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Pension simplification: the ultimate oxymoron?

Ten years have passed since the last legislation that profoundly affected the operation of pension, profit sharing, an stock bonus plans ("qualified plans"). That legislation, the Tax Reform Act of 1986, made sweeping changes to the laws governing qualified plans. The employee benefits community discovered that, in many respects, the Tax Reform Act of 1986 complicated the administration of qualified plans and increased the costs of maintaining qualified plans. Over time, the employee benefits community developed a wish list of changes they felt would simplify the administration of qualified plans and protect the interests of the participants. For many years, the employee benefits community worked for the implementation of these changes. These efforts were rewarded when President Clinton signed into law the Small Business Job Protection Act of 1996, Pub. L. No. 104-188 (the "act"). The remainder of this article is devoted to a review of the provisions in the act that tax practitioners will address on an ongoing basis.

Changes Affecting Code [sections] 401(k) Plans

The popularity of 401(k) plans has increased, despite complaints from plan administrators that the 401(k) plan discrimination tests (i.e., tests designed to make certain that 401(k) plans are not discriminating in favor of highly compensated employees or HCEs) are too complicated and expensive. The act addresses these concerns and contains several provisions that are designed to simplify the 401(k) plan discrimination tests, yet safeguard the benefits of the nonhighly compensated employees (non-HCEs). These 401(k) plan simplification provisions are effective over a three-year period from 1997 to 1999.

Changes Effective in 1997

* Use of Data From the Prior Year for Discrimination Testing Purposes

Prior to the act, 401(k) plans were required to determine the maximum pre-tax contributions ("deferral contributions") and matching contributions on behalf of HCEs by using data for the non-HCEs for the current plan year. As a result, 401(k) plans did not know until after the end of the current plan year if the 401(k) discrimination tests were satisfied.

If a 401(k) plan did not satisfy the discrimination tests, a refund of deferral contributions was generally required. The 401(k) plan had to distribute the excess amount to the participant quickly or face an excise tax.

The act allows 401(k) plans to determine the maximum deferral contributions and matching contributions on behalf of HCEs by using data for the non-HCEs for the preceding plan year, rather than the current plan year. This change allows a 401(k) plan to know the limits on HCE deferral contributions and matching contributions early in the current plan year. Therefore, any corrective steps needed to satisfy the discrimination tests can be taken in an orderly fashion during the current plan year. In an interesting twist, the act allows 401(k) plans to elect to continue to use the current plan year data for discrimination testing purposes; however, once the plan elects to use current plan year data, the plan cannot switch to prior year data without IRS approval.

Many plan administrators will welcome the ability to determine the maximum amount of deferral contributions at the start of the plan year and elect to use data from the prior plan year. However, if a 401(k) plan is using data from the previous plan year and the non-HCEs increase the level of contributions in the current plan year, then the effect of this increase on the HCE contributions will not be felt until the following year.

Plan administrators should review, as quickly as possible, the 1996 deferral contribution amounts and 1997 deferral contribution amounts to determine if the 401(k) plan should elect to use data from the current year or the prior year.

* Correction of Excess Deferrals

Under prior law, 401(k) plans satisfied the discrimination tests by returning excess deferral contributions to the HCEs who had the highest deferral percentages, as opposed to the HCE with the highest deferral amount. In operation, this favored the higher-paid HCEs because their higher salary levels kept their deferral percentages down. Now, plans may satisfy the 401(k) plan discrimination tests by returning excess deferrals starting with the HCE with the highest dollar amount.

Tax-Exempt Organizations. Beginning in 1997, tax-exempt organizations, other than state and local governments, will be able to maintain 401(k) plans.

Changes Effective in 1999

Two discrimination tests apply to the employee deferrals made to a 401(k) plan. The first discrimination test, the "ADP test," is satisfied if the actual deferral percentage (ADP) for HCEs for a plan year is equal to or less than either: 1) 125 percent of the ADP of all non-HCEs eligible to defer under the arrangement; or 2) the lesser of 200 percent of the ADP of all eligible non-HCEs or such ADP plus two percentage points. The second discrimination test is known as the "ACP test." Employer matching contributions and after-tax employee contributions under a 401(k) plan are subject to the ACP test. This discrimination test is similar to the ADP test.

The act provides that a 401(k) plan may adopt a "safe harbor" contribution formula that will eliminate the need to perform the ADP and ACP tests discussed above. A 401(k) plan satisfies the ADP test if the plan sponsor adopts one of the following three contribution formulas: 1) a matching contribution on behalf of each non-HCE that is equal to a) 100 percent of the employee's deferral contributions up to three percent of compensation and b) 50 percent of the employee's deferral contributions from three to five percent of compensation; 2) an employer nonelective contribution to a defined contribution plan of at least three percent of compensation for each non-HCE who is eligible to participate in the 401(k) plan, without regard to whether the non-HCE makes deferrals to the 401(k) plan; or 3) the employer matching contribution exceeds the amount of the matching contribution in formula 2) above, and the rate of additional employer matching does not increase as an employee's rate of deferral contributions increase.

