The "Taxpayer Relief Act of 1997" Brings More Changes to Qualified Plans and IRAs

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1 Imprtant Infrmatin Plan Administratin and Operatin August 1997* The "Taxpayer Relief Act f 1997" Brings Mre Changes t Qualified Plans and IRAs WHO'S AFFECTED The new law affects spnsrs f qualified defined benefit and defined cntributin plans, including gvernmental plans and church plans, as well as spnsrs f taxsheltered annuity plans and hlders f individual retirement accunts and annuities. BACKGROUND AND SUMMARY On August 5, 1997, President Clintn signed int law the Taxpayer Relief Act f 1997 (TRA'97). This new law includes bth revenue-raising prvisins and pensin simplificatin prvisins, including clarificatin f several prvisins that were just enacted last year in the Small Business Jb Prtectin Act f 1996 (SBJPA). Majr changes include an increase in the first level tax n prhibited transactins, increases t the current liability full funding limit fr defined benefit plans, an increase t the "small benefits" cashut threshld, and the eliminatin f the requirement t file cpies f emplyee bklets with the Department f Labr. In additin, special prvisins are aimed at plans spnsred by state and lcal gvernments, church plans and emplyee stck wnership plans (ESOPs). TRA'97 als makes majr changes t the availability f deductible individual retirement arrangements (IRAs) and creates tw new types f nndeductible IRAs: the Rth IRA and the Educatin IRA. ACTION AND NEXT STEPS Mst prvisins in TRA'97 are effective fr years beginning after December 31, Qualified plans and tax-sheltered annuity plans d nt have t be amended t reflect these changes until the 1999 plan year. Plans spnsred by state and lcal gvernments d nt have t be amended until the 2001 plan year. IN THIS ISSUE "Pensin" Simplificatin Revenue Raising Prvisins Additinal Changes State and Lcal Gvernment Plans Church Plans Emplyee Stck Ownership Plans (ESOPs) Individual Retirement Arrangements (IRAs) Effective Dates Summary f Qualified Plan Prvisins Effective Dates Summary f IRA Prvisins *Republished December 2004 t reflect Prudential Financial's acquisitin f CIGNA's retirement business. 2004, The Prudential Insurance Cmpany f America, all rights reserved.

2 The "Taxpayer Relief Act f 1997" Brings Mre Changes t Qualified Plans and IRAs The qualified plan changes made by the Taxpayer Relief Act f 1997 (TRA'97) may generally be classified as pensin simplificatin items, revenue-raising prvisins, and miscellaneus changes affecting gvernmental plans, church plans, and emplyee stck wnership plans (ESOPs). In additin, TRA'97 greatly increases the attractiveness f individual retirement arrangements (IRAs) and creates tw new types f nndeductible IRAs. "Pensin" Simplificatin Partners May Receive True Matching Cntributins Matching cntributins made t partners will n lnger be treated as 401(k) elective cntributins, subject t the annual limit n deferrals, the actual deferral percentage (ADP) test, and special rules n the vesting and distributin f 401(k) deferral cntributins. Instead, they are treated like matching cntributins made t any ther emplyee and are subject t the actual cntributin percentage (ACP) test. This prvisin is generally effective fr plan years beginning after December 31, Hwever, it applies t SIMPLE Plans fr plan years beginning after December 31, Rllver Cntributins Will Nt Disqualify a Plan TRA'97 requires the IRS t prvide clarificatin that a plan making a direct rllver distributin des nt have t have a determinatin letter in rder fr the receiving plan administratr t reasnably cnclude that the cntributin is a valid rllver. Eliminatin f Filing Requirements Effective August 5, 1997, plan spnsrs n lnger have t file summary plan descriptins (SPDs, als called emplyee bklets) and summaries f material mdificatins (SMMs) autmatically with the Department f Labr (DOL). While they must still be supplied t plan participants and beneficiaries within specific time perids, plan spnsrs nw nly have t prvide cpies t the DOL upn request. A maximum civil penalty f $1,000 per request may be impsed fr failure t supply these dcuments upn request frm the DOL. Tax Sheltered Annuity Plan Limit Revised TRA'97 makes tw changes t the cntributin limits that apply t tax-sheltered annuity plans. Effective fr years beginning after December 31, 1997, the includible cmpensatin n which a participant's maximum exclusin allwance is based will be a participant's grss cmpensatin. That is, it will be cmpensatin including elective deferral cntributins made t 401(k) plans, tax-sheltered annuity plans and cafeteria plans. TRA'97 als directs the IRS t issue regulatins revising the exclusin allwance rules t reflect the eliminatin f the standard cmbined plan benefit limit effective fr limitatin years beginning after December 31, Paperless Plan Administratin TRA'97 instructs bth the DOL and the IRS t prvide plan spnsrs with guidance fr prviding required ntices and btaining required cnsents using new technlgy. This guidance is t be designed t: 2004, The Prudential Insurance Cmpany f America, all rights reserved. Page 2

