The Economic Growth and Tax Reconciliation Act of 2001
The Economic Growth and Tax Relief Reconciliation Act of 2001 (the “2001 Act”), made many changes to employee benefit plans. This Client Alert focuses on the impact of the 2001 Act on defined contribution plans.
Increase in Contribution Limits. Beginning January 1, 2002, the defined contribution plan contribution limits will be increased as follows:
- Annual Additions. The current limit of $35,000 or 25% of the participant’s compensation will be increased to $40,000 or 100% of the participant’s compensation.
- 401(k) Contributions. Allowable salary reduction contributions will be increased from $10,500 in 2001 to $11,000 in 2002, and will increase by $1,000 each year until 2006 when the limit will reach $15,000. Thereafter, the limit will be indexed for inflation.
- Catch-Up Contributions. Employees who are at least age 50 can make “catch-up” contributions in 2002 equal to $1,000 (increased by $1,000 for each year after 2002 up to $5,000 in 2006). Such catch-up contributions are not limited by other restrictions in the Code or the plan and generally will not be subject to the Code’s ADP/ACP testing limits. The right to make catch-up contributions, however, is subject to the Code’s nondiscrimination rules. Thus, this right must be made available to employees on a nondiscriminatory basis.
Increase in Compensation Taken into Account. The $170,000 limit on compensation that may be taken into account for purposes of determining contributions, applying the deduction rules, and for non-discrimination testing will, beginning January 1, 2002, be increased to $200,000 and indexed for inflation thereafter.
Plan Loans for Sole Proprietors, Partners, and S-Corporation Shareholders. Currently, owner-employees such as sole proprietors, 10% partners, and 5% owner-employees of an S-Corporation do not have the same access to plan loans as other employees. The 2001 Act allows owner-employees to take out loans on the same basis as other employees.
Simplification of Top-Heavy Rules. The 2001 Act simplifies the top-heavy rules and excludes certain plans from the top-heavy requirements.
- Definition of Key Employee. Plans will no longer have to look back four years to determine which individuals are key employees; only current plan year employees will be counted. Moreover, the 2001 Act repeals the requirement that the plan sponsor’s top-ten owners be considered key employees.
- Matching Contributions Taken into Account to Satisfy Top-Heavy Contribution Requirement. Beginning January 1, 2002, matching contributions may be taken into account to satisfy the top-heavy contribution requirement without affecting their status for purposes of the ACP testing requirements.
- Distributions and Service Taken into Account to Determine Top-Heavy Status. Beginning January 1, 2002, instead of taking into account distributions from the past five years, only the distributions made in the year when the top-heavy determination is made must be taken into account to determine the plan’s top heavy status. The five-year rule continues to apply to in-service distributions. Also, beginning January 1, 2002, an individual’s account balance is not taken into account if the individual has not performed services for the employer for one year prior to the date the top-heavy determination is made.
- Safe Harbor Plans Exempt from Top-Heavy Rules. Beginning January 1, 2002, safe harbor 401(k)/401(m) plans will be exempt from the Code’s top-heavy requirements.
Increase to Limits on Deductible Contributions. For taxable years beginning after December 31, 2001, qualified 401(k) contributions are no longer subject to the limits on deductible contributions. Moreover, employers will be able to take deductions for contributions of up to 25% of the compensation of the plan’s covered employees. The definition of compensation has been expanded to include 401(k) contributions, contributions to a cafeteria plan or a governmental 457 plan, qualified transportation fringe benefits, and certain compensation deemed paid to disabled participants.
Faster Vesting of Matching Contributions. For contributions made in plan years beginning after December 31, 2001, matching contributions to a defined contribution plan must vest either 100% at the end of three years (three-year cliff) or 20% each year beginning in the second year such that a participant would be 100% vested at the end of six years (6-year graded).
Hardship Distributions. For distributions made after December 31, 2001, the twelve months during which participants cannot make contributions after a hardship withdrawal will be reduced to six months.
Simplification of Optional Forms of Benefits. For years beginning after December 31, 2001, a plan will have greater flexibility to eliminate optional forms of benefits. However, the QJSA and QPSA rules will still apply.
- Plan to Plan Transfers. Optional forms of benefits may be eliminated in a plan-to-plan transfer if (1) the participant voluntarily agrees to the transfer after receiving a notice of the consequences of the election, (2) the terms of both plans authorize the transfer, (3) the transferee plan allows any optional form of benefit being eliminated to be distributed in a lump sum, and (4) the transfer is made pursuant to a direct, trustee-to-trustee transfer rather than pursuant to a distribution.
- Elimination of Forms of Distributions Where Plan Retains Lump Sum Distributions. Except to the extent provided by IRS regulations, a plan can eliminate optional forms of benefits previously available but only if a lump sum distribution is available at the same time and based on the same portion of the participant’s account as the eliminated form of benefit.
Elimination of Same Desk Rule. The 2001 Act repeals the same desk rule effective for distributions made after December 31, 2001, regardless of when the severance occurs. Thus, for example, if a plan sponsor had employees who in the past experienced a severance from employment where the same-desk rule prevented a distribution, the plan sponsor could provide in the plan that such severance would, or would not, be treated as a distributable event under the plan. Just as under present law, however, a distribution may not be made if a participant’s benefits are transferred, in a plan-to-plan transfer, to the new employer’s plan.
Involuntary Cash-Outs. For distributions made after December 31, 2001, the amount of a participant’s benefit for purposes of the $5,000 maximum on involuntary cash-outs can be determined without regard to the participant’s rollover amounts.
Repeal of Multiple-Use Test. The 2001 Act repeals the “multiple use test” under the ADP/ACP testing rules. As a result, plan sponsors will be take advantage of the alternative limitations set forth in Internal Revenue Code Section 401(k)(3) and 401(m)(4).
If you have any questions about the Economic Growth and Tax Relief Reconciliation Act of 2001, please contact one of the authors listed at the top of the page.