Tax Bulletin (July 2001)
New Tax Law: Benefit Plan Sponsors
New Choices and Obligations
By Susan P. Serota and Peter J. Hunt, partners, and
Erin E. Raccah and Angelica M. Irizarry,
associates, in our New York office. If you have or can obtain the
or have an Acrobat-enabled web browser,
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or download the printed version of the
bulletin containing this article (a 490K pdf file).
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On June 7, 2001, President Bush signed into law the
Economic Growth and Tax Relief Reconciliation Act of 2001 (P.L. 107-16, the
"Act"), implementing the most significant changes to the tax laws affecting
retirement plans in the past 15 years. Employees will benefit from
opportunities for increased savings and greater portability between different
retirement vehicles. Employers will have greater flexibility in designing plans,
but they will be subject to new requirements, such as increased disclosure
obligations for amendments that reduce future pension benefits and new notice
requirements on distribution options.
Most of the provisions take effect January 1, 2002,
although some changes are delayed until later years. All of the provisions are set
to expire on December 31, 2010, absent further Congressional action.
Highlighted below are provisions of the Act that will affect
employee benefit plans offered by private sector employers and governmental and
tax-exempt organizations, as well as individual retirement accounts (IRAs).
Defined Contribution Plans: Higher Limits, Faster Vesting and Greater
Described below are some of the most significant changes
that affect 401(k) plans and other qualified defined contribution plans. Changes
specifically affecting 457 deferred compensation plans and 403(b) annuity plans
maintained by governmental and tax-exempt organizations are discussed under
"Tax Exempt Organizations and Governmental Plan
Sponsors: New Planning Opportunities."
- Maximum annual elective deferral contributions to a 401(k) plan increases
to $11,000 in 2002, increasing in $1,000 annual increments to $15,000 by
2006 (then indexed for inflation in $500 increments in later years).
- Maximum annual allocations (including both employer and employee
contributions) increase to the lesser of $40,000 or 100% of compensation
(indexed for inflation in $1,000 increments).
- The compensation limit for purposes of determining plan contributions and
benefits increases to $200,000 (indexed for inflation in $5,000
- 401(k) plans may permit participants over the age of 50 to make additional
"catch-up" contributions of $1,000 in 2002, increasing to $5,000 by 2006. If
this option is offered to any group of employees, it must be offered to all eligible
employees under all 401(k) plans maintained by the same or an affiliated
- Employer matching contributions must vest at least as fast as 100% after
three years of service, or 20% after two years of service and 20% per year
thereafter, with 100% vesting after six years of service.
- Participants in 401(k) plans, governmental 457 plans, and 403(b)
annuities can roll over distribution amounts between plans or to an IRA. After-
tax contributions may also be rolled over to an IRA or to another qualified plan
that can properly account for such contributions. This will require changes in
notices provided to participants when distributions are made from these
- Employees who continue in the same job for a successor employer after a sale
of the business may receive distributions from 401(k) plans. The "same desk"
rule that formerly prohibited a distribution in this situation has been repealed
and there is now deemed to be a "severance from employment" that permits a
distribution unless all or a portion of the 401(k) plan is assumed by the
- The Act makes it easier for sponsors of defined contribution plans to remove
unwanted forms of benefit payments without violating "anti-cutback" rules.
- The annual limit on an employer's tax deduction for contributions to a
qualified defined contribution plan is increased to 25% of the aggregate
compensation of plan participants. In addition, elective deferrals are now
deductible without limit.
- Beginning in 2003, employers may permit employees to have "deemed IRAs"
under a qualified defined contribution plan. This will allow employees to
contribute money under a plan outside of 401(k) limits, but subject to IRA
limits. Similarly, beginning in 2006, employers may permit employees to
designate elective deferrals as Roth IRA contributions, which would be taxed at
the time of deferral but not at distribution.
- After the U.S. Department of Labor issues appropriate regulations (within
three years after the enactment of the Act), plans must provide that any
mandatory cash-out distribution exceeding $1,000 be rolled over into an IRA.
- Hardship withdrawals from defined contribution plans (including hardship
withdrawals of employer matching contributions as well as elective deferral
amounts) will not be eligible for rollover. In addition, under the "safe harbor"
rules for hardship withdrawals from 401(k) plans, the period after a hardship
withdrawal during which employee contributions are prohibited is reduced to six
- The "multiple use" test affecting highly compensated participants in 401(k)
plans has been repealed.
Defined Benefit Plans: Higher Limits and Increased Disclosure
Defined benefit plan sponsors will need to amend their
plans to reflect increased benefit limits and provide increased disclosure to
participants in the event of reductions of future benefit accruals. Plan sponsors
will also be able to take advantage of increased deduction limits for qualified plan
- As is the case for qualified defined contribution plans, the compensation limit
for purposes of determining qualified defined benefit plan benefits is increased to
$200,000 (indexed for inflation in $5,000 increments).