3 Interpret the ntice, electin, cnsent, disclsure and time requirements, and related recrdkeeping requirements, as applied t the use f new technlgies while cntinuing t prtect the rights f participants and beneficiaries; and Clarify the extent t which writing requirements under the Internal Revenue Cde may permit paperless transactins. This deadline fr prviding this guidance is December 31, Nndeductible Plan Cntributins Effective fr tax years beginning after December 31, 1997, cntributins made t defined cntributin plans that are nt deductible because they exceed the cmbined plan deductin limit are nt subject t the 10% excise tax n nndeductible cntributins t the extent they d nt exceed the amunt f the emplyees' 401(k) elective deferral cntributins plus the emplyer's matching cntributins. Offset f Plan Benefits TRA'97 creates an imprtant new exceptin t ERISA's nnassignment and anti-alienatin rule. This new exceptin permits a qualified plan t reduce a participant's plan benefits in the event: The participant is cnvicted f cmmitting a crime invlving the plan; A curt enters a civil judgement (r cnsent rder r decree) against the participant with respect t a vilatin f the ERISA's fiduciary requirements; r A settlement agreement is reached between the Secretary f Labr r the Pensin Benefit Guaranty Crpratin and the participant in cnnectin with a vilatin f ERISA's fiduciary rules. The rder establishing the participant's liability must require the ffset f the plan's benefit t ffset the liability and the participant's spuse must cnsent t the ffset unless she is als a party t the judgement, unless the settlement prvides a 50% survivr annuity t the spuse. This new rule is effective fr judgements, rders and decrees issued and settlement agreements entered int n r after August 5, Plan Amendment Adptin Deadline In general, TRA'97 plan r cntract amendments are nt required until the first day f the first plan year beginning after December 31, Amendments t state and lcal gvernment plans are nt required until the first day f the first plan year beginning after December 31, If a plan amendment is made befre the amendment due date and prir t that amendment, the plan is perated in accrdance with the terms f that amendment, the plan will nt vilate the anticutback rules as the result f applying that amendment. Revenue-Raising Prvisins "Small Benefits" Cashut Threshld Increased The threshld fr making plan distributins withut needing participant r, if applicable, spusal cnsent has been raised frm $3,500 t $5,000, effective fr plan years beginning 2004, The Prudential Insurance Cmpany f America, all rights reserved. Page 3

4 after August 5, Like the ld threshld amunt, the new amunt is nt indexed fr inflatin. "Success Taxes" Eliminated TRA'97 has repealed the "success taxes." The success taxes are tw excise taxes impsed n taxpayers wh the gvernment feels are t successful in saving fr retirement. SBJPA suspended the applicatin f the 15% excise tax n "excess distributins" (fr 1997: annual distributins exceeding $160,000 r single sum distributins exceeding $800,000) frm qualified plans, tax sheltered annuity plans and IRAs fr distributins received in 1997, 1998 and TRA'97 has eliminated this tax altgether fr distributins received after December 31, In additin, TRA'97 has eliminated the 15% estate tax n excess retirement accumulatins. This tax applied t the balance in any retirement plan that exceeded the present value f a benefit that wuld nt have been subject t the 15% excise tax n excess distributins. This tax repeal applies t participants dying after December 31, Tax n Prhibited Transactins Increased Effective fr prhibited transactin ccurring after August 5, 1997, the first level tax n prhibited transactins is increased frm 10% t 15%. The secnd level tax, which applies if the transactin is nt crrected within a specified time perid, remains at 100% f the transactin amunt. Basis Recvery Rules Mdified Again SBJPA revised the methd fr determining the amunt f an annuity that was nt subject t an incme tax because it represented a return f the individual's investment in the annuity ("basis"). TRA'97 further mdifies these basis recvery rules by prviding a new table t be used t determine the basis recvery fr benefits based n the life f mre than ne annuitant. This new table must be used fr benefits that first becme payable after December 31, Additinal Changes Full Funding Limit is Increased The full funding limit fr a defined benefit plan is the lesser f the plan's accrued liability r 150% f its current liability. Fr plan years beginning after December 31, 1998, the 150% full funding limit is increased as fllws: Plan Year Beginning Limit 1999 and % 2001 and % 2003 and % 2005 and later 170% 2004, The Prudential Insurance Cmpany f America, all rights reserved. Page 4

