Alert. Client PROSKAUER ROSE SM. Employee Benefits Provisions Under the Economic Growth And Tax Relief Reconciliation Act of 2001

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1 PROSKAUER ROSE SM Client Alert Employee Benefits Provisions Under the Economic Growth And Tax Relief Reconciliation Act of 2001 On June 7, 2001, President Bush signed into law The Economic Growth and Tax Relief Reconciliation Act of 2001 (referred to herein as the Tax Act ). The Tax Act includes numerous provisions affecting employee benefits. This Client Alert briefly summarizes the Tax Act s significant retirement plan and employee benefits changes applicable to plan sponsors. The actual text of the Tax Act can be accessed at rules/1836cr.pdf and the actual text of the Joint Committee explanation of the provisions of the Tax Act can be accessed at som_1836.pdf. A copy of this Client Alert can be accessed at the Proskauer website ( A report for clients and friends of the firm June 2001 Effective Date Almost all of the changes concerning retirement plans established under Sections 401(a) and 403(b) of the Code1 are effective for years beginning after December 31, 2001, although some changes are phased in over several years. This effective date is particularly relevant to plan sponsors who are required to amend their plans by the end of the 2001 plan year to comply with prior law. Unless the remedial amendment period (to comply with prior law changes) is extended (which is unlikely) or the Internal Revenue Service promptly releases model amendments with regard to the Tax Act changes, plans sponsors will be required to amend their plans twice within a short period of time. In any case, plan sponsors will have to determine, before the end of 2001, how to deal with some of the changes. The Tax Act includes a sunset provision which provides that the entire Tax Act, including provisions affecting employee benefits, will expire after December 31, No one expects this to actually happen, and based on the history of the employee benefits laws, we can expect the provisions to be amended many times between now and December 31, Increase in Contribution and Benefit Limits The Code includes limits on the amount of compensation that may be considered for determining contributions to or benefits under tax-qualified plans and 403(b) annuities as well as limits on the benefits paid from such plans and arrangements. The Tax Act increases many of these limits. Plan documents may require amendments before the end of 2001 to avoid automatic increases in limits resulting in unintended additional costs. The annual covered compensation limit has been increased from $170,000 to $200,000, and will be increased for inflation in $5,000 increments. The annual dollar limit on benefits payable from defined benefit plans has been increased from $140,000 to $160,000, and will be increased for inflation in $5,000 increments. In addition, this limit will no longer be reduced for benefits commencing between age 62 and 65. The annual contribution limit on annual additions to defined contribution plans has been increased from the lesser of $35,000 or 25% of compensation to the lesser of $40,000 (indexed for inflation in $1,000 increments) or 100% of compensation. The dollar limit on annual elective deferrals to 401(k) plans, 403(b) annuities, salary reduction SEPs2 and 457 plans has been increased to $11,000 in 2002, and then in $1,000 increments until it reaches $15,000 in Thereafter, the limit will be indexed for inflation in $500 increments. This is an increase from the current limits of $10,500 for 401(k) plans, 403(b) annuities and salary reduction SEPs and $8,500 for 457 plans. The dollar limit on annual elective deferrals to SIMPLE plans has been increased from $6,500 to $7,000 in 2002, and then in $1,000 increments until it reaches $10,000 in Thereafter, the limit will be indexed for inflation in $500 increments. 1 All references to the Code or to specific Sections references refer to the Internal Revenue Code of 1986, as amended. 2 This term refers to simplified employee pensions under Code Section 408(k).

