NEW TRENDS IN PUBLIC SECTOR PLANS. By Cindy S. Birley and Rebecca L. Hudson Davis, Graham & Stubbs, Denver, CO

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1 RETIREMENT BENEFITS NEW TRENDS IN PUBLIC SECTOR PLANS By Cindy S. Birley and Rebecca L. Hudson Davis, Graham & Stubbs, Denver, CO THIS ARTICLE EXAMINES recent trends in the benefits that public sector plans provide to the large number of state and local government workers and retirees participating in these plans. The article discusses the significant provisions of the recently signed Economic Growth and Tax Relief Reconciliation Act of 2001 affecting governmental plans relating to such issues as portability, increased contribution limits and catch-up contributions. The article also details three trends: 1) providing matching contributions for 457 plan deferrals into qualified 401(a) plans; 2) the rise in self-direction of deferred retirement option programs ( DROPS ); and 3) self-directed retiree health savings plans. The overwhelming majority of state and local government workers and retirees are covered by pension plans. This article discusses recent trends in the benefits provided by public sector plans. It begins with a brief overview of the significant provisions of the recently signed tax legislation related to governmental plans, such as portability, increased contribution limits, and catch-up contributions. The article then discusses three trends in providing benefits to retired workers. First, it discusses matching contributions on 457 plan deferrals. In a traditional 457 plan, employees make pretax contributions to a retirement plan. Recently, employers are adding a match to the 457 deferral. The match is made in a 401(a) qualified plan. Next, the article examines deferred retirement option programs. While these programs have been used for years, employees are now self-directing their accounts. Finally, a new vehicle for retiree health care is addressed. Although there are many ways an employer may fund retiree medical benefits, this new technique is gaining interest since it allows employees to control the investment decisions on their accounts. Introduction Public sector plans are generally not subject to regulation by the federal government under the Employee Retirement Income Security Act of 1974 ( ERISA ) 1 Instead, state and local pension plans are created and governed by state and local laws which often have less stringent funding, vesting and other requirements. The federal tax rules governing state and local pensions are also less rigid than the rules that apply to private plans. For example, the vesting rules applicable to governmental plans are much more relaxed than the vesting rules applicable to private plans. 2 Moreover, nondiscrimination rules do not apply to state and local governmental plans. 3 Since states are considered to be sovereign governments, the federal government generally does not mandate that state and local government employees participate in Social Security. However, Social Security coverage is mandated for all state and local employees not covered by a public retirement system which provides benefits or contributions similar to Social Security. Some public sector entities have opted into Social Security through an agreement process. These entities cannot opt back out. Medicare is mandated for all employees hired after March 31, Davis Graham & Stubbs LLP

2 Those public sector entities not participating in Social Security often offer a higher retirement benefit to plan participants than public sector entities that do participate in Social Security. The plans are typically designed with both employee and employer contribution components. The employee contribution is typically pre-tax through a pick-up contribution by the employer under Code Sec. 414(h). Pick-up contributions are mandatory employee contributions to a governmental Sec. 401(a) qualified plan that are treated as pre-tax employer contributions. They may be made directly by the employer but are usually made through salary reduction. 4 This article focuses primarily on 401(a) qualified plans, but also touches upon the new legislation s impact on 403(b) and 457 plans, and as noted above, discusses a recent trend in 457 plans. A brief overview of the different types of plans follows. A qualified plan under Code Sec. 401(a) is afforded special tax treatment provided numerous requirements under Code Sec. 401(a) are met. The primary advantages of being a qualified plan are: 1) employer contributions are not taxable to the participants as they are made, 2) trust earnings are not taxable, and 3) favorable tax treatment is available to participants when they receive distributions (i.e., rollover treatment). Sec. 401(a) qualified plans generally fall into one of two categories: defined contribution plans and defined benefit plans. A defined contribution plan is a retirement plan that provides for an account for each plan participant and for benefits based solely upon: 1) amounts contributed to the account; 2) income, expenses, gains and losses on the account; and 3) any forfeitures of accounts of other participants which may be reallocated to such account. 