Economic Growth and Tax Reconciliation Act of 2001 (EGTRA)

 Issue

 Current Law

 EGTRA

Eligible persons will receive a non-refundable tax credit of up to 50 percent on up to $2000 in contributions to an IRA, 401(k), 403(b), SIMPLE, SEP or 457 plan. This credit is in addition to the tax deduction already associated with these contributions.

In the case of joint filers, individuals whose adjustable gross income is less than $30,000 are eligible for a 50 percent credit. Joint filers with adjusted gross income between $30,000 and 32,500 are eligible for a 20 percent credit. Joint filers with income between $32,500 and $50,000 are eligible for a 10 percent credit. The income threshold for single filers is one-half the threshold for joint filers.

Beginning in 2002, individuals who are age 50 or older will be allowed to make an additional contribution to a 401(k), 403(b), 457 plan equal to $1,000 in 2002, then increased by $1,000 each year until $5,000 in 2006, and then indexed in $500 increments. The catch-up amount for SIMPLE plans will be one-half of these amounts.

The amount of the catch-up contribution will not be subject to nondiscrimination testing, provided all participating employees over age 50 are eligible to make a catch-up contribution. Also the catch-up contribution will not count against the employers deduction limit under section 404, or against the individual's overall 415(c) dollar limit.

A plan is generally considered "top heavy" if more than 60 percent of plan assets are held on behalf of "key employees." Due to the design of this test, top heavy rules essentially affect only small business. Key employees generally include officers earning over half the Section 415 defined benefit plan dollar limit ($70,000 in 2001), 5 percent owners, 1 percent owners earning over $150,000, and the 10 employees with the larges ownership interest in the business (as long as they earn more than $30,000). Further, family members of 5 percent owners are deemed to be key employees under family attribution rules.

Top heavy plans must meet a special vesting schedule and make minimum contributions to all non-key employees to the extent contributions are made on behalf of key employees.

A number of changes have been made here:

• The definition of "key employee" is modified to delete the "top 10 owner" rule, provided that an employee will not be treated as a key employee based on his/her officer status unless the employee earns more that $130,000, and to eliminate the 4-year look-back rule for identifying "key employees."

• Matching contributions will now count toward satisfying the top heavy minimums.

• The matching contributions 401(k) plan safe harbor will be deemed to satisfy the top heavy rules. This does not mean that an accompanying profit sharing contribution automatically satisfies the top heavy rules, although the matching contributions will count toward otherwise satisfying the minimum.

• The 5-year look-back rule applicable to distributions will be shortened to one year. However, the 5-year look-back rule will continue to apply to in-service distributions.

• A frozen top heavy defined benefit plan will no longer be required to make minimum accruals on behalf of non-key employees.

Current law limits:

• 401(a)(17): annual compensation taken into account limited to $170,000.

• 402(g): elective deferrals limited to $10,500 per year.

• 415(b): maximum annual benefits are the lesser of 100 percent of three-year high salary or $140,000 (or less for pre-65 retirees).

• 415(c): maximum defined contribution plan contribution is the lesser of $35,000 or 25 percent of compensation.

• 457(b): contribution limit is generally $8,500 per year.

• SIMPLE: maximum elective deferral is $6,500 per year.

Beginning in 2002, the Act raises all of the significant dollar limits as follows:

• 401(a)(17) compensation limit to $200,000; and then indexed in $5,000 increments.

• 402(g) elective deferral limit to $11,000 in 2002; then increased $1,000 each year until $15,000 in 2006; and then indexed in $500 increments.

• 415(b) annual benefit limit to $160,000; and then indexed in $5,000 increments. Note that this provision applies to years ending after December 31, 2001.

• 415(b) annual benefit limit will no longer have to be reduced for retirements ages 62 through 65. Note that this provision applies to years ending after December 31, 2001.

• 415(c) contribution limit to $40,000, and then indexed in $1,000 increments.

• 457 elective deferral limit to $11,000 in 2000, then increased $1,000 each year until $15,000 in 2006; and then indexed in $500 increments.

• SIMPLE elective deferral limit to $7,000 in 2002, then increased $1,000 each year until $10,000 in 2005; and then indexed in $500 increments.

An eligible rollover from a 401 or 403(a) plan may be either (1)rolled over by the employee into an eligible retirement plan within 60 days, or (2)directly rolled over by the distributing plan into another 401 plan, 403(a) plan, or an IRA.

Amounts rolled over from a 401 or 403(a) plan to a conduit IRA may later be rolled back to a 401 or 403(a) plan.

403(b) assets may be rolled over into another 403(b) or an IRA. But, 403(b) assets may not be rolled over into a 401(k) plan or vice versa. After-tax contributions cannot be rolled over.

