Pension simplification: the ultimate oxymoron?

• Author: Barber, Steven K.

Ten years have passed since the last legislation that profoundly affected the operation of pension, profit sharing, an stock bonus plans ("qualified plans"). That legislation, the Tax Reform Act of 1986, made sweeping changes to the laws governing qualified plans. The employee benefits community discovered that, in many respects, the Tax Reform Act of 1986 complicated the administration of qualified plans and increased the costs of maintaining qualified plans. Over time, the employee benefits community developed a wish list of changes they felt would simplify the administration of qualified plans and protect the interests of the participants. For many years, the employee benefits community worked for the implementation of these changes. These efforts were rewarded when President Clinton signed into law the Small Business Job Protection Act of 1996, Pub. L. No. 104-188 (the "act"). The remainder of this article is devoted to a review of the provisions in the act that tax practitioners will address on an ongoing basis.

Changes Affecting Code [sections] 401(k) Plans

The popularity of 401(k) plans has increased, despite complaints from plan administrators that the 401(k) plan discrimination tests (i.e., tests designed to make certain that 401(k) plans are not discriminating in favor of highly compensated employees or HCEs) are too complicated and expensive. The act addresses these concerns and contains several provisions that are designed to simplify the 401(k) plan discrimination tests, yet safeguard the benefits of the nonhighly compensated employees (non-HCEs). These 401(k) plan simplification provisions are effective over a three-year period from 1997 to 1999.

Changes Effective in 1997

* Use of Data From the Prior Year for Discrimination Testing Purposes

Prior to the act, 401(k) plans were required to determine the maximum pre-tax contributions ("deferral contributions") and matching contributions on behalf of HCEs by using data for the non-HCEs for the current plan year. As a result, 401(k) plans did not know until after the end of the current plan year if the 401(k) discrimination tests were satisfied.

If a 401(k) plan did not satisfy the discrimination tests, a refund of deferral contributions was generally required. The 401(k) plan had to distribute the excess amount to the participant quickly or face an excise tax.

The act allows 401(k) plans to determine the maximum deferral contributions and matching contributions on behalf of HCEs by using data for the non-HCEs for the preceding plan year, rather than the current plan year. This change allows a 401(k) plan to know the limits on HCE deferral contributions and matching contributions early in the current plan year. Therefore, any corrective steps needed to satisfy the discrimination tests can be taken in an orderly fashion during the current plan year. In an interesting twist, the act allows 401(k) plans to elect to continue to use the current plan year data for discrimination testing purposes; however, once the plan elects to use current plan year data, the plan cannot switch to prior year data without IRS approval.

Many plan administrators will welcome the ability to determine the maximum amount of deferral contributions at the start of the plan year and elect to use data from the prior plan year. However, if a 401(k) plan is using data from the previous plan year and the non-HCEs increase the level of contributions in the current plan year, then the effect of this increase on the HCE contributions will not be felt until the following year.

Plan administrators should review, as quickly as possible, the 1996 deferral contribution amounts and 1997 deferral contribution amounts to determine if the 401(k) plan should elect to use data from the current year or the prior year.

* Correction of Excess Deferrals

Under prior law, 401(k) plans satisfied the discrimination tests by returning excess deferral contributions to the HCEs who had the highest deferral percentages, as opposed to the HCE with the highest deferral amount. In operation, this favored the higher-paid HCEs because their higher salary levels kept their deferral percentages down. Now, plans may satisfy the 401(k) plan discrimination tests by returning excess deferrals starting with the HCE with the highest dollar amount.

Tax-Exempt Organizations. Beginning in 1997, tax-exempt organizations, other than state and local governments, will be able to maintain 401(k) plans.

Changes Effective in 1999

Two discrimination tests apply to the employee deferrals made to a 401(k) plan. The first discrimination test, the "ADP test," is satisfied if the actual deferral percentage (ADP) for HCEs for a plan year is equal to or less than either: 1) 125 percent of the ADP of all non-HCEs eligible to defer under the arrangement; or 2) the lesser of 200 percent of the ADP of all eligible non-HCEs or such ADP plus two percentage points. The second discrimination test...