KEYWORD:

EMPLOYEE BENEFITS MEMORANDUM

Date:	June 21, 2001
Re:	Economic Growth and Tax Relief Reconciliation Act of 2001 (HR 1836)

On June 7, 2001, the President signed into law new tax legislation affecting employer- provided pension, profit sharing, and health benefit programs: the Economic Growth and Tax Relief Reconciliation Act of 2001 (HR 1836) ("EGTRRA"). This is a summary of some of the things this law will do. The expanded 204(h) notice requirements, discussed in Part VII of this memo, are the only provisions that are effective immediately. The remaining provisions are effective for plan years beginning after December 31, 2001, unless stated otherwise.

I. Increased Contribution and Benefit Limits

The EGTRRA provisions that have been receiving the most media attention are the increases in the amounts individual employees may contribute, or receive, from retirement plans, as follows:

beginning in 2002, an individual may defer up to $11,000 (increased from $10,500 this year) into a 401(k) plan. This limit will rise with additional $1,000 increases in each of the next four years to $15,000, with $500 adjustments in the years following. The increase sounds like good news for your highly compensated employees ("HCEs"), however, if your plan is not a safe harbor plan and you are consistently forced to make refunds to your HCEs as a result of nondiscrimination testing, the increase may not help unless your nonhighly compensated employees ("NHCEs") can be induced to contribute more to the plan (see description of new tax credits at the end of this section);

the maximum benefit an employee may receive under all of your defined contribution plans (415 test) is increased from the lesser of $35,000 or 25% of compensation to the lesser of $40,000 or 100% of compensation. This increase in the percentage limit benefits employees in the $140,000 to $170,000 salary range who were previously cut short of the $35,000 maximum by the 25% limit;

the maximum annual benefit an employee may receive under all of your defined benefit plans (415 test) will be increased from the lesser of 100% of three-year high salary or $140,000 (this year) to the lesser of 100% of three-year high salary or $160,000. Defined benefit plans not operating on a calendar year should pay particular attention to the effective date of this provision, since it is effective for plan years ending after December 31, 2001. In addition, this limit will now only be actuarially reduced for employees retiring before age 62;

the §401(a)(17) compensation limit, which limits the amount of employee compensation that may be taken into account in plan benefit formulas, contribution percentages, in the above-described 415 tests, and in nondiscrimination testing for defined benefit and defined contribution plans, is raised from $170,000 to $200,000. The new, higher limit will allow employers to drop their contribution percentage, while still sustaining the maximum benefit available for HCEs under the 415 test. For example, taking into account the old 415 limit for defined contribution plans described above, an employer that has an HCE earning a salary of $200,000 and deferring the $10,500 maximum would have to contribute 14.4% of the HCE's salary (capped at $170,000) to reach the $35,000 allowable limit. Now, with the EGTRRA increase in the compensation cap to $200,000, an employer would only have to establish a contribution percentage of 12.25% to reach the same $35,000 amount for HCEs earning $200,000 or more;

employees age 50 and older will be permitted to make "catch-up contributions" to 401(k), 457, and 403(b) plans in excess of the normal deferral limits. These additional contributions are limited to $1,000 in 2002, increased by $1,000 per year to $5,000 in 2006, and then increased in $500 increments thereafter. The amount of the catch-up contribution will not be subject to nondiscrimination testing, will not count against the employer's deduction limit, and will not be counted in the individual's 415 test provided all participants age 50 or older are eligible to make the catch-up contribution under the plan. A plan amendment is required to take advantage of this provision. Additionally, if amending the plan for catch-up contributions, you should pay particular attention to whether the employer match (if any) should apply to the catch-up contributions, as well as to the normal deferrals. It is permissible to match the catch-up contributions, however, this will almost inevitably hurt the plan in its nondiscrimination testing. Even though the catch-up contribution itself is not included in the nondiscrimination testing, the match on the catch-up contribution will be considered for nondiscrimination tests. Matching the catch-up contribution will most likely work against the plan since catch-up contributions are made on top of the normal deferral limit-therefore, the majority of the catch-up contributors will be highly compensated HCEs, employees, and the proportion of catch-up match will be stacked heavily in their favor; and

