2001 Lane Reports

2001 Tax Act: Opportunities To Save More For Retirement

Saturday, September 1, 2001

The bad news: on June 7, 2001, President Bush signed into law the Economic Growth and Tax Relief Reconciliation Act of 2001 (the "2001 Tax Act"), further complicating existing tax laws. The good news: with some planning and guidance from The Law Offices of Marc J. Lane, you can take advantage of the 2001 Tax Act and defer more of your hard earned dollars until retirement with qualified retirement plans or IRAs. Interested? Please read below.

The purpose of this article is to highlight some of the more important retirement plan related provisions in the 2001 Tax Act and show how you can benefit from these provisions. Beginning in 2002, both the maximum amount that can be contributed for your benefit to a defined contribution qualified plan and the percentage of your compensation upon which such contributions are based will increase. A plan is qualified if it meets the requirements imposed by the Internal Revenue Code ("IRC"). The benefits of a plan being qualified include tax deductibility of employer contributions; the ability for plan assets to grow tax-deferred; and plan participants being able to roll-over their account balances into IRAs without incurring tax. Examples of qualified plans include pension plans, profit sharing plans, and 401(k) plans.

The 2001 Tax Act also allows eligible individuals to contribute more to IRAs. Whether through qualified plans or IRAs, the 2001 Tax Act allows you to save more for your retirement years.

Changes Resulting From 2001 Tax Act

Under current law, as a condition of a retirement plan's tax qualification, IRC §415(c) requires that annual additions to an individual's defined contribution plan account may not exceed the lesser of $35,000 (indexed for the cost of living) or 25% of such individual's compensation. "Annual additions" include both employee and employer contributions. Beginning in 2002, the maximum aggregate amount that can be contributed on behalf of an employee (including both employee and employer contributions to one or more plans) will increase to the lesser of $40,000 or 100% of his or her compensation.

Employers that maintain defined benefit plans will also benefit from the 2001 Tax Act by being able to deduct more of their existing unfunded liabilities. A defined benefit plan is a pension plan whereby the employer promises the employee a certain pension benefit upon retirement such as 10% of the employee's highest 3-year average salary. In contrast, in a defined contribution plan the employer only promises to make an annual contribution to the employee's account under the plan such as 10% of annual compensation. The nature of a defined benefit plan requires an actuary to calculate the total employer contribution each year. Due to the additional costs of maintaining defined benefit plans, most small businesses prefer defined contribution plans.

The 2001 Tax Act also makes elective deferrals to 401(k) and other eligible plans even more attractive. Under current law, the maximum amount of compensation a taxpayer can elect to defer is $10,500. This limit will gradually increase as follows:

Taxable Year Dollar Limit

2002

$11,000

2003

$12,000

2004

$13,000

2005

$14,000

2006

$15,000

  
Once this limit reaches $15,000, it will subsequently increase based upon cost-of-living adjustments.

Elective deferrals are employees' voluntary pre-tax contributions to a qualified plan from his or her compensation. Qualified plans and other arrangements that can contain an elective deferral feature for which the above limitations apply include 401(k) plans, 403(b) tax-sheltered annuity plans, § 457 plans, and Salary Reduction Simplified Employee Pension Plans (" SARSEP"). Annual elective deferrals to Savings Incentive Match Plan for Employees ("SIMPLE" plans) will also increase, but not as quickly as for other plans.

Another benefit resulting from the 2001 Tax Act is that it allows plan participants, in any of the above discussed plans, who have attained the age of 50 to make additional annual elective deferrals, in excess of the maximum allowable amount for a given year, as follows: $1,000 for 2002; $2,000 for 2003; $3,000 for 2004; $4,000 for 2005; and $5,000 for 2006 and thereafter. As such, older employees participating in one of the above qualified plans or other arrangement will be able to elect to defer a larger portion of their compensation, allowing more of their dollars to grow tax deferred towards their retirement.

Benefits For Employers

Owners of closely-held businesses will find the opportunities to contribute more to qualified plans to be particularly beneficial because they may contribute more to participant accounts without needing to increase the base salaries upon which such contributions are based. Employers that make plan contributions based on employee compensation should note that the 2001 Tax Act increased the maximum compensation upon which annual plan contributions can be based, from $170,000 to $200,000, beginning in 2002.

Many employers establish profit sharing plans because they can be drafted to allow the employer annually to elect whether to contribute to the plan, and if so, at what level. However, in exchange for this flexibility, employers are only allowed to deduct contributions up to 15% of each employee's aggregate compensation. Effective in 2002, employers will be able to deduct plan contributions to a profit sharing plan (or other qualified plans) equal to 25% of a participant's compensation, up to $40,000 annually. A plan participant's elective deferrals to a qualified plan will also be separately deductible to the employer as a compensation expense, subject to the same $40,000 total annual limit.

