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EGTRRA — Mostly Good News

When President Bush signed the Economic Growth and Tax Relief Reconciliation Act (“EGTRRA”) last June, employers administering retirement plans received good news. The new law provides the opportunity, starting with this year, for increased retirement plan contributions by both employers and employees. In addition, the Act significantly simplifies some tasks for plan sponsors and administrators for 2002, including eliminating the “multiple use test” for nondiscrimination in 401(k) plans and the infamous “maximum exclusion allowance” calculation in 403(b) plans.

Plan Document Changes Required by the End of the 2002 Plan Year

Plan sponsors must make “good faith” amendments to incorporate EGTRRA changes in their retirement plans, generally by the end of the 2002 plan year. The IRS has provided model language for employers to use to adopt EGTRRA changes to plan documents, and also indicated that in many cases the changes can be adopted administratively before plan documents are changed. Some of our clients have already made the EGTRRA changes; for those who have not, we will be contacting you in the near future regarding plan amendments.

But Changes in Plan Operation are Needed Now

While a plan sponsor may not need to immediately adopt plan amendments, there are still many tasks that employers and those who administer their plans need to undertake now. In some cases, such as the new rollover notices to employees who are eligible to receive plan distributions, these actions are required. In other cases, such as where an employer wishes to let employees make additional “catch up” contributions to a plan, the employer and the plan administrator need to agree on the parameters for those contributions, recordkeeping and payroll systems need to be updated, and the new contribution opportunity needs to be communicated to employees.

The following describes a number of actions that are required, or that may be advisable, in light of the new law:

Defined Contribution Plans — Greater Contributions Allowed

Pre-tax Participant Contributions. EGTRRA allows employees to contribute more on a pre-tax basis to 401(k) plans, 403(b) tax-sheltered annuity plans and section 457 plans. EGTRRA also permits additional pre-tax “catch-up contributions” to be made to 401(k), 403(b) and (subject to certain limits) governmental 457 plans by those participants who will have attained at least age 50 by the end of the applicable year. The new EGTRRA pre-tax contribution limits, and additional catch-up limits, scheduled over the next five years are:

Year Limit on Regular Additional “Catch-up” Contributions
Pre-tax Contributions Allowed (if at least age 50 -end of year)

2002 $11,000 $1000
2003 $12,000 $2000
2004 $13,000 $3000
2005 $14,000 $4000
2006 $15,000 $5000

Employers that want to provide for the additional catch-up contributions to one plan, must permit catch-up contributions to any other plan in the employer’s “controlled group” of entities that accepts pre-tax contributions. Catch-up contributions are not subject to the various nondiscrimination testing rules that apply to pre-tax contributions and are not subject to the annual additions limitation discussed in the next section. Employers will need to specify in their plan documents whether or not catch-up contributions will be matched; the law does not require such a match. Employers with participants in “non-conforming states,” such as Massachusetts and California, need to consider the state income tax implications of allowing higher contributions, since the state income tax law may not yet recognize higher pretax contributions (and new rollover contributions) allowed by EGTRRA.

For not-for-profit employers, EGTRRA now permits significant additional contributions to be made to a 457(b) plan for a “top hat” group of key employees ($11,000 for 2002), on top of the increased contributions that can be made to the institution’s 403(b) or 401(k) plan. Deferrals to 457 plans will no longer be coordinated with deferrals to 403(b) and 401(k) plans, providing “top-hat” employees of tax-exempt organizations with a valuable opportunity to maximize retirement savings.

Higher Employee Contribution Limits as a Percentage of Pay. The maximum total allocation (the “annual additions limit”) permitted for participants in a defined contribution plan is increased by EGTRRA from the lesser of $35,000 or 25% of pay, to $40,000 or 100% of pay. Previously, in order to stay within the overall limit, employers have typically limited employee contributions to 401(k) plans to, for example, 15% of pay. With the EGTRRA change, employers may want to allow employees to contribute 50% or more of their pay to a plan, on a non-matched basis (subject to the rule that pre-tax contributions must still be limited to $11,000 annually, as adjusted as described above). Allowing greater contributions as a percentage of pay typically benefits lower paid employees, and can help in passing nondiscrimination tests.

Higher Pay Cap. In the 2002 plan year, under EGTRRA, retirement plan allocations can be made with respect to pay up to $200,000, versus $170,000 that could be taken into account in 2001. (For an employer that does not want the new, higher limit to automatically apply, the plan may have to be amended now to make sure the prior limit is not increased.) In most cases, employers will welcome the ability to recognize more compensation under the retirement plan for key employees. For an employer that provides a nonqualified plan to supplement retirement benefits for executives, it may now be possible to provide lesser benefits under the nonqualified plan to recognize the increased qualified plan benefits.

