Retirement Plan Savings Provisions, from Treasury Department's General Explanation of the Administration's 2004 Budget Proposal

---

Excerpted from the 2004 "blue book," at https://benefitslink.com/articles/2003_budget_bluebook.pdf (156 pages)

EXPAND TAX-FREE SAVINGS OPPORTUNITIES

Current Law

Individual Retirement Accounts (IRAs), including traditional, Roth, and nondeductible IRAs, are primarily intended to encourage retirement saving, but can also be used for certain education, medical, and other non-retirement expenses. Each of the three types of IRAs is subject to a different set of rules regulating eligibility and tax treatment.

Under current law, individuals under age 70-1/2 may make contributions to a traditional IRA, subject to certain limits. The contributions are generally deductible; however, the deduction is phased out for workers with incomes above certain levels who are covered by an employer-sponsored retirement plan. For taxpayers covered by employer-plans in 2003, the deduction is phased out for single and head-of-household filers with modified-AGI /23/ between $40,000 and $50,000 (increasing in stages to $50,000 to $60,000 in 2005), for married filing jointly filers with modified-AGI between $60,000 and $70,000 (increasing in stages to $80,000 to $100,000 in 2007), and for married filing separately filers with modified-AGI between $0 and $10,000. For a married, filing jointly taxpayer who is not covered, but whose spouse is covered by an employer-sponsored retirement plan, the deduction is phased out with modified-AGI between $150,000 and $160,000. Account earnings are not includible in gross income until distributed. Distributions (including both contributions and account earnings) are includible in gross income.

/23/ AGI plus income from education savings bonds, interest paid on education loans, employer-provided adoption assistance benefits, IRA deductions, deductions for qualified higher education expenses, and certain other adjustments.

To the extent a taxpayer cannot or does not make deductible contributions to a traditional IRA, a taxpayer under age 70-1/2 may make nondeductible contributions. In this case, distributions representing a return of basis are not includible in gross income, while distributions representing account earnings are includible in gross income. There is no income limit for nondeductible contributions to a traditional IRA.

Individuals of any age may make contributions to a Roth IRA. Allowable contributions are phased out for workers with incomes above certain levels. Contributions are phased out for single or head-of-household filers with modified-AGI between $95,000 and $110,000, for married filing jointly filers with modified-AGI between $150,000 and $160,000, and for married filing-separate filers with modified-AGI between $0 and $10,000. Account earnings accumulate tax free, and qualified distributions (including account earnings) are not included in gross income for income tax purposes. Nonqualified Roth IRA distributions are included in income (to the extent they exceed basis) and subject to an additional tax. Distributions are deemed to come from basis first.

The annual aggregate limit on contributions to all of a taxpayer's IRAs (traditional, nondeductible, and Roth) is the lesser of compensation or $3,000 for 2003 and 2004 ($3,500 for individuals age 50 and over). The contribution limit is scheduled to increase in stages to $5,000 ($6,000 for individuals age 50 and over) in 2008.

Taxpayers with AGI of $100,000 or less and who are not married filing separately can convert a traditional IRA to a Roth IRA. In general, the conversion amount is included in gross income (but not for the purposes of the $100,000 limit).

Early distributions from IRAs are generally subject to an additional 10 percent tax. The tax is imposed on the portion of an early distribution that is includible in gross income. It applies in addition to ordinary income taxes on the distribution. The additional tax does not apply to a rollover to an employer plan or IRA, or if the distribution is made in the cases of death or disability, certain medical expenses, first-time homebuyer expenses, qualified higher-education expenses, health-insurance expenses of unemployed individuals, or as part of a series of substantially equal periodic payments.

Minimum distribution rules require that, beginning at age 70-1/2, the entire amount of a traditional IRA be distributed over the expected life of the individual (or the joint lives of the individual and a designated beneficiary). Roth IRAs are not subject to minimum distribution rules during the account owner's lifetime.