2 Notice Requirements for Reduction in Future Benefits Many plan sponsors are aware of the requirement under Section 204(h) of ERISA to give written notice to participants in a defined benefit plan or money purchase pension plan no less than 15 days prior to the effective date of an amendment which causes a significant reduction in future benefit accruals. The Tax Act has added a similar requirement to the Code, primarily as a response to conversions to cash balance plans. The notice requirement under the Code applies in the case of a significant reduction in the rate of future benefit accruals, including any elimination or reduction of an early retirement benefit or retirement-type subsidy (this is an expansion of the ERISA requirement). The notice must provide, in a manner calculated to be understood by the average plan participant, sufficient information (to be defined in Treasury regulations) to allow participants to understand the effect of the amendment and it must be provided within a reasonable time before the effective date of the amendment. A plan sponsor that fails to comply with the notice requirement may be subject to an excise tax equal to $100 per day per affected participant. If reasonable diligence is exercised, and the plan sponsor unintentionally fails to comply with the notice requirement, the excise tax will be limited to $500,000 per year (certain additional exceptions apply). The Tax Act also modifies Section 204(h) of ERISA to provide that if a plan sponsor egregiously fails to satisfy the notice requirements, the plan may not be amended to reduce future benefit accruals. The notice requirement is effective immediately, but subject to a good faith standard until regulations are issued. Involuntary Cash-outs The Tax Act requires that unless a participant otherwise specifies, an involuntary cash-out ($5,000 or less) from a qualified retirement plan that exceeds $1,000 must be rolled over to a designated IRA. If the cash-out is rolled over to the default designated IRA (rather than pursuant to participant direction), the plan fiduciaries will maintain fiduciary responsibility for the IRA for the one year period following the rollover, or until the money is moved from the designated IRA, if earlier. This provision is not effective until final regulations are issued by the Department of Labor, which regulations are to be issued within three years. The Tax Act also provides that for purposes of the cash-out rules and determining whether a participant s benefit exceeds $5,000, a plan may exclude the value of any rollover contributions or earnings thereon. Modification in Top-Heavy Rules Pursuant to the top-heavy rules, if more than 60% of the contributions or benefits under a plan are for the benefit of key employees, the plan must provide for faster vesting and increased contributions or benefits to nonkey employees. The Tax Act has revised the definition of key employee as follows: (1) an officer with compensation in excess of $130,000 (adjusted for inflation in $5,000 increments); (2) a 5% owner; or (3) a 1% owner with compensation in excess of $150,000. The definition of a key employee has been modified to delete the top 10 owner rule, increase the threshold for officers from $70,000 to $130,000 (as adjusted) and delete the 4 year lookback rule for determining key employee status. The Tax Act also modifies the test for determining top-heavy status by shortening the 5 year look-back rule for distributions to one year (the 5 year look-back rule still applies to in-service distributions). In addition, an individual s accrued benefit or account balance will not be taken into account if he or she has not performed services for the employer during the one year period ending on the date the top-heavy determination is made. Under the Tax Act, a 401(k) plan with a matching contribution which satisfies the design-based safe harbors for elective deferrals and matching contributions will not be considered a top-heavy plan. Matching contributions will also count toward satisfying the top-heavy minimum benefit requirement. Finally, frozen defined benefit plans will no longer be required to provide topheavy minimum benefits. Changes Applicable to Defined Benefit Plans Funding and Deductibility Defined benefit plans are subject to minimum funding requirements designed to ensure that they have sufficient assets to pay benefits. No contribution is required under the minimum funding rules in excess of the full funding limit. In addition, contributions in excess of the full funding limit generally are not deductible and are subject to a 10% excise tax. The Tax Act gradually increases and then repeals the current liability full funding limit. The current liability full funding limit is increased from 160% to 165% for plan years beginning in 2002 and 170% for plan years beginning in It is then repealed for plan years beginning in Thus, in 2004 and thereafter, the full funding limit is the accrued liability under the plan (including normal cost) over the value of the plan s assets. The Tax Act provides that the 10% excise tax on nondeductible contributions will not apply to contributions to a defined benefit plan except to the extent they exceed the accrued liability full funding limit, if the employer so elects. An employer making such an election is not permitted to take advantage of the excise tax exceptions for certain terminating plans and certain contributions to defined contribution plans. The Tax Act extends the special rule allowing a deduction for unfunded current liability to all defined benefit plans covered by the Pension Benefit Guaranty Corporation insurance program, including multiemployer plans and plans with 100 or fewer participants. Valuations The Tax Act codifies proposed regulations providing that plan valuations must be as of a date within the plan year to which the valuation refers or within the month prior to the beginning of that year. The Tax Act also provides, as an exception to this general rule, that the valuation date may be any date within the immediately preceding plan year if, as of such date, plan assets are not less than 100% of the plan's current liability. A change in funding method to take advantage of this exception may not 2