5 Amunts that cannt be cntributed due t the current liability full funding limit must be amrtized ver 20 years. Hwever, any amrtizatin base remaining at the end f the 1998 plan year must be amrtized ver a perid equal t 20 years less the number f years since the base was established. New Limits Applied t 401(k) Plan Investments Fr plan years beginning after December 31, 1998, an emplyer stck investment limit applies t 401(k) plans that require elective deferrals equal t mre than 1% f an emplyee's cmpensatin t be invested in emplyer stck r emplyer real prperty. In these situatins, the ttal amunt f 401(k) elective deferrals that can be invested in emplyer stck is limited t 10% f the plan's ttal assets. Hwever, this limit des nt apply: If the value f the assets f all f the emplyer's prfit sharing and stck bnus plans des nt exceed 10% f the values f the assets f all the emplyer's pensin plans. T emplyee stck wnership plans (ESOPs). This new limit applies t elective deferrals fr plan years beginning after December 31, 1998 and earnings n thse deferrals. Hwever, pre-1999 earnings n deferrals are nt cunted tward the limit. State and Lcal Gvernment Plans 401(k) Plans Available t Certain Entities SBJPA made 401(k) plans available again t tax-exempt rganizatins. Hwever, state and lcal gvernments were still prhibited frm ffering 401(k) plans, unless they had been in existence befre May 6, Effective fr years beginning after December 31, 1997, TRA'97 permits mutual irrigatin r ditch cmpanies and state r municipal water districts t maintain 401(k) plans, even if the cmpany r district is cnsidered t be a state r lcal gvernment rganizatin. Nndiscriminatin Rules D Nt Apply Since the enactment f the Tax Refrm Act f 1986 (TRA'86), the IRS has cntinued t delay the effective date fr applying new and revised nndiscriminatin rules t plans spnsred by state and lcal gvernments. Effective fr plan years beginning n r after August 5, 1997, state and lcal gvernment plans are exempt by law frm the fllwing nndiscriminatin and minimum participatin rules: The minimum participatin requirement, applicable nly t defined benefit plans since the enactment f SBJPA. The minimum cverage requirement. The requirement that a qualified plan nt prvide benefits r cntributins in amunts that discriminate in favr f highly cmpensated emplyees (the "nndiscriminatin in amunts" requirement). The requirement that a plan's benefits, rights and features be available n a nndiscriminatry basis. The actual deferral percentage (ADP) test applicable t 401(k) plans. 2004, The Prudential Insurance Cmpany f America, all rights reserved. Page 5

6 The actual cntributin percentage (ACP) test applicable t plans that cntain psttax emplyee cntributins r emplyer matching cntributins. The nndiscriminatin rules applicable t tax-sheltered annuity plans. Special Limits Apply t Additinal Purchased Service Credits Many defined benefit plans spnsred by state r lcal gvernments let participants purchase additinal service credits. Under TRA'97, these purchases may be cunted tward either the defined cntributin annual additins limit fr the year f purchase r as part f the participant's verall accrued benefit subject t the defined benefit plan limit n accruals. During any year, ne participant may have his additinal service credits applied tward the defined benefit plan limit, while anther participant has his credits applied tward the annual additins limit. These special rules d nt apply t: The repayment upn rehire f distributins received at the time f an earlier terminatin f emplyment. Make up cntributins made under the veterans reemplyment rights law. "Pick up" cntributins. These rules apply t cntributins made after December 31, 1997 t purchase additinal service credits. A special transitin rule applies t plans that permitted such purchases befre January 1, Defined Benefit Dllar Limit Des Nt Apply t Plice and Firefighters In general, defined benefit plan benefits are limited t the lesser f 100% f the participant's average cmpensatin r (fr 1997) $125,000. The cmpensatin limit des nt apply t gvernmental plans. Effective fr years beginning after December 31, 1996, the dllar limit is nt reduced fr plice r fire department emplyees wh take early retirement. Hwever, it is increased when benefits begin after age 65. Church Plans Cntributins fr Self-Emplyed Ministers Effective fr years beginning after December 31, 1997, cntributins made t church plans fr self-emplyed ministers are nt included in the ministers' incme if thse cntributins wuld have been tax-exempt if the minister had been a church emplyee. Ministers Excluded frm Nndiscriminatin Testing Effective fr years beginning after December 31, 1997, a minister wh is emplyed by an rganizatin ther than a church, which des nt participate in the church plan being tested, des nt have t be cunted as a church emplyee fr purpses f nndiscriminatin testing. Emplyee Stck Ownership Plans (ESOPs) ESOPs f S Crpratins May Distribute Cash Effective fr tax years beginning after December 31, 1997, ESOPs spnsred by S crpratins may distribute cash t plan participants as lng as the emplyees have a right 2004, The Prudential Insurance Cmpany f America, all rights reserved. Page 6