5 A defined benefit plan, on the other hand, is a retirement plan that provides definitely determinable benefits. 6 For instance, a defined benefit plan might entitle a participant to a monthly pension for life equal to a percentage of the participant s monthly compensation. Generally speaking, in these types of plans, plan formulas are geared to retirement benefits and not to contributions). 7 A 403(b) retirement plan is very similar to a 401(k) plan, except that only employees of public schools and certain tax-exempt organizations can participate. 8 Through a salary reduction agreement, plan participants set aside money for retirement on a pre-tax basis. Like a 401(k) plan, the money grows tax-deferred until retirement and is taxed as ordinary income when withdrawn. Sec. 457 plans are nonqualified deferred compensation plans established by state and local government and tax-exempt employers. The effect of Code Sec. 457 is to shelter deferred compensation and income attributable to the deferred amounts from current taxation. Highlights of the Impact of the Economic Growth and Tax Relief Reconciliation Act of 2001 on Public Sector Retirement Plans The newly-enacted Economic Growth and Tax Relief Reconciliation Act of 2001 contains the most significant changes to retirement plans since the Tax Reform Act of Fortunately, unlike the 1986 Act, the retirement plan changes in this new law significantly expand the opportunities for retirement savings and portability and actually simplify some of the regulatory complexities. Set forth below is a brief summary of the pension reform provisions which impact public sector plans. -2-

3 Increasing portability. Effective for distributions made after December 31, 2001, eligible rollover distributions from Sec. 401(a) qualified plans, Sec. 403(b) plans and Sec. 457 plans generally may be rolled over into any of such plans or arrangements. Similarly, taxable amounts in traditional IRAs may be rolled over into a Sec. 401(a) qualified plan, Sec. 403(b) plan or Sec. 457 plan. Plans accepting such rollovers must separately account for such rollovers. However, no plan is required to accept rollovers. Effective for distributions after December 31, 2001, surviving spouses can roll over distributions to a Sec. 401(a) qualified plan, Sec. 403(b) plan or Sec. 457 plan in which the spouse participates. Plans accepting such rollovers must separately account for such rollovers. After-tax contributions. Employee after-tax contributions can be rolled into a defined contribution plan or a traditional IRA. Only a direct rollover is allowed to a defined contribution plan, and the plan must agree to separate accounting. Under prior law, after-tax employee contributions could not be rolled over. This provision applies to distributions after December 31, Service credit purchases. A participant in a state or local governmental defined benefit plan is not required to include in gross income a direct trustee-to-trustee transfer to a governmental defined benefit plan from a 403(b) plan or 457 plan if the transferred amount is used to 1) purchase service credits under a defined benefit plan 9 or 2) repay contributions and earnings to a defined benefit plan for amounts previously distributed upon a forfeiture of service credit under the plan (or another plan maintained by a state or local government employer within the same state). 10 This provision applies to transfers after December 31, Comment: The reason for the change is that many public sector employees work for multiple state or local government employers during their careers. Allowing such employees to use their Sec. 403(b) annuity and Sec. 457 plan accounts to purchase service credits or make repayments with respect to forfeitures of service credit will result in more significant retirement benefits for employees who would not otherwise be able to afford such credits or repayments. Sec. 457 distribution rules. Effective for distributions after December 31, 2001, the new law provides that amounts deferred under 457 plans are includible in income when paid, not when made available. Also, the special minimum distribution rules for 457 plans are repealed and replaced by the same minimum distributions rules as for Sec. 401(a) qualified plans. Amounts distributed from a Sec. 457 plan are subject to the early 10 percent withdrawal tax to the extent the distribution consists of amounts attributable to rollovers from another type of plan. 11 In addition, the new law clarifies that hardship distributions from Sec. 457 plans are not considered eligible rollover distributions. Repeal of coordination rules. For years beginning after 2001, rules coordinating the 457 annual maximum deferral limit ($8,500 for 2001) with contributions under other types of plans are repealed. Under prior law, in applying the limit, contributions under a 403(b) plan, elective deferrals under a 401(k) plan, salary reductions under a SEP, and contributions under a SIMPLE plan were taken into account. -3-