Reasons for Change

The three types of IRAs, each subject to different rules regarding eligibility, contributions, tax treatment, and withdrawal, create complexity in the Code. Taxpayers must determine their eligibility for each account and then must decide which plan is best given their circumstances. Furthermore, as their circumstances change over time, taxpayers must continually re-evaluate their eligibility for each plan and determine which plan best meets their needs. Currently, penalty-free withdrawals are allowed for a long list of qualified expenses not related to retirement, and this list has grown over time. The current list of non-retirement exceptions within IRAs weakens the focus on retirement saving, and places a burden on taxpayers to document that withdrawals are used for certain purposes that Congress has deemed qualified. In addition, the restrictions on withdrawals and additional tax on early distributions discourage many taxpayers from making contributions because they are concerned about the inability to access the funds should they need them. Replacing current law IRAs with two new accounts that taxpayers could use over their entire lifetime would simplify the decision-making process while further encouraging savings.

Proposal

The proposal would replace IRAs with Lifetime Savings Accounts (LSAs) that could be used for any type of saving, and a Retirement Savings Accounts (RSAs) that could be used for retirement saving.

Individuals could contribute up to $7,500 per year to their Lifetime Savings Accounts (LSAs), regardless of wage income. No income limits would apply to LSA contributions. Contributions would have to be in cash. Contributions would be nondeductible, but earnings would accumulate tax-free, and all distributions would be excluded from gross income, regardless of the individual's age or use of the distribution. As with current law Roth IRAs, no minimum required distribution rules would apply to LSAs during the account owner's lifetime.

Contribution limits would apply to all accounts held in an individual's name, rather than to contributors. Thus, contributors could make annual contributions of up to $7,500 each to the accounts of other individuals, but the aggregate of all contributions to all accounts held in a given individual's name could not exceed $7,500. Accounts held in a minor's name would become the property of the named individual when the individual attained age 18. Individuals could roll amounts from LSAs over to a member of the individual's family, as defined in section 529(e)(2), subject to the normal gift tax rules. The LSA contribution limit would be indexed for inflation.

Individuals could contribute up to $7,500 per year (or compensation includible in gross income, if less) to their Retirement Savings Account (RSA). As under current law IRA, for an individual who is married filing a joint return, the compensation limitation will only be binding if the combined includible compensation of the spouses is less than $15,000. No income limits would apply to RSA contributions. Contributions would have to be in cash. Contributions would be nondeductible, but earnings would accumulate tax-free, and qualified distributions would be excluded from gross income. The RSA contribution limit would be indexed for inflation.

Qualified distributions from the retirement account would be distributions made after age 58 or in the event of death or disability. Any other distribution would be a nonqualified distribution and, as with current non-qualified distributions from Roth IRAs, would be includible in income (to the extent it exceeds basis) and subject to an additional tax. Distributions would be deemed to come from basis first. As with current law Roth IRAs, no minimum required distribution rules would apply to RSAs during the account owner's lifetime.

Taxpayers would be able to convert balances in Archer Medical Savings Accounts (MSAs), Coverdell Education Savings Accounts (ESAs), and Qualified State Tuition Plans (QSTPs) to LSA balances. Because contributions to ESAs and QSTPs are made after-tax, conversions of these accounts would not be included in income. Because contributions to MSAs are not taxed, conversions of MSAs would be included in income. All conversions must be made before January 1, 2004, and contributions to MSAs, ESAs, and QSTPs made after enactment would not be eligible for conversion.

Existing Roth IRAs would be renamed RSAs and be made subject to the new rules for RSAs. Existing traditional and nondeductible IRAs could be converted into an RSA by taking the conversion amount into gross income, similar to a current-law Roth conversion. However, no income limit would apply to the ability to convert. Taxpayers who convert IRAs to RSAs before January 1, 2004 could include the conversion amount in income ratably over 4 years. Conversions made on or after January 1, 2004 would be included in income in the year of the conversion. Existing traditional or nondeductible IRAs that are not converted to RSAs could not accept any new contributions. New traditional IRAs could be created to accommodate rollovers from employer plans, but they could not accept any new individual contributions. Individuals wishing to roll an amount directly from an employer plan to an RSA could do so by taking the rollover amount (excluding basis) into gross income (i.e., "converting" the rollover, similar to a current law Roth conversion).

