Section Review

The Impact of the Economic Growth and Tax Relief Reconciliation Act of 2001 on 401(k) Retirement Plans

On June 7, 2001, President Bush signed the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) into law. The new laws embodied in EGTRRA will have a profound impact on retirement plans and arrangements, comprising more than 80 changes to the existing law. This article will focus on the changes that affect qualified plans under Section 401(k) of the Internal Revenue Code of 1986 (the “Code”) and how the Commonwealth of Massachusetts is addressing those changes. A. Increase in maximum annual salary deferral contributions Before EGTRRA, the annual maximum permitted salary-deferral contribution under a Code §401(k) plan was $10,500 (for 2001). The limit was adjusted annually in $500 increments for inflation. Under §402(g) of the code as amended by EGTRRA §611(d), however, the maximum allowable salary-deferral contribution to a 401(k) plan will be $11,000. For plan years beginning in 2003 and later the limit is increased in $1,000 increments annually until 2006 when it reaches $15,000. In years following 2006 there is an annual adjustment for inflation in $500 increments. B. Catch-up contributions for individuals age 50 and older Prior to the enactment of EGTRRA, the law had made no accommodations for individuals age 50 and older in 401(k) plans. For tax years beginning after 2001, however, individuals age 50 and older may increase their salary-deferral contributions beyond the maximum permitted amount as detailed above. Under the proposed regulations, an individual who will attain age 50 before the end of the calendar year is eligible to make catch-up contributions for that year even if the individual dies or terminates employment during the year. EGTRRA has added §414(v) to the code which provides that these individuals may make additional salary-reduction contributions equal to the lesser of (i) the applicable dollar limit (described below), or (ii) the individual’s compensation for the year reduced by his or her salary deferral contributions for the year. The applicable dollar limitation increases annually until 2006 as follows:
Year Additional Annual Salary Reduction Contribution Permitted for Individuals 50 and Over Maximum Annual Salary Reduction Permitted for Individuals Contribution 50 and Over
2002 $1,000 $12,000
2003 $2,000 $14,000
2004 $3,000 $16,000
2005 $4,000 $18,000
2006 $5,000 $20,000
After 2006, the $5,000 addition is adjusted for inflation. Universal availability In order to take advantage of the catch-up contribution provisions under EGTRRA, a plan must allow all eligible participants to make the same elections with respect to catch-up contributions. A plan failing to do so will be considered to have failed the nondiscrimination requirements under §401(a)(4) of the code with respect to benefits rights and features. In addition, the universal availability requirement in code §414(v)(4)(B) dictates that all plans maintained by employers treated as a single employer under the controlled group rules will be treated as one plan. If an employer chooses to allow catch-up contributions, all of the employer’s plans must provide for the same catch-up contributions. IRS Notice 2002-4 indicates that as long as all of the employer’s plans offer catch-up contributions by Oct.1, 2002, the universal availability requirement will be met even if the plans offered the contributions beginning on different dates. Exceptions to the universal availability rule: Employers do not have to offer catch-up contributions to employees who are covered by a collective bargaining agreement that was in effect on Jan. 1, 2002, until the first plan year beginning after the expiration of the agreement. Furthermore, plans that have been newly acquired as a result of merger, acquisition or a similar transaction must be amended to allow for catch-up contributions as soon as practicable but no later than the end of the year following the year in which such transaction occurred. Classifying a contribution as a catch-up contribution A salary-deferral contribution to a 401(k) plan is not deemed a catch-up contribution if it does not exceed either a statutory limit (under §402(g) or §415 of the code), an employer imposed limit or an actual deferral percentage (ADP) limit. As described above, the limitation under §402(g) of the code as amended by EGTRRA is $11,000 beginning in 2002. The code §415 limitation is a limitation on annual additions to a defined contribution plan on behalf of an individual. For plan years beginning in 2002 the code §415 limitation has been increased by EGTRRA to the lesser of $40,000 or 100 percent of compensation. Any contribution by an eligible individual in excess of either Code §415 or Code §402(g) limits, will be deemed a catch-up contribution. An employer-imposed limit is one that is not required by the code but is provided for in the plan, usually to assist the employer in complying with Code §415 limitations and/or ADP test compliance. A salary deferral contribution that exceeds an employer-imposed limit will be considered a catch-up contribution. The ADP limit is a limit on salary-deferral contributions due to the ADP test. The ADP test requires that salary-deferral contributions made by Highly Compensated Employees (HCEs), calculated as