4 Comment: Frequently, states have both a 457 plan and 403(b) plan, and might even have a grandfathered 401(k) plan. It is possible under the new rules to max-out each plan, which would collectively provide a richer benefit to the plan participants. Contribution limits. The deferral limit for 457 plans is increased from $8,500 to $15,000 over five years, beginning in 2002, and indexed for inflation after The annual contribution limit to a 457 plan will be as shown in Chart 1 (next page). Moreover, the new law allows an additional $5,000 catch-up pre-tax contribution to a 457 plan by individuals age 50 and older, phased in over five years beginning in 2002, and indexed for inflation. The catch-up rule for individuals age 50 or older does not apply during the participant s last three years prior to retirement. 12 The percentage of compensation limit has also been increased for years beginning after December 31, 2001, to 100 percent of compensation. Previously, lower percentages applied, for example, 25 percent of compensation for defined contribution plans and 33-1/3 percent for 457 plans. Comment: The dollar limits for deferrals will assume more importance than they did under prior law when lower compensation percentages applied. Comment: The increased limits for 401(a) defined contribution plans, along with the absence of nondiscrimination testing, will likely increase the trend toward implementing 401(a) defined contribution plans in the public sector, especially for management personnel. The difficulty in recruiting top level managers forces many public sector entities to offer separate, richer defined contribution plans to entice such managers away from the private sector. Tax treatment of benefits upon divorce. Under the new law, the qualified plan taxation rules for qualified domestic relations orders ( QDROs ) will apply to transfers, distributions, and payments made from a 457 plan after December 31, 2001 pursuant to a domestic relations order. Thus, amounts distributed to the spouse (or former spouse) are taxable to the spouse, but amounts distributed to an alternate payee (other than the spouse) are taxable to the plan participant. Comment: While this tax treatment is parallel to payments made from a private qualified plan, Code Sec. 414(p) does not otherwise apply. New Trends in Public Sector Retirement Plans The following discussion focuses on a number of recent trends in public sector retirement plans. Although it is a basic summary, it highlights several alternatives to consider when revising and/or implementing a particular type of plan. 401(a) matching contribution to 457 plan contribution. In the private sector, 401(k) plans have become very popular. The typical 401(k) plan has an employer-matching contribution. Competitive pressures and the desire to increase participation in their 457 plans have caused public sector entities to want to offer something comparable. Unless grandfathered, a governmental -4-

5 employer cannot maintain a 401(k) plan. 13 Thus, governmental employers that want to compete with private employers must attempt to make a 457 plan operate more like a 401(k) plan. This has led to the increasing trend of providing employer-matching contributions to 457 contributions. Those public sector entities which have implemented even small matching contributions have found participation levels in their 457 plans increased tremendously. Unlike the $10,500 limit (for 2001) for 401(k) elective deferrals, 14 the $8,500 limit (for 2001) for 457 plans 15 applies to all contributions to 457 plans (elective, matching, or non-elective). However, if the employer matching contributions are made to a 401(a) plan instead of to the 457 plan itself, the matching contributions will not count against the $8,500 limit. Thus, the recent trend has been for public sector employers to establish separate Code Sec. 401(a) plans to make employer matching contributions to 457 plan elective deferrals. Comment: Under the new law, the increased contribution limits might help participants avoid maxing-out their 457 limits, therefore possibly making the match outside the Sec. 457 plan less critical. If, however, a participant contributes an elective deferral of the maximum amount to the 457 plan, the 401(a) employer matching contribution is also still needed to make the larger corresponding contribution. Deferred retirement option programs. Deferred retirement option programs (commonly referred to as DROP programs) have been