Both LSAs and RSAs would become effective in 2003.

Revenue Estimate

($ in millions)

Fiscal Years
2003	2004	2005	2006	2007	2008	2004-2008	2004-2013
1,390	10,572	4,803	1,915	-648	-1,822	14,820	2,002

CONSOLIDATE EMPLOYER-BASED SAVINGS ACCOUNTS

Current Law

Qualified Retirement Plans: Under Code section 401, employers may establish for the benefit of employees a retirement plan that may qualify for tax benefits, including a tax deduction to the employer for contributions, a tax deferral to the employee for elective contributions and their earnings, and a tax exemption for the fund established to pay benefits. To qualify for tax benefits, the plan must satisfy multiple requirements. Among the requirements, the plan may not discriminate in favor of highly compensated employees (HCEs) with regard either to coverage or to amount or availability of contributions or benefits. The following cover some, but not all, of the defined-contribution plan rules.

Minimum Coverage Requirement. Qualified plans must satisfy one of the following tests: either the proportion of non-highly compensated employees (NHCEs) covered by the plan is not less than 70 percent of the proportion of highly compensated employees (HCEs) covered by the plan, or the plan covers a proportion of NHCEs found by the Secretary not to be discriminatory and the average benefit percentage of NHCEs is at least 70 percent of the average benefit percentage of HCEs (the "average benefit percentage" test). /24/

/24/ For the purposes of the latter test, the average benefit percentage is defined as all employer benefits or contributions divided by compensation. Technically, there is a third test, that at least 70 percent of NHCEs must be covered by the plan. However, this general 70 percent test is redundant in the sense that satisfying this test is sufficient (though not necessary) for satisfying the first test listed above.

Contribution Limits. The total annual contribution to a participant's account may not exceed the lesser of $40,000 or 100 percent of compensation.

General Nondiscrimination Requirement. Qualified plans, both defined-benefit and defined-contribution, must comply with the Section 401(a)(4) prohibition on contributions or benefits that discriminate in favor of HCEs. Detailed regulations spell out the calculations required for satisfying this provision, including optional safe harbors and a general test for nondiscrimination.

Contribution Tests. In addition to the general nondiscrimination requirement, defined-contribution plans that have after-tax contributions or matching contributions are subject to the actual contribution percentage (ACP) test. This test measures the contribution rate to HCEs' accounts relative to the contribution rate to NHCEs' accounts. To satisfy the test, the ACP of HCEs generally cannot exceed the following limits: 200 percent of the NHCEs' ACP if the NHCEs' ACP is 2% or less; two percentage points over the NHCEs' ACP if the NHCEs' ACP is between 2% and 8%; or 125% of the NHCEs' ACP if the NHCEs' ACP is 8% or more.

Three "safe-harbor" designs are deemed to satisfy the ACP test automatically for employer matching contributions (up to 6 percent of compensation) that do not increase with an employee's rate of contributions or elective deferrals. In the first, vested employer matching contributions on behalf of NHCEs are equal to 100 percent of elective deferrals up to 3 percent of compensation, and 50 percent of elective deferrals between 3 and 5 percent of compensation. In the second, vested employer matching contributions follow an alternative matching formula such that the aggregate amount of matching contributions is no less than it would be under the first design. In the third, vested employer non-elective contributions are at least 3 percent of compensation made on behalf of all eligible NHCEs.

