Copyright 1996 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. The information is not necessarily a complete summary of all materials on the subject.--ISSN 1089-1536
The Small Business Job Protection Act makes a number of changes to the pension rules. Many of them are beneficial, especially for small business owners, but a number are not. Some of the positive changes are significant enough to make you reconsider adopting a plan for your business if you decided against one in the past. Caution. Watch the effective dates. Some changes don't take effect for one or more years.
Introduction. The technical name is Savings Incentive Match Plans for Employees (SIMPLE). The intent is to encourage contributions to private plans by simplifying the top-heavy and discrimination rules that can make compliance onerous for smaller businesses, while providing benefits to rank-and-file employees. The provision is a valiant effort and does reduce the discrimination test problems, but the rules are not that simple, and there is a price to be paid for the relaxation of those tests.
SIMPLE plans can be adopted by employers who employed 100 or fewer employees earning at least $5,000 in compensation for the preceding year and who do not maintain another employer-sponsored retirement plan. A SIMPLE plan can be either an IRA for each employee or part of a qualified cash or deferred arrangement ('401(k) plan'). If established as an IRA, a SIMPLE plan is not subject to the nondiscrimination rules generally applicable to qualified plans (including the top-heavy rules) and simplified reporting requirements apply. Within limits, contributions to a SIMPLE plan are not taxable until withdrawn.
A SIMPLE plan can also be adopted as part of a 401(k) plan. In that case, the plan does not have to satisfy the special nondiscrimination tests applicable to 401(k) plans and is not subject to the top-heavy rules. The other qualified plan rules continue to apply.
A SIMPLE plan can be used by a corporation, partnership or by a self-employed individual. However, the business cannot have another qualified plan in effect at the time a SIMPLE plan is started.
SIMPLE retirement plans in IRA form. A SIMPLE retirement plan allows employees to make elective contributions to an IRA. Employee contributions have to be expressed as a percentage of the employee's compensation, and cannot exceed $6,000 per year. The $6,000 limit is indexed for inflation in $500 increments.
Contribution formulas. Under the provisions, an employer is required to satisfy one of two contribution formulas. Under the matching contribution formula, the employer generally is required to match employee elective contributions on a dollar- for-dollar basis up to 3% of the employee's compensation. Under a special rule, the employer could elect a lower percentage match for all employees (but no less than 1% of each employee's compensation). In order to use the lower matching percentage for any year, the employer has to notify employees of the applicable match within a reasonable time before the 60-day election period for the year. In addition, a lower percentage cannot be elected for more than 2 out of any 5 years.
Example--Fred Flood works for Madison Inc. Madison adopts a SIMPLE plan. Fred makes $40,000 in 1997 and elects to contribute 10% of his salary, or $4,000 for the year. Madison uses the regular contribution formula, and matches Fred's contribution dollar-for-dollar, up to the maximum of 3% of his salary. Madison's contribution is $1,200 (capped at 3% of $40,000 salary).
Example--The facts are the same as above, but Susan elects to defer only 2% of her $20,000 salary. Madison matches her $400 contribution dollar-for-dollar. There's no percentage cap since her contribution is less than the 3% of salary cap.
Example--The facts are the same as for Fred Flood above. However, Madison makes a special election to use a lower matching percentage. Madison matches Fred's contribution, but only up to 1% of his compensation. Thus, Madison's contribution is $400 (1% of $40,000). However, Madison may only elect this lower percentage in 2 out of 5 years.
Alternatively, for any year, an employer is permitted to elect, (in lieu of a matching contribution) a 2% of compensation nonelective contribution on behalf of each eligible employee with at least $5,000 in compensation for the year. If this election is made, the employer has to notify eligible employees of the change within a reasonable period before the 60-day election period for the year. No contributions other than employee elective contributions and required employer matching contributions (or required employer nonelective contributions) can be made to a SIMPLE account.
Example--Fred and Susan work for Madison. Fred makes $40,000 annually and makes an elective contribution to the company's SIMPLE plan equal to 10% of his compensation, $4,000. Susan earns $20,000 and makes no elective contribution. Madison elects the alternative rule. Madison must make an $800 contribution (2% of $40,000) on behalf of Fred and a $400 contribution (2% of $20,000) for Susan. Elective contributions aren't relevant under this approach.