a percentage of compensation, not exceed the same percentage calculated for non-HCEs by a certain amount. If a plan fails the ADP test, it must distribute excess contributions back to HCEs with the largest contribution amounts, or the plan may utilize other permissible corrective measures. Any salary-deferral contribution by an HCE eligble to make a catch-up contribution that is beyond the ADP limit will be deemed a catch-up contribution up to the statutory allowed amount. Example: At the end of the 2002 plan year, it is determined that a certain HCE may only defer $10,500 of his or her salary to the plan under an ADP limitation. If the HCE had in fact deferred $12,000, $1,000 (the catch-up contribution limit for 2002) will be deemed a catch-up contribution and the excess $500 must be returned. The HCE will have an $11,500 salary deferral contribution for the year. Employer matching contributions for catch-up contributions An employer that permits catch-up contributions and provides for an employer contribution to match participants’ salary deferral contributions in its 401(k) plan need not provide matching contributions for the catch-up contributions. If an employer does choose to match catch-up contributions as well, however, the entire matching contribution will be considered in the actual contribution percentage (ACP) nondiscrimination test (for employer contributions and employee after-tax contributions) and the Code §415 limit on annual additions. C. Vesting Prior to EGTRRA, an employee had to be vested in employer matching contributions made on his or her behalf, either fully after five years or in 20 percent increments each year starting with the employee’s third year of service with the employer and with the employee becoming fully vested after completing seven years of service. EGTRRA speeds up the two alternative vesting schedules for employer matching contributions. For plan years beginning after Dec. 31, 2001, an employee must be vested in his or employer matching contributions either fully after three years of service or in 20 percent increments beginning with the employee’s second year of service, with full vesting after completing six years of service. The pre-EGTRRA minimum-vesting schedules still remain in effect for employer contributions that are not matching contributions. D. Repeal of the multiple use test In addition to the ADP nondiscrimination test under §401(k) of the code and the ACP nondiscrimination test under §401(m) of the code that plans were required to satisfy, before EGTRRA, plans also had to satisfy the complicated multiple-use test that coordinated the ADP and ACP tests. Beginning in 2002, plans are no longer required to satisfy the multiple use test. The elimination of the multiple-use test will allow plans that currently impose contribution limits on HCEs due to the test to relax or remove such limits. E. Elimination of the “same desk rule” EGTRRA has expanded the situations under which an individual may receive a distribution of the salary-deferral portion in his or her 401(k) plan. Before EGTRRA, a plan participant (or his or her beneficiary) could only receive a distribution without penalty if the individual died, became disabled or incurred a “separation from service.” A separation from service occurred when an individual retired, resigned or was discharged from his or her duties. The “same desk rule” provided that it was not considered a separation from service when an employee continued the same job for a different employer due to merger, acquisition or other similar circumstances. Therefore, an employee who, due to those circumstances, ceased to work for the employer that maintained the plan, could not receive a distribution of his accounts attributable to salary-deferral contributions. The rule under Code §401(k)(2) and Code §401(k)(10) has been changed by EGTRRA to permit a distribution upon a “severance from employment.” The occurrence of a merger, acquisition or similar circumstances that results in an individual’s severance from employment will allow the individual to receive a distribution without penalty. The IRS has explained that a severance from employment occurs when the common-law employment association with the employer sponsoring the plan has severed. Several factors are taken into account in determining whether this has occurred: • An individual whose employment with one member of a controlled group of employers is terminated and whose employment with another member of that controlled group subsequently commences (even if the new employer does not maintain the plan) is not deemed to have incurred a severance from employment. • If the employee’s new employer chooses to assume sponsorship of the plan maintained by his or her previous employer or to accept transfers of the employee’s plan assets and liabilities, a severance from employment is not considered to have occurred. This change made by EGTRRA is not mandatory. A plan may continue to require that a separation from service occur in order to receive a distribution. An employer that wishes to provide for the new, less stringent standard, however, must amend the plan to do so. The plan may provide for severance from employment distributions on or after Jan. 1, 2002, irrespective of whether the severance occurred prior to that date. F. Salary-reduction