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10 New Tax Revisions That May Affect Your Employee Benefits

October 5, 2001
Related Topics: Benefit Design and Communication, Finance/Taxes, Featured Article
Many professionals in the employee-benefits field groused that for the lastcouple of years, there wasn't much to talk about from Washington in regard toemployee benefits, especially retirement plans. Well, on June 7th, they shutup.

With the slash of a pen, President Bush signed intolaw the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA).While many of us have identified this act with refunds and lower tax rates,there were many items in the bill that affect employers and the benefits theyoffer their employees.

While there are a number of procedural issues for theIRS to hammer out for employers, many of the provisions are intended to providelong-awaited simplification for retirement plans and an increased commitmentto help employees save more for retirement. Here are 10 of the more importantprovisions of the bill and how they can affect you:

  1. Increase in contribution maximum to 401(k) plans.
    Beginning in 2002, the maximum amount that can be contributed will be $11,000,up from $10,500 in 2001. It will be increased by $1,000 each year until2006, after which it will increase with inflation.

    The increase in the annual amount is not terribly significant, but whenit is coupled with other provisions of the law (see number 2), employersthat have to run a test to make sure they are not allowing higher-paid employeesto put significantly more into the plan than lower-paid employees (commonlyreferred to as the Average Deferral Percentage test) will find it easierto pass. It may also allow higher-paid employees to put more money intothe 401(k) plan than in years past.

  2. Increase in the total amount of compensation that is considered forcalculating the amount allowed to be contributed under certain retirementplans (e.g., profit sharing, 401(k), money purchase pension).
    Many plans, especially profit-sharing plans, state their contributions asa certain percentage of employees' compensation. This compensation amounthas been limited in the recent past and for 2001 is $170,000. Beginningin 2002, this amount will be increased to $200,000 and will be indexed withinflation in subsequent years.

    As indicated above, the increase in the allowable compensation may makeit easier for employers to pass the Average Deferral Percentage test, sincethe test looks at the amount contributed to the 401(k) plan divided by theallowable compensation. With the denominator increasing, the total percentagewill most likely decrease, making it easier for higher-paid employees tocontribute more to their plan without going over the permitted boundaries.

  3. Tax credits for low-income employees who contribute to 401(k)-type plans.
    Beginning in 2002, employees with incomes of up to $30,000 and who are marriedand filing jointly can deduct 50 percent of their contributions to a 401(k)plan (including 403(b), IRAs, and 457 plans), up to a maximum of $1,000.The deductible amount is decreased with incomes between $30,000 and $50,000.The income limitations are less for head of household and single taxpayers.

    While employers will not have to do anything to their retirement plan design,this is a wonderful tool to get the harder-sell lower-paid employees toparticipate in your 401(k) plan. It is worth highlighting as a part of yourretirement-plan communications.

  4. Catch-up contributions for older employees.
    Beginning in 2002, employers can allow employees age 50 or older to makeadditional "catch-up" contributions if they have otherwise metthe maximum contribution amounts under the plans. For 401(k) plans, theamount starts out at $1,000 for 2002 and increases by $1,000 each year until2006, after which it adjusts with inflation.

    The nice thing for employers is that these "catch-up" contributionsare not subject to any of the required discrimination tests. However, issuessuch as increased cost, especially for matching contributions that may haveto be made on the contributions and increased administration with trackingthe separate contributions, will have to be considered.

    NOTE: Some argue whether it is financially feasible for older individualsto continue to contribute to tax-deferred 401(k) plans versus making contributionsto a taxable investment account. The issues surround the tax rate that individualspay on their tax-deferred investments in retirement versus the long-termcapital gains rate that can be achieved on taxable investments, which canbe as low as 20 percent. While this is an individual tax decision, it maybe another point for an employer to consider when deciding whether to includethe "catch-up" provision as part of its plan.

  5. Faster vesting for matching contributions.
    Beginning in 2002, employers will have to apply a faster vesting scheduleto matching contributions, either fully 100 percent vested after three yearsor gradual vesting within six years.

    This rule applies only to matching contributions after January 1, 2002,so some increased administration will be necessary to track pre-EGTRRA andpost-EGTRRA contributions. Unless financially difficult, a change to 100percent vesting on all contributions may be the way to go, for both administrativeease and employee morale.

  6. Distributions from retirement plans can be rolled over to any plan.
    For distributions after January 1, 2002, amounts can generally be rolledover to any other qualified plan. For example, if an employee has moneyin a 401(k) plan and goes to work for a nonprofit employer that has a 403(b)plan, the employee can roll over the money from the 401(k) to the 403(b)plan as long as the new employer permits rollover contributions. This movementbetween non-IRA plans is not currently allowed.

  7. Maximum tax-deductible amount that employers can make to a retirementplan is increased to 25 percent.
    Some employers wish to make the maximum contribution allowed to certainprofit-sharing plans but have been limited to being able to put only 15percent into any one plan. Employers that wanted to put more away had toset up two plans, a profit-sharing plan with a contribution of 15 percentand a money purchase pension plan with a contribution of 10 percent. Nowwith this increased limit, employers can merge these two plans and saveon the administrative costs of the second plan.

  8. Increase in the maximum allowed child/dependent tax credit.
    Beginning in 2003, the amount of eligible child-care expenses for considerationof the credit will increase to $3,000 for one child and $6,000 for two children.The maximum credit percentage is increased to 35 percent (up from 30 percent).

    For employers that sponsor a pre-tax dependent care reimbursement plan,this provision is what determines whether a lower-paid employee choosesto participate in the reimbursement plan or take the federal tax credit(you can't do both). Since the amount will be increased, more individualsmay choose not to participate in the reimbursement plan. Employers willalso have to communicate the change in the tax law (but not until 2003),so that employees can make an informed choice of whether or not to participatein the reimbursement account.

  9. Tax break for educational assistance extends to graduate coursework.
    Beginning in 2002, up to $5,250 of employer-provided educational assistancecan be offered to employees tax-free for both undergraduate and graduatecoursework. The exclusion of graduate coursework had been made in 1997.

    The government had never made this tax break permanent, and it constantlyhad to be renewed, the last time excluding assistance for graduate coursework.This provision will now be permanently extended for all undergraduate courseworkand graduate coursework that begins after December 31, 2001.

  10. Tax break on costs for new start-up plans for small employers.
    For employers with fewer than 100 employees that haven't yet started a retirementplan for their employees, there will now be a financial incentive to doso. The IRS will provide a 50 percent tax credit on the first $1,000 ofannual administrative and educational start-up costs, assuming that theemployer is paying those expenses from its own pocket. This tax credit willbe allowed for the first three years that the plan operates. Again, theIRS is trying to encourage savings, and administrative costs are one ofthe biggest barriers to small companies starting retirement plans.

While some of these provisions may not apply to everyemployer, those that operate a retirement plan of any kind should carefullyreview their plan documents and these changes to see if any revisions shouldbe made. Many of the provisions listed above still require some guidance fromthe IRS, which is promised by the end of the year. But this shouldn't keep HRfolks from strategizing about how these provisions can impact their employeesas well as the bottom line.

Recent Articles by William Dickmeyer, CEBS

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