A 401(k) plan satisfies the ACP discrimination test safe harbor if it meets all of the following: 1) the contribution and notice requirements of the ADP safe harbor discussed below; 2) the 401(k) plan does not match deferral contributions or employee after-tax contributions in excess of six percent of a participant's compensation; 3) the rate of matching contribution for any HCE does not exceed the rate of matching contributions for a non-HCE; and 4) the level of the matching contribution does not increase as the participant's deferral contributions or after-tax contributions increase. Employer matching and nonelective contributions used to satisfy the safe harbor rules are required to be 100 percent vested when made and are subject to the withdrawal restrictions that apply to an employee's elective deferrals under a 401(k) plan.

Finally, each 401(k) plan is required to provide each employee eligible to participate with written notice, within a reasonable period before any year, of the employee's rights and obligations under the plan.

Many plan sponsors are currently either making contributions of at least three percent to a 401(k) plan (or to another defined contribution plan maintained in addition to the 401(k) plan) or are making matching contributions in the range called for in the ACP safe harbor. These employers may wish to run a cost analysis to determine if adoption of the ADP and ACP safe harbors make economic sense for the business. However, these employers need to bear in mind that adoption of the safe harbors entails a yearly contribution commitment and immediate vesting.

Savings Incentive Match Plan for Employees (SIMPLE Plan)

The act creates a new form of retirement vehicle for businesses--the SIMPLE plan. The SIMPLE plan can be in the form of a SIMPLE-IRA or in the form of a SIMPLE 401(k) plan. The SIMPLE-IRA plan replaces the salary reduction simplified employee pension plan, or SARSEP, beginning in 1997. Employers may continue SARSEPs established before 1997, but no new SARSEPs are allowed.

The SIMPLE plan is available only for employers that do not sponsor a qualified plan and that have 100 or fewer employees who received $5,000 or more in compensation during the preceding year. If an employer exceeds this 100-employee threshold, the act contains a two-year grace period to continue to maintain the plan. Each employee of the employer who received at least $5,000 in compensation during any two prior years and who is reasonably expected to receive at least $5,000 in compensation during the current year generally must be eligible to participate in the SIMPLE plan. Thus, the SIMPLE plan need not cover new employees and part-time employees whose earnings do not exceed the $5,000 threshold. The employer must give all eligible employees notice of their right to contribute to the plan at least 60 days prior to the start of the plan year.

A SIMPLE-IRA is funded by employee contributions and employer contributions made to the employee's IRA. The maximum employee contribution is $6,000 per year. This maximum employee contribution is indexed for inflation and will increase in $500 increments.

Under a SIMPLE-IRA, the employer is required to contribute to the SIMPLE-IRA each year. The employer has a choice of two contribution formulas: a matching contribution formula or a percent of compensation formula.

The SIMPLE-IRA matching contribution formula requires that the employer match the employee elective contributions on a dollar-for-dollar basis up to three percent of the employee's compensation. Under a special rule designed to allow the employer some measure of flexibility, the employer can elect a lower percentage matching contribution for all employees, but not less than one percent of compensation. The employer cannot make a lower percentage contribution for more than two out of any five years. Under the matching contribution formula, the employer must make a two percent of compensation contribution on behalf of each eligible employee.

If the employer elects a SIMPLE 401(k) plan, then each eligible employee may make deferral contributions and the employer is required to make certain yearly contributions. The employer has a choice of either making a matching contribution equal to the first three percent of each employee's deferral contributions for the plan year or making a contribution of two percent of compensation for all eligible employees. Unlike the SIMPLE-IRA, the employer cannot reduce the matching contribution percentage below three percent of compensation.

All SIMPLE 401(k) plan contributions are made into a qualified trust with individual accounts. The act limits the employee deferral contributions to a SIMPLE 401(k) plan to $6,000 per year.

The act requires that the employees be 100 percent vested in all amounts in the SIMPLE-IRA and SIMPLE 401(k) plans at all times.

Small businesses that have avoided qualified retirement plans because of the complicated discrimination tests and administrative costs may find the SIMPLE plans attractive. This is particularly true of businesses that are comfortable with a maximum contribution of $10,000 to $12,000 a year for the business owner.