Caution--Under this approach, no more than $150,000 of compensation can be taken into account in any year for an employee.
Tax Tip--You've got to work through some numbers to see which approach is most beneficial. Matching dollar-for- dollar may be costly if a high percentage of employees make the maximum contribution to the plan. On the other hand, choosing the alternative rule means you'll have to make contributions for employees who are making no contributions on their own.
Tax Tip--One of the drawbacks here is that you'll have to fund the plan, regardless of the profitability of the business. With a defined contribution, profit-sharing plan, you can decide on how much to contribute each year.
Vesting. All employer contributions to an employee's SIMPLE account must be fully vested immediately.
Participation. A SIMPLE plan must be open to all employees who have received $5,000 or more in compensation from the employer during any two preceding years or are reasonably expected to receive $5,000 or more in compensation during the year.
Nonresident aliens and employees covered under a collective bargaining agreement may be excluded from coverage.
Tax Tip--One of the big advantages of a SIMPLE plan is that you don't have to meet the 40% requirement applicable to 401(k)s, Keoghs, or SEPs. That rule requires that a plan benefit 40% of eligible employees. A SIMPLE plan can be used if only a small fraction of employees participate.
Tax treatment of contributions. Employer matching or nonelective contributions to a SIMPLE account are not treated as wages for employment tax purposes.
Example--Fred elects to contribute $4,000 of his compensation to the Madison's SIMPLE plan. Madison matches his contribution with $1,200. Madison's $1,200 contribution is not subject to FICA. Fred's elective contribution of $4,000 isn't included as wages on his W-2, but it is subject to FICA.
Top-heavy rules. The top-heavy rules of Code Sec. 416 don't apply to SIMPLE plans.
Only one plan. An employer maintaining a SIMPLE plan can't have any other type of qualified plan during the same year. Employer here includes a predecessor employer.
Administrative requirements. Each eligible employee can elect, within the 60-day period before the beginning of any year (or the 60-day period before first becoming eligible to participate), to participate in the SIMPLE plan by making elective deferrals, and to modify any previous elections.
An employer is required to contribute employees' elective deferrals to the employee's SIMPLE account within 30 days after the end of the month to which the contributions relate. Employees must be allowed to terminate participation in the plan at any time during the year (i.e., to stop making contributions). A plan can permit (but is not required) an individual to make other changes to his or her salary reduction contribution election during the year (e.g., reduce contributions).
An employer is permitted to designate a SIMPLE account trustee to which contributions are made on behalf of eligible employees.
The Act also amends the ERISA rules so that only simplified reporting requirements apply. The trustee must, on an annual basis, provide the employer maintaining the plan with a summary description containing the following:
The trustee must provide an account statement to each individual for whom a SIMPLE account is maintained within 30 days of the end of the calendar year. The statement must show the account activity during the year and balance at the end of the year.
Employers must notify employees of their opportunity to make a contribution under the plan, and provide a summary description prepared by the trustee.
In addition, an employer and any other plan fiduciary will not be subject to fiduciary liability resulting from the employee (or beneficiary) exercising control over the assets in the SIMPLE account. For example, if an employee makes an affirmative election with respect to the initial investment of contributions, the employer is relieved of any fiduciary responsibility.
Employers must provide employees with notice of their rights under the SIMPLE plan. There's a $50 per day penalty for failure to provide such notice, until the notice is provided.
Tax treatment of contributions. An employer can deduct matching contributions to a SIMPLE plan for a tax year if they're made by the due date of the tax return, including extensions.
Example--Madison is a calendar year taxpayer. At the end of 1997 it calculates that it owes $26,000 in matching contributions. Madison doesn't file its return on March 15, 1998, but gets an extension till September 15. It makes the $26,000 contribution on August 30, the same day it files its return. Madison can deduct the $26,000 on its 1997 tax return.
