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Legislation Contains Retirement and Other Savings Provisions

Washington, DC, May 31, 2001 - Congress passed on May 26 the "Economic Growth and Tax Relief Reconciliation Act of 2001" (H.R. 1836). The conference report, which reconciled the House and Senate versions of the legislation, passed the House by a vote of 240 to 154 and the Senate by a vote of 58 to 33. The President is expected to sign H.R. 1836 into law.

Title VI of the bill, which contains the IRA and pension provisions, is substantially similar to legislation previously proposed by Representatives Portman and Cardin in the House and Senators Grassley and Baucus in the Senate. Significant provisions include those that increase contribution limits to 401(k), 403(b), 457, SIMPLE plans and IRAs, permit "catch-up" contributions to IRAs and employer-sponsored plans for individuals 50 and older, permit after-tax "Roth" contributions to 401(k) and 403(b) plans, enhance portability, and modify current top-heavy rules. The bill also expands Education IRAs and Section 529 qualified tuition programs. Although many of the provisions are effective January 1, 2002, specific effective dates vary. The bill also contains a "sunset" provision under which its provisions cease to apply for taxable, plan, or limitation years beginning after December 31, 2010. The Institute has consistently expressed support for legislative initiatives that expand retirement security opportunities for Americans.

Highlights of the bill are listed below.

Individual Retirement Accounts (Title VI, Subtitle A)

Expanding Pension Coverage (Title VI, Subtitle B)

Enhancing Fairness for Women (Title VI, Subtitle C)

Increasing Portability for Participants (Title VI, Subtitle D)

Education Savings Provisions (Title IV)

Individual Retirement Accounts (Title VI, Subtitle A)
A. Increase in Annual Contribution Limit.
The bill increases the current $2,000 annual contribution limit to IRAs and Roth IRAs as follows: $3,000 in 2002 through 2004; $4,000 in 2005 through 2007; $5,000 in 2008 and thereafter. Beginning in 2008, the limit is indexed for inflation in $500 increments.

B. Catch-Up Contributions to IRAs by Individuals Age 50 or Over.
The bill permits individuals who have reached age 50 to make additional "catch-up" IRA contributions of up to $500 in years 2002 through 2005, and $1,000 in 2006 and thereafter.

C. Deemed IRAs.
The bill provides that if an eligible retirement plan (a qualified retirement plan, tax-shelter annuity, or governmental 457 plan) permits employees to make voluntary employee contributions to a separate account or annuity that (i) is established under the plan, and (ii) meets the requirements applicable to either traditional IRAs or Roth IRAs, then the separate account or annuity is deemed a traditional IRA or a Roth IRA, as applicable, for purposes of the Code.

Expanding Pension Coverage (Title VI, Subtitle B)
A. Increased Contribution and Benefit Limits.
Code Section 415(c) Limit. The bill increases Code Section 415’s limitation on annual additions to defined contribution plans from $30,000 to $40,000. This amount is indexed for inflation in $1,000 increments (see also bill Section 632, which increases the "25 percent of compensation" rule to 100 percent of compensation).

Code Section 401(a)(17) Limit. The bill increases Section 401(a)(17)’s limit on the amount of compensation that may be taken into account under a plan for determining benefits from $170,000 under current law to $200,000, indexed for inflation in $5,000 increments.

Code Section 402(g) Limit. The bill increases the elective deferral limitation under Section 402(g), beginning in 2002, in annual increments of $1,000 until the limit reaches $15,000 in 2006. Thus, the limit is $11,000 in 2002, $12,000 in 2003, etc., until it reaches $15,000 in 2006.

457 Plan Contribution Limit. The contribution limit for section 457 plans conforms to the 402(g) limit (i.e., the limit would be $11,000 in 2002, $12,000 in 2003, etc., until it reaches $15,000 in 2006). In the three years prior to retirement, the limit for 457 plans is twice the otherwise applicable dollar limit.

SIMPLE Plan Contribution Limit. The bill increases the SIMPLE plan contribution limit in $1,000 increments beginning in 2002 until it reaches $10,000 in 2005. Thus, the SIMPLE plan contribution limit would be $7,000 in 2002 and $8,000 in 2003, etc., until it reaches $10,000 in 2005.

