Current Issues and Procedures for Section 401(K) Plans
Constance M. Hiatt
All section references are to the Internal Revenue Code (“IRC”) unless otherwise indicated. “ACP” refers to active contribution percentage; “ADP,” to actual deferral percentage; “APRSC,” to administrative policy regarding self-correction; “EPCRS” to employee plans compliance resolution system; “GUST,” to the changes required by the Uruguay Round Agreements Act (GATT), the Uniformed Services Employment and Reemployment Act, and the Taxpayer Relief Act of 1997; “HCE,” to highly compensated employee; “IRA,” to individual retirement account; “IRS,” to Internal Revenue Service; “MRD,” to minimum required distribution; “NHCE,” to non-highly compensated employee; “QDRO,” to qualified domestic relations order; “SCP,” to self-correction program; “TVC,” to tax sheltered annuity voluntary correction program; and “VCP,” to voluntary compliance program. A. Introduction 1. First, what exactly is a section 401(k) plan? It is a retirement plan that is funded by employee contributions and, in many cases, matching contributions from the employer.
Constance M. Hiatt is a partner at Hanson, Bridgett, Marcus, Vlahos & Rudy, LLP, San Francisco. A member of the Western Pension and Benefits Conference and the National Association of Public Plan Attorneys, she formerly was a trustee for the San Francisco City and County Public Employee Retirement System. The author thanks Linh D. Trinh of Hanson, Bridgett, Marcus, Vlahos & Rudy, LLP for her able assistance in the preparation of this outline. A complete set of the course materials from which this outline was drawn may be purchased from ALI-ABA. Call 1-800-CLE-NEWS and ask for Customer Service. Have the order number of the course materials—SG017—handy. 45
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2. These plans have several advantages. Among these are that the employee’s contributions are taken from pre-tax salary, and the funds grow tax-free until withdrawn (at which time they are taxed at the employee’s then marginal tax rate). Also, these plans are largely self-directed and portable. 3. Both for-profit and many types of tax-exempt organizations are permitted to establish these plans for their employees. 4. New tax legislation has somewhat altered the rules for these types of plans. B. Economic Growth and Tax Relief Reconciliation Act of 2001 1. The Economic Growth and Tax Relief Reconciliation Act of 2001, Pub. L. No. 107-16, 115 Stat. 38, is friendly to employees who want to save more for retirement and the employers who want to help. The new annual limits on benefits, increased limits on deductions, repeal of the multiple-use test, and increased portability should generate more dollars for plans. All the provisions of the law are scheduled to expire for taxable or plan years ending on or next after December 31, 2010. 2. Annual Limits. The new statute raises the limits under sections 401(a)(17), 402(g), and 415(c) effective for years beginning after December 31, 2001. a. For section 415(c) (defined contribution plans), the limit is lesser of $40,000 or 100 percent compensation. b. For 402(g) limit for 401(k) and 403(b) plans: Year 2002 2003 2004 2005 2006 Limit $11,000 $12,000 $13,000 $14,000 $15,000
c. Section 401(a)(17): $200,000 annual compensation limit. 3. Super Deferrals After Age 50. Additional deferrals are permitted for a section 401(k), 403(b), and 457 plan for employees who are projected to reach age 50 by year end and who cannot make other elective deferrals on account of the limits on deferrals in section 402(g), section 415 limits, or “comparable limitation or restriction contained in the terms of the plan,” including nondiscrimi-
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nation tests. The additional contributions permitted are up to a certain applicable dollar amount or, if less, the participant’s compensation less elective deferrals for the year. a. The applicable dollar amounts for future years are: 2002 2003 2004 2005 2006 $1,000 $2,000 $3,000 $4,000 $5,000
b. After 2006, the amounts are indexed for inflation. c. The additional catch-up contributions are not subject to any other contribution limits and are not taken into account in applying other limits. d. As long as offered to all eligible employees, catch-up contributions are not subject to the non-discrimination rules. e. Any matching contribution on additional contribution is subject to the normal rules for testing. f. The additional contributions may be significant for highly compensated employees who work after age 50. 4. New Vesting Requirements for Matching Contributions. Employer matching contributions must vest no later than 100 percent after three years (i.e., a threeyear cliff) or a graduated schedule of 20 percent a year, beginning with year two so that contributions are 100 percent vested in year six. Effective for contributions for plan years beginning after December 31, 2001 (delayed effective date for collective-bargaining agreements). 5. Employee Tax Credit for Deferrals. Employees who earn less than $50,000 per year (for single employees, $25,000 per year) will have a credit on their individual tax return for a percentage of elective contributions up to $2,000. The credit is 50 percent for couples earning up to $30,000, 20 percent for couples earning between $30,000 and $32,500 and 10 percent for couples earning $32,500 to $50,000. a. Thus, the maximum credit is $1,000. The credit may encourage participation by non-highly compensated employees, which may enhance the
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nondiscrimination test results for deferrals (ADP test).For example, an employee who is married and has joint taxable income of $30,000 and an approximate new tax rate of 26 percent (on income over $12,000) can receive a credit of $1,000 if she defers $2,000 under a 401(k) plan. b. The new tax credit of $1,000 offsets over $3,800 in taxable income, which exceeds the deferral amount of $2,000 necessary to generate the tax savings. 6. Conversion to After-Tax Contributions. After 2005, a 401(k) plan can permit employees to designate part of their elective contributions as a “Roth contribution.” Roth contributions will be treated similar to elective deferrals, i.e., Roth contributions must be 100 percent vested, held in separate accounts and subject to 401(k) distribution restrictions. Distributions from Roth accounts will be taxed like distributions from a Roth IRA—no tax on distribution, including earnings, if distributed after 591⁄2, death, disability or a five year period after the participant’s first Roth contribution. The special Roth contributions are subject to the limits on elective deferrals under section 402(g). 7. Deduction Limit Increase—Section 404. The limit on an employer’s deduction is increased to 25 percent of total compensation and will no longer include elective deferrals made to a 401(k) plan. Effective for years beginning after December 31, 2001. 8. Hardship Withdrawals. An employee who takes a hardship distribution must cease his or her elective deferrals for six months after a hardship distribution (reduced from the prior rule requiring suspension for 12 months). a. Additionally, a plan may designate all of a distribution made on account of a hardship as an ineligible distribution which cannot be rolled over and which is subject to the regular withholding rules. b. Many plans distribute hardship amounts from employer contributions in addition to elective deferrals. The plan sponsor may now decide to treat all amounts distributed as a hardship distribution. 9. Portability: Transfers From Different Types of Plans. A section 401(a) plan may, but is not required to, accept rollovers from a 403(b) plan, an IRA and a 457 plan. (A hardship distribution from a 457 plan may not be rolled over.) Additionally, after-tax amounts can be rolled over from a qualified plan, 403(b) or 457 plan to any of the same or an IRA, if separately accounted for under the recipient plan. After-tax amounts cannot be rolled over from an IRA.