Tax treatment of distributions. Distributions from a SIMPLE plan to participants are taxed much like IRAs. Thus, any amount distributed to a participant is subject to income tax, and, if it's an early withdrawal (i.e., before age 59-1/2), and there is no exception, the amount is subject to a 10% penalty tax.
Caution. A special 25% penalty applies to employees who withdraw contributions within the first 2 years the employee first participates in the SIMPLE plan.
This penalty is substantial. You don't want to make a mistake here and get hit with the penalty tax.
Distributions can be rolled over from one SIMPLE account to another. You can roll over a distribution from a SIMPLE account to an IRA tax free if you've participated in the plan for 2 years. Distributions can not be rolled over to a qualified plan.
Other points. The term employer here includes commonly controlled businesses, controlled groups of corporations and affiliated service groups. For example, you own 100% of Madison Inc. which has 60 employees. You also own 85% of Chatham Inc. which has 70 employees. These businesses are under common control. Thus, the total number of employees is 130. You exceed the 100-employee limit. Leased employees may also affect eligibility.
Employers who establish a SIMPLE plan, but later fail to qualify, (e.g., because employee count exceeds 100), can continue the plan for 2 years.
As a result of the introduction of the SIMPLE plan, the law allowing SARSEPs is repealed, effective January 1, 1997. New SARSEPs can't be established after December 31, 1996, but ones established before that date can continue to receive contributions under the current rules.
Comment--While SARSEPs (Salary Reduction Simplified Employee Plans) are not without drawbacks, you might want to give them consideration before the end of the year.
Summary.The SIMPLE plan provisions are effective for years beginning after December 31, 1996. While they may be attractive to many small companies, you should evaluate them thoroughly with your tax advisor before committing yourself. One of the disadvantages of SIMPLE plans are that contributions are more limited than under most other qualified plans. It's not a decision to be made lightly.
Under the new law a cash or deferred arrangement (401(k) plan) will be deemed to satisfy the special nondiscrimination tests applicable to employee elective deferrals and employer matching contributions if the plan satisfies the contribution requirements applicable to SIMPLE plans. In addition, the plan is not subject to the top-heavy rules for any year this safe harbor is satisfied. The plan, however, is subject to the other qualified plan rules.
The safe harbor is satisfied if the employer does not maintain another qualified plan and (1) employee's elective deferrals are limited to no more than $6,000, (2) the employer matches employees' elective deferrals up to 3% of compensation (or, alternatively, makes a 2% of compensation nonelective contribution for all eligible employees with at least $5,000 of compensation) and (3) no other contributions are made to the arrangements. Contributions have to be 100% vested. Employers cannot reduce the matching percentage below 3%.
Comment--The intent of this provision is to allow employers with 401(k) plans to avoid the complicated top-heavy and nondiscrimination rules. The price that's paid is that the maximum elective deferrals to the plan are $6,000, while elective deferrals to a regular 401(k) plan are capped at $9,500 for 1996. You've got to work through the numbers and discuss your situation with your tax advisor before deciding on a course of action.
Five-year averaging repealed. The new law repeals 5- year averaging for lump-sum distributions from qualified plans. Depending on the amount of the distribution, this averaging method can result in significantly lower taxes. The provision is effective for taxable years beginning after December 31, 1999.
Important. The Act preserves 10-year averaging (and capital gain treatment on the per-1974 portion of a lump-sum distribution) for those individuals who qualified under the transition rule of the 1986 Act. Thus, individuals who were age 50 before January 1, 1986 can still use 10-year averaging on one lump-sum distribution.
Tax Tip--This is a big change for anyone contemplating retirement. You've got to consider this in conjunction with the temporary repeal of the 15% excise tax on excess distributions ($750,000, see below). If you qualify for 5-year averaging it may make sense to take your lump-sum distribution now rather than wait. The savings can be substantial. Again, you've got to work through the numbers.
Under prior law, up to $5,000 of a special employer-provided death benefit could be excluded from the income of an estate or beneficiary of a deceased employee. The new law repeals this exclusion for decedents dying after August 20, 1996.