The 402(g), 457 plan, and SIMPLE plan limits are indexed for inflation in $500 increments. The modifications to these limits are effective for years beginning after December 31, 2001.

B. Top-Heavy Rule Modification.
Effective for years beginning after December 31, 2001, the bill modifies the top-heavy rules in a number of respects. First, the bill provides that a plan consisting solely of a cash-or-deferred arrangement that satisfies the design-based safe harbor under Sections 401(k)(12) and 401(m)(11) is not top-heavy. Second, the bill provides that matching contributions may be taken into account for purposes of making the minimum contributions required under the top-heavy rules. Third, distributions made during the year ending on the date the top-heavy determination is made may be taken into account to satisfy the rule. Fourth, the bill applies the current 5-year rule, which is applicable to distributions taken into account for purposes of determining the present value of accrued benefits or account values, is extended to in-service distributions.

With respect to the "key employee" definition, the bill repeals the four-year look-back rule for determining key employee status, repeals the top-10 owner key employee category, and provides that an employee is deemed a key employee only if he or she is a key employee during the preceding plan year.

Thus, an employee is considered a "key employee" if, during the prior year, the employee was:

an officer with compensation in excess of $130,000 (adjusted for inflation in $5,000 increments),

a five-percent owner, or

a one-percent owner with compensation in excess of $150,000.

The bill does not modify the applicability of the family attribution rules, including for example, in determining whether an individual is a 5-percent owner for purposes of the top-heavy rules.

C. Nonrefundable Credit for Elective Deferrals and IRA Contributions.
The bill provides a nonrefundable tax credit to eligible taxpayers for elective contributions to 401(k) plans, 403(b) plans, 457 plans, SIMPLEs, SEPs, traditional, or Roth IRAs, and for voluntary after-tax employee contributions to qualified retirement plans. The maximum annual contribution eligible for the credit is $2,000; the maximum credit rate (which would vary based on AGI) is 50 percent of the contribution. Only joint filers with AGI of $50,000 or less, heads of household with $37,500 or less, and individual filers with $25,000 or less are eligible for the credit. The credit is in addition to any deduction or exclusion that would otherwise apply to the contribution and is available to persons age 18 or older, other than full-time students or persons claimed as a dependent on another taxpayer’s return. In addition, Treasury is required to report annually to Congress on the status and effect of the credit. The provision is effective for taxable years beginning after December 31, 2001 and before January 1, 2007.

D. Credit for Pension Plan Start-Up Costs of Small Employers.
The bill provides a nonrefundable tax credit for 50 percent of the administrative and retirement-education expenses of a small employer (100 employees or less) that adopts a new qualified defined benefit or defined contribution plan, SIMPLE plan, SEP, or payroll deduction IRA program. The credit applies to 50 percent of the first $1,000 in such expenses for the plan for each of the first three plan years. The amount for which the tax credit is received is not deductible. To be eligible for the credit, the plan must cover at least one nonhighly compensated employee; if the credit is for the cost of a payroll deduction IRA, the arrangement must be made available to all employees with at least three months of service. The credit would be effective with respect to costs paid or incurred in taxable years beginning after December 31, 2001, with respect to plans established after such date.

Enhancing Fairness for Women (Title VI, Subtitle C)
A. Catch-Up Contributions for Individuals Age 50 or Over.
The bill permits individuals who have reached age 50 before the end of the plan year to make additional elective contributions to 401(k), 403(b), SEP, SIMPLE, and 457 plans. The catch-up limit for 401(k), 403(b), SEP, and 457 plans are $1,000 for 2002, $2,000 for 2003, $3,000 for 2004, $4,000 for 2005, and $5,000 for 2006 and thereafter. The catch-up amount for a SIMPLE is $500 for 2002, $1,000 for 2003, $1,500 for 2004, $2,000 for 2005, and $2,500 for 2006 and thereafter. These limits are indexed for inflation in $500 increments in 2007 and thereafter.

The catch-up contributions are not subject to specific nondiscrimination rules. A plan that provides for catch-up contributions, however, must allow all eligible individuals participating in the plan to make catch-up contributions in order to satisfy the general Section 401(a)(4) requirement with respect to benefits, rights, and features. For purposes of this rule, all plans of related employers are treated as a single plan. Finally, an employer may make matching contributions with respect to catch-up contributions, which would be subject to the normally applicable nondiscrimination rules. The provision is effective for years beginning after December 31, 2001.