contributions after hardship withdrawal Through EGTRRA, Congress has recommended that the secretary of the Treasury change the current IRS Regulations (the regulations) concerning salary deferral contributions following an individual’s withdrawal of funds from a plan on account of financial hardship. In order to permit a participant from withdrawing funds from a plan for financial hardship, the plan administrator must determine that the withdrawal will meet a participant’s immediate and heavy financial need. The regulations set forth a safe harbor under which a distribution is automatically deemed as necessary to satisfy the individual’s financial need. One of the safe-harbor provisions requires that the participant be prohibited from making salary-deferral contributions for 12 months following the hardship withdrawal. EGTRRA directs the IRS to revise this aspect of the safe harbor to a six-month period effective for calendar years after Dec. 31, 2001. Although the IRS has acknowledged in Notice 2001-56 that the six-month period is in fact correct, the regulations have not yet been revised. A 401(k) plan that is not amended to reduce the prohibition period to six months will not fail to meet the safe harbor. In addition, under the safe harbor, the regulations require that the employer limit the salary-deferral contributions of a participant in the year following his or her hardship withdrawal, to the applicable Code §402(g) limit for that year less the participant’s salary reduction deferral for the year the hardship distribution occurred. IRS Notice 2002-4 eliminates this limitation on salary-deferral contributions, effective for calendar years after Dec. 31, 2001 for individuals who received hardship distributions in or after 2001. Again, plans do not have to be amended to reflect this change in order to comply with the IRS safe harbor. The major impact of this EGTRRA related change will be to allow an individual who has taken a hardship withdrawal in the beginning of the year to increase his or her salary deferral contribution in the end of the year to make up for lost time. G. EGTRRA’s sunset provision Most of EGTRRA’s provisions, with no exception for those related to retirement plans, will expire after Dec. 31, 2010. Pre-EGTRRA law will be reinstated after that date if Congress does not act to extend the EGTRRA provisions. Retirement plans that take advantage of the more generous contribution limits under EGTRRA do face a theoretical threat of plan disqualification if contributions exceed the pre-EGTRRA limit after 2010. H. Massachusetts and EGTRRA Massachusetts remains among a handful of states that have not adopted the changes to retirement-plan law provided for in EGTRRA. Existing Massachusetts law follows the code as amended in 1998 and would require the legislature to enact a new law adopting the EGTRRA changes, whereas many state laws automatically conform to the changes. The Massachusetts Department of Revenue (DOR) has released a Technical Information Release (TIR 02-07, dated May 10, 2002), that sets forth current Massachusetts treatment of retirement-plan salary-deferral contributions in comparison to federal treatment under EGTRRA. TIR 02-06, also dated May 10, 2002, states that Massachusetts will continue to recognize the federal determination of the qualified status of a plan. Therefore, a 401(k) plan updated under EGTRRA’s provisions and sponsored by a Massachusetts employer will not be disqualified under Massachusetts law despite the state’s nonconformance with EGTRRA’s provisions. Massachusetts Sen. Robert O’Leary has, however, introduced Senate Bill 2339, which provides for full EGTRRA conformity in Massachusetts. The bill is currently scheduled for a public hearing in front of the Legislature’s Taxation Committee but faces major obstacles. According to the published Massachusetts Department of Revenue, Revenue Impact Analysis, the DOR has estimated that conforming to EGTRRA would cost the state approximately $20 million in tax revenue over the next two fiscal years. This estimate may be revised downward by the DOR upon further review. Impact of Massachusetts nonconformance Although the qualified status of a plan will not be affected, the failure of Massachusetts to adopt the provisions of EGTRRA relating to retirement plans will have a significant impact on individuals who participate in plans updated for EGTRRA. These taxpayers will have a portion of their salary-deferral contributions that is not taxable at the federal level but, at the same time, is taxable in Massachusetts. For example, a Massachusetts resident over the age of 50 who defers the maximum allowable amount of compensation under EGTRRA for 2002, $12,000, will owe Massachusetts income taxes on the $1,000 attributable to the catch-up contribution for that year. • • • The EGTRRA provisions relating to retirement plans have been designed to benefit both plan sponsors and plan participants. The laws generally make it easier for employers to maintain plans and also encourage individual participation by increasing the maximum amount of allowable pre-tax contributions. As the Commonwealth of Massachusetts has not yet adopted EGTRRA’s retirement plan laws, it remains unclear whether its residents will be able to fully benefit from its provisions.
©2014 Massachusetts Bar Association