However, there are still concerns with a SIMPLE plan. First, the employer is required to contribute to the SIMPLE plan each year. The requirement of a yearly contribution under a SIMPLE plan may be a problem for a business with a cyclical cash flow. By contrast, a 401(k) plan can provide for discretionary matching contributions or for no matching contributions. Second, all employer contributions to a SIMPLE plan are 100 percent vested. Under a qualified plan, 100 percent vesting can take up to six years. Third, part-timers earning more than $5,000 must be included in the SIMPLE plan. Under a qualified plan, individuals working less than 1,000 hours a year may be excluded from the plan by the adoption of a one year of service requirement. Finally, the higher-paid employees are limited to a $6,000 contribution and a three percent match. This is significantly less than the maximum individual contribution of the lesser of 25 percent of compensation or $30,000 in a defined contribution qualified plan.

Required Distributions From Qualified Plans

Prior to the act, a qualified plan was required to provide that distributions commence to participants no later than April 1 of the year following the year in which the participant attains age 70 1/2 (the "required beginning date"). Distributions were required to commence even if the participant continued to work past his or her required beginning date.

Effective for years beginning after December 31, 1996, distributions for participants (other than five percent owners of the business) are not required to begin until the April 1 of the calendar year following the later of: 1) the calendar year in which the participant attains age 70 1/2; or 2) the calendar year in which the participant retires.

The minimum distribution rules for five percent owners are not changed. As a result, five percent owners are still required to begin receiving distributions no later than April 1 of the calendar year following the calendar year in which the owner attains age 70 1/2.

The plan sponsor must determine if it wishes to allow a participant to defer commencement of payments until he or she retires. If so, a plan amendment is required. In addition, the plan sponsor can elect to allow participants who are over 70 1/2 and currently receiving mandatory distributions to halt distributions until the participant retires. If the sponsor makes this election, a plan amendment is also required.

Lump Sum Distributions

Lump sum distributions from qualified plans are eligible for special five-year forward averaging. In general, a lump sum distribution is a distribution within one taxable year of the account balance or accrued benefit of the participant. A taxpayer is permitted to make an election with respect to a lump sum distribution received on or after the employee attains age 59 1/2 to use five-year forward income averaging under the tax rates in effect for the taxable year in which the distribution is made. In general, this allows the taxpayer to pay a separate tax on the lump sum distribution that approximates the tax that would be due if the lump sum distribution were received in five equal installments.

Under the Tax Reform Act of 1986, individuals who attained age 50 by January 1, 1986, can elect to use 10-year averaging in lieu of five-year averaging. In addition, such individuals may elect to retain capital gains treatment with respect to the pre-1974 portion of a lump sum distribution.

Effective January 1, 2000, the act repeals five-year forward income averaging of lump sum qualified plan distributions. However, individuals who reached age 50 before January 1, 1986, will still be eligible to elect 10-year forward income averaging or capital gains treatment under the rules in effect prior to the Tax Reform Act of 1986.

The five-year income averaging election is generally exercised on smaller distributions. Plan sponsors should encourage participants who are near retirement to consult with their professional advisors to determine the new law's effect on their circumstances.

Spousal Consent to Certain Distributions and Beneficiaries

Prior to the act, all pension and certain profit sharing plans were required to pay benefits in excess of $3,500 in the form of a qualified joint and survivor annuity (QJSA). If the participant dies prior to the commencement of payment of benefits, the plan must provide the surviving spouse with a survivor annuity (QPSA). Benefits may be paid from a plan subject to these survivor annuity rules in a form other than a QJSA or QPSA (such as a lump sum payment) only if the participant's spouse waives the QJSA or QPSA. In order for the spouse's waiver to be valid, certain notice, election and spousal consent requirements must be satisfied.

Prior to the act, there was no model spousal consent form. Consequently, the spousal consent forms that have been prepared since 1984 vary from simple "sign here" forms to treatises of six to 10 pages in length. Many plan administrators charged with obtaining spousal consent have complained that the complexity of the spousal consent forms is a constant source of complaints by participants and spouses.

The act directs the Secretary of the Treasury to develop, before 1997, sample language for inclusion in spousal consent forms ("sample language"). At the time this article was written, the QJSA/QPSA sample language had not been released. When the sample language is issued, the plan administrator should review the sample language to determine if it is appropriate for use by the plan. If the sample language is adopted by large numbers of plan administrators, then a uniform spousal consent may eventually replace the hodgepodge of forms currently being used.

Minimum Waiting Period for Qualified Plan Distributions

If a qualified plan provides payment in the form of a qualified joint and survivor annuity (QJSA), the plan must provide participants with a written explanation of the form of benefit payments. Once the explanation is given to the participant, the qualified plan must wait 30 days before payment can be made. Plan administrators have found that many participants wish to be paid as quickly as possible. As a result, the 30-day waiting period has caused both confusion and frustration for all parties.