7 t require the emplyer t purchase emplyer securities and will nt vilate ERISA's prhibited transactin rules in ding s. Unrelated Business Incme Tax Des Nt Apply t S Crpratin ESOPs Effective fr tax years beginning after December 31, 1997, S crpratin incme r lss items will nt flw thrugh t ESOPs spnsred by thse crpratins. Therefre these ESOPs will nt be subject t unrelated business incme tax (UBIT) n thse items. Individual Retirement Arrangements (IRAs) Increased Eligibility fr Deductible IRAs Effective fr tax years beginning after December 31, 1997, an individual will nt be cnsidered t be an active participant in an emplyer-spnsred retirement plan merely because his r her spuse is such an active participant. This new prvisin will make deductible IRAs available t mre individuals. In additin, the phaseut incme range fr deductible IRAs is raised. The $2,000 deductin limit will nw be phased ut as fllws: Single Taxpayers Tax Year AGI Phase-Out Range 1998 $30,000 $40, $31,000 $41, $32,000 $42, $33,000 $43, $34,000 $44, $40,000 $50, $45,000 $55, and later $50,000 $60, , The Prudential Insurance Cmpany f America, all rights reserved. Page 7

8 Jint Returns Tax Year AGI Phase-Out Range 1998 $50,000 $60, $51,000 $61, $52,000 $62, $53,000 $63, $54,000 $64, $60,000 $70, $65,000 $75, $70,000 $80, $75,000 $85, and later $80,000 $100,000 The Rth IRA Effective fr tax years beginning after December 31, 1997, individuals may make annual nndeductible cntributins f as much as $2,000 t new Rth IRAs. Hwever, the $2,000 limit is phased ut fr individual taxpayers with AGI between $95,000 and $110,000 and married taxpayers filing jintly with AGI between $150,000 and $160,000. Distributins frm Rth IRAs are nt taxable if they are made at least five years after the first cntributin was made t a Rth IRA and On r after the IRA hlder reaches age 59½; T a beneficiary after the death f the IRA hlder; T the IRA hlder n accunt f his disability; r Fr first-time hme buyer expenses. In additin, Rth IRAs are nt subject t the minimum required distributin rules r incidental death benefit rules applicable t ther IRAs. In fact, taxpayers wh have reached age 70½ may cntinue t cntribute t Rth IRAs. Taxpayers with AGI f less than $100,000 may rllver r cnvert an existing IRA t a Rth IRA befre January 1, 1999, subject t certain rules fr including the transferred amunts in incme. In additin, ld-style nndeductible IRAs are still available. Hwever, the maximum amunt any individual can cntribute t all his IRAs (deductible and nndeductible) in ne tax year is $2, , The Prudential Insurance Cmpany f America, all rights reserved. Page 8

