EGTRRA and Qualified Plans: Highlights of the Key Plan Amendment Issues
July 2001
The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), which was signed into law on June 7, 2001, generally enhances benefits available for employees covered by qualified retirement plans, including 401(k) plans, defined benefit pension plans and employee stock ownership plans (ESOPs). Many of the EGTRRA’s benefits provisions are either mandatorily or permissively effective beginning in 2002 (and a few provisions could be effective in 2001). In some cases, if plans are not amended to reflect the EGTRRA’s provisions, the less favorable pre-EGTRRA rules will continue to apply. The following is a brief summary of some of the key provisions of the EGTRRA that require action or attention by employers before the end of 2001.
Defined Contribution Plans
Increase in Code § 415(c) Plan Contribution Limits
Under current law, contributions for a limitation year may not exceed the lesser of $35,000 (for 2001) or 25 percent of a participant’s compensation. Under the EGTRRA, for limitation years beginning after December 31, 2001, the annual contribution limit is increased to the lesser of $40,000 (indexed for inflation) or 100 percent of a participant’s compensation. In addition, the deduction limit for profit sharing plans, including 401(k) plans, has been increased to 25 percent (from 15 percent) of participant compensation for tax years beginning after December 31, 2001. This change means that participants may be able to receive or make additional plan contributions and that some employers’ nonqualified supplemental savings plans may no longer be necessary or will apply to far fewer employees.
Plan Amendments: Most defined contribution plans contain text that specifically includes the pre-EGTRRA dollar limit, with adjustments for cost of living increases. However, plans should be reviewed to ensure that the applicable provisions will permit an automatic upward adjustment to reflect the EGTRRA (and not simply to reflect a cost of living increase). If amendments are needed, such plans should be revised before the end of the 2001 limitation year in order to be sure to benefit from the new contribution limit in the 2002 (and future) limitation years. Otherwise, the lower pre-EGTRRA limit may continue to apply.
Increase in Code § 401(a)(17) Compensation Limit
Under current law, the maximum amount of compensation that may be taken into account when determining a participant’s contributions is $170,000 (for 2001). Under the EGTRRA, the compensation limit is increased to $200,000 for plan years beginning after December 31, 2001 and is indexed thereafter.
Plan Amendments: Many plans incorporate this limit by reference to Code § 401(a)(17), so an amendment may not be necessary to incorporate the EGTRRA’s change. However, all defined contribution plans should be reviewed to determine whether they are appropriately drafted to permit implementation of the increased compensation limit.
Increase in 401(k) Elective Deferral Limit
The EGTRRA increases the portion of a 401(k) plan participant’s compensation that may be contributed on a pre-tax basis—from $10,500 (for the 2001 calendar year) to $11,000 for 2002; $12,000 for 2003; $13,000 for 2004; $14,000 for 2005; and $15,000 for 2006 and later years (indexed for inflation).
Plan Amendments: As with the § 401(a)(17) compensation limit, many plans incorporate this rule by reference. However, plans should be reviewed and amended as necessary to ensure that the current plan text does not preclude the automatic increases made by the EGTRRA. Failure to include the appropriate language may require continued application of the lower pre-EGTRRA contribution limits.
Faster Vesting for 401(k) Plan Matching Contributions
Under current law, matching contributions are required to vest no slower than either 100 percent after five years of service (cliff vesting), or 100 percent after seven years of service (graduated at 20 percent per year beginning after completing three years of service). Solely with respect to matching contributions made for plan years beginning after December 31, 2001, the EGTRRA shortens the minimum vesting period to either 100 percent after three years of service, or 100 percent after six years of service (graduated at 20 percent per year beginning after completing two years of service).
Plan Amendments: Plans that do not provide matching contribution vesting at least as fast as under the new vesting rules will need to be amended. In addition, because this change solely applies to matching contributions, a plan with both matching and profit sharing contributions could continue to apply the plan’s existing vesting schedule to the profit sharing contributions. Also, because the change applies only to matching contributions for plan years beginning after December 31, 2001, an employer could continue to apply the prior vesting rules to pre-2002 plan year matching contributions. In deciding how to address the EGTRRA provision, employers also should consider whether the additional cost of applying the new, more generous vesting schedule to all contributions (past and future matching and other employer contributions) might outweigh the administrative complexity that multiple vesting schedules may entail.