around for years but the trend now is to provide employees with investment discretion on these accounts once the participant satisfies the criteria to enter the DROP. Under a DROP, a participant who would otherwise be entitled to retire and receive benefits under a defined benefit retirement plan instead chooses to continue working. However, instead of directly receiving his monthly pension payment, the participant has his monthly pension payments credited to a separate account (the DROP account) under the plan. The DROP account is adjusted for earnings, gains and losses. When the participant eventually retires, the DROP account is paid to the participant, in addition to whatever benefit the employee has acquired under the defined benefit plan based on earlier years of service. Example: Suppose that Sally Jones is covered by a retirement plan which provides that she will receive an annual benefit beginning at retirement of 2.5 percent of final average compensation 16 times her years of service. Suppose further that the retirement plan caps service at 30 years, but also permits Sally Jones to retire as early as age 55 with 30 years of service, without actuarial reduction for the early retirement. If Sally Jones has final average compensation of $40,000 per year at age 55, and has attained 30 years of service, she could retire immediately with an annual benefit of 2.5 percent x 40,000 x 30 (years of service), or $30,000. Alternatively, she could continue working until age 60. At that point, she would have 35 years of service instead of 30, but the benefit would not have increased unless her compensation increased, since service is capped at 30 years. -5-

6 CHART 1: Annual Contribution Limit to a 457 Plan Plan Year Contribution Limit 2002 $11, $12, $13, $14, $15,000 Under the above scenario, Sally has little incentive to keep working. Sally s employer may lose a valuable employee if it does not provide a further incentive for Sally to stay. A DROP plan would provide Sally Jones with a third alternative. Instead of retiring at age 55 on a $30,000 per year benefit, or deferring retirement to age 60 and receiving the same annual benefit of $30,000 (if her compensation did not increase), she could elect to continue working for five years until age 60, but to have her compensation frozen (for the defined benefit formula) at the level it was when she was 55. In exchange for her giving up the right to the potential increase in compensation in the benefit formula, her employer would agree to transfer $30,000 for each of the five years of her continued employment into a separate account set up for her under the retirement plan. When she retires at 60, she will receive (1) $30,000 per year, plus (2) the value produced by taking the $30,000 per year credited to the account plus increases (or decreases) to the account due to earnings/losses. Most plans design the DROP distribution to be paid in a lump sum. This is very appealing to many employees, as it provides an opportunity to receive a large lump-sum payment at retirement. This lump sum can be used to pay off a home mortgage, purchase a boat or motor home, create an estate for dependents, etc. In addition, participants still receive a lifetime monthly benefit from the defined benefit plan. DROP feature as component of defined benefit plan. The manner in which earnings are credited on the DROP account is important to the determination of whether the DROP feature is viewed as a component of the defined benefit plan or whether it changes the nature of the existing defined benefit plan to a hybrid plan. If the DROP accounts are credited with the rate of return fixed by outside sources and which is not subject to employer discretion, then the DROP would most likely meet the definitely determinable benefit requirement, and be considered an integral feature of a defined benefit plan. 17 So what s new? hybrid plans. Public sector employers are letting participants self-direct their DROP accounts. Allowing such self-direction creates a hybrid plan. A hybrid plan is a defined benefit plan with a defined contribution component. The defined contribution component of a hybrid plan is defined in Code Sec. 414(k)(2) as consisting of benefits based on the separate account of a participant. 18 The DROP feature could be considered a defined contribution component with separate accounts for participants. The manner of crediting earnings, -6-