The new law provides that basis recovery on payments from qualified plans is generally determined under a method similar to the prior-law simplified alternative method provided by the IRS. The portion of each annuity payment that represents a nontaxable return of basis is equal to the employee's total basis as of the annuity starting date, divided by the number of anticipated payments under the following table:
Age Number of Payments
Age 55 or under 360
56-60 310
61-65 260
66-70 210
More than 70 160
Example--Fred retires at age 60. He made after-tax contributions to his pension plan of $62,000. His monthly income from the plan is $500. He computes his monthly recovery of basis in the plan by dividing the $62,000 by the number of payments for his age group, 310. Thus, the monthly exclusion is $200 (the recovery of his basis). The amount of each monthly payment that's taxable is $300 ($500 payment less $200 basis recovery).
Tax Tip--The new law changes the number of months for recovery. Thus, compared to the old rules, the amount taxable each month is higher. The difference is generally somewhat less than 10%, but if you were contemplating starting to draw down an annuity, you might want to do so before the effective date. Check with your tax advisor on all the consequences.
The new rules are effective for annuity starting dates beginning 90 days after the date of enactment.
The new law modifies the rule that requires all participants in qualified plans to commence distributions by age 70-1/2 regardless of whether or not they're still employed by the employer. Now, distributions generally are required to begin by April 1 of the calendar year following the later of (1), the year in which the employee reaches age 70-1/2 or (2), the year in which the employee retires. (In the case of a 5% owner of the employer, distributions must begin no later than April 1 of the year he or she reaches age 70-1/2.)
In addition, in the case of an employee who retires in a year after reaching age 70-1/2, the law generally requires the employee's accrued benefit to be actuarially increased to take into account the period after age 70-1/2 in which the employee was not receiving benefits under the plan.
Comment--Employees who continue to work for the employer don't have to begin distributions at age 70-1/2, but later distributions will be increased to take that deferral into account.
If an employee has already started to receive distributions, a plan may allow the participant to stop distributions until he or she is required to begin them under this new rule.
Under prior law the definition of a highly compensated employee involved a number of complicated tests. And deciding who was a highly compensated employee is only the first step in determining whether or not a plan is discriminatory.
Under the new law an employee is treated as highly compensated if he or she (1) was a 5% owner of the employer at any time during the year or the preceding year or (2) had compensation for the preceding year in excess of $80,000 (indexed for inflation) and (if the employer elects) the employee was in the top 20% of employees by compensation for the year. The Act repeals the rule requiring the highest paid officer to be treated as a highly compensated employee.
Comment--The new rules should not only make determining who is a highly compensated employee easier, it's more than likely less employees will be classified as highly compensated. That should make passing the nondiscrimination tests much easier. Note that the rule that the highest paid officer is automatically a highly compensated employee is repealed.
The provision is effective for years beginning after December 31, 1996.
Under prior law, a special rule applied to family members of certain highly compensated employees for purposes of the nondiscrimination rules applicable to qualified plans. If the family member meets certain tests, the $150,000 compensation limit applies to all family members. For example, you own 60% of Madison Inc. and take a salary of $140,000. Your daughter is also employed by Madison and has a salary of $100,000. For purposes of determining the contribution limit, you and your daughter's salaries are combined and one $150,000 limit applies.
The new law repeals these family aggregation rules.
Comment--This will allow small businesses that employ family members to make larger contributions and deductions to qualified plans.
Under prior law, a plan is not qualified unless it benefits no fewer than the lesser of (a) 50 employees or (b) 40% of all a company's employees. The requirement may not be satisfied by aggregating comparable plans, but may be applied separately to different lines of businesses. A line of business must have at least 50 employees.
The new law clarifies that this provision only applies to defined benefit plans and not to defined contribution plans. For defined benefit plans the law changes the 40% rule to 'the greater of (a) 40% of all employees or (b) 2 employees (or one employee if the company has only one employee)'. Finally, the requirement that a line of business have at least 50 employees does not apply in determining whether a plan satisfies the minimum participation rule on a separate line of business basis.
Tax Tip--Small businesses that were considering a plan but thought they could not meet the old requirements should reconsider.
The provision is effective for years beginning after December 31, 1996.
The new law makes a number of changes to the nondiscrimination provisions for qualified cash or deferred arrangements. We'll only discuss the highlights.
