2001 Tax Act

Last weekend, Congress passed the Economic Growth and Tax Relief Reconciliation Act of 2001. The President has announced that he will sign the Act. Although the centerpiece of the Act was the phased reduction in personal income tax rates, the Act contains a number of significant, and exciting, changes affecting employee benefit plans.

The following is a brief summary of the most significant of these benefit changes. As with all new legislation, we will need to study and digest the specifics of the Act and, in several cases, we will need to await regulatory guidance. However, employers should begin to familiarize themselves with the Act now, because a number of its employee benefit provisions are due to take effect soon.

For perhaps the first time in memory, virtually every employee benefit change in the Act is a favorable one, presenting wonderful benefit opportunity after wonderful benefit opportunity. We believe that the best method to ensure that no opportunity is missed is to have a discussion to review the plans you maintain, the opportunities available with respect to each plan, and the steps necessary to exploit those opportunities. We have labored enthusiastically this week to build modules which permit us to bring our clients to a position of certainty in planning for these opportunities in a very short time frame (e.g., in a one hour phone call). We suggest that you read the following for background and then call us to schedule such a discussion.

Increases the salary reduction contribution limits for 401(k), 403(b) and 457(b) plans to $11,000 in 2002, $12,000 in 2003, $13,000 in 2004, $14,000 in 2005 and $15,000 in 2006.

Establishes an additional "catch-up" salary reduction contribution limit for participants age 50 and older in a 401(k), 403(b) or governmental 457(b) plan of $1,000 in 2002, $2,000 in 2003, $3,000 in 2004, $4,000 in 2005 and $5,000 in 2006. These catch-up contributions are exempt from other contribution limitations and non-discrimination rules (although the plan must allow all eligible participants to participate in the same manner in the catch-up contribution feature).

Increases the 415(c) annual addition limit for defined contribution plans to the lesser of $40,000 or 100% of the participant's compensation.

Increases the 415(b) annual benefit limit for defined benefit plans to $160,000 in 2002, with actuarial reductions in the limit no longer required for retirements between ages 62 and 65.

Removes the 415(b) 100% "three-year-high average" compensation limit for multiemployer plans.

3. Repeal of Maximum Exclusion Allowance Limit. In one of the most favorable changes for 403(b) plans, the Act repeals the extremely unnecessary and difficult "MEA" limit for 403(b) plans, effective for plan years beginning after December 31, 2001. Together with the increase in the 415(c) limit discussed in item 2, above, this means that the increasing dollar limit discussed in item 1, above, now will be the only meaningful limit on salary reduction contributions to 403(b) plans. This raises not only significantly greater savings opportunities for employees, but also considerably decreased administrative burdens for employers.

4. 457(b) Plan Contribution Limit. The Act increases the annual contribution limit for 457(b) plans (so-called "eligible deferred compensation plans") to the lesser of the dollar limits discussed in item 1, above or 100% of compensation, effective in 2002. (As was the case prior to the new legislation, a 457(b) plan sponsor may provide that a participant who is within three years of his or her normal retirement age may make an additional contribution to the plan--up to, in certain cases, twice the otherwise applicable dollar limit; however, in such a case the new "catch-up" contribution for age 50 or older participants in a governmental 457(b) plan, described in item 1, is unavailable.) Also beginning in 2002, contributions to other types of defined contribution plans by the participant no longer count against the dollar limits applicable to the 457(b) deferrals. In other words, individuals who are eligible under a 457(b) plan do not have to coordinate the contribution limit under the 457(b) plan with the contribution limit under Code section 402(g) (pertaining to elective salary reduction contributions under 401(k) and 403(b) plans). This many create significant deferral opportunities for executive employees of tax-exempt entities; for example, hospital executives.

5. 401(a)(17) Recognizable Compensation Limit. The current $170,000 limit on compensation that can be recognized by a qualified plan increases to $200,000 in 2002, and the COLA rules are changed so the limit will be increased in $5,000 increments. This will mean greater benefits for higher paid employees under qualified retirement plans. This change also will require review of most nonqualified supplemental retirement plans that were meant to "make whole" for this limit.

Permits plans to exclude elective deferrals for purpose of calculating the 404 deduction limit.