effective in 2002, certain individuals with adjusted gross income less than $22,500 and joint filers with adjusted gross income of less than $50,000 will be eligible to receive a nonrefundable tax credit equal to a maximum of 50% of the first $2,000 contributed to an IRA, 401(k) plan, 403(b) plan, SIMPLE or SEP plan, or 457 plan. This credit is in addition to the deduction already associated with the traditional IRA contribution and the fact that the amounts deferred into a plan are temporarily excluded from taxable income. These tax credits should have some positive effect on plan nondiscrimination testing in that they should encourage NHCEs to contribute more to the plan. Since the tax credit is nonrefundable, however, the NCHE must owe tax after all other deductions and credits for the retirement savings credit to be beneficial.

II. Employer Deduction Increases

Profit sharing and stock bonus plans, including 401(k) plans, will have an increased deduction limit under EGTRRA. Effective in 2002, the aggregate deduction limit for an employer's contributions to these types of plans is increased from 15% of total compensation provided to eligible employees to 25% of total eligible employee compensation.

Effective in 2002, EGTRRA makes all employee deferrals deductible by the employer.

Additionally, EGTRRA changes the make-up of the deduction limit fraction, which is employer contributions over total eligible employee compensation. Beginning in 2002, EGTRRA excludes employee deferrals from the numerator (where they are currently included) and changes the definition of compensation in the denominator to include employee deferrals.

The above changes have the following practical effects:

All Deferrals Deductible: An employer may now deduct all employer deferrals as a business expense, in addition to the 25% deduction based on matching and traditional profit sharing employer contributions. Previously, the employer could only deduct those deferrals that did not exceed the old 15% limit;

Greater Deductions Available: Increased deduction percentage aside, by decreasing the numerator of the deduction limit fraction, while at the same time increasing the denominator, EGTRRA makes it possible for an employer who was previously bumping up against the deduction limit to produce a greater deduction with the same amounts of employer contributions to the plans;

Disappearance of an Administrative Trap: Under current law, employee deferrals are backed out of the definition of total employee compensation. This treatment is counter-intuitive, and many employers mistakenly contribute amounts to their plans greater than the deduction limit because they base their contribution percentage on employee compensation, including deferrals. Under EGTRRA, total employee compensation will include deferrals; and

Only One Plan Necessary to Achieve Maximum Deductible Contributions: The increase of the deduction percentage from 15% to 25% obviously makes larger deductions available to the employer for its contributions to a plan. However, there is another side effect to this increase. Currently, an employer that wishes to maximize deductible contributions must utilize a special rule that increases the deduction limit to 25% percent if the employer makes contributions to both a pension plan and a profit sharing plan. Normally, employers accomplish this by establishing both a profit sharing plan and a money purchase pension plan. Once EGTRRA's deduction provisions become effective in the employer's 2002 taxable year, a 401(k), profit sharing, or stock bonus plan alone can provide the same result (a 25% limit on employer contributions).

III. Changes Specific to 401(k) Plans

Effective for plan years beginning after December 31, 2001, the Multiple Use Test is repealed. The Multiple Use Test is the last, complicated layer of nondiscrimination testing of 401(k) deferrals, match, and after-tax contributions. The Multiple Use Test is only applied when the plan does not pass at least one of the ADP and ACP tests by the more restrictive "125% Test," rather than the "2 Times Test." The repeal is a welcome change-the Multiple Use Test is a heavy administrative burden for plans and is a frequent, yet hard-to-explain cause for plan refunds to highly compensated employees. Additionally, the IRS has recently taken the controversial position that the Multiple Use Test applies to safe harbor 401(k) plans (those that meet certain employer contribution or match levels and are supposedly exempt from ADP testing). In the absence of a change of heart by the IRS, the repeal will only subject safe harbor plans to one more year of testing (for the 2001 plan year).

Although a participant is immediately vested in his or her employee deferrals, the plan may not distribute any amounts from the deferral account unless the distribution is on account of death, disability, retirement, reaching age 59 ½, termination, or a hardship withdrawal. Currently, once a hardship withdrawal has been taken, to satisfy the hardship safe harbor the plan is required to suspend that participant's ability to make deferrals into the plan for 12 months. Beginning in 2002, EGTRRA shortens this suspension period to six months. Most 401(k) plans will need an amendment to incorporate this change, if desired. However, since the suspension period is part of the hardship withdrawal safe harbor and since 6 months will be the minimum period required to prove that an employee was truly in financial need at the time of the hardship withdrawal, it is acceptable to retain the 12 month suspension period.