Vesting. In general, employer contributions must vest at least as quickly as under one of the following schedules. Under graded vesting, twenty percent is vested after three years of service and an additional twenty percent vests with each additional year of service, so that the employee is fully vested after seven years of service. Under cliff vesting, the employee has no vested interest until five years of service has been completed, but is then fully vested. However, matching contributions must vest more quickly: under graded vesting, the first twenty percent must vest after two years of service, so that the employee is fully vested after six years of service, and under cliff vesting, the employee becomes fully vested after three years of service.

401(k) plans. Private employers may establish 401(k) plans, which allow participants to choose to take compensation in the form of cash or a contribution to a defined-contribution plan ("elective deferral"). Section 403(b) and 457 plans are similar "cash-or-deferred arrangements" that are not qualified plans and are subject to separate rules (see below). In addition to the rules applying to qualified defined-contribution plans, 401(k) plans are subject to additional requirements.

Annual deferrals under a 401(k) plan may not exceed $12,000 in 2003 (increasing to $15,000 by 2006). Participants aged 50 or over may make additional "catch-up" deferrals of up to $2,000 (increasing to $5,000 by 2006). Elective deferrals are immediately fully vested.

401(k) plans are subject to an actual deferral percentage (ADP) test, which generally measures employees' elective-deferral rates. In applying the ADP test, the same numerical limits are used as under the ACP test. Three 401(k)-plan "safe-harbor" designs (similar to the safe-harbor designs for the ACP test described above) are deemed to satisfy the ADP test automatically.

SIMPLE 401(k) plans. Employers with 100 or fewer employees and no other retirement plan may establish SIMPLE 401(k) plans. Deferrals of SIMPLE participants may not exceed $8,000 in 2003 (increasing to $10,000 by 2005). SIMPLE participants aged 50 or over may make additional "catch-up" deferrals of up to $1,000 (increasing to $2,500 by 2006). All contributions are immediately fully vested. In lieu of the ADP test, SIMPLE plans are subject to special contribution requirements, including a lower annual elective deferral limit and either a matching contribution not exceeding 3 percent of compensation or non-elective contribution of 2 percent of compensation. /25/

/25/ Employer contributions and employee deferrals may be made to SIMPLE IRAs under rules very similar to those applicable to SIMPLE 401(k) plans.

Thrift plans. Employers may establish thrift plans under which participants may choose to make after-tax cash contributions. Such after-tax contributions, along with any matching contributions that an employer elects to make, are subject to the ACP test (without the availability of an ACP safe harbor). Employee contributions under a thrift plan are not subject to the $12,000 limit that applies to employee pre-tax deferrals.

Top Heavy Plans. Additional tests and requirements are applied to plans in which more than 60 percent of the benefits accrue to "key" employees. Key employees are defined as officers with compensation in excess of $130,000, more-than-five-percent owners, and more-than-one-percent owners with compensation in excess of $150,000. The rules include an accelerated vesting schedule and more stringent requirements for minimum benefits and contributions for non-key employees.

Definition of compensation. Current law provides multiple definitions of employee compensation for different qualified plan purposes, such as the limits on contributions and benefits, the limits on deductions for contributions, the determination of highly compensated and key employees, and the application of nondiscrimination and minimum coverage rules.

The definition of "highly compensated employee" is any employee who is a five-percent owner in the current or previous year, or had compensation above a specified value ($90,000 in 2003). However, employers may elect to amend the latter definition by including only employees in the top 20 percent of employees ranked by compensation.

Permitted disparity and cross-testing. Permitted disparity allows for larger contributions or benefits with respect to compensation in excess of the Social Security wage base ($87,000 for 2003). Cross-testing allows defined-contribution plans to satisfy nondiscrimination tests based on projected account balances at retirement age, rather than current contribution rates (thus it allows for larger contributions for older workers).

Roth-treatment of contributions. Effective after December 31, 2005 participants in 401(k) and 403(b) plans can elect Roth treatment for their contributions: That is, contributions would not be excluded from income and distributions would not be included in income. Roth contributions must be accounted for in a separate account. There are no required minimum distributions during an employee's lifetime, but heirs, other than a spouse, are subject to required minimum distributions.

