GT Alert

Year-End Retirement Planning for Business Owners, Professionals and Executives

October 2002
By Jeffrey S. Kahn and Cynthia Groszkiewicz, Greenberg Traurig

  View or download the PDF version of this Alert here.

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 individual’s 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 participant’s 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:

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 plan’s 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 plan’s investment returns. The tax deductibility of contributions to a defined benefit plan, although subject to compliance with the Internal Revenue Code’s minimum funding rules, can nevertheless be substantially greater for older employees than contributions under a profit sharing or 401(k) plan.

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 participant’s 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 from creditors.

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 company’s 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 been adopted.

GUST Restatement Reminder

During the mid to late 1990’s, 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

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