Permits plans to include elective deferrals in the definition of compensation used in calculating the deduction limit.

Phases-up the full funding limit for defined benefit plans to 170% and then repeals it in 2004, generally extends the maximum deduction rule of 404(a)(1)(D) (allowing defined benefit plans to make fully deductible contributions equal to the unfunded current liability) to all defined benefit plans regardless of size, and permits plans to fund up to their termination liability in the year of plan termination.

7. Enhanced Portability. The Act makes these long-awaited improvements to the qualified plan portability rules:

Rollovers are permitted among 401(a), 403(b), governmental (but not tax-exempt entity) 457(b) plans, effective beginning in 2002.

Rollovers of IRAs are permitted to employer-sponsored retirement plans, effective beginning in 2002 -- that is, even if the IRA is not a pure "conduit IRA".

Rollovers of after-tax contributions are permitted to employer-sponsored retirement plans and IRAs, effective beginning in 2002. Because of special recordkeeping burdens that such a rollover may entail, employers should consult with us before adding a rollover feature for after-tax contributions to their plans.

8. Vesting Requirements. Effective in 2002, the Act changes the maximum vesting rules available for matching employer contributions to either three-year cliff vesting or two to six year graduated vesting.

9. Top-Heavy Rules. Effective in 2002, the top heavy rules have been simplified (but, unfortunately, not repealed), as follows:

Frozen defined benefit plans will not have to make top-heavy minimum contributions.

10. Cash-outs. The Act requires that involuntary cash-outs greater than $1,000 must automatically be rolled-over to an IRA unless the participant affirmatively elects otherwise. This default rollover rule does not take effect until the Secretary of Labor issues regulations which will prescribe safe harbor standards with respect to investments in the default IRA.

11. Multiple Use Test. Effective in 2002, the unnecessary prohibition against the multiple use test of the 125% nondiscrimination test applicable to 401(k) plans is repealed. Employers who have a matching contribution feature in their 401(k) plans should find that compliance with the 401(k) and (m) nondiscrimination requirements is much easier after 2001.

12. Plan Loans. Plan loans for partners and S-Corp shareholders are permitted, beginning January 1, 2002.

13. User Fee Waiver. For determination letter requests made after December 31, 2001, "new small employer plans" (i.e., plans less than five years old with no more than 100 participants) are exempt from paying the user fee ordinarily required in order to apply for a determination letter.

14. Roth 401(k) Plans. Beginning in 2006 (we would not recommend holding one's breath), the Act permits "Roth 401(k) plans" which are similar to current Roth IRAs.

15. Same Desk Rule. The Act repeals, effective 2002, the extremely troublesome "same desk rule" that often plays havoc with employer attempts to effect distributions in corporate transaction situations. Employers maintaining plans currently holding assets attributable to former employees with respect to whom the "same desk rule" has prevented distributions should now review opportunities to make distributions to these former employees.

16. Anti-Cutback Rules. Effective in 2002, the Act reforms the "anti-cutback" rules by permitting defined contribution plans to eliminate most optional forms of benefit distributions following plan mergers and similar events (codifying a recent IRS regulation).

17. Defined Benefit Valuations. The Act permits use of prior year valuation dates for well-funded defined benefit plans, effective in 2002.

18. Employer Tax Credit. The Act provides for a limited tax credit for start-up costs incurred in connection with new small business retirement plans, available for plans established in 2002.

19. Notice Requirements. The Act expands the notice requirements for plan amendments, such as cash balance conversions, that significantly reduce future normal or early retirement age benefit accruals, effective immediately.

20. Employee Tax Credit. The Act creates a tax credit for low-income (i.e., those earning $25,000 or less annually) contributors to 401(k) plans, 403(b) plans, 457(b) plans or IRAs equal to up to 50% of $2,000 of contributions to these arrangements, available only from 2002 through 2006.

21. 95% Rule. The Act reinstates the so-called "95% rule", retroactively effective to its prior sunset date, that eases coverage testing requirements for 401(k) plans maintained by for-profit employers associated with not-for-profits. This rule will facilitate satisfaction of the coverage requirements by HCE-predominant for-profits associated with not-for-profits. This reinstatement will have the most profound impact on for-profit "friendly P.C.s" associated with tax-exempt hospitals and health systems, which now will be able to have 401(k) plans benefitting physicians, conditioned on compliance with the new rules.

