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New Changes in Retirement Plan Law

Part 3: Of Interest to Sponsors of 401(k) Plans, Defined Benefit Plans, and Small Plans

Anthony Mathews

August 2001

Two months ago, we started with a discussion of the ESOP-related provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001. Last month, we reviewed the general pension provisions in the new law. This month, we finish our discussion of the new law with an examination of the provisions of special interest to sponsors of 401(k) plans, defined benefit plans, and small plans.

Section 401(k) Plans

Limits on employees’ elective salary deferrals under Internal Revenue Code sections 401(k), 403(b), and 457 are all increased to $11,000 in 2002, then increased $1,000 each year until reaching $15,000 in 2006, and then indexed in $500 increments.
For years beginning after December 31, 2001, the covered compensation used for purposes of computing the Section 404 deduction limit will include elective deferrals to qualified plans (rather than excluding those amounts, as is the case through this year.
In addition, whereas employees’ elective deferrals have always been included in the deduction limit as if they were employer contributions, after 2001, employees’ salary deferrals will not affect the employer’s deductible maximum.
For years beginning in 2002 and thereafter, all matching contributions to 401(k) plans will have to adopt one of two (probably accelerated) vesting schedules: (a) a 3-year cliff vesting schedule calling for 0% vesting for less than 3 years of service and then 100% thereafter, or (b) a 6-year graded vesting schedule (with vesting beginning in the employee's second year of service and increasing in 20% increments thereafter). These schedules are familiar as the required "top-heavy" schedules.
Where 401(k) plans cannot pass at least one of the ADP or ACP tests with the 1.25 times test, they have been subject to a special "multiple use" test. Mercifully, the requirement to pass this test is repealed effective in 2002.
The deferral limits applicable to 401(k) plans and 457 plans are no longer coordinated beginning in 2002.
For participants over age 50, a qualified plan "catch-up" contribution will be allowed in a 401(k), 457, or 403(b) plans. The "catch up" contribution allowed will be $1,000 in 2002, then increased each year by $1,000 until it reaches $5,000 in 2006. The catch-up contribution limit will then be indexed in $500 increments thereafter.
The "catch-up allowed in SIMPLE plans will be 50% of the amount allowed for regular plans.
"Catch-up" contributions will be exempt from nondiscrimination (ADP/ACP) testing, provided all employees over age 50 participating are eligible to make a catch-up contribution. Such amounts are also exempt from consideration as annual additions.
Starting in 2006, "Roth" type 401(k) plans will be permitted allowing for after tax contributions and tax free distributions.

Defined Benefit Plans

Code Section 415(b) has required actuarial benefit reductions for retirements taken before age 65. For years beginning after 2001, there will be no required reduction for retirements between ages 62 to 65.
The defined benefit dollar limit in Code Section 415(b) is increased to $160,000 in 2002, then indexed in $5,000 increments thereafter.
The full funding limit is phased up to 170% and then repealed in 2004. The maximum deduction rule of Section 404(a)(1)(D) would be extended to all PBGC-covered plans regardless of size. Further, such plans would be permitted to fund up to termination liability in the year of plan termination.
With regard to "cash balance" plans, the new law basically directs the Treasury Department to expand the ERISA Sec. 204(h) notice requirement for plan amendments significantly reducing benefit accruals. The provision directs the Treasury to provide simplified notice requirements for plans with less than 100 participants.

Small Plan Changes

A new tax credit for the start-up costs of a new small business retirement plan (less than 100 participants) was added in the amount of a 50% tax credit on up to $1,000 of start up costs. The tax credit can be taken for each of the first 3 years of the plan. The frequently talked about and more generous tax credit for employer contributions to a new small business retirement plan was dropped.
New small employer plans will be exempt from having to pay an IRS user fee (currently $700 for an individually designed plan) when applying for a determination letter as to the plan’s qualification.
The SIMPLE plan annual contribution limit is increased $1,000 each year beginning in 2002 until it reaches $10,000 in 2005, and thereafter will be indexed in $500 increments each year.

Conclusion

It is safe to say that there has not been a more comprehensive package of pension plan improvements and changes in more than 2 decades. Atypically for pension provisions, these come in a package of tax changes that have a built in "off switch" or "sunset provision" which states that all provisions will revert to current law, if not further authorized, in 10 years. So we may get to do it all over again.

Anthony Mathews is the coauthor of our book Section 401(k) Plans and Employee Ownership, which has been revised throughout to reflect the new laws.

Biography and list of other "Administrator's Notebook" installments

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