B. Equitable Treatment for Contributions of Employees to Defined Contribution Plans.
The bill:

increases the Section 415(c) limit on annual additions from 25 percent of compensation to 100 percent,

increases the 33 1/3 percent of compensation limitation on deferrals under 457 plans to 100 percent, and

repeals the exclusion allowance applicable to contributions to Section 403(b) annuities. Thus, such annuities are subject to the limits applicable to tax-qualified plans.

The bill also directs Treasury to revise the regulations relating to the exclusion allowance under Section 403(b)(2) to eliminate the requirement that contributions to a defined benefit plan be treated as previously excluded amounts for purposes of the exclusion allowance. With respect to the increase in the defined contribution plan limit under Section 415(c), the Explanatory Statement provides that the conferees intend that the Secretary of Treasury will use the Secretary’s existing authority to address situations where qualified nonelective contributions are targeted to certain participants with lower compensation in order to increase the average deferral percentage of nonhighly compensated employees.

The provision is generally effective for years beginning after December 31, 2001. Special effective dates are provided for the modifications to 403(b) plans.

C. Faster Vesting of Certain Employer Matching Contributions.
The bill requires employer matching contributions (as defined in Code Section 401(m)(4)(A)) to be vested on a three-year cliff or six-year graded vesting schedule, generally effective for contributions made for plan years beginning after December 31, 2001.

D. Modification to the Minimum Required Distribution Rules.
Effective on the date of enactment, the bill directs the Secretary of Treasury to modify the life expectancy tables under the regulations relating to minimum distribution requirements under Code Sections 401(a)(9), 408(a)(6) and (b)(3), 403(b)(10) and 457(d)(2) to reflect current life expectancy.

E. Clarification of Division of 457 Plan Assets in Divorce.
The bill applies the tax rules for qualified plan distributions pursuant to a qualified domestic relations order (QDRO) (Code Section 402(e)(1)(A)) to 457 plans, and clarifies that the plan does not violate any restrictions on distributions when making payments to an alternate payee under a QDRO. This provision applies to transfers, distributions, and payments made after December 31, 2001.

F. Provisions Relating to Hardship Withdrawals.
The bill provides that any distribution "made upon hardship of the employee" is ineligible for rollover and subject to the withholding rules applicable to ineligible rollover distributions. This provision modifies the rule enacted by the Internal Revenue Service Restructuring and Reform Act of 1998, which excluded the portion of a hardship distribution attributable to an employee's elective deferral from the definition of "eligible rollover distribution." The provision applies to distributions made after December 31, 2001. The Explanatory Statement provides that the Secretary of Treasury has the authority to issue transitional guidance with respect to this provision to provide sufficient time for plans to implement the new rule.

The bill also directs the Secretary of the Treasury to revise regulations addressing 401(k) hardship distributions to reduce from 12 to six months the period during which an employee must be prohibited from making contributions after taking a distribution on account of hardship. The revised regulations are to be effective for years beginning after December 31, 2001.

G. Pension Coverage for Domestic and Similar Workers.
Under the bill, the 10-percent excise tax on nondeductible contributions does not apply to contributions to a SIMPLE plan or SIMPLE IRA that are nondeductible solely because the contributions are not made in connection with an employer’s trade or business. Thus, for example, employers of household workers are able to make contributions to such plans without imposition of the excise tax. However, as under present law, the contributions remain nondeductible.

Increasing Portability for Participants (Title VI, Subtitle D)
A. Rollovers of Retirement Plan and IRA Distributions.
Effective for distributions made after December 31, 2001, eligible rollover distributions from qualified retirement plans, Section 403(b) annuities and governmental Section 457 plans generally may be rolled over to any of such plans or arrangements. Similarly, taxable amounts in traditional IRAs (i.e., all but account basis) may be rolled over into a qualified plan, Section 403(b) annuity or governmental Section 457 plan. No plan, however, is required to accept rollovers.

Distributions from a qualified plan are not eligible for capital gains or income averaging treatment if there was a rollover to the plan that would not have been permitted under current law.