22. Hardship Distributions. Effective January 1, 2002, the Act revises the "deemed necessary to satisfy financial need" hardship safe harbor so participants are only restricted from making salary reduction contributions for six months following their hardship distributions (as opposed to one year under prior law).

1. Dividend Reinvestment. The Act allows ESOP dividends to be reinvested without loss of the dividend deduction, effective beginning in 2002. However, the Secretary of Treasury has authority to disallow a deduction for "unreasonable dividends".

2. S-Corporation ESOPs. Effective for plan years beginning after December 31, 2004 with respect to S-Corp ESOPs in existence on March 14, 2001 (and effective for plan years ending after March 14, 2001 for new S-Corp ESOPs), the Act places restrictions on what some considered "abusive" S-Corp ESOPs (e.g., those where the employer's owners want to establish an S-Corporation ESOP with themselves as significant participants). We ask that all S-Corp ESOP sponsors examine with us closely the impact of these new rules on their plans.

1. Increase in Limits. The Act increases the IRA contribution limits to $3,000 in 2002, $4,000 in 2005 and $5,000 in 2008, with a special catch-up contribution for people age 50 and older that permits them to contribute an extra $500 for 2002 through 2005, and $1000 for 2006 and thereafter. These increases apply to both traditional and Roth IRAs.

2. Coordination of IRAs with Employer Plans. Effective beginning in 2003, the Act permits employer-sponsored plans to facilitate IRA contributions without the IRA contributions being considered part of the employer-sponsored plan. For example, an employer-sponsored plan may have a provision permitting employees to make contributions to a separate account or annuity, which account or annuity meets normal IRA requirements, without subjecting such "deemed IRA contributions" to ERISA participation, funding, enforcement and other ERISA provisions which relate solely to employer-sponsored qualified plans.

3. Education IRAs. The Act increases the contribution limit for Education IRAs to $2,000 per year, beginning in 2002. In addition, Education IRAs may be used for elementary and secondary education, as well as college education, beginning in 2002.

1. Adoption Assistance. The Act indefinitely extends the life of Code Section 137 adoption assistance programs, which were previously scheduled to sunset at the end of this year, increases the expense limitations under those programs to $10,000, and increases the compensation limitations, effective 2002.

2. Tuition Assistance. The Act permanently extends Code Section 127 tuition assistance programs and expands these programs to include graduate-level courses, effective 2002.

3. Dependent Care Credit. The Act increases the various limitations relating to the dependent care tax credit under Code Section 21, effective as of 2003. Code Section 21 allows qualifying individuals to reduce their taxes, up to a specified dollar amount limit, by a certain percentage of dependent care expenses incurred. Whether an individual is a qualifying individual, and the applicable percentage for each qualifying individual, is based on the individual's adjusted gross income. Under the Act, the start of the adjusted gross income phase-out range has been increased, with the result being that the range of qualifying adjusted gross incomes has been changed from $0-$28,000 to $0-$43,000. The Act also increases the dollar limit on the tax credit from $2,400 to $3,000 for one qualifying individual and from $4,800 to $6,000 for two or more qualifying individuals and increases the maximum percentage of dependent care expenses which may be credited from 30% of incurred dependent care expenses to 35% of those expenses.

These increases in the dependent care tax credit limitations may make the dependent care tax credit a more attractive alternative to certain employees than an employer's Code Section 129 dependent care flexible spending account arrangement. Code Section 129 DFSAs generally must satisfy a requirement under the Code whereby the average benefits provided to non-highly compensated employees must equal at least 55% of the average benefits provided to highly compensated employees. For purposes of this test, the Code permits employers to exclude from consideration those employees earning less than $25,000 per year. Unfortunately, this $25,000 limit was not been increased by the Act. Although this may have been an oversight, and although this may be corrected in subsequent legislation, in the meantime, if an employer believes that there may be a significant number of employees earning between $25,000 per year and $43,000 per year who will opt out of the DFSA in favor of using the improved dependent care tax credit, the employer should consider the implications under the 55% test.

We look forward to working with you to take maximum advantage of all of these wonderful benefit opportunities.