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Thelen LLP
What a difference a few years make
Just
a few years ago, employers and employees faced severe restrictions
on contributions and benefit accruals under tax-qualified
plans, including penalty taxes for favorable investment
returns. The pendulum has swung back in favor of greater
tax deferrals. Here are some examples of opportunities available
now:
- Cash
Balance Plan for Employees. An employer gives its
employees the opportunity to accrue a benefit under a
cash-balance defined-benefit plan instead of (or in addition
to) a profit-sharing benefit and be guaranteed a stable
earnings rate until retirement. The employer funds the
benefit annually (much like a profit-sharing plan) and
receives the benefit of any annual investment returns
that exceed the guaranteed rate.
- Funding
Executive Deferred Compensation. A company adopts
a defined benefit pension plan (perhaps the same cash
balance plan described above) to fund large deferred compensation
liabilities for top executives without having to commit
to substantial additional benefits for non-executives.
This eliminates the insolvency risk to the executive and
provides a more tax-efficient manner of funding deferred
compensation liabilities.
- Getting
More Tax-Qualified Benefits to Executives. An employer
contributes 5 percent of pay for all employees to a combined
profit-sharing plan and 401(k) plan. This provides an
insufficient benefit for senior executives, so the plan
is amended to provide for a 12 percent contribution for
the senior executive group. This is allowed because special
testing shows that a 12 percent contribution for executives
and a 5 percent contribution for relatively younger employees
yield a comparable benefit at retirement.
- Deferring
Self-Employment Income (such as director's fees).
An individual, age 50, with $50,000 of self-employment
income (e.g., directors' fees reportable on Schedule C)
contributes and deducts in 2003 up to $24,000 in profit-sharing,
401(k) and catch-up contributions to a Keogh plan (in
addition to employer-provided benefits received under
an employer's plan if that individual is otherwise employed).
A few years ago, that limit would have been about $6,500.
What has changed?
These
new opportunities have been created primarily by the following
recent legal and regulatory changes:
| 1. |
An
employee's maximum contribution under a profit-sharing
plan would have been reduced if he or she also participated
in a traditional defined benefit plan (and vice versa).
Now, the limits applicable to an employee participating
in one type of plan generally do not affect benefits
received in the other type of plan. |
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| 2. |
A
participant receiving distributions in excess of $150,000
a year was subject to a 15 percent penalty on the excess.
That penalty tax no longer applies. |
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| 3. |
The
overall limit on contributions to an employee's account
was the lesser of 25 percent of pay or $30,000. Now
that limit is 100 percent of pay or $40,000. |
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| 4. |
The
maximum tax deduction an employer could receive for
profit-sharing contributions was 15 percent of total
participant pay. Now that limit is 25 percent of pay,
and 401(k) contributions no longer count against the
limit. (This change effectively created single-participant
401(k) plans.) |
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| 5. |
Older
employees were subject to the same 401(k) limits as
younger employees. Now, older employees can contribute
extra "catch-up" contributions of $2,000 in
2003, increasing to $5,000 in 2006. |
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| 6. |
A
plan could consider no more than $150,000 of an employee's
compensation, and if a spouse also participated in the
plan, the spouse's compensation counted against the
limit. That limitation now is $200,000, and the spouse
has a separate limit. |
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| 7. |
Self-employed
individuals owning at least 10 percent of a business
could not borrow from their retirement account. That
prohibition is gone, and now even sole proprietors can
borrow up to $50,000 from their single-participant Keogh
plans. (Although this is not an increased deferral rule,
a plan loan provides a convenient funding source.) |
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| 8. |
Finally,
the IRS has gradually clarified how to test plans for
discrimination, giving employers a high degree of certainty
that a particular contribution and benefit formula will
not destroy the plan's tax qualification. Also, cash-balance
defined-benefit plans have become more common (and the
rules more clear), giving employers a whole new approach
to delivering retirement benefits. |
What should employers do?
Employers
of all sizes (even sole proprietors) should discuss with
their advisers how to use these rules effectively to achieve
employer and employee retirement objectives.
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For more information about the issues covered in this report, please contact David S. Foster in our San Francisco office at 415-369-7020 or at dsfoster@thelen.com or contact your Thelen attorney. For more information about Thelen's Construction and Government Contracts Department, click here.
©2003 Thelen LLP
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