New Tax Law Would Make Major Changes in Defined Contribution Plan Rules

The tax law passed by Congress would make a variety of changes in the rules for defined contribution plans, particularly with respect to limitations on contributions to 401(k) plans. These changes are costly, however, and even if there is a tax law that survives the battle between the President and Congress, some or all of these provisions may not survive. The principal changes are outlined below:

1. Elective Deferral Limits: Limits on elective deferrals to 401(k) plans would be increased to $11,000 per year in 2001 and another $1,000 per year for each subsequent year through 2004, at which point they would be increased annually by the cost of living. Contribution limits in SIMPLE plans would increase to $10,000 in 2004.
2. After-tax Elective Deferrals: Employees could choose to designate their elective deferrals as "plus" contributions. These would be treated much like Roth IRA contributions. They would be after-tax going into the plan, but not taxable coming out.
3. Section 415 Limits: The 25% of pay limit under Section 415 of the Code for the maximum amount any individual can defer or have contributed to defined contribution plans would be lifted to 100% of pay, subject to the dollar limits specified above. However, the bill does not change the existing $30,000 cap on total contributions/deferrals, nor does it alter the maximum amounts that can be contributed as a percentage of the aggregate amount of pay under Section 401 (generally 25% of the eligible pay of all plan participants) without incurring excise taxes. In an ESOP, the new law would have the effect of allowing individual employees to contribute much more to their 401(k) plans than is currently the case in some plans. For instance, if a company is contributing 20% of pay to an ESOP, and an employee making $50,000 wants to put in another $10,000 into a 401(k) plans in the year 2000, under existing law, this would violate the Section 415 rules because the total of company and employee contributions plus deferrals would be 40% of pay. Under the new tax bill, this would be allowed.
4. Catch-up Contributions: Employees over 50 can make additional pre-tax "catch-up" contributions to a 401(k) plan above the normal limits, with percentages gradually increasing through 2005.
5. Faster Vesting for Matching Contributions: Employer matches to elective deferrals must match 100% after three years where there is cliff vesting or after six years where there is graduated vesting.
6. Elective Deferrals Not Subject to Plan Deduction Limits: Employee elective deferrals would no longer count in calculating limits on the total amounts employers are allowed to contribute to plans.
7. Top-Heavy Rules: The definition of key employees would be simplified and family aggregation rules would no longer apply in determining who is a 5% owner.
8. Allowable Compensation Increased: The maximum amount allowable to be counted in calculating contribution limits would increase by $5,000 increments to $200,000 in 2005.

The net effect of these changes would primarily be to allow greater employee elective deferrals to 401(k) plans, even in the presence of generously funded company plans, such as ESOPs or profit sharing plans. The dollar limits on these deferrals, as well as the $30,000 limit, would put a ceiling (if a generous one) on how much more could be deferred.