New tax law significantly improves benefits of 401(k) and other qualified plans.

• Author: Misher, Norman J.

1. Introduction

   On June 7, 2001, President Bush signed into law the Economic Growth and Tax Relief Reconciliation Act of 2001 (the Act). Although the Act is perhaps best known for the lowering of tax rates and phase out of the estate tax, it also made important changes to the rules governing all qualified plans, especially 401(k) plans. These changes generally increase the amount of contributions and benefits that can be provided under these plans and should encourage employers to establish new qualified plans and continue maintaining existing plans, as well as enable highly compensated individuals to utilize more fully the benefits associated with these plans.

   Many of the Act's provisions affecting the operation of qualified plans become effective in 2002. Thus, employers should immediately review their benefit pro grams in order to determine the extent to which the new law may have an effect on their programs.

   This article guides tax executives through the labyrinth of changes that the Act makes in the employee benefit provisions of the Internal Revenue Code. The following specific areas are addressed:

   * 401(k) plans and other defined contribution plans,

   * increase in contribution and benefit limits under qualified plans,

   * expansion of rollover rules and related distribution changes,

   * individual retirement accounts,

   * employee stock ownership plans,

   * other employee benefit and compensation changes, and

   * amendment requirements for qualified plans. II. 401(k) Plans and Other Defined Contribution Plans

   1. Increases in Dollar Limit on 401(k) Elective Deferrals

      Current law limits the amount of the 401(k) elective deferrals that an individual can elect to have an employer contribute on his behalf to a 401(k) plan. For 2001, the maximum 401(k) elective deferral is $10,500. The Act raises the limit on annual 401(k) elective deferrals to $11,000 in 2002, increasing the limit in $1,000 annual increments thereafter until the limit reaches $15,000 in 2006, with future increases for cost of living to be made in $500 increments. Thus, the annual limits through 2006 will be $11,000 in 2002, $12,000 in 2003, $13,000 in 2004, $14,000 in 2005 and $15,000 in 2006.

   2. Increase in Compensation Limit

      For purposes of applying annual deduction and contribution limits as well as for nondiscrimination testing purposes, current law limits the annual compensation of each participant that may be taken into account under a qualified plan to $170,000. For plan years beginning after December 31, 2001, the Act raises this limit to $200,000, indexed thereafter in $5,000 increments.

      This increase should make it easier for 401(k) plans to satisfy the special nondiscrimination test applicable to elective deferrals (i.e., the "ADP Test," see F. below), because the test is based on the percentage of an employee's pay and a larger compensation base reduces the contribution percentages of certain highly compensated employees. In other words, $10,000 is approximately 5.9 percent of $170,000 but only 5.0 percent of $200,000.

      In addition, by raising the compensation base, the Act allows employers to increase the contributions that can be made on behalf of highly compensated employees under a profit-sharing plan. For example, where an employer contributes a uniform percentage of compensation to the profit-sharing account of each employee, employees who earn in excess of the current compensation limit will now see the contribution to their accounts increase. For an employer who contributes a pool of money to be allocated among its employees, the increased limit will skew the contributions in favor of the higher compensated employees, enabling them to receive a larger portion of the profit-sharing contribution.

   3. Changes in Deduction Limits

      1. Increase in Compensation Limitation. Under current law, an employer may deduct contributions to a 401(k) plan (or any other profit-sharing plan) for a taxable year up to a maximum of 15-percent of the aggregate compensation paid to employees covered by the plan for that year. Contributions in excess of this limit may be subject to a ten-percent excise tax. Where an employer sponsors both a defined benefit (or a money purchase plan) and a defined contribution plan, deductible contributions are generally limited to 25 percent of the aggregate compensation paid to covered employees during the taxable year. The current 15-percent limitation on deductible contributions to defined contribution plans has forced employers who want to provide contributions in excess of 15 percent of aggregate compensation to maintain a money purchase plan in addition to their profit-sharing or 401(k) plan so that they can deduct contributions up to the maximum limit of 25 percent.

