Tax Credits for New Small Employer
An employer's costs related to the
establishment and maintenance of a retirement plan generally are
deductible as business expenses. However, there is no tax credit for
Beginning in 2002, small businesses
with 100 employees or less will be eligible for an annual tax credit
of 50 percent on up to $1000 of administrative costs for the first
three years of a new plan. The credit is available only if at least
one non-highly compensated employee is participating..
Participant Loans for Small
Generally, plans may make loans to
participants. But, prohibited transaction rules prevent sole
proprietors, partners, and Subchapter S corporation shareholders
from taking participant loans.
The prohibited transaction rules
are modified to allow for participant loans to sole proprietors,
partners, and Subchapter S corporation shareholders. The provision
also applies prospectively to pre-existing loans.
Repeal of the Multiple Use Test
In addition to two
nondiscrimination tests (the ADP and ACP tests), some 401(k) plans
must also satisfy the complicated multiple use test.
The multiple test is repealed.
Tax Credits for Lower Income Savers
Currently there is no tax credit
for low and moderate income savers.
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.
Catch-up contributions for Older
The Code limits the amount that can
be contributed to a defined contribution plan on behalf of an
employee for any year. In the case of elective deferrals, the limit
is $10,500 per year. There are no separate limits for older workers.
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.
Modifications of Top Heavy Rules
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
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
A number of changes have been made
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
A frozen top heavy defined
benefit plan will no longer be required to make minimum accruals
on behalf of non-key employees.
Modification of Safe Harbor Relief
for 401(k) Plan Hardship Withdrawals
401(k) plans generally must
restrict distributions of amounts attributable to elective
contributions. An exception to this restriction applies in the case
of certain hardship distributions. Treasury regulations provide a
safe harbor for determining whether a distribution qualifies as a
hardship distribution. To qualify for this safe harbor, a
participant receiving a hardship distribution must be prohibited
from making elective contributions to the plan for the 12 months
following the date of distribution.
Treasury is directed to revise its
safe harbor hardship distribution rules to reduce to 6 months the
period of time participants must be prohibited from making
additional elective contributions. Also, hardship withdrawals under
the terms of the pan will not be treated as eligible rollover
Modifications to Limits on
Retirement Plan Contributions and Benefits
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.
A sponsor of a profit sharing plan
cannot deduct contributions to the plan in excess of 15 percent of
aggregate employees' compensation. In the case of a stand-alone
money purchase plan, the deduction limit is the minimum funding
requirement for the plan.
The deduction limit for profit
sharing plans is increased to 25 percent of aggregate employees'
compensation. Money purchase plans will be treated as profit sharing
plans for purpose of the 404 deduction limit and thus will be
subject to the 25 percent limit.
Increase in 25 Percent of
Under Section 415(c), total annual
contributions to a defined contribution plan may not exceed the
lesser of 25 percent of compensation or $35,000.
The 25 percent of compensation
limitation has been increased to 100 percent of compensation. The
dollar limitation will still apply. The provision also repeals the
maximum exclusion allowance applicable to 403(b) plans.
Repeal of "Same Desk
Under the "same desk
rule," a distribution to a terminated employee is not allowed
if the employee continues performing the same functions for a
successor employer. The same desk rule applies to 401(k), 403(b) or
The same desk rule is eliminated by
replacing "separation from service" under Section
401(k)(2)(B) with "severance from employment." Conforming
changes are also made for 403(b) and 457 plans. The provision
applies to distributions are after December 31, 2001, regardless of
when the severance from employment occurred.
Employers May Disregard Rollovers
for purposes of Cash-Out Amounts
Terminated participants' benefits
may be cashed out if the non-forfeitable present value of such
benefits does not exceed $5,000.
A plan is permitted to ignore
amounts attributable to rollover contributions when determining the
Rollovers Among Various Types of
Employment -Based Retirement Plans and IRAs
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
Amounts rolled over from a 401 or
403(a) plan to a conduit IRA may later be rolled back to a 401 or
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
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)
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
Elective deferrals will no longer
be considered employer contributions for purposes of the Section 404
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
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
Plan sponsors must pay a user fee
to the IRS in order to obtain a determination letter that their plan
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
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
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
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
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
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
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
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
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
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
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
Automatic Rollovers of Certain
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
The valuation date for a defined
benefit plan for a plan year must generally be in the same plan
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
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 advice
is not generally considered income to the employees, although some
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.