Beginning in 2006, participants may elect "Roth" (essentially after-tax) treatment for their elective deferrals, and upon distribution, both the after-tax contributions and the earnings accumulated on those amounts may be withdrawn tax-free. An amendment is necessary to take advantage of this provision.

Please see Section IV, "Rules for All Qualified Plans" to see more changes applicable to 401(k) plans.

IV. Individual Retirement Account ("IRA") Changes

Although traditionally, private employers may not offer IRAs to their employees, several changes made to IRA rules in EGTRRA will affect the administration of your plans. The changes are designed to utilize employer plans to encourage, or at a minimum ease, the use of IRAs by employees as an additional vehicle for retirement saving.

Eligible individuals will be able to make "catch-up contributions" to IRAs, in addition to their catch-up contributions in their qualified retirement plan. The IRA catch-up contributions begin at $500 in 2002 and do not increase until 2006, at which time they are increased to $1,000.

EGTRRA increases the current $2,000 annual contribution limit to IRAs and Roth IRAs to $3,000 in 2002 up to $5,000 in 2008, at which time it will be indexed for inflation in $500 increments.

EGTRRA also provides that, beginning in 2003, if an eligible retirement plan permits employees to make voluntary employee contributions to a separate account that is established under the plan and meets requirements applicable to either traditional IRAs or Roth IRAs, then the separate account will be considered an IRA for purposes of the Internal Revenue Code. These accounts are called "Deemed IRAs," and a plan amendment will be required to take advantage of this new allowance.

As mentioned previously, 401(k) and 403(b) participants may elect "Roth" treatment for their employee deferrals and earnings on those deferrals after December 31, 2005.

As discussed below in the Top Heavy provisions in Section VII, 401(k) safe harbor plans utilizing the match safe harbor are exempt from the top heavy rules. Note, however, that profit sharing components of these 401(k) plans must still satisfy the top heavy provisions, and if they do not, the safe harbor match will count toward the minimum contribution amount required.

V. Changes Specific to Defined Benefit Plans

Generally, contributions to a defined benefit plan that exceed the full funding limit are not deductible. EGTRRA increases the limit to 165% in 2002, to 170% in 2003, and thereafter, the current liability funding limit is repealed entirely.

EGTRRA also provides that the 10% excise tax imposed on employers who make nondeductible contributions to qualified plans (nondeductible because they were in excess of the deductible employer contribution limits) will no longer apply to any contributions to a defined benefit plan up to the accrued liability full funding limit.

VI. Changes Specific to 457 and 403(b) Plans

Currently, a maximum of $8,500 may be deferred by a participant in a 457 plan (sponsored by governments or tax exempt entities). This limit is set off against any deferrals under other types of arrangements, so that, for example, an employee who is a participant in a 457 and 401(k) plan may not defer anything into the 457 plan once he or she has set aside more than $8,500 in the 401(k) plan. EGTRRA provides that the section 457 limit on deferred compensation will not be reduced by elective deferrals under other types of arrangements.

Currently, amounts deferred (and earnings on those amounts) in a 457 plan are included in a participant's income at the time when the amounts are available to the participant, whether or not the amounts are actually distributed at that time. This harsh rule potentially leaves many 457 participants in a position where they owe tax on amounts that they have not even received from the plan. Effective in 2002, for government plans (and NOT tax exempt entity plans), amounts deferred in a 457 plan are taxed to participants only when paid.

Distributions from a 457 plan due to a QDRO are currently taxed to the participant, instead of the recipient spouse. Obviously, this is an unfair result. EGTRRA provides that, for distributions and payments from a 457 plan made after December 31, 2001, amounts paid to the spouse or former spouse pursuant to the QDRO will be taxed to the spouse.

Effective 2002, the same minimum distribution rules that apply to all qualified retirement plans will also apply to 457 plans (instead of the minimum distribution rules applicable now, which are unique to 457 plans).