7 instead of being fixed as discussed above, could be variable based on the performance of the participant s chosen investment portfolio. 19 If the DROP feature is considered to be a Code Sec. 414(k) arrangement, then the DROP does not need to meet the definitely determinable requirement, which only applies to defined benefit plans. Under a defined contribution plan, a participant s benefit is equal to the amount contributed to his account under the plan, increased by the actual investment gains and losses on that account. Will a hybrid plan pass the Code Sec. 415 limits? Code Sec. 415 has separate limits for defined benefit plans and defined contribution plans. Under Code Sec. 415(b), the maximum annual benefit provided to a participant by a defined benefit plan generally cannot exceed $140,000 (for 2001). 20 Under a defined contribution plan, Code Sec. 415(c) limits the annual additions to a participant s account to the lesser of $35,000 (for 2001) 21 or 25 percent (through 2001) 22 of the participant s compensation for the year. 23 Annual additions are the sum of the employer contributions, employee contributions and forfeitures allocated to a participant s account for the year. The question is whether the DROP payment counts as an annual addition. If so, the Code Sec. 415(c) limits may easily be exceeded. Comment: For instance, in the Sally Jones example above, if the DROP payment is treated as an annual addition, Sally would have exceeded the Code Sec. 415(c) limit. The DROP payment itself is 75 percent of Sally s compensation ($30,000/$40,000). The limit for 2001 is 25 percent of compensation. For a hybrid DROP, Code Sec. 414(k) permits segregation of the defined benefit component and the defined contribution component. In other words, for Code Sec. 415 purposes, the 401(a) qualified plan is treated as a defined benefit plan with respect to the participant s retirement benefits, and as a defined contribution plan with respect to his DROP account. This is true, so long as the participant s benefit under the DROP portion of the plan is based on the balance of a separate account for the participant. For this condition to be met, the participant s DROP account must be based solely on contributions to that account and the actual investment gains and losses on that account. 24 In testing the DROP as a separate defined contribution plan for Code Sec. 415 purposes (assuming the requirements of Code Sec. 414(k) are met), it becomes necessary to determine the annual additions (the sum of employer contributions, employee contributions and forfeitures) allocated to the participant s DROP account each year. 25 Code Sec. 415 regulations state that amounts attributable to employer contributions and employee contributions which are transferred from one qualified plan to another qualified plan are not included in the determination of the annual additions to a participant s account. 26 Comment: Since Code Sec. 414(k) permits defined contribution DROPs to be treated as separate plans for Sec. 415 testing purposes, the DROP payment is not treated as an annual addition. Thus, in the Sally Jones example, the DROP payment would not be treated as an annual addition and the Code Sec. 415(c) limit should be easily met. -7-

8 Comment: Thus, for those employers wanting to add a defined contribution element without sacrificing the defined benefit plan, the DROP hybrid may provide a good solution. New Trend in Public Sector Retiree Medical Benefits Providing adequate medical benefits for retirees at a reasonable cost presents a challenge for many public sector entities. While there are various ways public employers have met this challenge, the retiree health savings plan is increasingly being used to help fund these medical benefits. A retiree health savings plan is a new vehicle which allows employees to accumulate employer contributed assets to pay for medical expenses in retirement on a tax-free basis. The participant may self-direct the funds in his or her retiree health savings account. Contributions. The employer can make two types of contributions to the plan: direct employer contributions and contributions attributable to unused vacation and sick leave. These contributions can be made in any combination, and there is no dollar limit on the amount for either type. Direct employer contributions can be either a flat dollar amount or a percentage of earnings for each participant. The employer can establish a vesting schedule for direct employer contributions. The employer and employee will pay no Social Security and Medicare taxes (collectively FICA ), if applicable, or income tax on the contributed funds, and, if used for medical expenses, no FICA or income tax will be due at distribution. The plan can also provide a way to shelter unused sick and vacation leave. Employees may not choose whether or not contributions attributable to such leave are made to the retiree health savings plan. The employer establishes an unused leave contribution formula. For example, the employer might require all accumulated leave in excess of a certain number of hours to be contributed to the plan on an annual basis. Participants are 100 percent vested in contributions attributable to unused leave. A typical formula for contributing accrued sick leave and/or accrued vacation might be as follows: On January 1 of each