Increased dollar limits. Section 611 of the new law increases the following plan limits: 1) the elective deferral limit for 401(k) plans, 403(b) plans, and 457 plans is $11,000 in 2002, $12,000 in 2003, $13,000 in 2004, $14,000 in 2005, and $15,000 in 2006, with cost-of-living increases (in $500 multiples) thereafter, 2) the dollar limit under §415(c)(1)(A) (pertaining to annual additions under defined contribution plans) is $40,000 for 2002, with cost-of-living increases (in $1,000 multiples) thereafter, 3) the dollar limit under §415(b)(1)(A) (pertaining to the annual benefit payable under defined benefit plans) is $160,000 for 2002, with cost-of-living increases (in $5,000 multiples) thereafter, 4) the compensation dollar limit under IRC §401(a)(17) is $200,000 for 2002, with cost-of-living increases (in $5,000 multiples) thereafter, and 5) the elective deferral limit for SIMPLE-IRAs and SIMPLE 401(k) plans is $7,000 for 2002, $8,000 for 2003, $9,000 for 2004, and $10,000 for 2005, with cost-of-living adjustments (in $500 multiples) thereafter. Also, under section 615 of the new law, individuals who are eligible under a 457 plan do not have to coordinate the contribution limit under the 457 plan with the contribution limit under IRC §402(g) (pertaining to elective deferrals under 401(k) and 403(b) plans), starting in 2002.

Increased deduction limits for employers. Deduction limits for profit sharing plans and stock bonus plans are significantly increased through a combination of three changes (see sections 614 and 616 of the new law): 1) the 15% limit under IRC §404(a)(3) is increased to 25% of aggregated participant compensation, 2) 401(k) deferrals are separately deductible with regard to the 25% limit and do not "eat away" the 25% limit applicable to other employer contributions (e.g., matching contributions, nonelective contributions), and 3) participant compensation used to calculate the 25% limit described in 1) is based on section 415 compensation, which means it is "grossed up" for elective deferrals made by participants under 401(k) plans, cafeteria plans, etc. For example, suppose the aggregate compensation of all participants in a 401(k) plan is $1,000,000 (before compensation is reduced for elective deferrals), and the participants defer a total of $50,000 under the 401(k) arrangement. Further suppose the employer matches those deferrals 100% and makes a profit sharing contribution in the amount of $200,000. The entire $300,000 (i.e., $50,000 401(k) deferrals, $50,000 matching contributions, and $200,000 profit sharing contributions) is fully deductible. The 25% deduction limit is $250,000 (i.e., 25% x $1,000,000), which supports the deduction for the matching contributions and profit sharing contributions. The $50,000 of 401(k) contributions are also fully deductible, without regard to the 25% limit, and do not reduce the $250,000 deduction limit applicable to the matching contributions and profit sharing contributions. These changes take effect for employers' taxable years that begin in 2002 and later. Since the deduction limit under §404(a)(3) has been increased to 25%, the law also subjects money purchase plans to this deduction limit (rather than the deduction limit under §404(a)(1)) for post-2001 taxable years of the employer. Thus, the pension plan deduction rules under §404(a)(1) will apply only to defined benefit plans. However, the Treasury has authority to create exceptions to the 25% limit for money purchase plans (e.g., to address contributions made to satisfy funding deficiencies that might otherwise cause the 25% limit to be exceeded). The deduction limit increases described in this paragraph should eliminate the need for money purchase plans in most situations.