- For limitation years ending after December 31, 2001, the maximum annual
benefit payable from a qualified defined benefit plan is increased to $160,000
(indexed for inflation in $5,000 increments). Note that for defined benefit plans
with non-calendar limitation years, the increased dollar limit is effective
immediately. This limit is reduced if benefit payments begin before age 62, and
increased if payments begin after age 65. As under prior law, the annual benefit
can never exceed 100% of the participant's average compensation for his or her
highest three years.
- Tax deduction limits on funding are significantly relaxed. The current
liability full funding limit is increased to 165% of current liability in 2002,
170% in 2003, and repealed entirely in 2004. Contributions made to fully fund
terminating plans will be fully deductible.
- Effective immediately, increased disclosure to participants is required in the
event of a significant reduction in future benefit accruals in a defined benefit or
money purchase pension plan, including the elimination or significant reduction
of early retirement benefits or similar subsidies. This notice must include
sufficient information to describe to participants the effect of the amendment.
The notice must be given within a reasonable time before the reduction takes
effect, and may be sent prior to adoption of the amendment modifying the benefit
so long as no material changes are made after the notice is given. Violations are
subject to a penalty of $100 per day per participant. Egregious violations could
invalidate the desired reduction in benefits.
Tax Exempt Organizations and Governmental Plan
Sponsors: New Planning Opportunities
Beginning in 2002, participants in 403(b) annuity plans
and 457 deferred compensation plans will be given many of the same contribution
opportunities as participants in 401(k) plans. In addition, the Act provides a
number of new planning opportunities for sponsors of these plans.
- 403(b) annuity plans and 457 deferred compensation plans will be
permitted to allow elective deferral contributions up to the same limits as
401(k) plans: $11,000 in 2002, increasing in $1,000 annual increments to
$15,000 by 2006 (indexed for inflation in later years).
- Like 401(k) plans, 403(b) plans and
governmental 457 plans can allow participants over
age 50 to make additional "catch up" contributions up to $1,000 in 2002,
increasing to $5,000 by 2006. In lieu of "catch up" contributions, participants
in all 457 plans who are in their last three years before normal retirement age may
be allowed to contribute up to two times the otherwise applicable annual elective
deferral limit up to $22,000 in 2002, increasing to $30,000 by 2006
(indexed for inflation in later years).
- Participants in governmental 457 plans, 403(b) plans and 401(k) plans
will be able to roll over distributions between plans or to an IRA.
- Sponsors of 403(b) plans and 457 plans will be able to permit
trustee-to-trustee transfers for the purchase of permissive service credit under
governmental defined benefit pension plans.
- Elective deferral contributions made under a 457 plan will no longer be
reduced by elective deferrals made by the participant under other plans
sponsored by the same employer. This means, for example, that an employee who
participates in both a 457 plan and a 403(b) plan may elect to defer up to
$22,000 in 2002.
- Participants in governmental 457 plans will no longer be taxed when
amounts are "made available" to them; instead, amounts will be taxed when
actually paid (and taxation can be further delayed if the amounts are rolled over
to an IRA or to another eligible plan).
Individual Retirement Accounts: Higher Limits and Greater Flexibility
Individuals with IRAs will benefit from being able to
contribute greater amounts to their accounts and from the ability to roll over
account balances to and from other qualified plans or IRAs.
- The annual limit on contributions to an IRA is increased to $3,000 for the
years 2002 through 2004, $4,000 for the years 2005 through 2007, and
$5,000 for 2008 and later years.
- Individuals over the age of 50 may make additional catch-up contributions of
$500 for years 2002 through 2005 and $1,000 for 2006 and thereafter.
- Amounts distributed from an IRA may be rolled over into a 401(k) plan,
governmental 457 plan, or 403(b) annuity. As discussed above, IRAs will be
able to receive rollover contributions from these other plans, including
rollovers of after-tax contributions.
Plan Sponsors Should Begin Considering New Options and Taking Steps to
Comply With New Requirements
Because most of the new changes are effective January 1,
2002, employee benefit plan sponsors should begin considering changes they
might want to implement. Plan sponsors should also begin taking steps to comply
with new obligations, such as additional disclosure in the event of a benefit
reduction and revised distribution notices.
Materials Available On-Line
Readers who are using Acrobat Reader 3.0 or later (or an
Acrobat 3.0 or
later-enabled web browser) to review this bulletin can obtain the referenced
legislative materials through the links in the following list.
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