year, the employer will convert all excess sick leave hours not used the prior year, up to a maximum of 40 hours, to their cash equivalent by multiplying those hours in excess of 480 by the employee s current hourly rate of pay. An amount equal to the cash equivalent will then be contributed to the employee s individual retiree savings account. Example: Suppose Fred Smith is paid at the hourly rate of $10.00 per hour and as of December 31, 2001, Fred has 500 hours of accumulated sick leave. On January 1, 2002, a contribution of $ will be made to Fred s account. (500 accumulated hours minus 480 hours = 20 x $10.00 = $200.00). Integral part requirements. The Internal Revenue Service ( Service ) has allowed public sector entities to establish tax-exempt trusts which are deemed to be an integral part of the organization. 27 The Service has held that providing employee welfare benefits to retirees is an essential function of a state or local government s activities. As an essential function, the provision of welfare benefits qualifies as an integral part of the government s activities in furtherance of its tax-exempt purpose. Since the provision of welfare benefits is an integral part of -8-

9 government activities, the vehicle used to fund the activity is also considered part of the governmental entity, and enjoys the entity s tax-exempt status. 28 In order for a trust to qualify as an integral part of the employer, the employer must exert substantial control directing the plan and have substantial financial involvement in funding the plan. Substantial control simply means that the employer controls the integral pan entity by holding the power to amend or terminate it and by naming the parties that manage the daily operations of the entity, including the trustees. The trustees can be named solely by the employer, named in conjunction with the employee group(s) covered by the trust, or can be a directed trustee hired by the employer. Substantial financial involvement means that the employer has the primary responsibility for funding the trust. Employer contributions meet this requirement. The Service considers both direct employer contributions and contributions attributable to accumulated unused vacation and sick leave to be employer contributions. 29 Types of benefits. The employer chooses the medical benefits that will be offered to participants. The employer may offer reimbursement for all qualifying medical expenses as defined in Code Sec. 213 (i.e., medical costs that would otherwise be deductible by the employee on his or her individual tax return). Alternatively, the employer may pick and choose the benefits that will be provided. For example, reimbursements may be made available only for health insurance premiums, COBRA premiums, Medicare supplemental insurance premiums, dental insurance premiums, out-of-pocket medical costs, qualified long-term care insurance, etc. The employer may allow reimbursement for only one benefit, or for any combination of qualifying medical costs. 30 The plan may also provide for a death benefit for survivors of deceased employees. The design choices include: (1) the surviving spouse/dependents of the employee continuing to use the account for medical expenses (the account is transferred to the spouse/dependents), or (2) a death benefit payment made to the employee s designated beneficiary(ies). Benefit eligibility. The employer determines the benefit eligibility criteria for participants. For example, the employer might select retirement (as defined in other retirement plans) as the appropriate time for benefit eligibility. Alternatively, a specific age (e.g., 65) could be chosen, or a combination of retirement and a specific age. Tax free medical reimbursements. Benefits paid in the form of medical expense reimbursements are not taxed to the participant, his or her spouse, or dependents. No income tax withholding or reporting is required, and the benefits need not be reported at all by the recipient on his or her income tax return. Other benefits. Death, de minimis, and severance benefits, if provided through the retiree health savings plan are taxable benefits. 31 In these instances, the recipient of the funds (either a beneficiary or the participant) will receive a tax reporting form, and income tax will be payable. In the case of death payments made in the year of death, de minimis payments, and severance payments, FICA and income taxes will be withheld by the employer. -9-