Effective for plan years beginning after December 31, 1996, a plan may permit a participant to elect, with proper spousal consent if applicable, to waive the 30-day waiting period and receive a distribution seven days after the explanation is provided. A plan sponsor will need to amend its qualified plan in order to allow a participant to elect to waive the 30-day waiting period. The 30-day waiting period must be strictly followed until the amendment is in place. In addition, a plan sponsor must review its payment of benefits documents to make certain that this election is explained clearly to the participant and spouse.

Qualified Domestic Relations Orders Sample Language

A participant in a qualified plan generally cannot assign or alienate his or her benefits under the plan. An exception to this rule applies in the case of qualified plan benefits paid to a former spouse pursuant to a qualified domestic relations order (QDRO). The QDRO must be entered by a state domestic relations court and must satisfy certain statutory requirements.

However, as with the spousal consent documents discussed above, no standard or model QDRO has evolved. Consequently, plan administrators have asked for further assistance in the form of a "model" QDRO. The Secretary of the Treasury is directed to develop sample language for inclusion in a QDRO no later than January 1, 1997. As with the QJSA model language, plan administrators must review the QDRO model language to determine if the language is appropriate for use by the plan. If so, the plan administrator may wish to prepare a model QDRO using the model language.

Definition of Highly Compensated

Qualified retirement plans are not allowed to discriminate in favor of "highly compensated employees" or HCEs. Previously, the Internal Revenue Code contained a very complicated procedure for determining if an employee was "highly compensated." The act provides a simplified definition of HCE. An HCE is an employee who was a five percent owner of the employer at any time during the year or the preceding year or had compensation for the preceding year in excess of $80,000 (which is indexed for inflation). If the employer elects, the definition of HCE can be further restricted to an individual with compensation in excess of $80,000 and who was in the top 20 percent of employees by compensation for such year. The act also repeals the rule requiring the highest paid officer to be treated as an HCE. The simplified definition of an HCE is effective for plan years beginning after December 31, 1996.

For most employers, the new definition of HCE will result in fewer HCEs. For example, under prior law, any employee earning more than $66,000 was considered highly compensated. Now, an employee earning $66,000 to $80,000 will not be considered an HCE. Employers should review all discrimination tests to determine the impact the new definition will have on plan operation. The discrimination tests that appear to be most affected are the Code [sections] 401(k) discrimination tests and the Code [sections] 410 coverage tests.

Excise Tax on Excess Distributions Suspended

A 15 percent excise tax is generally imposed on annual distributions in excess of $155,000 (indexed for inflation) and lump sum distributions in excess of $775,000 (also indexed for inflation).

The act suspends the 15 percent excise tax on excess distributions from qualified plans, tax-sheltered annuities, and IRAs for distributions received from January 1, 1997, through December 31, 1999. The excise tax on excess accumulations is not changed or suspended by the act.

This provision of the act is not revenue neutral. Rather, this provision is a net revenue producer. Therefore, any individual contemplating a large withdrawal during the three-year suspension should consult with his or her advisors to make certain that the acceleration of taxes caused by the withdrawal is offset by other factors (such as potential savings on estate taxes).

Minimum Participation Rules Eliminated

Beginning in 1997, defined contribution plans will no longer be required to satisfy the 401(a)(26) "50 employee or 40 percent of all employees" minimum participation rule.

Repeal of Family Aggregation Rules

The act repeals the current rules that require certain HCEs and their family members be treated as a single employee. This rule has unfairly punished family businesses and has been an administrative nightmare. The repeal of family aggregation was effective for plan years beginning in 1997.

Plan Amendments

Plan amendments reflecting the act's provisions generally must be adopted by the first day of the first plan year beginning on or after January 1, 1998. However, plans must be operated in compliance with each of the act's provisions beginning on each provision's effective date.

Prohibited Transactions

The tax increases from five percent to 10 percent for prohibited transactions that occur after August 20, 1996.

Individual Retirement Accounts

Prior to the act, nonworking spouses could contribute up to $250 to an IRA. Beginning in 1997, nonworking spouses may contribute up to $2,000 annually to an IRA if the combined compensation of both spouses is at least equal to the amount contributed.

Steven K. Barber is a shareholder in the law firm of Fowler, White, Gillen, Boggs, Villareal and Banker, P.A., in Tampa, and is in charge of the firm's Employee Benefits Group. He received his B.S. in 1975 and his J.D. in 1979 from the University of South Carolina.

This column is submitted on behalf of the Tax Section, Joel D. Bronstein, chair, and Michael D. Miller and David C. Lanigan, editors.
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Author:Barber, Steven K.
Publication:Florida Bar Journal
Date:Feb 1, 1997
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