Additional Pre-Tax Contributions for Older Employees
The EGTRRA provides that 401(k) plans may be amended to permit employees age 50 or older to make additional pre-tax salary reduction contributions. Under current law, no such additional contributions are permitted. The EGTRRA permits additional pre-tax contributions of up to $1,000 for the tax year beginning in 2002; $2,000 for 2003; $3,000 for 2004; $4,000 for 2005; and $5,000 for 2006 and thereafter (indexed for inflation). These additional contributions generally are not taken into account for nondiscrimination testing purposes or plan contribution limits. Thus, even if a participant’s "regular" salary reduction contributions must be reduced due to application of the nondiscrimination rules, the participant’s ability to make these additional contributions will not be affected.
Plan Amendments: Plans may be amended to permit these additional contributions for tax years beginning on or after January 1, 2002. Also, a plan may be amended to provide that matching contributions will be (or will not be) made on these additional contributions (although any such matching contributions will be taken into account for nondiscrimination testing purposes). However, a number of technical issues are raised by the addition of these contributions to a 401(k) plan and, therefore, employers should not amend their plans to permit these contributions without further guidance.
Elimination of "Same Desk" Rule
Under current law, elective deferrals generally may not be distributed from a 401(k) plan before a participant’s attainment of age 59½, death, disability or "separation from service." A participant’s termination of employment is not considered a separation from service in some cases (often involving mergers, acquisitions and outsourcing) where employees continue on at the same job but for a different employer after the transaction. The EGTRRA effectively eliminates this "same desk" rule by providing that distributions are available upon any "severance from employment," provided a participant’s plan account is not transferred (other than by rollover or elective transfer) to a plan sponsored by the new employer. This new rule applies to distributions made after December 31, 2001, regardless of when the actual severance from employment occurred (even in prior years). Note that this statutory change does not affect the rule that an employee’s transfer from Company A to Company B, where both companies are within the same controlled group, generally is not a severance from employment or other distributable event under the Internal Revenue Code.
Plan Amendments: The foregoing change is the default rule that will apply in the absence of specific plan provisions addressing participants’ rights to distributions upon the occurrence of certain corporate events. The EGTRRA specifically contemplates that a plan may be drafted to retain the prior "same desk" rule, if desired. Alternatively, a plan also may be drafted to specify certain events which will (or will not) be considered distributable events. Employers that desire distribution events or timing different from that provided under the default rule should amend their plans accordingly. Also, some employers’ plans already contain provisions addressing the permissibility of distributions upon certain corporate events. Those plan provisions also should be reviewed to consider whether changes should be made to reflect the EGTRRA’s provisions. Finally, employers should note that the effective date for this new rule—distributions made after December 31, 2001—applies regardless of whether the plan year for the plan is the calendar year or a fiscal year. Thus, in addition to the foregoing considerations, employers that were previously prohibited from distributing participants’ benefits due to the same desk rule should immediately review their participant population to determine whether and in what manner to apply this new rule to such participants.
Repeal of Nondiscrimination Testing "Multiple Use" Test
The EGTRRA repeals the "multiple use" test that previously prohibited using a generally more lenient test for both actual deferral percentage (ADP) testing of pretax deferrals and actual contribution percentage (ACP) testing of matching and after-tax contributions.
Plan Amendments: 401(k) plans that provide for matching and/or after-tax contributions should be amended to reflect that the multiple use test is repealed for plan years beginning on or after January 1, 2002. Unless a plan is so amended, the plan language imposing the multiple use test may continue to apply.
Cash-Outs Determined Without Regard to Rollover Contributions
Upon termination of employment, a participant’s accrued benefit with a value of $5,000 or less may be cashed out without a participant’s consent (assuming the plan contains appropriate cash-out language). If the benefit exceeds $5,000, it may not be distributed without the participant’s consent. Under the EGTRRA, a plan may be drafted to exclude from determination of the value of a participant’s benefit (solely for cash-out purposes) any rollover contributions made by the participant to the plan (plus related earnings). Plans may be amended in order to apply this rule for distributions made after December 31, 2001.
Plan Amendments: For plans that permit rollover contributions, employers should consider amending their plans to add this new cash-out rule.
Defined Benefit Plans
Increase in Code § 415(b) Plan Benefit Limits
The EGTRRA increases the annual limit on the amount of benefits that may be paid under qualified defined benefit plans. Under current law, this annual limit is generally the lesser of 100 percent of a participant’s average compensation or $140,000 (for 2001). The EGTRRA increases the dollar limit to $160,000 (as indexed). In addition, the EGTRRA provides that this revised limit is reduced for benefit commencement before age 62 (rather than "social security retirement age") and is increased for benefit commencement after age 65. These changes in the annual limit apply for limitation years ending after December 31, 2001.