10 Nondiscrimination Requirements. Unlike 401(a) qualified plans, health and welfare plans in the public sector are subject to nondiscrimination testing. These plans are generally covered by nondiscrimination requirements that already apply to health and welfare plans (under Code Sec. 105(h)). 32 Conclusion The public sector is generally much more paternalistic than the private sector in its approach to providing retirement benefits (in part due to the absence of Social Security and Medicare benefits for some of the public sector employees). Recent trends, however, in part to mimic the private sector and to retain workers, have been toward empowering and passing responsibility to the participants through the transfer of the market risk and benefit to the participants through more self-directed investment vehicles. Cindy S. Birley is an attorney practicing at the Denver law firm Davis Graham & Stubbs LLP. Ms. Birley has 17 years of experience in the employee benefits/executive compensation field. Ms. Birley has extensive experience with public sector plans. Ms. Birley graduated, summa cum laude, from the University of Iowa with a B.B.A. in accounting and received her Juris Doctorate from the University of Michigan School of Law and her LL.M. in taxation from the University of Denver. Ms. Birley has also received a certificate as a Certified Public Accountant in the State of Iowa. She is a member of the American Bar Association, the Colorado Bar Association and the Denver Bar Association. She is also a member of the National Association of Public Pension Attorneys. Rebecca L. Hudson is an attorney practicing at the Denver law firm Davis Graham & Stubbs LLP. Ms. Hudson concentrates her practice on qualified pension and nonqualified deferred compensation matters. Ms. Hudson graduated from the University of Michigan with an A.B. in psychology, from the College of William and Mary with a Masters in Education, and received her Juris Doctorate and LL.M. in taxation from the University of Denver. The authors give special thanks to William Krems, Robert Johnson and Richard Merkel for their assistance. ENDNOTES 1 2 Employee Retirement Security Act of 1974, Pub. L. No Sec. 4(b). ERISA and the Code contain three provisions for a governmental plan. First, ERISA Sec. 3(32) defines the term for purposes of the substantive rules contained in Title I of ERISA (participation, funding, vesting, fiduciary responsibility, claims procedures, etc.). If a plan is a governmental plan, then ERISA Sec. 4(b)(1) exempts it from all of the provisions of Title I. Second, ERISA Sec. 4021(b)(2) exempts governmental defined benefit plans from the plan termination insurance program under Title IV. Finally, Code Sec. 414(d) defines the governmental plans that receive special treatment under the Code s rules for qualified retirement plans and Code Sec. 403(b) arrangements. See, e.g., Code Sec. 411(e)(1)(A) (vesting).401(a)(5)(g) (coverage and nondiscrimination). -10-

11 See, e.g., Code Sec. 401(a)(5)(G) (coverage and nondiscrimination). Pick-up contributions are available on a prospective basis only. Code Sec. 414(i). Defined contribution plans include the following: money purchase pension plan, target benefit plans, profit sharing plans, thrift or savings plans, and 401(k) plans. Code Sec. 414(j). The most common types of defined benefit plans are flat benefit plans (the benefit is based solely on a percentage of compensation) and unit benefit plans (the employee s years of service with the employer is multiplied by a percentage of compensation). The plan document will provide a formula that determines the benefit amount earned. Generally, the longer someone works under the same defined benefit plan, the larger the retirement benefit. See Code Sec. 403(b). Allowing participants to buy years of service credit is quite common in the public sector. In purchasing service credit, a participant may be able to receive an unreduced pension at an earlier age. Prior to the new legislation, a plan participant could not make a tax-free transfer of the money he had saved in his 403(b) plan or 457 plan to purchase service credits. Under the new law, a public sector employee will be able to use funds from these retirement savings plans to purchase service credits on a tax-free basis, i.e., through a direct transfer without first having to take a taxable distribution of these amounts. Similar to the purchase of service credit, an employee can use amounts from a 403(b) annuity or 457 plan to repay amounts that were previously refunded due to a forfeiture of service credit (under the employee s current plan or another plan maintained by a government employer within the same state). See Code Sec. 72(t), which imposes an additional 10 percent tax on certain early distributions from Sec. 401(a) qualified plans, Sec. 403(b) plans and IRAs. This catch up rule permits a participant to defer amounts that could have been deferred, but were not, within the 457 plan limits in prior years in which he was eligible to participate and was subject to the hunts. The maximum amount is $15,000. Code Sec. 457(b)(3). Code Sec. 401(k)(4)(B). The Tax Reform Act of 1986 provided that Sec. 401(k)(4)(B) does not apply to cash or deferred arrangements adopted by a governmental entity before May 6, Therefore, if