Catch-up contributions for individuals age 50 and older. Starting in the year in which an individual reaches age 50 and subsequent years, a plan may allow the individual to make a "catch-up" contribution. See section 631 of the new law. The catch-up contribution rule may be provided under a qualified plan, a 403(b) plan, a 457 plan maintained by a governmental entity, a SIMPLE-IRA plan or a SIMPLE-401(k) plan. The maximum catch-up contribution for qualified plans, 403(b) plans, and 457 plans is $1,000 in 2002, $2,000 in 2003, $3,000 in 2004, $4,000 in 2005, and $5,000 in 2006. The maximum catch-up contributions for SIMPLE-IRAs and SIMPLE-401(k) plans is $500 in 2002, $1,000 in 2003, $1,500 in 2004, $2,000 in 2005, and $2,500 in 2006. The 2006 limit is subject to cost-of-living adjustments (in $500 multiples) starting in 2007. The catch-up contribution does not count against the IRC §402(g) limit (pertaining to maximum elective deferrals under 401(k) and 403(b) plans), the IRC §415 limit (as increased by the provisions of this new law), the IRC §457(b) limit, the SIMPLE limits under IRC §408(p) and IRC §401(k)(11), the SEP limits under IRC §402(h), the deduction limit under §404, nor the plan's limit on elective deferrals (e.g., if a 401(k) plan's normal limit on elective deferrals is 10% of compensation, the catch-up contribution would be in addition to the maximum deferrals permitted under the plan's normal limit). The right under a qualified plan to make catch-up contributions must be available on a nondiscriminatory basis to eligible participants (e.g., the plan could not allow only highly compensated employees who are over age 50 to make catch-up contributions). Catch-up contributions will not cause a plan to fail the ADP and ACP tests under 401(k) plans, the 401(a)(4) nondiscrimination test on the amount of contributions or benefits provided by the employer, or the coverage tests under IRC §410(b). The Treasury will have to prescribe operating rules on how to run the applicable nondiscrimination tests where an employees has made catch-up contributions (or contributions that can be potentially characterized as catch-up contributions). Catch-up contributions are allowed starting in 2002.

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Elimination of 25% annual additions limit for defined contribution plans; elimination of maximum exclusion allowance for 403(b) plans. Section 632 of the new law significantly increases contribution limits for middle-income and lower-income participants. The annual additions limit under §415(c)(1)(A) is increased from 25% to 100% of compensation. Thus, for 2002, the annual additions limit is 100% of compensation for participants who earn less than $40,000, and the limit is $40,000 for participants who earn $40,000 or more. This should eliminate violations of the §415 limit for participants who defer significant percentages of their income through the 401(k) arrangement. For example, suppose a participant under a 401(k) plan earns $35,000 a year and is married to an individual whose employer does not offer a 401(k) arrangement. The couple decides to have the participant in the 401(k) defer $11,000 for 2002 (i.e., the elective deferral limit for 2002, as increased by the new law). The annual additions limit for this employee is $35,000 (i.e., 100% of compensation, determined prior to the 401(k) deferral), so an additional $24,000 could still be allocated to this participant (e.g., matching contributions, employer nonelective contributions). Under old law, this participant's 415 limit was 25% x $35,000, or $8,750, and the participant's 401(k) deferrals had to be less than that amount if there were other annual additions allocated, such as matching contributions. Corresponding amendments are made to 403(b) plan limits and 457 plan limits. For 403(b) plans, the maximum exclusion allowance under IRC §403(b)(2) is repealed, effective January 1, 2002, substituting the §415 limit. For 457 plans, the 33-1/3% limit under prior law is replaced by a 100% of compensation limit, to coordinate with the §415 limit that is applicable to qualified plans and 403(b) plans.

Higher benefit limits for early retirement. Under section 611 of the new law, the dollar limit under IRC §415(b)(1)(A) (pertaining to defined benefit plans) is applicable to benefits that commence between the ages of 62 and 65, starting in limitation years that end in 2002 or later. (Current law links the dollar limit to benefits commencing at social security retirement age.) A reduction to the dollar limit will apply only to benefit commencement before age 62 (rather than before social security retirement age) and the increase in the dollar limit will apply to benefit commencement after age 65 (rather than after social security retirement age). If you are having a deja vu experience right now, there is a reason for that. This is the way the law stood before the Tax Reform Act of 1986. Significantly higher benefits will be available for those retiring in their 50s and 60s, hopefully making defined benefit plans more attractive retirement vehicles, particularly for small employers.