Direct rollover and withholding rules are extended to Section 457 plans. Amounts distributed from a Section 457 plan are subject to the early withdrawal tax to the extent the distribution consists of amounts attributable to rollovers from another type of plan; Section 457 plans accepting such rollovers must separately account for such rollover amounts. In addition, hardship distributions from governmental Section 457 plans are not considered eligible rollover distributions.

B. Rollover of After-Tax Contributions.
Effective for distributions made after December 31, 2001, the bill permits the rollover of after-tax contributions from a qualified plan to another qualified plan or a traditional IRA. Plan-to-plan rollovers of after-tax monies must be direct rollovers. Plans accepting such rollovers must separately account for them.

After-tax contributions in an IRA (including those rolled from a qualified plan and nondeductible contributions to an IRA) are not permitted to be rolled over from the IRA to a qualified plan, 403(b) annuity, or 457 plan. In the case of a distribution from an IRA that is rolled over into those plan types, the distribution is attributed first to taxable amounts (i.e., all amounts other than after-tax contributions).

Additionally, the Explanatory Statement provides that the IRS is directed to issue rules with respect to reporting and mechanisms to address mistakes relating to rollovers and to develop forms (for example, by expanding the Form 8606) to assist individuals in tracking after-tax contributions rolled over to an IRA.

C. Hardship Exception to 60-Day Rollover Rule.
The bill authorizes the Secretary of Treasury to waive the 60-day rollover requirement if the failure to waive such requirement would be against "equity or good conscience," including cases of casualty, disaster, or other events beyond the reasonable control of the individual. The provision applies to distributions after December 31, 2001.

D. Anticutback Rule Relief with Respect to Forms of Distribution.
The bill permits the transfer of a participant’s accrued benefit from one defined contribution plan to another even though the transferee plan does not provide all of the forms of distribution available under the transferor plan. Such transfers are permitted if:

The bill also provides that a defined contribution plan is not treated as violating the anticutback rule (Code Section 411(d)(6)) if the plan is amended to eliminate a form of distribution previously available as long as a lump-sum distribution is available (for those benefit accruals that would have been protected under Section 411(d)(6)). The proposal is effective for years beginning after December 31, 2001.

Furthermore, Treasury is directed to issue regulations that allow a plan amendment that reduces or eliminates benefits or subsidies which create significant burdens or complexities for plans and participants, provided that the rights of any participant is not adversely affected in a more than de minimis manner. Such regulations must be issued by December 31, 2003.

E. Repeal of Same-Desk Rule.
Effective for distributions after December 31, 2001, the bill modifies the distribution restrictions applicable to 401(k) plans, 403(b) arrangements, and 457 plans to permit distribution upon "severance from employment," rather than from "separation from service."

F. Purchase of Service Credit in Governmental Defined Benefit Plans.
The bill permits state and local government employees to transfer assets (in a trustee-to-trustee transfer) from their 403(b) arrangement or 457 plan to purchase service credits under their defined benefit plan, effective for trustee to trustee transfers after December 31, 2001.

Education Savings Provisions (Title IV)
A. Education IRAs
Increased Contribution Limit. The bill increases the annual contribution limit to an Education IRA from $500 per designated beneficiary to $2,000.

Phase-out of Contribution Limit. The bill increases the income-eligibility limits for married taxpayers contributing to Education IRAs by increasing the phase-out range for married taxpayers filing a joint return to twice the range for single taxpayers. Thus, the phase-out range for married taxpayers filing a joint return is increased from $190,000 to $220,000 of modified adjusted gross income.

Expansion of Qualified Education Expenses. The bill expands the definition of qualified education expenses for which account distributions may be used to include qualified elementary and secondary education expenses.

Special Needs Beneficiaries. Under current law, contributions to an Education IRA are not permitted once the beneficiary reaches age 18. The bill eliminates this age limitation for beneficiaries with "special needs." The Explanatory Statement provides that the conferees intend that Treasury regulations will define this term to include an individual who because of a physical, mental, or emotional condition requires additional time to complete his or her education.

Entities Eligible to Contribute to Accounts. The bill clarifies that corporate and nonprofit entities may contribute to Education IRAs, and are not subject to the income limitations applicable to individual contributors.