Rollovers must be made within 60 days, or they are treated as a taxable distribution.

The Act permits rollovers from the various types of defined contribution arrangements (i.e., 401(k), 403(b), and governmental 457) to each other without restriction.

Rollover notice and withholding rules are extended to distributions from governmental 457 plans, and distributions from such plans will be subject to the 10 percent early withdrawal tax to the extent the distribution consists of amounts attributable to rollovers from another type of plan.

After-tax employee contributions can be included in an eligible rollover distribution to a qualified plan or an IRA.

Further, taxable IRA amounts (whether or not from a conduit IRA) can be rolled over to a qualified plan, 403(b) annuity, or governmental 457 plan. Also, surviving spouses are permitted to roll over distributions to a qualified plan, 403(b) annuity, or governmental 457 plan.

Finally, IRS is given authority to extend the 60-day rollover period where failure to comply is due to casualty, disaster, or other events beyond the reasonable control of the individual.

Modifications to Limits on IRAs

Current IRA contribution limit is $2,000. It is not indexed for inflation. There is no additional contribution permitted for individuals age 50 or older. In addition, there are no rules for allowing employers to facilitate IRA contributions by employees as an "add-on" to the employer-sponsored retirement plan

IRA contribution limit increased to $3,000 in 2002 through 2004; $4,000 in 2005 through 2007; and then indexed thereafter in $500 increments.

For individuals age 50 or older, limit increased by $500 in 2002 through 2005 and by $1,000 in 2006 and thereafter. This amount is not indexed.

Effective in 2003 qualified retirement plans and 403(b) annuities will be permitted to facilitate IRA contributions by those employees eligible as an "add-on" to their qualified retirement plan or 403(b) annuity.

Exclusion of Elective Deferrals from Deduction Limit

Generally, employer contributions (including employees' elective deferrals) to a qualified plan are deductible subject to certain limits. For example, elective deferrals are generally not deductible to the extent that, in the aggregate, they exceed 15 percent of the total compensation of covered employees.

Elective deferrals will no longer be considered employer contributions for purposes of the Section 404 deduction limits.

Repeal for Coordination Requirements for Section 457(b) Plans

A maximum of $8,500 in deferred compensation may be put away per year in a 457(b) plan. This limit is generally reduced by elective deferrals under other types of arrangements.

The Section 457 limit on deferred compensation will not be reduced by elective deferrals under other types of arrangements.

Definition of Compensation

For purposes of the contribution limits under Section 415, compensation includes elective deferrals. However for purposes of the deduction limits under Section 404, compensation does not include elective deferrals.

For purposes of the deduction limits under Section 404, the definition of compensation will now include elective deferrals.

Roth 401(k) and 403(b) Plans

Defined contribution plans are generally allowed to receive after-tax contributions. However, allocable income on such contributions is subject to income tax when distributed. There is no current provision in the law exempting such income amounts from taxation, like distributions from a Roth IRA

Beginning in 2006, 401(k) and 403(b) plans can permit participants to elect a tax treatment for their deferrals similar to Roth IRA contributions. Such after-tax contributions will be tested along with pre-tax deferrals as part of the ADP test. The 402(g) limit will apply to the combined amount of pre-tax and after-tax Roth 401(k) or 403(b) contributions. Because of their special tax treatment (i.e., distributions, including earnings, exempt from tax), these contributions will have to be accounted for separately. Further, like Roth IRAs, in order to receive this special tax treatment 5 years must elapse from when a participant first makes a Roth 401(k) or 403(b) contribution to when a distribution is made. Roth 401(k) and 403(b) contributions (and earnings) can be rolled over to a Roth IRA.

Elimination of IRS user Fee for Determination Letters

Plan sponsors must pay a user fee to the IRS in order to obtain a determination letter that their plan is qualified.

The IRS user fee for a determination letter will now be waived with respect to any retirement plan maintained by an employer with 100 or less employees. This waiver applies only for requests mad during the first 5 plan years (or the end of the current remedial amendment period, if longer).

Faster Vesting of Employer Matching Contributions

Employee contributions to a qualified plan are immediately vested. Employer matching contributions either must be fully vested after the employee has completed 5 years of service, or must become vested in increments of 20 percent for each year, beginning with the third year of service, with full vesting after the employee has completed seven years of service.

Employer matching contributions will have to be vested under a maximum 3-year cliff or 6-year graded vesting schedule. In the case of graded vesting, vesting will have to begin with the employee's second year of service.

Modification of Minimum Distribution Rules

Section 401(a)(9) requires certain minimum distributions from retirement plans and IRAs starting at the later of age 70 ½ or retirement (except that deferral until retirement is not permitted with respect to IRAs and 5 percent owners).