The maximum deductible contribution to other qualified plans, such as pension plans, will also increase to 25% of a participant's aggregate compensation. Unlike profit sharing plans, employers sponsoring defined contribution pension plans must contribute a fixed, nondiscretionary percentage of employees' compensation to the pension plan each year. Further, while the opportunity for elective deferrals is available through profit sharing plans, it is not available through pension plans. Therefore, the available deduction to an employer and opportunity for deferral to an employee under a profit sharing plan containing a 401(k) feature will be greater than that which will be available under a defined contribution pension plan. As such, the 2001 Tax Act may decrease the cost to employers of maintaining qualified plans because multiple plans are no longer necessary to achieve the highest possible income deferral. Employers that earn sufficient income will now be able to achieve the maximum deferral by maintaining just one plan.

Additionally, as mentioned previously, the 2001 Tax Act increases the maximum amount of compensation a taxpayer can annually elect to defer, from $10,500 in 2001, to $15,000 in 2006. This amount will subsequently increase based upon cost-of-living adjustments. This increase is particularly advantageous to business owners sponsoring 401(k) plans because, subject to discrimination tests imposed by the IRC, they will be able to elect to defer more of their compensation without needing to match such deferrals to their employees.

Benefits For Employees

The most direct benefits for employees, depending on the plan in which they participate, of the 2001 Tax Act are: (1) total annual contributions of up to $40,000 (rather than $35,000) can be made to an employee's plan account, and (2) the amount employees may elect to defer will gradually increase from $10,500 in 2001, to $15,000 by 2006. Further, plan participants who have attained the age of 50 will be able to make additional annual income deferrals, in excess of the maximum allowable amount for a given year, as follows: $1,000 for 2002; $2,000 for 2003; $3,000 for 2004; $4,000 for 2005; and $5,000 for 2006 and thereafter. As such, older participants in plans allowing elective deferrals will be able to defer a larger portion of their compensation, allowing more of their dollars to grow tax deferred towards their retirement. For example, in 2002, a 50 year old 401(k) plan participant could elect to defer up to $12,000.

Another exciting feature of the 2001 Tax Act, which will be available beginning in 2005, is that 401(k) and 403(b) plans will be able to have a Roth IRA feature. Under this feature, employees will be able to elect to be currently taxed on all or part of their elective deferrals, such taxable amounts constituting the Roth IRA portion of an employee's plan account. Amounts in the Roth IRA portion of a 401(k) or a 403(b) plan account will continue to grow tax-free and distributions would not be taxable to the employee if they satisfy the rules applicable to Roth IRAs. 401(k) plans will not be required to contain Roth IRA provisions, but given the popularity of Roth IRAs, employers should consider including this provision in their 401(k) plans.

In addition to opportunities to contribute increased amounts to qualified plans, employees will also benefit from faster required minimum vesting schedules for employer matching contributions. Effective for 2002, employer matching contributions must vest as if the plan were top heavy, which means such amounts must vest subject to a three-year cliff schedule or a six-year graded schedule. Three-year cliff vesting means the employee becomes 100% vested in the employer matching contributions after three years of service but not vested at all until then. Under the six-year grade vesting the employee is vested 20% after 2 years of service and an additional 20% for each additional year of service until fully vested after 6 years of service. Under current law, employer contributions may vest subject to a longer schedule.

Increased IRA Contribution Limits

The 2001 Tax Act also allows eligible individuals to contribute more to their IRAs. For the years 2002 through 2004, the maximum annual contribution to a traditional or Roth IRA will increase from $2,000 to $3,000; for 2005 through 2007, the maximum annual contribution will increase to $4,000; and increase to $5,000 for 2008 and thereafter. Additionally, beginning in 2002, individuals who attain age 50 before the close of a plan year will be able to make additional annual "make up" contributions of $500 for 2002 through 2005, and $1,000 for years thereafter.

The opportunity to defer additional current income to IRAs is significant. For example, a 50-year-old individual who under current law annually contributes only $2,000 to an IRA will be able to contribute an additional $25,000 through the year 2010. Such contributions can grow tax-deferred until the year the individual reaches the age of 70˝, at which time the IRA owner must begin withdrawing minimum required distributions. The amounts remaining in the IRA, even during the years minimum required distributions are required, would continue to grow tax-deferred.

Conclusion

The 2001 Tax Act significantly expands opportunities for taxpayers in all tax brackets to defer more of their income to qualified plans or IRAs, thereby allowing such contributions to grow tax-deferred. Larger annual contributions and the ability of these contributions to grow tax-deferred will hopefully result in larger amounts available for your retirement years.

We understand that it can be difficult to keep track of how much you can contribute to qualified plans or IRAs during a given year. If you are an employer sponsoring a qualified plan, we will be happy to work with you to determine if your business still needs multiple plans to allow you to maximize your annual qualified plan contributions. If you are an employee, we will be happy to work with you to make certain that you are making the maximum possible contributions to your qualified plans and IRAs. Let us help you take advantage of the 2001 Tax Act.


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The Lane Report is a publication of The Law Offices of Marc J. Lane, a Professional Corporation. We attempt to highlight and discuss areas of general interest that may result in planning opportunities. Nothing contained in The Lane Report should be construed as legal advice or a legal opinion. Consultation with a professional is recommended before implementing any of the ideas discussed herein. Copyright, 2003 by The Law Offices of Marc J. Lane, A Professional Corporation. Reproduction, in whole or in part, is forbidden without prior written permission.

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