Pension and Individual Retirement Account Implications of EGTRRA

Pension and Individual Retirement Account Implications of EGTRRA

The “Economic Growth and Tax Relief Reconciliation Act of 2001” (EGTRRA) was passed by Congress on May 26, 2001 and signed into law by President Bush on June 7, 2001. This legislation will affect numerous tax-related areas, including income tax rates, estate planning, and retirement planning.

The implications to retirement plans and individual retirement accounts (IRAs) are significant. The legislation phases in opportunities for employees and IRA owners to save larger amounts for retirement. The legislation also increases the portability of benefits for retirement plan participants and reduces certain regulatory burdens placed on employers.

All changes will become effective for plan years beginning on or after January 1, 2002, except for provisions affecting defined benefit plans, which will become effective for plan years ending after December 31, 2001. The following is a discussion of the more notable changes:

The law changes summarized above will provide significant opportunities for individuals to enhance their retirement savings in the future. In addition, the reduced regulatory burdens may provide new advantages to employers who establish and maintain retirement plans. If you would like to discuss these changes in greater detail, please call us at 503-399-1070, or e-mail us at the following address:
Randy Cook –

  • Higher Contribution Limits for Qualified Retirement Plans. The new law will increase the elective deferral contribution limits for 401(k) plans, 403(b) plans, and 457 plans. The following table details the rising contribution limits through 2006. Following 2006, employee contribution limits will be indexed for inflation.
    Year Employee Contribution Limit
    2002 $11,000
    2003 $12,000
    2004 $13,000
    2005 $14,000
    2006 $15,000

    The law also allows plan participants over the age of 50 to make additional employee contributions. Such contributions will not be taken into account in applying other contribution limits, and are not generally subject to nondiscrimination rules. These amounts are over and above the contribution limits established in the table above for individuals age 50 and older. The rationale for the change is to allow older workers who have not saved enough for retirement to “catch up” on their plan contributions. The following table reflects the additional amounts that may be deferred, which will be adjusted annually for inflation in $500 increments after 2006:

    Year Additional “Catch up” Contributions
    2002 $1,000
    2003 $2,000
    2004 $3,000
    2005 $4,000
    2006 $5,000

    The deferral limit for Section 457 plans (i.e., plans sponsored by governmental entities and certain non-profit corporations) may be further increased in the last three years prior to retirement. That limit increases to twice the regular limit shown above, but may not be combined with the “catch up” contribution amount.

  • Higher Contribution Limits for Individual Retirement Accounts. The new law will also increase the amount that IRA holders may contribute each year to an IRA. The annual contribution limit will gradually increase to $5,000 in 2008, as shown in the following table:
    Year IRA Contribution Limit
    2002-04 $3,000
    2005-07 $4,000
    2008 $5,000

    Following 2008, the $5,000 IRA contribution limit will be indexed for inflation in $500 increments. As with qualified plans, additional “catch up” contributions for individuals over the age of 50 will be allowed for IRAs. Those individuals will be allowed to contribute an additional $500 for years 2002 through 2005, and an additional $1,000 for years 2006 through 2008.