Treasury is directed to update the current life expectancy tables to reflect current life expectancy.

Clarification of Tax Treatment of Section 457 Plan Benefits Upon Divorce

An active employee's benefit under a qualified plan may be paid to a former spouse without violating the restriction on in-service distributions. Further, such distributions are taxable to the former spouse as the recipient. These rules do not apply to Section 457(b) plans.

Distributions of Section 457 plan benefits pursuant to a QDRO will be taxed under the same rules applicable to qualified plans (i.e., taxable income to the recipient of the distribution).

Pension Coverage for Domestic and Similar Workers

Employers of household workers can establish a pension plan for their employees. However, contributions are not deductible and also subject to an excise tax.

The 10 percent excise tax on non-deductible contributions will not apply to contributions made to a SIMPLE plan on behalf of household workers. The provision will not apply to contributions on behalf of family members.

Treatment of Forms of Distribution

Under the "anti-cutback rule", when a participant's benefits are transferred from one plan to another, the transferee plan must preserve all forms of distribution that were available under the transferor plan. The anti-cutback rule also provides that, without regard to a transfer, a plan may not eliminate forms of distribution.

An employee may elect to transfer benefits from one plan to another without requiring the transferee plan to preserve optional forms of benefits, if the following requirements are satisfied:

• The transfer was a direct transfer.

• The transfer was authorized under the terms of both plans.

• The transfer was pursuant to a voluntary election by the participant upon receipt of proper notice.

• The participant could have elected a lump sum distribution.

In addition, under the provision, except to the extent provided in regulations, a form of distribution in a DC plan may be eliminated with respect to a participant if 1)a lump sum distribution is available when the distribution form is being eliminated, and 2)such lump sum is based on the same or greater portion of the participant's account as the distribution form being eliminated.

Treasury is also directed to issue regulations allowing the elimination of optional forms of benefits and early retirement subsidies under defined benefit plans, provided such elimination does not adversely affect the rights of any participant in more than a de minimus manner.

Purchase of Service Credit in Governmental Defined Benefit Plans

Under state law, state and local employees often have the option of purchasing credit for prior service (such as for years served in another state). These employees cannot currently use the money in their 403(b) or 457 plans to purchase service credits.

State and local government employees will be able to use funds from their Section 403(b) arrangements or Section 457 plans to purchase service credits under their defined benefit plans.

Time of Inclusion of Benefits Under Section 457 Plans

Amounts deferred under an eligible Section 457 plan are includible in income when the amounts are paid or made available. Section 457 plans have special minimum distribution rules.

Amounts deferred under an eligible deferred compensation plan maintained by a state or local government will be includible in income when paid. A Section 457 plan will satisfy the minimum distribution rules as long as it satisfies the rules of Section 401(a)(9). No other special rules will apply.

Complete Repeal of 150 Percent of Current Liability Funding Limit-Maximum Deduction Rule

Contributions to a defined benefit plan that exceed 150 percent of current liability are not tax deductible. This limit will phase up to 170 percent by 2005.

The limit will be increased to 165 percent in 2002 and 170 percent in 2003. For plan years beginning after December 31, 2003, the current liability full funding limit is completely repealed. Also, code Section 404(a)(1)(D) is changed to allow funding up to unfunded current liability for all plans regardless of size, provided the plan is covered by the PBGC insurance program. In other words, funding up to unfunded current liability is not available to plans of professional service employers that have fewer than 25 participants. Further, in the case of a terminating plan, the plan will be permitted to fund up to the amount required to make the plan sufficient for benefit liabilities under Title IV of ERISA.

Non-Deductible Excise Tax

A 10 percent excise tax is imposed on employers who make nondeductible contributions to qualified plans.

The 10 percent excise tax on nondeductible contributions will no longer apply to any contributions to a defined benefit plan up to the accrued liability full funding limit.

Multi-employer Plan Changes

Under Section 415(b), maximum annual benefits in a defined benefit plan are the lesser of $130,000 or 100 percent of the three-year-average high compensation. For early retirees, that limit must be actuarially reduced.

Multi-employer plans will be exempt from the Section 415(b) percentage of compensation limit (the dollar limit will still apply). In addition, multi-employer plans will not be aggregated with single-employer plans or other multi-employer plans for purpose of applying the percentage of compensation limitation.

401(k) Investment in Employer Stock and Employer Property

Section 1524 of the Taxpayer Relief Act of 1997 places certain limits on investment of employee salary reduction contributions in employer stock or employer real property.

The provision in TRA '97 preventing more than 100 percent of elective deferrals from being invested in employer securities or real property is clarified as not applying to elective deferrals invested in real property before January 1, 1999.