Prior-year data. The Act modifies the nondiscrimination tests applicable to elective deferrals and employer matching and after-tax employee contributions to provide that the maximum permitted actual deferral percentage (and actual contribution percentage) for highly compensated employees for the year is determined by reference to the actual deferral percentage (and actual contribution percentage) for nonhighly compensated employees for the preceding rather than the current, year. Alternatively, an employer is allowed to elect to use the current year actual percentage.
Safe harbor for cash or deferred arrangements. The Act provides that a cash or deferred arrangement satisfies the special nondiscrimination tests if the it satisfies one of two contribution requirements and satisfies a notice requirement.
A plan satisfies the safe harbor contribution requirements if it either (1), satisfies a matching contribution requirement or, (2), the employer makes a nonelective contribution to a defined contribution plan of at least 3% of an employee's compensation on behalf of each nonhighly compensated employee who is eligible to participate in the arrangement without regard to whether the employee makes elective contributions under the arrangement.
A plan satisfies the matching contribution requirement if, under the arrangement: (1), the employer makes a matching contribution on behalf of each nonhighly compensated employee equal to (a) 100% of the employee's elective contributions up to 3% of compensation and (b) 50% of the employee's elective contributions from 3 to 5% of compensation, and (2), the rate of match with respect to any elective contribution for highly compensated employees is not greater than the rate of match for nonhighly compensated employees.
Alternatively, if the rate of matching contribution for any rate of elective contribution requirement is not equal to the percentages described above, the matching contribution requirement will be deemed to be satisfied if (1), the rate of an employer's matching contribution does not increase as an employee's rate of elective contribution increases and (2), the total amount of matching contributions at such rate of elective contribution at least equals the total amount of matching contributions that would be made if matching contributions satisfied the above percentage requirements.
Alternative method of satisfying nondiscrimination test for matching contributions. Under this safe harbor, a plan is treated as meeting the special nondiscrimination test if (1), the plan meets the contribution and notice requirements under the safe harbor method for special nondiscrimination requirements and (2), the plan satisfies a special limitation on matching contributions.
After-tax employee contributions. These will continue to be tested under the actual contribution percentage (ACP) test. Employer matching and nonelective contributions used to satisfy the safe harbor rules cannot be considered in calculating the test.
Tax Tip--Safe harbors are just that. You don't have to use them, but they make it easier and cheaper to comply with the requirements of the law.
Comment--There's no question that the new rules reduce the uncertainty in meeting the requirements. In fact the changes discussed above and certain others suggest that business owners reconsider a qualified plan if the option was dismissed because the nondiscrimination requirements couldn't be reasonably met.
The provision relating to the use of prior-year data is effective for years beginning after December 31, 1996. The provisions providing for a safe harbor and the alternative method of satisfying the special nondiscrimination provisions are effective for years beginning after December 31, 1998.
The Act provides that elective deferrals to section 401(k) plans and similar arrangements, elective contributions to nonqualified deferred compensation plans of tax-exempt employers and state and local governments (sec. 457 plans), and salary reduction contributions to a cafeteria plan are considered compensation for purpose of the limits on contributions and benefits.
This provision is effective for years beginning after December 31, 1997.
For purposes of the general nondiscrimination rules, the social security retirement age is a uniform retirement age and the subsidized early retirement benefits and joint and survivor annuities are not treated as not being available to employees on the same terms merely because they are based on an employee's social security retirement age.
Present law limits on contributions and benefits under qualified plans based on the type of plan (whether a defined contribution or defined benefit). For a defined contribution plan, annual contributions are limited to the lesser of $30,000 (1996) or 25% of compensation. For a defined benefit plan, the annual benefit is limited to $120,000 (1996) or 100% of the participant's average compensation for the highest 3 years. For a participant covered under both types of plans a complicated set of rules applies to limit benefits.
The new law repeals this combined plan limit, effective for limitation years beginning after December 31, 1999.
Present law imposes a 15% excise tax on excess distributions from qualified retirement plans, tax-sheltered annuities and IRAs. Excess distributions are distributions from such plans that exceed $150,000 ($750,000 in the case of a lump-sum distribution) during any calendar year. An additional 15% estate tax is imposed on an individual's excess retirement accumulation.