Portability of benefits among all employer-sponsored retirement plans; rollovers of pre-tax IRA distributions to employer-sponsored plans; trustee-to-trustee transfers of after-tax contributions. Sections 641, 642 and 643 of the new law significantly expands the portability of benefits: 1) distributions from qualified plans, 403(b) plans, and governmental 457 plans may be rolled into any of such plans, or into IRAs (e.g., a qualified plan distribution could be rolled over into a 403(b) custodial account, or vice versa), 2) pre-tax distributions from IRAs (i.e., distributions from traditional IRAs that are not treated as a return of basis under the IRC §72 rules) are eligible for rollover into qualified plans, 403(b) plans, or 457 plans, and 3) after-tax employee contributions under a qualified plan are eligible for a direct trustee-to-trustee transfer to another qualified plan or to an IRA. Conforming amendments are made to IRC §402(f), which requires notice of rollover rights, so that 403(b) plans and governmental 457 plans are subject to the notice requirement, and distributions from a governmental 457 plan, that are attributable to rollovers from qualified plans or 403(b) plans to the 457 plan, remain subject to the premature distribution penalty rules under IRC §72(t). Section 644 of the new law also gives Treasury the authority to extend the 60-day rollover period for reasonable circumstances. Finally, section 645 expands the elective transfer exception under IRC §411(d)(6) so that optional forms of benefit may be voluntarily waived by an employee through an elective transfer transaction, so long as the transferee plan includes a single sum payment option.

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Automatic rollovers for involuntary distributions. If a plan makes an involuntary distribution of more than $1,000, and the employee does not affirmatively elect to receive cash or to make a direct rollover, the default method of payment must be a direct rollover to an IRA. See section 657 of the new law, which amends IRC §401(a)(31). The Secretary of Labor must issue regulations that will prescribe safe harbors with respect to investments in the default IRA, so that the plan administrator will be relieved of fiduciary liability with respect to such rollover. This default rollover rule does not take effect until the Secretary of Labor issues those regulations.

Changes to top heavy rules. Section 613 of the new law makes some significant changes to the top heavy rules: 1) the 5-year testing period for determining key employees is modified to a 1-year testing period (i.e., the data for the four prior years are irrelevant), 2) the compensation requirement for the officer test (pertaining to the identification of key employees) is increased to $130,000 (subject to cost-of-living adjustments, in $5,000 multiples, starting in 2003, 3) the top ten owner test is eliminated from the definition of key employee, 4) matching contributions will count toward satisfying the employer's top heavy minimum contribution liability and are still counted in the ACP nondiscrimination test, 5) a 1-year lookback, rather than a 5-year lookback, applies for adding back distributions made after a separation from service or termination of the plan, when determining whether a plan is top heavy, 6) safe harbor 401(k) plans that offer a matching contribution that satisfies the requirements of IRC §401(m)(11) are exempt from the top heavy rules, and 7) top heavy minimum accruals are not required under a defined benefit plan for any plan year that no key employee or former key employer benefits under the plan (using the coverage testing rules to determine whether an employee benefits). These rules take effect for top heavy determinations and key employee determinations for plan years beginning in 2002 or later.

Multiple use test repealed in 2002. The multiple use test under IRC §401(m)(9) is repealed for plan years beginning in 2002 and later. See section 666 of the new law. Due to this repeal, the full "2% spread" may be used in both the ADP test and the ACP test.

Faster vesting for matching contributions under non-top-heavy plans. A plan that is not top heavy must apply the top heavy vesting schedules for matching contributions that are made in plan years that begin in 2002 or later. See section 633 of the new law. The top heavy schedules require 100% vesting after a participant has three years of service (known as "3-year cliff vesting") or 100% vesting after six years of service, provided that the participant's vesting percentage is no less than 20% after two years of service, 40% after three years of service, 60% after four years of service, and 80% after five years of service (sometimes known as "6-year graded vesting"). The accelerated vesting rule only need apply to a participant who has at least one hour of service credited after the effective date of this new rule. Top heavy plans are not affected because they already apply the top heavy vesting schedules to matching contributions.

Uniform loan rules for all business owners. Section 612 of the new law eliminates the current prohibition on making plan loans to certain participants who are owners of an unincorporated employer (e.g., sole proprietorship, partnership, LLC) or S corporation. These individuals may receive loans from the plan, without engaging in a prohibited transaction, for year beginning after December 31, 2001.