a governmental entity adopted a cash or deferred arrangement prior to that date, then any cash or deferred arrangement adopted by the entity at any time is treated as adopted before that date. See Sec (f)(2)(B)(i) of the Tax Reform Act of 1986 (Pub. L. No ). See Code Sec. 402(8). The Economic Growth and Tax Relief Reconciliation Act of 2001 increases the Sec. 402(8) annual maximum deferral limit to $11,000 in 2002, $12,000 in 2003, $13,000 in 2004, $14,000 in 2005, and $15,000 in Thereafter, the limit is indexed in $500 increments. As noted above, the Economic Growth and Tax Relief Reconciliation Act of 2001 increases the deferral limit for 457 plans from the current limit of $8,500, to $15,000 over five years (beginning in 2002), and indexes the limit for inflation after Although there are variations of the definition, final average compensation is typically defined as average compensation over the final three years of employment. This is analogous to the treatment of a cash balance plan, many of which have been qualified as defined benefit pension plans. A cash balance plan often credits earnings to accounts based on Treasury Bill rates, which are variable. Once the Treasury Bill rate method has been selected, the returns are fixed by the external benchmark. A typical use of a Sec. 414(k) arrangement is to add a separate account feature to an existing over-funded defined benefit plan in order to replace an existing defined contribution plan. The idea is to use the surplus pension plan assets to fund the separate account benefit, thereby reducing the current cash flow cost of providing the defined contribution benefit. Although it seems likely, it is not entirely clear whether Code Sec. 414(k) will govern the treatment of the DROP feature. In Guilzon v. Commissioner, 985 F.2d 819 (5th Cir. 1993), the court stated that a plan was not necessarily -11-

12 required to allocate actual gains and losses for Code Sec. 414(k) treatment. Concluding that an account can qualify as separate without having earnings and losses allocated to it, the court held that the separate account requirement of Sec. 414(k) was satisfied. Id. at 823. In contrast, in Montgomery v. U.S., 18 F.3d 500 (7th Cir. 1994), the court stated that the investment-performance feature of defined contribution plans is essential to designation as a defined contribution component of a plan under Code Sec. 414(k). Without an investmentperformance feature, there is no defined contribution plan. The court thus held that without a defined contribution plan component, there is no hybrid plan. Id. at 502. This amount is increased to $160,000 in 2002, and thereafter is indexed in $5,000 increments. This amount is increased to $40,000 in 2002, and thereafter is indexed in $1,000 increments. As noted above, for plan years beginning after December 31, 2001, the percentage of compensation limit has been increased to 100 percent of compensation for defined contribution plans. Note that when testing a defined benefit plan for compliance with the Sec. 415(b) limits, a participant s benefits under all his employer s defined benefit plans are added together. Similarly, when testing contributions to a participant s account in a defined contribution plan for compliance with the Sec. 415(c) limits, contributions for the participant to all his employer s defined contribution plans are added together. See Rev. Rul , C.B. 197 (Jan. 1, 1979). Of course, if Sec. 414(k) does not apply to the DROP the Sec. 415(b) limits remain. In other words, the amount of the annuity that would be paid to the participant from the DROP, were his DROP account to be converted to an annuity for his life, could not exceed the Code Sec. 415(b) limit adjusted for age ($140,000 in 2001) in any year. Treas. Reg. Secs (b)(2)(iv), (b)(3)(iv). See, e.g., PLR (Dec. 28, 1999). In Treasury Regulation Sec, (a)(3), the Service recognized that an entity formed under local law is not recognized as a separate entity for federal tax purposes if it is both wholly owned by a state or local government and is an integral plan of the state or local government. PLR Information about what constitutes a qualifying medical expense can be found in IRS Publication 502, Medical and Dental Expenses (available on the IRS Web site at A cash-out payment is a de minimis payment. For example, if the account balance is less then $5,000, it will typically be paid out to the participant in a lump-sum. Generally speaking, this means that coverage must be extended to: (1) at least 70 percent of all employees, or 80 percent or more of all employees who are eligible to benefit under the plan if 70 percent or more of all employees are eligible to benefit or (2) an employee classification which does not discriminate in favor of highly compensated individuals. Also, benefits must be provided on a substantially equal basis to all covered employees. -12-