  • Low Income Tax Credit for Retirement Contributions. As another retirement savings incentive, the new tax law will provide a temporary tax credit for contributions to IRAs and employer-sponsored retirement plans for lower income workers. The credit will remain in effect through 2006. Depending on the individual’s income, the credit ranges from 10 to 50 percent of the contribution. The maximum contribution eligible for the credit is $2,000. The contributions remain tax-deductible, but are designed to provide greater incentive for taxpayers with adjusted gross incomes of $50,000 or less on a joint return, $37,500 for head of household, and $25,000 for singles. To be eligible for the credit, the taxpayer must be over age 18, not a full time student, and not a dependent of another taxpayer.
  • Profit Sharing Plan Limits. An employer may currently contribute to its profit sharing plan up to 15% of “eligible payroll.” For purposes of this rule, the term “eligible payroll” means wages paid to participants in the plan, less any amounts deferred into a 401(k) or Section 125 (“Cafeteria”) plan. The new law will allow employer profit sharing contributions of up to 25% of “gross” eligible payroll (i.e., wages paid to participants, unreduced for 401(k) or Section 125 deferrals.
  • Individual Participant Limits. Under current rules, an employee can receive total retirement plan contributions of no more than the lesser of 25% of his or her compensation, or $35,000. This overall limit includes both employer and employee contributions. Beginning in 2002, an employee can receive total retirement plan contributions of up to the lesser of 100% of his or her compensation, or $40,000. This $40,000 contribution limit will thereafter be indexed for inflation in $1,000 increments. Further, the maximum amount of compensation that will be used to calculate contributions will increase in 2002 from $170,000 to $200,000. This increased amount will thereafter be indexed for inflation in $5,000 increments.
  • Defined Benefit Plan Limit. The maximum pension benefit a retiree can receive under a defined benefit plan will increase from $140,000 per year to $160,000 per year. This limit will be reduced for benefits paid prior to age 62, and increased for benefits paid after age 65. Following 2002, the limit will be indexed for inflation in $5,000 increments. In addition, the maximum amount an employer can contribute to a defined benefit plan will increase to 165% of current liability over assets in 2002, and 170% of current liability over assets in 2003. After 2003, the limit will no longer apply.
  • Top-Heavy Rules. The new law will change the definition of who is considered a “key employee” for top heavy plan purposes. Beginning in 2003, a key employee will be defined as an officer with compensation in excess of $130,000, a five percent owner, or a one percent owner with compensation in excess of $150,000. Determinations will be based on distributions in the year being assessed and balances for employees who have performed services in the one-year period prior to the determination date. If a plan is found to be top heavy, then matching contributions will be taken into account in determining whether the non-key employees have received the required minimum benefit. Safe harbor 401(k) plans which consist solely of salary deferrals and matching contributions will be exempt from the top-heavy rules.
  • Retirement Plan Loans. Under the new law, owner-employees (i.e., partners, sole proprietors and “S” corporation shareholders) will be permitted to borrow from their retirement plan accounts under the same rules applicable to non-owner employees.
  • Hardship Withdrawals. Current law prohibits participants who have taken a hardship distribution from making elective deferrals for one year following the distribution. Beginning in 2002, the new law will reduce this exclusion period to six months.
  • After-tax Roth Capabilities in 401(k) and 403(b) Plans. Beginning in 2006, employees participating in 401(k) and 403(b) plans will have the option of having some or all of their contributions afforded the same tax treatment as Roth IRAs. The amounts currently deferred into these types of plans enjoy tax deferral, but not tax exemption. The new law allows employees to elect to have their salary deferral amount made subject to tax of the time of contribution so that they may ultimately enjoy tax-free distributions at retirement.
  • Rollovers Among IRAs and Retirement Plans. Under the new law, IRA and retirement plan assets will generally be more portable from one type of retirement savings vehicle to another. Tax deductible IRAs may be rolled over to profit sharing, money purchase pension, 401(k), 403(b) and 457 plans. In addition, profit sharing, money purchase pension, 401(k), 403(b) or 457 plans may be rolled over to any other profit sharing, money purchase pension, 401(k), 403(b), 457 plan or IRA. With respect to section 457 plans, these liberal rollover rules will only apply to governmental plans, and not to plans maintained by non-profit organizations. In addition, the non-taxable portion of an IRA (i.e., the portion funded with post-tax dollars), still may not be rolled into any other type of retirement plan.
  • Vesting Schedules for Matching Contributions. Beginning in 2002, matching contributions must be vested at least as rapidly as one of the following two schedules: 1) 100% after three years of service; or 2) 20% per year for a participant’s second through sixth years of service, with 100% vesting occurring after six years.