9 Additinal Exceptin t 10% Excise Tax n IRA Distributins Effective fr tax years beginning after December 31, 1997, the 10% additinal tax n early distributins will nt apply t amunts withdrawn frm any IRA (deductible, nndeductible and Rth IRAs) t pay first-time hme buyer expenses. Penalty-Free IRA Distributins t Pay Educatinal Expenses After December 31, 1997, an individual may take penalty-free distributins frm all types f IRAs t pay higher educatin expenses fr himself, his spuse, r either ne's child r grandchild fr academic perids beginning after December 31, Qualifying expenses include tuitin, fees, bks, supplies, required equipment, rm and bard and graduate expenses. The amunt f these expenses that may be paid with IRA distributins is reduced by tax-free schlarships and ther tax-free assistance that the student receives. The Educatin IRA In additin t taking penalty-free distributins frm regular IRAs t pay educatinal expenses, beginning January 1, 1998, taxpayers may establish Educatin IRAs fr each child under age 18. Annual nndeductible cntributins f as much as $500 may be made fr each eligible child. Like the Rth IRA cntributin limit, this $500 limit is phased ut fr individual taxpayers with AGI between $95,000 and $110,000 and fr married taxpayers filing jint returns with AGI between $150,000 and $160,000. Distributins frm these accunts are tax free if they d nt exceed the amunts spent n the fllwing qualified educatin expenses: pst-secndary tuitin, fees, bks, supplies, equipment and basic rm and bard expenses. Any amunts remaining in the IRA after all qualifying expenses have been paid must be distributed when the beneficiary reaches age 30. At that time, the earnings will be subject t tax and penalty. Hwever, befre the beneficiary reaches age 30, the remaining balance may be rlled ver r transferred tax-free t anther Educatin IRA fr a family member f the beneficiary. IRA Investments Effective fr tax years beginning after December 31, 1997, IRA assets may be invested in certain platinum cins and gld, silver, platinum r palladium bullin. Effective Dates Summary f Qualified Plan Prvisins Of the "Taxpayer Relief Act f 1997" Changes Effective in 1997 Partners May Receive True Matching Cntributins in SIMPLE Plans Eliminatin f SPD and SMM Filing Requirements Plan Benefits May Be Offset t Repay Amunts Owed t the Plan Threshld fr "Small Benefits" Cashuts Increased 15% Excise Tax n Excess Distributins Repealed 15% Estate Tax n Excess Retirement Accumulatins Repealed 2004, The Prudential Insurance Cmpany f America, all rights reserved. Page 9

10 First Level Tax n Prhibited Transactins Increased t 15% Nndiscriminatin Rules D Nt Apply t State and Lcal Gvernment Plans Defined Benefit Dllar Limit is Nt Reduced fr Early Retirement f Plice r Firefighters Changes Effective in 1998 Partners May Receive True Matching Cntributins in Nn-SIMPLE Plans DOL and IRS t Prvide Guidance n Paperless Plan Administratin DC Plan Cntributin Deductin Limit Revised Basis Recvery Rules Mdified 401(k) Plans Available t Certain Gvernmental Entities Special Limits Apply t Additinal Service Credits Purchased by Participants in Gvernmental Plans Cntributins May Be Made t Church Plans fr Self-Emplyed Ministers Certain Ministers are Excluded frm Church Plan Nndiscriminatin Testing ESOPs f S Crpratins May Distribute Cash Unrelated Business Incme Tax Des Nt Apply t S Crpratin ESOPs Changes Effective in 1999 TRA'97 Plan Amendments Must Be Made t Nn-Gvernmental Plans Defined Benefit Plan Full Funding Limit is Increased 401(k) Plan Investments in Emplyer Stck Limited t 10% f Plan Assets Changes Effective in 2000 Tax-Sheltered Annuity Plan Limit Aligned With General Plan Limits Changes Effective in 2001 TRA'97 Plan Amendments Must Be Made t State and Lcal Gvernment Plans Effective Dates Summary f IRA Prvisins f the "Taxpayer Relief Act f 1997" Changes Effective in 1998 Active Participant Definitin Changed fr Purpses f Establishing a Deductible IRA Phase-Out Incme Ranges fr Deductible IRAs Increased Nndeductible Rth IRAs Available IRA Withdrawals t Pay First-Time Hme Buyer Expense Nt Subject t 10% Early Distributin Excise Tax 2004, The Prudential Insurance Cmpany f America, all rights reserved. Page 10

11 IRAs May Make Penalty-Free Distributins t Pay Educatinal Expenses Nndeductible Educatin IRAs Available IRA Assets May Be Invested in Certain Cins and Bullin Pensin Analyst by Prudential Retirement The Pensin Analyst is published by Prudential Retirement, a Prudential Financial business, t prvide clients with up-t-date infrmatin n current legislatin and regulatry develpments affecting qualified retirement plans. This publicatin is distributed with the understanding that Prudential Retirement is nt rendering legal advice. Plan spnsrs shuld cnsult their attrneys abut the applicatin f any law t their retirement plans. Prudential Financial is a service mark f The Prudential Insurance Cmpany f America, Newark, NJ and its affiliates. Editr: Mitzi Rman (860) , The Prudential Insurance Cmpany f America, all rights reserved. Page 11