Salary reduction simplified employee pensions (SARSEPs). Employees can elect to have contributions made to a SARSEP or to receive the amount in cash. The amount the employee elects to have contributed to the SARSEP is not currently includible in income and is limited to the dollar limit applicable to employee deferrals in a 401(k) plan. SARSEPs are available only for employers who had 25 or fewer eligible employees at all times during the prior taxable year and are subject to a special nondiscrimination test. The rules permitting SARSEPs were repealed in 1996, but employee deferral contributions can still be made to SARSEPs that were established prior to January 1, 1997.

403(b) plans: Section 501(c)(3) organizations and public schools may establish tax-sheltered annuity plans, also called 403(b) plans. In general these plans are subject to different rules than qualified plans under section 401. Benefits may be provided through the purchase of annuities or contributions to a custodial account invested in mutual funds. Contribution limits (including catch-ups), deferral limits, and minimum distribution rules are generally the same as for 401(k) plans. However, certain employees with 15 years of service may defer additional amounts according to a complicated three-part formula. Some 403(b) plans are subject to some nondiscrimination rules.

Governmental 457 plans: State and local governments may establish Section 457 plans. /26/ In general, these plans are subject to different rules than qualified plans that are defined under section 401. Participant contributions are tax-deferred until substantially vested, and plan earnings are tax-deferred until withdrawal, due to the exemption enjoyed by state and local governments. Participant elective contributions may not exceed the lesser of 100 percent of compensation or $12,000 in 2003 (increasing to $15,000 by 2006). However, participants may make additional contributions of up to twice the standard amount in the last three years before normal retirement age. Participants aged 50 or over may make additional "catch-up" contributions of up to $2,000 (increasing to $5,000 by 2006).

/26/ Tax-exempt organizations are permitted to establish section 457 plans, but such plans are not funded arrangements and are generally limited to management or highly compensated employees.

Reasons for Change

The rules covering employer retirement plans are among the lengthiest and most complicated sections of the tax code and associated regulations. The extreme complexity imposes substantial compliance, administrative, and enforcement costs on employers, participants, and the government (and hence, taxpayers in general). Moreover, because employer sponsorship of a retirement plan is voluntary, the complexity discourages many employers from offering a plan at all. This is especially true of the small employers who together employ about two-fifths of American workers. Complexity is often cited as a reason the coverage rate under an employer retirement plan has not grown above about 50 percent overall, and has remained under 25 percent among employees of small firms. Reducing unnecessary complexity in the employer plan area would save significant compliance costs and would encourage additional coverage and retirement saving.

Proposal

The proposal would consolidate those types of defined-contribution accounts that permit employee deferrals or employee after-tax contributions and simplify defined-contribution plan qualification rules.

The proposal would become effective for years beginning after December 31, 2003.

Consolidate 401(k), SIMPLE 401(k), Thrift, 403(b), and Governmental 457 plans, as well as SIMPLE IRAs and SARSEPs, into Employer Retirement Savings Accounts (ERSAs), which would be available to all employers and have simplified qualification requirements.

ERSAs would follow the existing rules for 401(k) plans, subject to the plan qualification simplifications described below. Thus, employees could defer wages of up to $12,000 annually (increasing to $15,000 by 2006), with employees aged 50 and older able to defer an additional $2,000 (increasing to $5,000 by 2006). The maximum total contribution (including employer contributions) to ERSAs would be the lesser of 100 percent of compensation or $40,000. The taxability of contributions and distributions from an ERSA would be the same as contributions and distributions from the plans that the ERSA would be replacing. Thus, contributions could be pre-tax deferrals or after-tax employee contributions or Roth contributions, depending on the design of the plan. Distributions of Roth and non-Roth after-tax employee contributions and qualified distributions of earnings on Roth contributions would not be included in income. All other distributions would be included in the participants' income.

