1975, March, Pg. 497. The Pension Reform Act of 1974 Part 4.

• Author: by R. Michael Sanchez

4 Colo.Law. 497

Colorado Lawyer

1975.

1975, March, Pg. 497.

The Pension Reform Act of 1974 Part 4

497Vol. 4, No. 3, Pg. 497The Pension Reform Act of 1974 Part 4by R. Michael Sanchez, James F. Wood and Douglas M. CainThe Pension Reform Act of 1974(fn507) (the Act) includes a special provision for the benefit of individuals who are not covered by qualified retirement plans, government plans, or certain other plans. Such individuals may now contribute to their own retirement savings plans in an amount up to 15 percent of earned income or $1,500, whichever is less. Contributions are deductible, and an individual need not itemize his deductions to take advantage of the deduction.

Contributions in excess of the 15 percent or $1,500 limit will be subject to a 6 percent tax, payable each year until the excess is "corrected." However, no tax is imposed on contributions over the 15 percent or $1,500 limit if they qualify as "rollover" contributions. Rollover contributions basically are transfers of assets between and among individual retirement plans and certain qualified plans.

Contributions must be made to one of three acceptable investment devices---an individual retirement account, an individual retirement annuity or a retirement bond. Each has its particular requirements.

Earnings on funds contributed to individual plans accumulate tax-free until distribution. All amounts distributed (both earnings and contributions) are treated as ordinary income. Distributions from individual plans do not qualify for lump sum distribution treatment, but do qualify for income averaging treatment under the general provisions in I.R.C. §§ 1301-05.

As a general rule, the Act creates a strong disincentive for distributions to individuals who have not attained age 591/2 and creates an even stronger disincentive for accumulations in plans whose individual contributors (or beneficiaries) have attained age 701/2. Distributions to the former are labeled "premature distributions" and are generally subject to a 10 percent additional tax. No additional tax is imposed if the individual is disabled or has died. Minimum distributions not begun upon the individual's reaching age 701/2 are subject to a 50 percent excise tax.

Other sections of the Act apply to individual plans in varying degrees. Some reporting requirements are imposed upon trustees of individual accounts and upon issuers of annuities and certain other contracts. There are no vesting, participation or funding requirements per se. The prohibited transactions rules of I.R.C. § 4975 apply in part. Any transaction prohibited by I.R.C. § 4975 is prohibited with respect

498to individual plans. For purposes of the prohibited transactions rules, the person for whose benefit a plan is created is treated as the owner-employee of the plan. The penalty for engaging in a prohibited transaction, however, is not an excise tax, but a constructive distribution of the plan's assets. This will result in the inclusion of the assets in the individual's gross income and may trigger the 10 percent additional tax. Certain other transactions also produce adverse tax consequences.The inclusion of a provision for individual retirement plans in the Pension Reform Act of 1974 represents an attempt on the part of Congress to grant to individuals not covered by plans, opportunities similar to those which have been granted to employees under corporate plans, H.R. 10 plans (Keogh plans), government plans, and the like. Disparities still exist between individual retirement plans and other plans, but the individual retirement plan offers opportunities for tax savings and, for reasons to be discussed, merits serious consideration.

REQUIREMENTS FOR CONTRIBUTIONS TO INDIVIDUAL PLANS

General RequirementsExcept in the case of rollover contributions, all contributions to individual plans must be made in cash.(fn508) Transfers of property other than cash will not qualify for a deduction. Only cash contributions made to individual retirement accounts and cash purchases of individual retirement annuities and retirement bonds will qualify for the deduction.(fn509)

Contributions must be made during the taxable year.(fn510) There is no provision which allows an individual to make contributions after the taxable year.(fn511) However, a taxpayer may contribute in excess of the amount allowed and then recoup the excess amount later with no penalty for doing so.(fn512) Recoupment must occur, however, before the time the individual's return is due (including extensions).(fn513)

Contributions must be made for the benefit of an individual.(fn514) Contributions may be made "by or on behalf of" an individual.(fn515) If made on behalf of an individual by an employer, the contribution is includable in the individual's gross income, whether or not a deduction for such payment is allowed after the application of the various rules below.(fn516) Thus, amounts contributed by employers are subject to FICA and FUTA taxes.(fn517) However, employer contributions are not subject to withholding for income tax purposes if at the time of the contribution it is reasonable for the employer to believe that the employee will be entitled to receive a deduction for the contribution.(fn518) Presumably, the employer has the burden to show a reasonable basis for such a belief. Hopefully, the regulations will address this problem.

Who May Deduct ContributionsGenerally, the deduction for contributions to individual retirement plans is available to anyone who, during any part of the taxable year in which he makes a contribution to an individual plan, is not an "active participant" in a plan described in I.R.C. § 401(a), which includes a trust exempt from tax under I.R.C. § 501(a), a qualified employee annuity plan, a qualified bond purchase plan, or a government plan.(fn519) The deduction is not available to anyone who is an employee of an I.R.C. § 501(c)(3) organization or of a public school, if he receives a contribution from his employer for an annuity contract under I.R.C. § 403(b), whether or not his rights in the contract are nonforfeitable.(fn520)

The term "active participant," while extremely important in the determination of who may deduct his contributions to an individual plan, is never defined in the Act. However, § 3(7) of the Act does define "participant" to mean:... any employee or former employee of an employer, or any member or former member of an employee organization, who is or may become eligible to receive a benefit of any type from an employee benefit plan which covers employees of such employer or members499of such organization, or whose beneficiaries may be eligible to receive any such benefit.(fn521)

While this definition of participant includes both "employees" and "former employees," the definition of an "active participant" in a qualified plan seems to be limited to a participant for whom benefits are accrued or for whom contributions are being made currently (or might have been made). The Report of the House Committee on Ways and Means states that:Generally, for purposes of the retirement savings deduction, an employee is to be considered an active participant in a plan if, for the year in question, benefits are accrued under the plan on his behalf (as in a defined benefit pension plan), the employer is obligated to contribute to the plan on the employee's behalf (as in a money purchase pension plan), and the employer would have been obligated to contribute to the plan on the employee's behalf if any contributions were made to the plan (as in a profit-sharing plan).(fn521a)

An individual generally will not be considered an active participant in a plan after he has separated from service with a vested interest in the plan.(fn521b) Also, an individual will not be considered an active participant in a plan after his employer has completely terminated contributions under the plan, even though the trust continues to provide benefits for the individual.To avoid substantial administrative problems, if an individual becomes a participant in a plan and under that plan is given past service credit for prior years of service with the employer, he will not be considered to have been an active participant in the plan in the years for which the past service credit is given.(fn521c)

One injustice seems apparent from the guidelines in the House Committee Report. The participant in an integrated defined contribution plan to whom no allocation is made because the contribution percentage does not exceed the integration level would be ineligible for an IRA because he seems to be an "active" participant. The regulations should address this problem to permit such an individual to contribute to his own IRA at least for each year during which contributions are below the integration level. While the administrative problems with such a regulation may be difficult, the disadvantage of leaving this type of active participant without any qualified retirement benefit opportunity is even more troublesome.

The House Report also reveals that if an employee is given the option to elect not to be covered by a qualified plan and he so elects, generally he will not be treated as being an active participant in the plan for purposes of the retirement savings deduction. The report goes on to address one narrow area of potential abuse. An employee's opportunity to become a participant apparently will not disqualify him for a retirement savings deduction; disqualification...