Prohibited Allocations of Stock in a S Corporation ESOP

ESOPs may purchase S corporation stock. The ESOP is not subject to tax on distributable income from such S corporation stock. Income tax is deferred on the sale of certain employer securities to an ESOP. A 50 percent excise tax is imposed on certain prohibited allocations of securities acquired in such a transaction.

If there is a non-allocation year with respect to an S corporation ESOP then:

• The value of the prohibited allocation is taxable to the person receiving such allocation;

• The 50 percent excise tax will be imposed on the S corporation; and

• An excise tax will be imposed on the S corporation with respect to any synthetic equity owned by a disqualified person.

These provisions are intended to ensure that S corporation ESOPs provide broad-based employee coverage.

Automatic Rollovers of Certain Involuntary Distributions

A qualified plan may distribute a participant's vested accrued benefit that does not exceed $5,000 without the participant's consent. Such involuntary distribution may be rolled over to an IRA or an employer-sponsored plan.

An involuntary distribution is excess of $1,000 will have t be directly rolled over to an IRA designated by the employer, unless the participant affirmatively elects to roll over the amount to another IRA or qualified plan, or elects to receive the amount in cash. DOL is directed to issue safe harbors under which designation of an IRA by the employer and selection of an investment will satisfy ERISA's fiduciary rules. The provision is not effective until such regulations are issued.

Expanded 204(h) Notice Requirements

Participants must be notified of a plan amendment significantly reducing future benefit accruals at least 15 days before such amendment takes effect. The notice must be given after the plan sponsor has formally adopted the amendment. Treasury regulations provide that participants need not be given an individual statement detailing how their own benefits will be affected by the amendment.

Requires that affected participants be given a notice of a plan amendment significantly reducing future benefit accruals within a reasonable period of time (as defined by Treasury) before the amendment takes effect. The notice will have to provide sufficient information (as defined by Treasury) to allow participants to understand the effect of the amendment. In the case of plans with 100 participants or less, the Treasury may provide for a simplified notice or exempt such plans from the expanded notice.

An amendment that eliminates or significantly reduces a subsidy is treated as having the effect of significantly reducing the rate of future benefit accruals.

Failure to comply with the notice requirement will subject the employer to an excise tax equal to $100 per day per failure up to $500,000.

This provision is effective on the date of enactment. Good faith reliance applies until Treasury regulations are issued.

Modification of Timing of Plan Valuations

The valuation date for a defined benefit plan for a plan year must generally be in the same plan year.

Defined benefit plans will be permitted to use a valuation date up to one year prior to the beginning of the plan year. The change will apply at the election of the employer but will not be available to an under-funded plan.

ESOP Dividends May be Reinvested Without Loss of Dividend Deductions

Dividend deductions are allowed on dividends paid on employer stock to an un-leveraged ESOP only if the dividends are paid to the employees in cash; the deduction is denied if the dividends remain in the ESOP for reinvestment.

An employer will be allowed to deduct dividends paid to an ESOP when its employees are allowed to elect to take the dividends in cash or leave them in the plan for reinvestment in employer stock.

Repeal of Uneccessary Transition Rule

The Tax Reform Act of 1986 modified the definition of highly compensated employee, but provided limited grandfather relief from these changes. 1996 legislation substantially changed the definition of HCE.

The special TRA '86 Act grandfather applicable to the definition of HCE is repealed in light of the changes to the HCE definition in 1996.

Employees of Tax-Exempt Entities

Prior to 1996, most tax exempt enities could not sponsor 401(k) plans. The IRS established a special rule under which employees of tax-exempt entities could, under certain circumstances, be excluded in applying the coverage rules to a 401(k) plan. This special rule could apply, for example, where a tax-exempt entity had a taxable subsidiary that maintained a 401(k) plan. In 1996, the restriction on tax-exempt entities offering 401(k) plans was removed. The special rule was then terminated with the 1998 plan year.

Employees of a tax-exempt entity who are eligible to make elective deferrals under a Section 403(b) arrangement could be excluded in applying the coverage rules to a Section 401(k) plan (or a related Section 401(m) plan) if: 1) no employee of a tax exempt 501(c)(3) organization is eligible to participate in the Section 401(k) [or 401(m)] plan; and 2) 95 percent of the non-excludable employees who are not employees of a tax-exempt 501(c)(3) organization are eligible to participate in the Section 401(k) [or 401(m)] plan. This provision is effective as if included in the Small Business Job Protection Act of 1996.

Employer-Provided Retirement Education

Employer-provided retirement advice is not generally considered income to the employees, although some uncertainty exits

Clarifies that retirement advice provided to employees on an individual basis will be a nontaxable fringe benefit to the extent such services are made available on substantially equivalent terms.