Extension of Time to Contribute and to Remove Excess. The bill extends the time by which contributions must be made to an Education IRA for a given taxable year from December 31 to April 15, adopting language similar to that applicable to traditional IRAs. The bill also provides that excess contributions made for a taxable year may be removed up until June 1 of the year following that year without incurring a 10-percent penalty tax for the distribution.

Coordination with HOPE and Lifetime Learning Credits and Qualified Tuition Programs. The bill alters the manner in which Education IRA distributions are coordinated with credits received under the HOPE and Lifetime Learning Credits programs and any qualified tuition programs in a given year. Specifically, the bill allows an individual to claim a HOPE or Lifetime Learning Credit and take a qualified distribution from an Education IRA on behalf of the same student in the same tax year, as long as the credit and distribution are used for different educational expenses. Similarly, the bill permits contributions to be made to both an Education IRA and a qualified tuition program on behalf of the same beneficiary in the same year. If distributions from Education IRAs and qualified tuition programs exceed the beneficiary's qualified higher education expenses for the year (after reduction by amounts used in claiming the HOPE or Lifetime Learning Credit), the beneficiary must allocate the expenses between the distributions to determine the amount includible in income.

Effective Date of Education IRA Provisions. The Education IRA provisions are effective for taxable years beginning after December 31, 2001.

B. Qualified Tuition Programs (Section 529 Plans)
Expansion to Private Educational Institutions. The bill expands the qualified state tuition program provisions to enable private educational institutions to establish such programs under Code Section 529. The bill, however, requires that programs established by private institutions be in the form of tuition credit or certificate programs, and not "savings account plans." As under the current rule, only qualified state institutions would be permitted to establish "savings account plans." Additionally, the bill requires that a private eligible educational institution establishing a qualified tuition program must hold its assets in a trust created or organized in the U.S. for the exclusive benefit of designated beneficiaries that complies with the requirements of Code Section 408(a)(2) and (5) (relating to trust requirements for IRAs).

Repeal of "More Than De Minimis Penalty" Provision and Imposition of 10-Percent Tax. The bill repeals the current rule that a qualified state tuition program must impose a "more than de minimis" monetary penalty on any refund of earnings not used for qualified higher education expenses of the beneficiary. The bill imposes a 10-percent tax (as is currently applicable to nonqualified distributions from Education IRAs) on the amount of a distribution from a qualified tuition plan that is includible in gross income.

Exclusion from Gross Income. The bill provides that distributions used for qualified higher education expenses are excludible from gross income. However, with respect to distributions from programs established by eligible private educational institutions, the provision excluding distributions from gross income would become effective January 1, 2004.

Coordination with HOPE and Lifetime Learning Credits and Education IRAs. Similar to the coordination provision for Education IRAs, the bill allows an individual to claim a HOPE or Lifetime Learning Credit and receive distributions from a qualified tuition program on behalf of the same student in the same tax year, as long as the credit and distribution are used for different educational expenses. The bill also permits contributions to be made to both an Education IRA and to a qualified tuition program on behalf of the same beneficiary in the same year.

Rollovers and Designated Beneficiary Changes. The bill clarifies that the rollover of credits or other amounts between qualified tuition programs for the same beneficiary are permissible if limited to one transfer within any 12-month period. Furthermore, the bill provides that first cousins are considered "members of the family" for purposes of designated beneficiary changes permitted under Section 529(c)(3)(C). This "member of the family" definition also applies to Education IRAs.

Adjustment of Limitation on Room and Board Distributions. The bill provides that the maximum room and board allowance is the amount applicable to the student in calculating costs of attendance for federal financial aid programs under Section 472 of the Higher Education Act of 1965, as in effect on the date of enactment, or, in the case of a student living in housing owned or operated by an eligible educational institution, the actual amount charged the student by the educational institution for room and board. This definition also applies to Education IRAs.

Special Needs Beneficiaries. The bill modifies the definition of qualified higher education expenses to include expenses of a special needs beneficiary, which are necessary in connection with his or her enrollment or attendance at the eligible education institution. The definition of these expenses, as well as the definition of a special needs beneficiary, are consistent with that for Education IRAs.

Effective Date of Section 529 Plan Provisions. Except as otherwise noted above, the provisions relating to Section 529 qualified tuition plans are effective for taxable years beginning after December 31, 2001.