3 be made unless plan assets are not less than 125% of the plan's current liability. Multiemployer Plans The Tax Act includes a number of special provisions that apply to multiemployer plans, such as the removal of the 100% of compensation limit on the maximum annual benefit payable from defined benefit plans. Multiemployer plans will not be required to be aggregated with single employer plans for purposes of applying the 100% of compensation limit. In addition, the Tax Act includes clarification on the treatment of contributions to multiemployer plans. Changes Applicable to Defined Contribution Plans Contribution Deduction Limit Increased The Tax Act provides that the deduction limit for employer contributions to stock bonus and profit sharing plans is increased from 15% to 25% of compensation. In addition, for purposes of calculating this limit, compensation includes amounts deferred pursuant to a salary reduction agreement. For purposes of the contribution limits, however, such deferrals will not be treated as employer contributions. In addition, a money purchase pension plan will be treated like a profit sharing plan or a stock bonus plan for deduction purposes. Roth Contributions Pursuant to the Tax Act, for taxable years beginning after December 31, 2005, a Section 401(k) plan or a 403(b) annuity may permit a participant to elect to designate all or a portion of his or her elective deferrals (subject to applicable limits) as Roth Contributions. Roth contributions will be similar to after-tax contributions, but like Roth IRAs, earnings on contributions will not be taxable upon distribution, as long as the contributions and earnings thereon are separately accounted for and distributions are made no earlier than 5 years after the first Roth Contribution is made and on or after the participant's attainment of age 59-1/2, death or disability. Catch-Up Contributions The Tax Act provides that individuals who are age 50 and above as of the end of a plan year may make catch-up contributions with respect to their elective deferrals under a 401(k) plan, 403(b) annuity, SEP, SIMPLE or 457 plan. The annual dollar limit on elective deferrals under a 401(k) plan, 403(b) annuity, SEP or 457 plan for such individuals will be increased annually by $1,000 beginning in 2002 until the catch-up reaches $5,000 for 2006 and thereafter. With regard to a SIMPLE, the annual dollar limit will be increased annually by $500 beginning in 2002 until the catch-up reaches $2,500 for 2006 and thereafter. These amounts will be indexed for inflation in $500 increments in 2007 and thereafter. The catch-up contributions are not subject to any other contribution limits and are not subject to nondiscrimination rules, as long as all eligible participants have the right to make a catch-up election. The special catchup provision for certain 403(b) annuities under existing law remains unchanged. Deemed IRAs Under Employer Plan The Tax Act provides that a 401(a) plan, a 403(b) annuity or a governmental 457 plan may permit employees to make voluntary contributions to a separate account or annuity that is established under the plan and the meets the requirements applicable to either traditional IRAs or Roth IRAs. The Deemed IRA and contributions thereto will not be subject to the plan's rules but will be subject to the exclusive benefit and fiduciary rules of ERISA. Relaxation of Anticutback Rule The Tax Act provides that a defined contribution plan to which benefits are transferred need not preserve the optional forms of benefit available under the transferor plan if certain requirements are satisfied. These requirements include (1) obtaining the consent of affected participants after such participants are provided with a notice describing the consequences of their election to consent to the transfer, and (2) the transferee plan provides a single sum distribution option. The provisions apply in the case of a direct transfer or a merger which has the effect of a direct transfer between plans. The joint and survivor annuity requirements have not been modified by the Tax Act. Treasury is also directed to provide by regulations that the elimination or reduction of an early retirement benefit, retirementtype subsidy, or an optional form of benefit is permitted in the case where such an amendment does not adversely affect the rights of a participant in more than a de minimis manner. Repeal of Same Desk Rule The Tax Act has modified the distribution restrictions applicable to 401(k) plans, 403(b) annuities and 457 plans to provide that distributions may occur upon severance from employment rather than separation from service, allowing distributions even if the employee continues working at the same job with a successor employer. A plan sponsor may, however, choose to retain the more restrictive provisions. This change provides employers with more flexibility in the mergers and acquisitions context by providing employees with the ability to roll over plan accounts from the plan of a previous employer to the plan of a new employer or to take a distribution (and pay the excise tax). Acceleration of Vesting for Matching Contributions. The Tax Act has accelerated the existing vesting requirements for employer matching contributions to a 401(k) plan. Pursuant to the Tax Act, employer matching contributions must either (1) be 100% vested upon completion of 3 years of service (as opposed to 5 years under prior law), or (2) vest on a graded schedule at the rate of 20% per year beginning with the second year of service (as opposed to the third year under prior law). The prior vesting requirements remain applicable to all other employer contributions. 3

4 Hardship Distributions Treasury has been directed to issue regulations reducing from 12 to 6 months the suspension period following a hardship withdrawal during which an employee is prohibited from making elective and employee contributions to an employer maintained plan. In addition, the Tax Act expands the prior rule concerning the inability to rollover hardship distributions of elective deferrals to provide that no hardship distribution is an eligible rollover distribution. Accordingly, all hardship distributions are subject to withholding. Repeal of Multiple Use Test The multiple use test has been repealed. This test limited 401(k) plans with matching contributions or after-tax contributions from satisfying the nondiscrimination testing requirements of both the actual deferral percentage test and the actual contribution percentage test by utilizing one of the permitted alternatives. Plan Loans The Tax Act eliminates the restrictions on plan loans to owneremployees. Accordingly, sole proprietors, partners and owners of a subchapter S corporation may receive plan loans under the same rules as all other plan participants. Rollovers Pursuant to