Effective 2002, State and local government employees may purchase, if the plan so provides, permissive service credits in a State defined benefit plan with funds from a 457 or 403(b) plan.

Effective for limitation years beginning after December 31, 1999, 403(b) contracts will again be disaggregated from other plans for purposes of 415 unless the participant controls the employer.

Effective in 2006, 403(b) plan participants may elect "Roth" treatment for their deferrals.

VII. Miscellaneous Rules Applicable to All Tax-Qualified Plans

Participants have been, and are still, immediately vested in their employee deferrals or after-tax contributions to a plan. However, plans are allowed to set up vesting schedules to delay the time in which participants vest in the employer-provided match in qualified plans. Currently, the lengthiest time frames allowed for vesting in the match are 5 year "cliff" vesting (where the participant is 0% vested until completion of 5 years of service, at which time he or she becomes 100% vested) or 7 year "graded" vesting (where the participant becomes 20% vested in the match account after completing 3 years of service and the participant's vesting percentage increases in 20% increments until he or she is 100% vested by the end of 7 years of service). EGTRRA shortens the allowable time frames for vesting in match accounts to a maximum 3 year "cliff" vesting or 6 year "graded" vesting, where the participant vests in 20% increments beginning in the second year of service. This is an important change that will begin in 2002 (special rules apply to collectively bargained plans). You should check your plan documents to determine whether the plan vesting schedule for matching contributions is at least as generous as the new vesting schedules under EGTRRA. This means that vesting must begin and grow as fast as the schedules provided by the IRS (for example, 5 year graded vesting, where the participant does not begin to vest until the 3rd year of service would not be acceptable). Please note that the new vesting schedules do not apply to other types of employer-provided contributions, such as profit sharing contributions or qualified nonelective contributions.

Effective immediately, EGTRRA expands the 204(h) notice requirements so that participants must now be notified within a reasonable period of time before the effective date of an amendment that significantly reduces future benefit accruals, without having to wait until after the employer adopts the amendment, as is currently required. Additionally, an amendment that eliminates or reduces a subsidy will now be treated as a significant reduction in future benefit accruals. Failure to comply with the new rule will subject the employer to a tax of $100 per day per "unnotified" participant up to $500,000. The Treasury will issue regulations that will provide further guidance on the new notice rules. Until that time, employers will be held to a good faith interpretation of the provision. This is actually a helpful new rule for plan sponsors, since the timing of the distribution of the notice under the old rule (after adoption, but 15 days before effective date) was so tricky to accomplish.

The "same desk rule" is repealed and is replaced with a "severance from employment" standard. Mergers, sales and acquisitions of companies are becoming more and more commonplace. Currently, these business transactions cause some problems for plan administrators. Specifically, an employee who is a participant in the qualified defined contribution plan of the selling employer was prevented by the "same desk rule" of the IRS from taking a distribution from that plan if he or she was employed by the new employer in substantially the same job as that held with the old employer, even if the employee was no longer benefiting under the old plan due to the sale or merger. Beginning in 2002, participants of a 401(k), 403(b), or 457 plan may now take a distribution from the plan upon these types of sale or merger events. Essentially, the same desk "separation from service" rule (which was only applicable to defined contribution plans) was replaced with the more lenient "severance from employment" rules previously only applicable to defined benefit (pension) plans, so that distributions in merger, sale and acquisition situations will normally be allowed. This is true for distributions occurring in 2002, even if the sale or merger causing the "severance from employment" occurred before that time.

Plan loans to subchapter S owners, partners, and sole proprietors will no longer be considered prohibited transactions. Loans to IRA owners are still prohibited.

Beginning in 2003, as mentioned in the IRA section of this memo, Deemed IRAs are allowed under qualified plans.

The rule disallowing rollover treatment for 401(k) hardship distributions is extended to hardship distributions from any qualified plan.

EGTRRA directs the IRS to modify the life expectancy tables under the §401(a)(9) minimum required distribution regulations (the rules that require the plan to begin distributions to retired participants in the year in which they reach age 70 ½ to reflect current life expectancy).

Effective upon the publication of DOL regulations, automatic "cash-outs" of small amounts ($1,001 to $5,000) must be transferred to an IRA unless the participant affirmatively elects otherwise. Cash-outs can be calculated without taking into account any rollovers from other plans.

