Year-End Retirement Planning for Business Owners, Professionals and
By Jeffrey S. Kahn and
Cynthia Groszkiewicz, Greenberg
View or download the PDF version of this Alert
Accumulating adequate funds for retirement has become more difficult
with the recent decline in the stock market. Fortunately, the 2001 tax act,
also known as the Economic Growth and Tax Relief Reconciliation Act of 2001
("EGTRRA"), contains many favorable provisions for retirement plans. These
new provisions, which became effective in 2002, allow plan sponsors and
business owners to fund significantly larger amounts for themselves and
their key employees on a tax deductible basis than under prior law. However,
businesses must act before December 31, 2002 to take advantage of these
changes for this year.
|"These new provisions allow plan
sponsors and business owners to fund significantly larger amounts
for themselves and their key employees on a tax deductible basis."
This GT Alert will highlight the pension changes that have been made
by EGTRRA and provide some examples of their use.
Increased Compensation Limitation
Before EGTRRA, annual compensation in excess of $170,000 could not be
taken into account in determining an individualís contributions, benefits,
tax deductions, or used for non-discrimination testing purposes. Beginning
in 2002, the maximum allowable compensation has been increased to $200,000
and is indexed for inflation in $5,000 increments. This increased compensation
limit is already proving to be helpful in providing greater benefits to
highly compensated employees and lowering the minimum contribution costs
for nonhighly compensated employees.
Increased Defined Contribution Allocation Limitations
The old limit on the amount in a defined contribution plan (i.e., the
total of profit sharing, money purchase pension contributions, ESOPs, 401(k)
salary deferrals, matching contributions and participant forfeitures) that
could be allocated to any participantís account was the lesser of 25% of
gross compensation or $35,000. Beginning in 2002, the limitation has been
increased to the lesser of 100% of compensation or $40,000, which will then
be indexed for inflation in $1,000 increments.
Increased Deduction Limitations
Before EGTRRA the employer contribution deduction limitation was 15%
of eligible compensation for profit sharing plans, 401(k) and stock bonus
plans and 25% of eligible compensation for money purchase pension plans.
Eligible compensation was limited to taxable compensation not to exceed
$170,000. Beginning in 2002, the contribution deduction limitation was increased
for profit sharing plans to 25% of gross compensation. With this change
businesses will no longer need to maintain both a money purchase pension
plan and a profit sharing plan in order to make the maximum deductible contribution.
In addition, employee 401(k) deferral contributions are no longer counted
towards the deduction limit.
Increased 401(k) and 403(b) Deferral Limitation
The current maximum amount of compensation that any participant may defer
in a 401(k) plan or 403(b) tax deferred annuity is the lesser of 100% of
compensation or $11,000 ($12,000 in 2003). This limit is increased in $1,000
increments until 2006 when the limit reaches $15,000.
Catch-up Deferrals for Individuals 50 or Older
EGTRRA allows participants who are age 50 or older to make additional
"catch-up" 401(k) deferral contributions. The maximum catch-up is $1,000
in 2002 and increases by $1,000 each year thereafter until it reaches $5,000
in 2006. The catch up is $2,000 in 2003. These catch-up rules also apply
to 403(b) tax deferred annuities and Section 457(b) plans.
New Plan Designs
In recent years, many companies have found that they can preserve the
flexibility of a profit sharing plan yet still reward their older, higher
paid employees. This can be done by using a plan designed called New Comparability
or Cross-Testing. New Comparability allows plans to separate employees by
job classifications and have contributions allocated differently among the
classes. Under the new higher limits provided by EGTRRA, an effective plan
design for many companies includes a 401(k) salary deferral feature and
a discretionary profit sharing formula using the New Comparability method
of allocations. This combination often allows the key people to defer the
maximum allowed by law of $40,000 per year with a maximum staff cost of
5% of payroll. The below illustration shows how this might work compared
to a traditional profit sharing plan:
By switching from a traditional profit sharing plan the company saved
over $8,000 on staff costs. Using a similar plan design with a larger staff
could reduce the companyís contributions dramatically.
The Return of the Defined Benefit Pension Plan!
Defined benefit pension plans are the traditional plans of big business.