Plan Amendments: Most defined benefit plans contain text that specifically includes the pre-EGTRRA dollar limits, with adjustments for cost of living increases. However, plans should be reviewed and amended as needed to reflect the increased $160,000 indexed limit. In addition, in order to reflect the change in the limitation that generally applies to participants commencing benefits between ages 62 and 64, the EGTRRA’s committee report provides that if a plan defined benefit is so drafted, it could provide benefit increases for participants who began receiving benefits under the plan before 2002. (In such cases, the maximum benefit is the benefit that could have been provided had the EGTRRA’s provisions been in effect at the time the participant commenced benefits.) Because the EGTRRA’s changes to Code § 415(b) are effective for limitation years ending after December 31, 2001, employers that desire to permit such benefit increases with respect to employees who retire before the first day of that first limitation year (i.e., before January 1, 2002 for plans with a calendar year limitation year) should amend their plans as soon as possible.
Increase in Code § 401(a)(17) Compensation Limit
Under current law, the maximum amount of compensation that may be taken into account when determining a participant’s plan benefits is $170,000 (for 2001). Under the EGTRRA, the compensation limit is increased to $200,000 for plan years beginning after December 31, 2001 and is indexed thereafter.
Plan Amendments: Many plans incorporate this limit by reference to Code § 401(a)(17), so an amendment may not be necessary to incorporate the EGTRRA’s change. However, all defined benefit plans should be reviewed to ensure that they are appropriately drafted to permit implementation of the increased limit.
Disclosure to Participants of Reduction of Future Benefit Accruals
Under current law, an amendment to a defined benefit plan (or a money purchase pension plan) that reduces the rate of future benefit accrual is not effective unless a notice describing the amendment (a "204(h) notice") is provided to participants after the amendment is adopted but no later than 15 days before its effective date.
The EGTRRA revises these rules to provide broader notice requirements and to provide an excise tax for failure to provide proper notice. Under the EGTRRA, the notice must provide "sufficient information" (to be defined by U.S. Treasury regulations) to allow participants to understand the amendment’s effect. Rather than 15 days (as under the pre-EGTRRA rule), the notice must be provided within a "reasonable time" before the effective date of the amendment and may be given before the amendment is adopted. These notice requirements generally apply for plan amendments taking effect on or after the date of enactment (June 7, 2001). The EGTRRA provides that the Treasury is required to issue detailed regulations under this provision within 90 days of enactment (i.e., by September 5, 2001). Prior to the issuance of regulations, employers must make a good faith effort to comply with the EGTRRA’s provisions. Failure to provide proper notice may result in imposition of a new $100 per day excise tax for each omitted individual.
Miscellaneous
No Extension of GUST Remedial Amendment Period
As a result of enactment of the EGTRRA, there was some speculation that the GUST remedial amendment period would be extended. However, in IRS Notice 2001-42, issued on June 28, 2001, the IRS stated that the GUST remedial amendment period will not be extended. Therefore, there is no change to the general pre-EGTRRA requirement that qualified plans must be amended for the GUST legislation and filed with the IRS for a favorable determination letter no later than the last day of a plan’s 2001 plan year (i.e., December 31, 2001 for calendar year plans).
IRS to Publish Model Plan Amendments
In IRS Notice 2001-42, the IRS stated that it will issue model plan amendments before the end of August 2001 with respect to certain qualified plan provisions of the EGTRRA. Thus, except in particular cases (such as certain defined benefit plans impacted in 2001 by the Code § 415(b) changes discussed above), employers generally should wait until after the model amendments are issued before adopting plan amendments to reflect the EGTRRA.
Impact of Code § 401(a)(17), 402(g), and 415 Changes on Nonqualified Plans
Employers with nonqualified plans, the contributions or benefits under which are based on any of these Code limits, should examine their plans to determine the impact of the EGTRRA’s increase in these limits. In most cases, the amount being paid from (or contributed to) such a nonqualified plan will be reduced as a result of the changes.
SPDs and SMMs
As with other changes to qualified plans, plan amendments will need to be described in a summary of material modifications (SMM) or a revised summary plan description (SPD) to be distributed to participants according to standard Department of Labor (DOL) disclosure requirements—within 210 days after the close of the plan year in which the modifications are adopted. However, because of the significant nature of many of the EGTRRA’s changes, it might be worthwhile to notify employees of plan changes or provide an updated SPD on a more current basis.
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Please note that the foregoing is merely a summary of certain provisions of the EGTRRA, specifically those provisions involving qualified retirement plans where action may need to be taken this year. There are also many changes under the EGTRRA that will affect so-called Section 403(b) and Section 457 plans of tax-exempt and governmental entities.