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Tax credits for certain contributions and plan-related expenses. The new law adds some new tax credits for certain contributions and plan-related expenses. The credits are nonrefundable, meaning that an individual (or eligible employer) cannot generate an income tax refund with respect to such credits. Section 618 of the new law adds new IRC §25B, which allows individuals who meet certain adjusted gross income (AGI) limits to claim an income tax credit. The credit may pertain to 401(k) contributions, 403(b) contributions, 457(b) contributions (if the employer is a government), and voluntary after-tax employee contributions. The maximum amount of contributions eligible for the credit is $2,000 per year, and the credit equals a specified percentage (not exceeding 50%) of such contributions, based on the individual's AGI. The credit is first available for contributions made in 2002, and expires December 31, 2006. Section 619 of the new law adds IRC §45E, which allows a small employer a credit of up to 50% of "qualified start up costs." Start up costs include expenses incurred in the establishment or administration of the plan, and expenses attributable to retirement-related education of the employer's employees. The plan must cover at least one person who is not a highly compensated employee. The provision is designed to promote the establishment of qualified plans, SEPs or SIMPLE plans by small employers (generally 100 or fewer employees in prior year with compensation of $5,000 or more). The credit is available only for the first three years of the plan's existence, and any amount for which the employer claims a credit is not eligible for a deduction. The credit is first available for costs incurred in an eligible employer's taxable year that begins in 2002. Another Senate proposal to allow small employers a credit for a portion of their contributions to a qualified plan was dropped by the Conference Agreement.

Roth 401k or 403b option starting in 2006. Section 617 of the new law adds new IRC §402A, which permits a 401(k) plan or 403(b) plan to allow a participant to designate all or part of his elective deferral as a Roth contribution. An elective deferral that is designated as a Roth contribution would not be excludable from gross income. Separate accounting for the Roth contributions (and attributable earnings) would have to be maintained. Qualified distributions from Roth accounts would be tax-free, just like qualified distributions from Roth IRAs. The taxation of the distributions attributable to Roth accounts would be the only special treatment for such contributions. Otherwise, the Roth contribution, along with any elective deferrals that are made on a pre-tax basis, are subject to the otherwise applicable limits (i.e., the dollar limit under IRC §402(g), the catch-up contributions rules for individuals over age 50, and the ADP nondiscrimination test under IRC §401(k) (other than catch-up contributions)). Roth accounts would be eligible for rollover only into Roth accounts under another 401(k) or 403(b) plan, or into a Roth IRA.

Increased IRA contribution limits. Section 601 of the new law increases the $2,000 IRA contribution limit to $3,000 in 2002, 2003 and 2004, $4,000 in 2005, 2006 and 2007, and $5,000 in 2008. Starting in 2009, the $5,000 limit is subject to cost-of-living adjustments (in $500 multiples). Additional contributions are allowed for individuals who are age 50 or over, equal to $500 for 2002, 2003, 2004, and 2005, and $1,000 in 2006 (subject to cost-of living adjustments, in $500 multiples, starting in 2007). The law does not change the rules for deductibility. So, individuals who are active participants in qualified plans (as determined under current law) are not able to deduct the IRA contribution unless they do not exceed specified limits on adjusted gross income (current law AGI limits are retained).

IRA accounts in defined contribution plans. Starting in 2003, qualified defined contribution plans, 403(b) plans, and governmental 457(b) plans may allow participants to make IRA contributions to a separate account maintained under the plan. This is like the old "qualified voluntary employee contribution accounts" or "deductible employee contribution" accounts that were allowed from 1982 through 1986.

