified plans. Unlike qualified plans, nonqualified plans cannot be advance-funded or insured.

Increased pretax contributions. Under prior law, an individual’s 401(k), 403(b) or Keogh contributions, plus the employer match and other pretax benefits such as profit sharing, could not total more than 25% of his or her compensation or $35,000—whichever was lower. Now, the maximum is the lesser of $40,000 or 100% of pay. (Catch-up contributions do not count toward these limits.) Further increases, triggered by inflation adjustments in the consumer price index, may occur until the act sunsets in 2011. While an inflation-adjustment had been in place before, changes in how increases are calculated (including a larger increment rate of $1,000 and a clause allowing increments to be cumulative) now will permit maximum contribution limits to rise faster. The IRS has issued model amendments that will allow employers to easily adopt this and other EGTRRA changes. These amendments normally have to be adopted before December 31, 2002. For some standard prototype plans, it already is too late for an employer to adopt these amendments for 2002.

Modified “top-heavy” rules. The top-heavy pension rules, originally put in place to protect the pensions of lower-level employees at companies with qualified plans, have long been problematic for small businesses. The rules adversely affected thousands of smaller plans that, according to the old definition, were top heavy if more than 60% of plan assets were held on behalf of key employee s—a term that was defined broadly. Businesses were forced to meet a special vesting schedule and make minimum contributions to all non-key employees.

To rectify this situation, Congress modified the definition of a key employee—a move that will narrow the number of workers who come under the definition. Unless they own 5% of the business, executives now must make at least $130,000 to be considered key employees. In addition, Congress eliminated the five-year, look-back rule. Now, deciding who is a key employee is based on distribution records going back only one year. Further, matching contributions now count toward satisfying top-heavy minimums if an employer amends its plan properly. If the only contributions the employee makes to the plan are matching ones and those contributions satisfy the safe-harbor rules, the plan will be deemed to have met the minimum top-heavy benefit requirements.

Borrowing from pension funds. In a major victory for Main Street, sole proprietors, partners and S corporation shareholders now are permitted to take loans from their company’s pension plan. This provision also applies to already outstanding loans. In the past, many business owners borrowed from their plans without realizing it was against the law—causing the plans to become disqualified.

SMALL BUSINESSES BENEFIT

Since approximately two out of three employees of small businesses still have no retirement coverage, some provisions in the 2001 act were specifically designed to ease the administrative burdens and expenses small companies that sponsor new plans face. For example, 401(k) plan providers frequently had to jump through hoops before their plan passed discrimination tests. Now, requirements are less stringent, and Congress eliminated the multiple-use test, which was particularly onerous.

In addition, employers with 100 or fewer employees setting up a qualified plan for the first time are now eligible for a tax credit. The annual credit is 50%, to a maximum of $1,000, of the administrative costs for the first three years of the new plan. There is only one string attached: At least one non-highly-compensated employee must participate in the plan. The IRS user fee, which plan sponsors previously had to pay to obtain a determination letter saying their plan was qualified, also has been waived for employers with 100 or fewer employees that set up retirement plans over the first five years of the act.

MATURE WORKERS AND RETIREES

To help solve the nation’s looming Social Security crisis, Congress enacted other provisions to benefit older workers. Previously, employees could contribute only $10,500 to their 401(k) plan annually, regardless of age. Beginning this year, in addition to higher limits, employees who are 50 years or older can make an additional $1,000 contribution to their 401(k), 403(b), SAR-SEP or 457 plan. This amount will increase by $1,000 each year until 2006, when older workers will be able to squirrel away an extra $5,000. Best of all, the catch-up contributions will not count against the employer’s deduction limit or against the employee’s overall dollar limit.

Similar provisions are in place for older workers with Simple pension plans, who typically work for smaller businesses. These workers can contribute an additional $500 in 2002, with further increments of $500 a year until 2006, when they’ll be able to contribute $2,500 more to their Simple plan than their younger peers.

IRA contributions also will be affected. Those 50 and older can contribute an extra $500 in 2002, with an additional $500 increase in 2005. Starting in 2006, older savers will be permitted to invest an additional $1,000 per year into their IRAs.

The act also relaxes key requirements regarding how and when retirees receive qualified plan distributions. Under prior law individuals were required to begin receiving distributions at the later of the date they retired or age 70 1¦2 . (Owners of 5% had to start at age 70 1¦2 .) Congress has directed the Treasury to update current life expectancy tables. In addition, regulations the IRS issued in January 2001 simplified minimum distribution calculations, which should allow individuals to take smaller required distributions.

PUT THE CLIENT FIRST

EGTRRA provides CPAs with a perfect opportunity to help clients review and rewrite their pension plans. With these legislative changes in place, companies can design a stronger retirement program than they ever have had in the past and dramatically improve their overall benefit offerings. CPAs must take care to amend plans on a timely basis to take advantage of the many favorable increases in limits. As always, however, the client’s needs and desires must guide all decisions. CPAs should tailor plan revisions to meet a client’s objectives while still satisfying the requirements the new law imposes.