Vesting of Employer Matching Contributions

• Faster Vesting. Employer matching contributions made to any 401(k) plan or 403(b) plan with respect to any employee with at least 1 hour of service on or after the commencement of the 2002 plan year must either vest 100% after 3 years (versus 5 years under prior law), or vest 20% per year over 2-6 years (versus 3-7 years under prior law). While most plans with matching contributions already meet the new standard, plans that do not must make sure that vesting percentages for post-2001 matching contributions are calculated in accordance with the new law.

Revised Rollover Rules

• Rollovers from Retirement Plans. New rollover rules allow most non-periodic distributions from tax-qualified retirement plans, 403(b) tax sheltered annuities and governmental 457 retirement plans (collectively, “eligible plans”) to be rolled over to any other type of eligible plan, effective January 1, 2002. Previously, a distribution from a tax-qualified plan, such as a 401(k) plan, could not be rolled over to a different type of plan, such as a 403(b) plan. In addition, effective January 1, 2002, voluntary after-tax contributions can be directly rolled over into an IRA or an employer-sponsored plan of the same type (other than a governmental 457 plan) so long as the after-tax contributions and earnings thereon are separately accounted for. With the new rules, a revised rollover explanation must be provided to participants receiving distributions.

• Revised Rollover Explanation Required. The IRS has published two revised “safe harbor” explanations to participants — one for tax-qualified plans (including 401(k) plans) and 403(b) tax-sheltered annuities, and the other for governmental 457 plans — that reflect the new rules. A copy of the IRS’ safe harbor notice for tax-qualified plans and 403(b) tax-sheltered annuities is enclosed. Use of the new notice (or a similar notice that fully describes the new rules) is now required. If you would like an electronic version of this notice, which can be customized for your plan, or a Spanish version recently released by the IRS, please let us know and we will be happy to forward it to you.

• Rollovers to Retirement Plans. Retirement plans can choose to accept a wider array of rollover contributions, although an employer need not accept any rollover contributions into its plan. Employers should discuss with their recordkeepers any new amounts that they might want to allow employees to transfer into their plans, to make sure they understand any administrative obstacles. For example, even though it is now possible for a 401(k) plan to accept a direct rollover of employee after-tax contributions from another 401(k) plan, if the accepting plan does not also itself allow employees to make after-tax contributions, allowing such a direct rollover into the plan may well be more of a headache than it’s worth.

Defined Benefit Plans – Greater Benefits Permitted

• Higher Maximum Benefit. Besides being able to take into account pay up to $200,000 in calculating benefits, the limit on the annual benefit that can be paid by a defined benefit plan has increased from $140,000 in 2001 to $160,000 in 2002. And, the limit is now generally reduced only for retirement before age 62, rather than before Social Security normal retirement age as under prior law.

Other Items To Be Addressed.

• Administration of Hardship Withdrawals. 401(k) and 403(b) plans that permit hardship withdrawals can reduce the period that an employee who receives a hardship withdrawal is precluded from plan participation from 12 months to six months (so-called “safe harbor” plans, exempt from plan nondiscrimination testing, may need to make this change in order to continue to qualify as “safe harbor” plans). In addition, once the suspension period ends, the participant who received the hardship distribution need not have his permitted deferrals limited by any amounts deferred in the year in which he received the hardship distribution. These changes should simplify administration of hardship distributions and help employees resume elective deferrals without penalty for having taken the hardship distribution.

• Deductibility of ESOP Dividends. Employers that maintain Employee Stock Ownership Plans (“ESOPs”) may want to take advantage of new provisions allowing employers to deduct dividends paid on Company shares held by the ESOP, where employees have the choice of either receiving the dividends in cash or of having the dividends reinvested in employer stock in the plan.

• Saver’s Tax Credit. Employers will want to communicate the new “saver’s credit,” included in EGTRRA, to encourage plan participation by lower-paid employees (i.e., married couples with joint incomes under $50,000). The income tax credit can amount to as much as $1,000 per plan participant. The IRS has issued an Announcement in both English and Spanish informing employees about this new credit.

• Higher Plan Contribution Deduction Limit. The deduction limit for employer contributions to defined contribution plans has generally been increased to 25% (from 15%) of the compensation of plan participants. Besides allowing employers to increase contributions where desired, this change means that employers who have in the past maintained two plans covering the same group of employees (such as a profit sharing plan and a money purchase plan) in order to maximize their deductible contributions, may be able to combine those plans going forward, thereby significantly reducing their administrative burden.

The above is a general summary highlighting some of the important changes made by EGTRRA. It is not intended to address all EGTRRA provisions, and is not tailored to your specific plans. If you have questions regarding any of the EGTRRA changes, or would like more details about how they apply to your plans, please contact Sherry Dominick, Karen Clute or Chris Lindgren.