Tax Act Offers Greater Retirement Flexibility
GRAND RAPIDS — Although the 2001 Tax Act’s rate cuts and estate and gift tax changes have received top media billing, a local attorney says many retirement plan changes in the new law deserve at least equal attention.
William R. Hineline, chairman of the employee benefits practice group at Law, Weathers & Richardson, says the act has increased virtually every important dollar figure and percentage limit, while making many other favorable changes. The net result, he indicates, is that beginning this year, many employees covered by a company retirement plan will have better tools with which to build a secure retirement. He said that summation includes CEOs of major corporations, owner-employees of closely held corporations, middle managers, and employees of all pay levels.
Hineline listed some of the major changes in the act (widely known as EGTRRA):
** High-Pay Employees — The act has raised the limit on how much of an employee’s compensation can be taken into account when figuring various limitations (such as maximum annual contributions or pensions) on employer-sponsored retirement plans. The increase is from $170,000 last year to $200,000.
Hineline illustrated with a hypothetical corporation’s profit-sharing plan that contributes 10 percent of each participating employee’s salary to his or her plan account. In the case of an employee earning $250,000, the firm last year could contribute $17,000 to his account (10 percent of $170,000).
This year, its contribution for the employee will be $20,000 (10 percent of the new $200,000 limit).
** Defined Contribution Plans — Two important annual limits apply to defined contribution plans: One restricts how much the employer and employee can contribute to each participant’s account; the other restricts how much the employer can deduct.
The 2001 maximum contribution to each participant’s account was 25 percent of compensation or, if less, $35,000. The maximum deductible contribution was 15 percent of the compensation paid to all employees covered by the plan.
Now, the maximum that can be contributed to each participant’s account is 100% of compensation, or $40,000, whichever is less. The maximum deductible contribution will be 25 percent of the compensation of all employees covered by the plan.
Hineline explains that the higher contribution and deduction limits mean most employers will either terminate their money purchase pension plans or merge those plans into their profit-sharing plans in 2002. He stressed that it is important that the employer take this step by March 1.
** Defined Benefit Pensions — Companies that pay a fixed annual or monthly amount when the employee retires will be able to make larger pension payments. The maximum pension that a plan can fund is 100 percent of a participating employee’s average compensation for his three highest-paid years, limited by a dollar cap that the Tax Act now raises from $160,000 from $140,000.
** Regular Wage Earners — Hineline reports employers should be aware of five major changes for 401(k) plans:
1. The limit on pre-tax wages an employee can defer each year rose this year to $11,000 from $10,500 and then rises in $1,000 increments to $15,000 in 2006. The same maximums also apply to 403(b) annuities, and salary reduction SEPs (Simplified Employee Pensions).
2. A new concept called “catch-up” contributions allows employees who are 50 or older to make additional annual deferrals of pre-tax dollars. The maximum catch-up contribution for 401(k) plans (as well as for 403(b) annuities, and salary reduction SEPs) is $1,000 for 2002, $2,000 for 2003, $3,000 for 2004, $4,000 for 2005, and $5,000 for 2006 and later years. As a bonus, the catch-up contribution will not be subject to the various limitations and requirements that normally apply to elective deferrals.
3. Beginning this year, an employee’s elective deferrals to a 401(k) plan will not be subject to the 25 percent deduction limits for profit-sharing plans. This will make it feasible for companies to allow employees to make larger elective deferrals or to increase the company contribution.
4. Starting this year, elective deferrals (as well as an employee’s elective set-asides in a cafeteria plan) are treated as compensation for purposes of applying the deduction limits that apply to profit-sharing plans (as well as some other plans, such as ESOPs).
5. Matching contributions that a company makes to a 401(k) account will have to vest at a faster pace. For this year’s contributions, an employee either must be 100 percent vested in matching contributions after three years of service, or after six years (20 percent vested after two years, plus an additional 20 percent for each subsequent year). The plan may have a more rapid vesting schedule for matching contributions, but it can’t use a slower one than the tax law requires.
** Lower-Income Employees — From this year through 2006, lower-income wage earners have an unprecedented incentive to save for retirement: a nonrefundable credit of up to 50 percent of elective contributions to employer plans or IRAs, in addition to any deduction or exclusion that would apply.
Hineline reported that the maximum annual contribution eligible for the credit is $2,000. The credit rate (50, 20, or 10 percent) depends on the taxpayer’s filing status and AGI. For example, a joint filer with up to $30,000 AGI gets a 50 percent credit. The credit drops to 20 percent if AGI is $30,000 to $32,500, and to 10 percent if AGI is $32,500 to $50,000. There is no credit for joint filers if AGI is above $50,000.
Only a person 18 or over (other than a full-time student, or someone allowed as a dependent on another taxpayer’s return for the year) is eligible for the credit. Special anti-abuse provisions will apply.
** Top-Heavy Rules — According to Hineline, the act relaxed these rules by changing the definitions of “Key Employee” and “Officer.” This means a firm may use matching contributions to satisfy the top-heavy minimum for non-key employees and still be treated as contributions under the ACP test.
** Rollovers and Direct Transfers — Hineline reports that in general the act permits rollovers among qualified retirement plans, 403(b) annuities, and Section 457 plans. He said after-tax employee contributions also may be included in a rollover and that plans now can disregard rollover contributions (and their earnings) in determining whether a participant’s account balance exceeds $5,000 for purposes of the involuntary cash-out rules.
** Plan Loans — The act allows owner-employees and S Corporation Shareholders to take participant loans from plans.
Hineline advises that the IRS has issued some model amendments to reflect EGTRRA changes. He stressed, however, that not all of those amendments are applicable to all plans. He also indicated that companies must make some decisions regarding plan design, including whether to merge or terminate some plans. And that’s the sort of decision, he said, that should come only after obtaining the advice of a qualified attorney or consultant.