the Tax Act, many of the restrictions on rollovers between plans and IRAs have been relaxed. Eligible rollover distributions from qualified retirement plans, 403(b) annuities, governmental 457 plans and IRAs may now be rolled over to any of such plans or arrangements that accept the rollovers. Accordingly, the requirement to roll over to a similar plan or arrangement is no longer applicable. In addition, employee after-tax contributions now may be rolled over to another qualified plan or IRA, if accounted for separately. The Tax Act also provides that surviving spouses may roll over distributions to their own employer plans rather than only to an IRA. The Service has been given the ability to waive the requirement that rollovers must be made within 60 days of a distribution in cases where equity or good conscience would require such a waiver. ESOPs The Tax Act includes certain provisions specific to employee stock ownership plans or ESOPs. The provisions on deductibility of dividends paid on securities held in an ESOP have been expanded to provide employers with the ability to deduct dividends paid on employer securities held by an ESOP if participants elect to have the dividends reinvested in qualifying employer securities and participants also have the option of receiving the dividends in cash. The Tax Act also amends the requirements for ESOPs of subchapter S corporations with the intention of limiting the establishment of ESOPs by such entities to those that provide broad-based employee coverage and that benefit rank-and-file employees as well as highly compensated employees and owners. Changes Specific to Tax-Exempt and Governmental Employers Repeal of Exclusion Allowance The complex exclusion allowance applicable to contributions to 403(b) annuities has been repealed. Thus, 403(b) annuities will now be subject only to the limits applicable to tax-qualified plans. 457 Plans The Tax Act includes a number of provisions unique to 457 plans, some of which apply qualified plan rules to 457 plans. These changes should help to simplify the administration of 457 plans. The percentage of compensation limitation on deferrals under a 457 plan has been increased from 33-1/3% to 100% of compensation. As described above, the dollar limit on deferrals under a 457 plan has also been increased; this limit will be doubled in the 3 years prior to retirement. The Tax Act repeals the rules coordinating the 457 dollar limit with contributions made to other types of plans. The special minimum distribution rules applicable only to 457 plans have also been repealed; thus, 457 plans are now subject to the minimum distribution rules applicable to qualified plans. In addition, the Tax Act provides that amount deferred under a 457 plan of a state or local government will be includible in income when paid. The current rule providing that amounts are includible in income when paid or made available will continue to apply to 457 plans maintained by other types of employers. The Tax Act applies the tax rules for qualified plan distributions pursuant to a qualified domestic relations order (QDRO) (in cases of participant divorce) to distributions in similar cases from a 457 plan. Purchase of Service Credits The Tax Act provides that a participant in a state or local government plan will not be required to include in gross income a direct trustee-to-trustee transfer to a governmental defined benefit plan from a 403(b) annuity or a 457 plan if the transferred amount is used to (1) purchase permissive service credits under the plan, or (2) repay contributions and earnings with respect to an amount previously refunded under a forfeiture of service credit under the plan or another plan maintained by a state or local government employer within the same state. 401(k) Testing Treasury has been directed to revise its regulations regarding the minimum coverage rules to provide that employees of a taxexempt charitable organization who are eligible to make elective deferrals under a 403(b) annuity may be excluded for purposes of the nondiscrimination testing of a 401(k) plan maintained by another member of the controlled group if (1) no employee of the tax-exempt entity is eligible to participate in the 401(k) plan, and (2) at least 95% of the employees who are not employees of the tax-exempt entity are eligible to participate in such 401(k) plan. This change resolves an issue which arose when the establishment of 401(k) plans by tax-exempt employers was again authorized in Accordingly, this change is retroactive for plan years beginning after December 31,

5 Miscellaneous The Tax Act includes a provision clarifying that retirement advice provided to employees by an employer is a nontaxable fringe benefit to the extent the services are made available on substantially equivalent terms to all employees. Pursuant to the Tax Act, Treasury is instructed to modify the mortality tables used for minimum distributions to reflect current life expectancies. The Tax Act includes certain incentives for small employers to establish retirement plans. The Tax Act also makes permanent the $5,250 tax exclusion for educational assistance programs, as well as expanding the exclusion to apply to graduatelevel courses. Has Your Address Changed? Please let us know if your mailing address needs to be updated. Contact Deborah Chernoff with the correct information either via dchernoff@proskauer.com or fax: NEW YORK WASHINGTON NEWARK LOS ANGELES BOCA RATON PARIS Client Alert Proskauer s Tax Department includes over 25 attorneys with significant and diverse tax, executive compensation and employee benefits law experience. The following individuals serve as contact persons and would welcome any questions you might have: Ira G. Bogner ibogner@proskauer.com Jacob I. Friedman jfriedman@proskauer.com Andrea S. Rattner arattner@proskauer.com Michael S. Sirkin msirkin@proskauer.com Lisa A. Berkowitz Herrnson iherrnson@proskauer.com You may also contact any other member of Proskauer s Tax Department in: New York Washington Boca Raton Los Angeles Newark Paris Proskauer is an international law firm with more than 550 attorneys who handle a full spectrum of legal issues worldwide. This publication is a service to our clients and friends. It is designed only to give general information on the developments actually covered. It is not intended to be a comprehensive summary of recent developments in the law, treat exhaustively the subjects covered, provide legal advice or render a legal opinion PROSKAUER ROSE LLP. All rights reserved. 5