This provision repeals the excise tax on excess distributions for amounts received in 1996, 1997, 1998 and 1999. The additional 15% estate tax is not repealed.
Tax Tip--If you have a large balance in an IRA or a qualified plan, you might want to consider taking a distribution if doing so now will enable you to avoid the excise tax in the future. That's even more true if you can structure your personal tax situation to be in a lower bracket than usual. Check with your tax advisor, but remember you only have three years and 4 months to act.
Effective for tax years beginning after December 31, 1996 employers can make contributions on behalf of disabled employees without a special election and to highly compensated employees if the defined contribution plan provides for the continuation of contributions on behalf of all participants who are permanently and totally disabled.
Under the new law, the prior-law 'historically performed' test is replaced with a new test under which an individual is not considered a leased employee unless the individual's services are performed under primary direction or control by the service recipient. As under prior law, the determination of whether someone is a leased employee is made after determining whether the individual is a common-law employee of the recipient.
Whether services are performed by an individual under the primary direction or control by the service recipient depends on the facts and circumstances. Primary direction and control means that the service recipient exercises the majority of direction and control over the individual. Factors that are important considerations include whether the individual is required to comply with instructions of the service recipient about when, where, and how he or she is to perform the services, whether the services must be performed by a particular person, whether the individual is subject to the supervision of the service recipient, and whether the sequence or order of how the work is performed is set by the service recipient.
For example, an individual who works under the direct supervision of the service recipient would be considered subject to the direction or control of the recipient even if another company hired and trained the individual, had the ultimate (but unexercised) legal right to control the individual, paid his wages, withheld his employment and income taxes and had the exclusive right to fire him. Thus, for example, temporary secretaries, receptionists, word processors, and similar office personnel who are subject to the day-to-day control of the employer in essentially the same manner as a common law employee are treated as leased employees if the period of service threshold (1 year) is reached.
Example--Madison Inc. contracts with Chatham Co. to provide 5 workers and a supervisor to maintain its machinery. In the past Madison has always used its own workers to repair and rebuild its equipment. While Madison schedules when machines will go down for major overhaul and determines the level of repairs, Chatham and/or the Chatham supervisor at Madison determine how the work is performed and generally when it is performed. The workers are on the job more than a year.
Under prior law Madison would be leasing the workers because, historically, they performed the same job for Madison. Under the new law the workers would not be leased because they are not under the primary direction and control of Madison. It makes no difference that Madison historically performed the work using its own employees.
Example--Assume the facts are the same as in the example above, but the workers have no supervisor. Instead, a Madison employee can direct the workers as to when and how to do the work. Chatham trained the workers, pays all employment taxes, and is the only one who can fire them. Here the workers are leased employees because Madison has direct and primary control.
Caution-- Even before applying the new leased employee test, you must determine if the worker is an employee or not.
The committee report states that certain professionals (e.g., attorneys, accountants, actuaries, doctors, computer programmers, systems analysts, and engineers) who regularly make use of their own judgment and discretion on matters of importance in the performance of their services and are guided by professional, legal, or industry standards, are not leased employees even though the common law employer (the leasing company or similar provider in this case) does not closely supervise the professional on a continuing basis, and the service recipient requires the services to be performed on site and according to certain stages, techniques, and timetables. In addition, outside professionals who maintain their own businesses (e.g., attorneys, accountants, computer programmers, etc.) generally would not be considered to be under such primary direction or control.
Caution--The committee report notes that the principal purpose of changing the leased employee rules is to relieve the unnecessary hardship and uncertainty for employers. However, it is not intended that the new test enable employers to engage in abusive practices. The IRS is instructed to draft regulations to prevent abuses. For example, one potentially abusive situation exists where the benefit arrangements of the service recipient overwhelmingly favor its highly compensated employees, the employer has no or very few nonhighly compensated common-law employees, yet the employer makes substantial use of the services of nonhighly compensated individuals who are not its common-law employees.