         Effective for taxable years beginning after 2001, the Act raises the limit on deductible employer contributions to a profit-sharing plan to 25 percent of the compensation paid during the taxable year to plan participants. The Act also specifies that money purchase pension plans will be treated like profit-sharing plans for deduction limitation purposes. Thus, it will no longer be necessary to maintain two plans in order to take advantage of the maximum 25-percent deductible contribution limitation.

      2. Treatment of 401(k) Elective Deferrals for Deduction Purposes. For purposes of the deduction limitations, the employee compensation base upon which the maximum deductible employer contribution is calculated currently includes only taxable compensation and, as such, does not include salary reduction amounts such as elective deferrals to 401(k) plans or contributions to a section 125 cafeteria plan. In addition, current law treats elective contributions deducted from employees' pay as employer contributions when applying the limits on deductible contributions.

         Effective for years beginning after 2001, the Act liberalizes these rules by (i) changing the definition of compensation for purposes of applying the deduction limits to include salary reduction amounts and (ii) excluding salary reduction amounts in applying the new 25-percent maximum deduction limitation on total employer contributions to defined contribution plans. Thus, the compensation base upon which the maximum permitted deductible contribution by the employer is calculated has been increased to include 401(k) elective deferrals, but these deferrals are no longer counted toward the 25-percent limitation on such contributions. Consequently, 401(k) elective deferral contributions will no longer need to be limited to ensure that employer deduction limits are not exceeded.

   4. New Catch-Up Contributions Under 401(k) Plans

      In an attempt to enable older workers to enhance their retirement benefits, the Act establishes special "catch-up" contribution provisions for employees who have attained age 50. Beginning in 2002, such an employee who has made the maximum permitted elective deferrals under a 401(k) plan, as determined under all applicable Code provisions (e.g., the annual limit on 401(k) elective deferrals) or under the plan, may make an additional elective contribution to the plan if the plan so permits. The maximum permitted catch-up contribution amount generally starts at $1,000 in 2002 and is increased in $1,000 annual increments until it reaches $5,000 in 2006, adjusted for inflation in $500 increments thereafter. The catch-up contribution provisions do not apply to after-tax employee contributions.

      The IRS recently issued proposed regulations which provide that catch-up eligible participants are those employees who are projected to reach age 50 by the end of the calendar year. Thus, all employees who will be at least 50 years old by December 31st of a calendar year, are treated as if they are 50 as of January 1st of that year, regardless of whether they terminate employment or survive to their actual birthday.

      Besides the annual maximum catch-up contribution limit itself, catch-up contributions are not subject to any other contribution limits nor are they taken into account in applying other contribution limits. In addition, catch-up contributions are not subject to the nondiscrimination rules otherwise applicable to 401(k) plans (i.e., the "ADP Test," see F. below). If a catch-up contribution feature is provided in a plan, however, the plan (and all similar plans within the employer's controlled group) must allow all participants to make the same election with respect to catch-up contributions. Lastly, an employer is permitted to make matching contributions with respect to catch-up contributions, but any such matching contributions are subject to all normally applicable limits and rules, including the nondiscrimination rules applicable to matching contributions (i.e., the "ACP Test," see F. below).

      Two examples provided in the Act's legislative history are worth mentioning here: Example I describes a highly compensated 401(k) participant employee over age 50 whose maximum annual deferral of $15,000 for the year 2006 is reduced to $8,000 by the 401(k) nondiscrimination rules. Under the Act, the employee may make an additional elective catch up contribution of $5,000 (the maximum permitted catch up contribution for 2006). The employee in Example 2 is over age 50, earns $30,000 for the year 2006 and participates in the employer's 401(k) plan whose terms permit a maximum deferral of 10 percent of compensation. The employee's maximum permitted elective deferral is $8,000:$3,000 under the terms of the plan, plus an additional $5,000 under the catch-up provisions of the Act.

   5. Faster Vesting of Employer Matching Contributions

      Current law requires that employer matching contributions under a qualified plan vest at least as rapidly as under one of two alternative minimum vesting schedules: (1) five-year cliff vesting which requires 100-percent vesting after five years of service or (2) seven-year graded vesting, which requires 20-percent vesting after three years of service, with an additional...