Top Heavy Rules:

Currently, a plan is considered "top heavy" and discriminatory in favor of highly paid employees if more than 60% of plan assets are held on behalf of "key employees." Key employees are generally 5% owners, 1% owners with compensation over $150,000, officers earning over half of the 415 defined benefit dollar limitation ($70,000 in 2001), and the 10 employees earning over $30,000 who have the largest ownership interest in the business. Attribution rules also apply to make family members of 5% owners "key employees." The rules generally only affect small businesses. If found to be "top heavy," a plan must make contributions to all non-key employees and meet a special vesting schedule.

EGTRRA changes the top heavy rules in the following ways: (1) the "top 10 owner" rule for determining "key employees" is eliminated; (2) the 4 year look-back rule for determining "key employees" is eliminated; (3) only 5% owners, 1% owners with compensation in excess of $150,000, and officers earning more than $130,000 (adjusted for inflation in $5,000 increments) will be considered "key employees;" (4) matching contributions will count toward satisfying the top heavy minimum contributions; (5) the 5 year look-back rule applicable to distributions will be shortened to 1 year, although the 5 year rule will still apply to in-service distributions; (6) a top-heavy defined benefit plan will not be required to make minimum accruals on behalf of non-key employees if the plan is frozen; and (7) safe harbor 401(k) plans utilizing the match safe harbor are exempt from the top heavy rules.

Rollover Rules

Rollovers between and among 401(k), 403(b), 457, and other qualified retirement plans will now be allowed. Additionally, taxable amounts from an IRA (non-Roth IRA contributions) may be rolled over into any 401(k), 403(b), 457, or any other qualified retirement plan.

After-tax employee contributions will also be permitted to be rolled over into another qualified plan or an IRA.

Distributions to the surviving spouse of a deceased participant may now be rolled over into an IRA or the spouse's retirement plan, if that plan permits.

Currently, an eligible rollover must be made within 60 days of distribution. EGTRRA gives authority to the IRS to extend the 60 day rule in appropriate circumstances where delay is equitable.

Plan rollover notices must be revised to reflect these changes. A model notice will be provided by the IRS.

Amounts rolled over from other qualified plans will no longer be considered when the current employer is applying the "cash out" rule. The cash out rule allows employers to automatically distribute a participant's account upon that participant's termination from service if the present value of the account balance is less than $5,000. This rule will be helpful for your plan administration, since in this mobile job market, employees move from job to job and often carry their retirement plan balances with them. The new EGTRRA rule simplifies administration by allowing employers to disregard amounts saved through other employers' plans that have been rolled over (including the earnings upon these amounts) when calculating the $5,000 cash out rule limit, thus enabling the employer to effectively "clean out" more small balances.

VIII. Special Reductions in Costs for Small Employer Plan Sponsors

The IRS charges fees, ranging in cost based on the size of the plan and scope of review, for plan "determination letters" that establish that the Service has reviewed the plan and deemed it in compliance with current tax rules. Determination letters are not mandatory, but they are the best means to ensure that the plan meets the criteria for favorable tax treatment of a qualified retirement plan. The IRS will waive its user fees for determination letter requests submitted after December 31, 2001, by small employer plan sponsors (those with 100 or fewer employees) for the first five years of the plan (or longer, if allowed by a remedial amendment period applicable during the plan's first five years).

The plan sponsor's costs of establishing and maintaining a retirement plan are generally deductible as business expenses. Under EGTRRA, small employer plan sponsors will also be eligible to receive a nonrefundable tax credit of 50% of expenses incurred in the establishment and start-up of a retirement plan, up to $500. This credit is only available during the first three years of the plan's existence and is only applicable to start-up type expenses paid in years after December 31, 2001. Additionally, the plan must have at least one NHCE participating to receive the credit. The employer may not claim a deduction on the amount of expenses taken as the tax credit, but may deduct any expenses greater than the credit amount.

IX. Sunset Provision

The provisions of EGTRRA will not last indefinitely without further Congressional action. The entire tax bill, including the retirement plan provisions, will expire after December 31, 2010. If no extension is passed, the law will revert to its status prior to EGTRRA.