Hardship withdrawals - suspension relief, new rollover rules. Treasury regulations currently require a 401(k) plan to suspend a participant's right to make elective deferrals or after-tax employee contributions for a period of one year following a hardship withdrawal if the plan is subject to the "safe harbor" hardship rules under those regulations. Section 636 of the new law requires the Treasury to reduce the mandatory suspension period to six months, for hardship withdrawals that occur after December 31, 2001. IRC §402(c)(4)(C) currently treats a hardship withdrawal of 401(k) contributions as ineligible for rollover, so that the mandatory withholding rule does not apply to such withdrawals. Section 631 of the new law applies this treatment to all hardship withdrawals, not just to those attributable to 401(k) contributions. This eliminates the need for the plan administrator to determine what portion of the hardship withdrawal is attributable to 401(k) contributions in order to administer the rollover and withholding rules.

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"Same desk" rule eliminated for 401(k) and 403(b) plans. The reference to "separation from service" is replaced by "severance from employment" in IRC §401(k)(2) and IRC §403(b), thereby eliminating the "same desk" rule problem in business acquisitions. So long as the buyer is not maintaining the seller's plan with respect to the transferred employees, distribution from the seller's 401(k) plan or 403(b) will be permitted to the transferred employees. The type of entities involved in the business transaction will not be relevant in determining whether a distribution event has occurred as it is under current law.

User fee relief for small employers. Small employers are exempt from paying user fees on obtaining a determination letter for a new plan, so long as the determination letter is requested within the first 5 years of the plan (or at the end of a remedial amendment period, if later, that began during that first 5 years). Small employers are generally those who do not have more than 100 employees with compensation of $5,000 or more in the prior year.

Provisions favoring funding of defined benefit plans. Section 651 of the new law repeals the current liability funding limit under IRC §412(c)(7) for plan years beginning in 2004 and later, with an increase in the funding limit for 2002 and 2003 before the limit is fully repealed. Section 652 amends IRC §404(a)(1)(D) to allow employers to make fully deductible contributions equal to the unfunded current liability, without regard to whether the plan has 100 or more participants (as under current law). However, if the plan has 100 or fewer participants, the liability attributable to benefit increases for highly compensated employees within the last 2 years is disregarded to compute the special deduction limit. When a plan subject to Title IV of ERISA is terminated, the amount needed to make the plan sufficient for benefit liabilities is substituted for unfunded current liability to determine the deduction limit for the employer. Section 653 of the new law amends IRC §4972(c) to permit an employer to disregard defined benefit plan contributions to determine whether the employer has made nondeductible contributions that are subject to the 10% excise tax under IRC §4972.

Modifications to ERISA §204(h) notice requirements. Under current law, ERISA §204(h) requires an employer to provide 15 days advance notice to participants when a pension plan is amended to substantial reduce the future rate of benefit accrual. Section 659 of the new law amends ERISA §204(h) to prescribe more specific notice requirements, but to modify the 15-day notice rule to a "reasonable period" before the effective date of the amendment, and allows the notice to be provided before the amendment is actually adopted by the employer. Failure to provide the notice, no longer results in a continuation of the pre-amendment formula, except under "egregious failures." The primary enforcement tool instead will be through an excise tax, imposed under new IRC §4980F, in the amount of $100 per day per individual who has not received the notice. There are waivers of the excise tax for certain failures where the employer has exercised "reasonable diligence." These modifications apply to amendments that take effect after the date of enactment of the new law, although the period for providing the notice will not end earlier than 3 months after such enactment date.

Allocation restrictions under S corporation ESOPs. New IRC §409(p), as added by section 656 of the new law, prohibits allocations of employer securities to certain "disqualified persons" who are participants in an ESOP maintained by an S corporation. The purpose of the allocation restrictions is to ensure that ESOPs are established for S corporations in order to provide broad-based employee coverage and to benefit rank-and-file employees as well as highly compensated employees and historical owners. The effective date for S corporation ESOPs in existence on March 14, 2001, is not until the first plan year beginning after December 31, 2004. For an S corporation ESOPs established after March 14, 2001, the effective date is plan years ending after March 14, 2001 (e.g., calendar year 2001 for a plan with a December 31 plan year). In addition, if a corporation that maintained an ESOP as of March 14, 2001, was not an S corporation on that date, the nonallocation rules become effective as of the first plan year ending March 14, 2001, so that any change to an S corporation after March 14, 2001, immediately subjects the plan to the nonallocation rules.