Existing 401(k) and Thrift plans would be renamed ERSAs and could continue to operate as before, subject to the simplification described below. Existing SIMPLE 401(k) plans, SIMPLE IRAs, SARSEPs, 403(b) plans, and governmental 457 plans could be renamed ERSAs and be subject to ERSA rules, or could continue to be held separately, but if held separately could not accept any new contributions after December 31, 2004.

ERSA Nondiscrimination Testing. The following single test would apply for satisfying the nondiscrimination requirements with respect to contributions for ERSAs: the average contribution percentage of HCEs could not exceed 200% of NHCEs' percentage if the NHCEs' average contribution percentage were 6% or less. In cases in which the NHCEs' average contribution percentage exceeded 6%, the goal of increasing contributions among NHCEs would be deemed satisfied, and no nondiscrimination testing would apply. For this purpose, "contribution percentage" would be calculated for each employee as the sum of all employee and employer contributions divided by the employee's compensation. The ACP and ADP tests would be repealed. Plans sponsored by state and local governments would not be subject to this test. A plan sponsored by a section 501(c)(3) organization would not be subject to this nondiscrimination test (unless the plan permits after-tax or matching contributions) but would be required to permit all employees of the organization to participate.

ERSA Safe Harbor. The design-based safe harbor described below would be sufficient to satisfy the nondiscrimination test for ERSAs described above. The design of the plan must be such that all eligible NHCEs are eligible to receive fully vested employer contributions (including matching or non-elective contributions, but not including employee elective deferrals or after-tax contributions) of at least 3 percent of compensation. To the extent that the employer contributions of 3 percent of compensation for NHCEs are matching contributions rather than non-elective contributions, the match formula must be one of two qualifying formulas. The first formula would be a 50 percent employer match for the elective contributions of the employee up to 6 percent of the employee's compensation. The second would be any alternative formula such that the rate of an employer's matching contribution does not increase as the rate of an employee's elective contributions increase, and the aggregate amount of matching contributions at such rate of elective contribution is at least equal to the aggregate amount of matching contributions which would be made if matching contributions were made on the basis of the percentages described in the first formula. In addition, the rate of matching contribution with respect to any elective contribution of a HCE at any rate of elective contribution cannot be greater than that with respect to an NHCE.

Roth ERSAs. The effective date for Roth contributions to ERSAs would be after December 31, 2003 (changed from after December 31, 2005, under current law).

Simplify defined-contribution plan qualification requirements.

Defined-contribution plan qualification requirements would be simplified as follows:

Minimum Coverage Requirement. The following single test would apply: plans would be required to cover a percentage of NHCEs that is not less than 70 percent of the share of HCEs that are covered. The existing rules for applying this test would remain, but the general 70 percent test and the average benefit test would be repealed.

Top-heavy rules. The top-heavy rules would be repealed.

Permitted disparity and cross-testing. Permitted disparity and cross-testing would no longer be permitted.

Definitions of compensation and highly compensated employee. The uniform definition of compensation would be all compensation provided to an employee by the employer for purposes of income tax withholding for which the employer is required to furnish the employee a written statement Form W-2, plus elective deferrals. The definition of "highly compensated employee" would be any employee with compensation for the prior year in excess of the Social Security wage base for that year. For 2003, the Social Security wage base is $87,000. The wage base is indexed and increases every year.

Revenue Estimate /27/

($ in millions)

Fiscal Years
2003	2004	2005	2006	2007	2008	2004-2008	2004-2013
0	-171	-253	-263	-277	-293	-1,257	-3,000

/27/ The revenue estimate shown differs from the estimate included in Table 4-3 of Analytical Perspective of the Budget of the United States Government for Fiscal Year 2004.

---

BenefitsLink is an independent national employee benefits information provider, not formally affiliated with the firms and companies who kindly provide much of the content and advertisements published on this Web site, including the article shown above.