Tax Tip--If you've got leased employees you should review their situation in the light of the new rules. You may or may not be better off. You may have to make adjustments to your qualified plans or modify your agreement with the company who provides you with leased employees. Check with your advisor. Another point. You may now find leasing employees more attractive than before.
The provision is effective for years beginning after December 31, 1996, except that the Act will not apply to relationships that have been previously determined by an IRS ruling not to involve leased employees.
Almost every time Congress makes changes to the rules for qualified plans, employers and self-employed individuals must make changes to their plans.
The new law provides that any required amendments to a plan or annuity contract need not be made before the first plan year beginning on or after January 1, 1998. The date for amendments is extended to the first plan year beginning after January 1, 2000 in the case of a governmental plan.
Under prior law, certain special aggregation rules apply to plans maintained by owner employees of unincorporated businesses that do not apply to other qualified plans. The new law eliminates these special aggregation rules (Code Sec. 401(d)) for tax years beginning after December 31, 1996.
Caution--Contributions can only be based on your earned income from the business in whose plan you participate.
Example--You own a 60% interest in Madison Co., a partnership that acts as a manufacturers' rep for electronic equipment. You also operate a repair business, Chatham Co., for printing equipment as a sole proprietorship with 5 employees. Madison has a qualified profit-sharing plan. Under prior law you could not participate in Madison's plan without covering the employees in Chatham with a plan at least as good as Madison's. Under the new law you can participate in Madison's plan, however, contributions are limited to your earned income from Madison.
Comment--This change should be very beneficial for small business owners that do business through more than one entity. In fact, you may want to reconsider a plan if you decided against one because of this rule. Check with your advisors.
The Act requires the IRS to develop a model spousal consent form, no later than January 1, 1998, waiving the qualified joint and survivor annuity (QJSA) and qualified preretirement survivor annuity (QPSA) forms of benefit. The form must be in plain language and must disclose the waiver is irrevocable and that it may be revoked by a qualified domestic relations order (QDRO).
In addition, the IRS must develop a model QDRO no later than January 1, 1997.
Comment--Spouses of participants in a retirement plan have certain rights. This has been a complicated issue, and employers have been caught in the middle more than once. Moreover, many individuals didn't understand the consequences of these provisions. Creating standard language, issued by the IRS, should make things simpler.
The new law makes a number of changes to church plans and one important change to tax-exempt organizations. We'll only mention the changes briefly.
Tax-exempt organizations. These organizations may now offer 401(k) plans to their employees. State and local governments (including political subdivisions and agencies) still cannot maintain a 401(k) plan.
Church plans and highly compensated employees. Church plans must now use the definition of highly compensated employees contained in Code Sec. 414(q)(1).
Self-employed ministers. Self-employed ministers are now allowed to participate in a church plan. The self-employed income of the minister is considered his or her compensation. Self-employed ministers can deduct their contributions.
The new law makes several changes to the rules for state and local government plans. Since the details are probably of limited interest to most of our readers, we'll only cover the two most important provisions.
Trust requirements for deferred compensation plans. Under prior law amounts deferred under a Section 457 deferred compensation plan of a state or local government had to remain subject to the claims of the employer's creditors. This provision has been repealed, effective as of the date of enactment. Now such amounts must be held in trust and not subject to creditor's claims. However, a trust does not have to be established until January 1, 1999.
Government plans under Code Sec. 415. The rule limiting distributions from a defined benefit plan to 100% of a participant's average compensation for his or her highest 3 years is repealed with respect to government plans. Under the new law distributions are limited to $120,000 per year (indexed for inflation).
The new law also makes changes to the treatment of length of service awards for volunteers and to distributions under deferred compensation plans of state and local governments.
Under the new law, vesting rules for multiemployer plans are the same as under other qualified plans. Thus, participants must now vest over a period of from 3 to 7 years or must fully vest after 5 years. This provision is effective for plan years beginning on or after the earlier of (1) the later of January 1, 1997, or the date on which the last of the collective bargaining agreements pursuant to which the plan is maintained terminates, or (2) January 1, 1999.
Comment--The reduced time to vest means that more employees are likely to become fully vested. That will change the actuarial assumptions and could cause a plan to be underfunded.