Nevertheless, they can also be an effective tax planning tool for small
businesses. Under these plans, employees do not have their own accounts
as they would with a 401(k) or profit sharing plan. Rather, the company
sets aside an actuarially determined amount so that at a certain age (usually
normal retirement date) an employee receives a monthly pension (based upon
a percentage of his or her salary) for the rest of his or her life. This
amount is guaranteed to the employee by the plan regardless of the planís
investment performance. The company is actually funding any investment losses
on a tax deductible basis, while the benefit of the participant is uneffected
by the planís investment returns. The tax deductibility of contributions
to a defined benefit plan, although subject to compliance with the Internal
Revenue Codeís minimum funding rules, can nevertheless be substantially
greater for older employees than contributions under a profit sharing or
In a private company, a defined benefit plan can often provide significant
tax deductions to the business owner resulting in a large tax deferred accumulation
of retirement funds at retirement. EGTRRA has increased the defined benefit
limitation to enhance this benefit significantly. This comes at a very opportune
time for many baby boomers who are nearing retirement and realize that their
401(k) accounts will be inadequate.
Increased Defined Benefit Limitation
Before EGTRRA the maximum benefit that could be provided to any participant
in a defined benefit pension plan was an annual annuity commencing at the
participantís Social Security Retirement Age equal to the lesser of 100%
of the highest three-year average annual compensation or $140,000. Unlike
in a large public company pension plan, in a pension plan for a closely
held company, this benefit is usually paid out in the form of a lump sum.
Beginning with plan years that end in 2002, the annual maximum benefit has
been increased to $160,000 payable as early as age 62. Prior to EGTRRA in
the Small Business Job Protection Act of 1996, Congress had repealed Section
415(e) of the Internal Revenue Code which had restricted defined benefit
contributions where a company had previously maintained a defined contribution
plan. The combination of these changes will significantly increase the annual
deductible contributions and the maximum lump sum amount that can be paid
to key employees at retirement. In addition, the existing "full funding
limit," which sometimes restricts deductible contributions, has been eased.
Defined benefit plans can be extremely valuable for older individuals who
wish to defer more than the maximum $40,000 allowed in a defined contribution
plan. Any business owner, professional or key executive who has reached
age 45, should now consider a defined benefit pension plan. The following
example illustrates the impact of a defined benefit pension plan after EGTRRA:
This illustrates that for the older business owner, a defined benefit
pension plan will often generate annual contributions of 2 to 3 times more
than a defined contribution plan.
IRAs May be Rolled Over to Qualified Plans
Beginning in 2002, all IRA accounts, not just IRAs funded exclusively
with rollovers from qualified employer plans, may be rolled over into qualified
employer plans. In many jurisdictions the ability to rollover IRA funds
to a qualified plan can significantly increase the protection of those assets
Plan Loans to Owners
Under prior law, plan loans to sole proprietors, partners, and shareholders
of S Corporations (including family members) were prohibited unless an exemption
was obtained from the Department of Labor. Beginning in 2002, these loans
are now permitted. Shareholders of C Corporations continue to be permitted
to take out plan loans, but loans from IRAs are still not allowed.
Same Desk Rule Repealed
A problem that often occurred after a merger or acquisition was that
employees who kept their jobs could not receive a distribution of their
401(k) or 403(b) accounts from the old companyís plan because they had not
technically "separated from service." This rule, known as the Same Desk
Rule," has been repealed and participants may now receive distributions
upon a "severance of employment."
No IRS User Fees for First Five Years
The IRS user fee for a determination letter request (ranging from $125
to $1,250 for most plans) will be waived if the plan covers at least one
nonhighly compensated employee, the employer has 100 or fewer employees
and the request is submitted before the end of the fifth plan year.
These changes all became effective and available in 2002. However, in
order to take advantage of most of the changes that increase benefits, plan
designs have to be reviewed and the new or amended plans need to be adopted
before December 31, 2002. It should also be noted that although Congress
has considered many other pension reform proposals during 2002 that might
further increase retirement savings, to date none of these proposals have
GUST Restatement Reminder
During the mid to late 1990ís, Congress passed several major pieces of
legislation that affected qualified retirement plans, collectively these
laws are referred to as GUST. The GUST remedial amendment period for individually
designed plans generally ended on the later of February 28, 2002, or the
last day of the 2001 plan year. However, the GUST remedial amendment period
for prior adopters of pre-approved plans, and for employers that timely
certified their intent to adopt a pre-approved plan that has been restated
for GUST, will be extended to at least December 31, 2002. Whether
a plan sponsor has their own individually designed plan or has adopted a
prototype or pre-approved plan, it is their responsibility to make sure
their plan is up-to-date for all changes in the law.
© 2002 Greenberg Traurig
For more information, please review our Tax Practice or Executive Compensation
& Employee Benefits Group description, or feel free to contact one of our
This GT ALERT is issued for general purposes only and is not intended
to be construed or used as legal advice. Greenberg Traurig attorneys provide
practical, result-oriented strategies and solutions tailored to meet our
clientsí individual legal needs. The Firmís responsive approach to client
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and resources to provide cost-effective solutions.