A Summary of Proposed Retirement Savings Reform

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by Christine P. Roberts
Mullen & Henzell, LLP

On January 31, 2003, the Bush Administration announced proposed changes to the way our current tax structure encourages retirement savings. Essentially, the proposed changes would shift retirement planning responsibility from employers to individual taxpayers. The proposals, if enacted, will constitute a fundamental change in the retirement plan landscape as it currently exists. (The Administration's summary of the proposals can be found at http://www.treas.gov/press/releases/kd3816.htm). The purpose of this memo is to alert you to the proposed changes, briefly outline them, and discuss their likely impact on the ways you currently save for retirement.

There are two main proposals: one overhauls the existing system of individual retirement accounts or annuities ("IRAs"), and the other overhauls existing employer-sponsored salary deferral retirement plans under Internal Revenue Code Sections 401(k), 403(b), and 457, SIMPLE plans (both SIMPLE 401(k) and SIMPLE IRAs), and SARSEPS.

Proposed Changes to IRA System

Currently individual taxpayers may contribute to a traditional IRA on a pre-tax basis, or to a Roth-IRA on an after-tax basis. (Non-deductible contributions to a traditional IRA are also allowed.) The contribution limits are low ($3,000 in 2003, plus an additional $500 for those aged 50 and older) and in many cases taxpayers who earn above a certain level cannot make deductible IRA contributions. Other complicated rules govern withdrawals from IRAs prior to retirement. Under the new proposal, there would be two IRA-like savings vehicles: a Lifetime Savings Account ("LSA") and a Retirement Savings Account ("RSA") subject to the following rules:

A taxpayer may contribute up to $7,500 each to an LSA and an RSA, for a total of $15,000 annually. The $7,500 level will be indexed for inflation. Taxpayers may also contribute $7,500 annually to an LSA for any other individual, such as a spouse. Contributions to an LSA or RSA are not deductible from current income but no taxes apply upon withdrawal, as is currently the case with Roth-IRAs. In other words, earnings on investments in LSAs and RSAs accumulate tax-free. LSAs are primarily intended for shorter-terms savings towards things such as education, housing, or healthcare needs, and allow participants to withdraw funds penalty free at any time, for any reason. RSAs are intended for retirement savings and call for tax-free distributions after age 58, death, or disability.

Proposed Changes to Employer-Sponsored Plans

It is important to note that most of the proposed reforms primarily affect employer-sponsored salary deferral arrangements under IRS Code Sections 401(k), 403(b), and 457 (as applied to governmental employers), under SIMPLE 401(k) and IRA plans, and SARSEP plans. Traditional pension plans are not affected.

Essentially, the proposed reforms would combine all these different types of salary deferral plans into one plan, the Employer Retirement Savings Account, or "ERSA" Plan, which will be subject to the same salary deferral limits that currently apply to Section 401(k) or 403(b) plans (i.e., $12,000 per year in 2003 plus $2,000 additional deferral for employees aged 50 or older; increasing to $15,000 and $5,000, respectively, in 2006). ERSA contributions would be in addition to individual taxpayer contributions to the LSA and RSA accounts described above, so that an individual participating in an ERSA in addition to an LSA and RSA could put away $27,000 in after-tax money in 2003 ($29,000 if age 50 or over). ERSA plans will follow existing rules for Section 401(k) plans, but with simplified and streamlined rules in the areas of eligibility, nondiscrimination testing, and other elements of plan design. Some of the most significant changes are as follows:

Any employer can adopt an ERSA plan-- irrespective of status as for-profit, not-for-profit, private or governmental entity. A plan would pass minimum coverage testing if the percentage of an employer's nonhighly compensated employees covered under a plan equals at least 70% of the percentage of the employer's highly compensated employees covered under the plan. The other coverage testing alternatives would be repealed. ERSAs would retain "ADP" nondiscrimination testing of salary deferrals that currently applies under 401(k) plans, but in a greatly simplified format. Under the new rules, highly compensated employees ("HCEs") earning $200,000 or over could defer the maximum amount ($12,000) provided that average deferral levels by non-highly compensated employees equal at least 3%. Current rules would limit HCE deferrals to $10,000 under the same circumstances. If the average deferral level by non-highly compensated employees equals 6% or more, HCEs earning less than $200,000 may defer any percentage of compensation up to the maximum amount. Simplified "safe-harbor" rules for 401(k) plans would continue under the ERSA scheme, but the price of entry-- the safe harbor matching contribution-- would be reduced from 4% to 3% of compensation. ERSAs sponsored by governmental entities would be completely exempt from all nondiscrimination rules, and those sponsored by charitable entities would also be exempt, provided that all employees are eligible to participate and the plan accepts no after-tax contributions.

The following additional ERSA rules would also apply to all defined contribution plans (profit sharing, money purchase, etc.), but not to traditional pension plans:

Plans could not employ "permitted disparity" (offsetting benefits for Social Security), or "cross-testing" based on age or other categories in order to pass nondiscrimination testing of benefits. "Top-heavy" rules would be repealed. Plans would recognize only one definition of plan compensation: the amount reported on Form W-2 for wage withholding, plus the amount of ERSA deferrals. Plans would recognize only one definition of "highly compensated employee" - all individuals with compensation for the prior year above the Social Security wage base.

So What Can We Expect if the Proposals Become Law?

Obviously, there is no certainty as to whether or when these proposed changes will become law. However, if the changes do come to pass as currently drafted, individual taxpayers and employers can expect the following changes in 2003 and 2004:

The IRA System

• Contributions to traditional or non-deductible IRAs and to Roth-IRAs will stop after 2003.
• Taxpayers will have the opportunity in 2003 to convert to LSAs their existing Archer Medical Savings Accounts, Coverdell Education Savings Accounts, and Qualified State Tuition Plans. Conversions cannot occur after 2003; unconverted accounts cannot receive contributions after that point.
• Taxpayers will have the opportunity to convert traditional or non-deductible IRAs to RSAs any time, but will be able to spread the tax on the conversion over a four-year period only if they convert in 2003.
• No new contributions to unconverted traditional or non-deductible IRAs can occur after 2003, other than rollover contributions.
• Existing Roth-IRAs will be renamed RSAs.

Employer-Sponsored Retirement Plans

• Effective in 2004, all 401(k) plans will automatically convert to ERSAs.
• Section 403(b) plans, SIMPLE plans, SARSEPs, and governmental 457 plans may continue indefinitely, but in a "frozen" state-- i.e., no new contributions allowed. (Section 457 plans maintained by private non-profit entities would continue to exist unchanged.)
• Employee desire to participate in such plans will likely diminish-- if an employee can put away up to $15,000 per year in a combined LSA/RSA arrangement, what incentive would the employee have to contribute to an employer plan as well?
• Small business owners' sponsorship of retirement plans may also decline or disappear, because business owners can set aside up to $15,000 per year for themselves under the combined LSA/RSA arrangement.

As significant as the above changes may be, it is important to keep in mind that the new proposals do not replace the following types of plans:

1. Straight profit-sharing plans (i.e., no 401(k) component)
2. Money purchase pension plans
3. Defined benefit (traditional pension) plans
4. Cash balance plans
5. Stock bonus plans

Although the Administration's proposals will limit the financial incentive for most small businesses to sponsor or maintain these types of plans, they will continue to exist and be relevant to larger employers and some smaller employers with special retirement planning needs that aren't met by the LSA/RSA/ERSA combination.

Some Policy Considerations

It is beyond question that many of the rules governing retirement savings in this country have become so complex that they discourage retirement savings by individual taxpayers and small businesses. As an example, the IRS booklet for taxpayers on IRAs, SEPs, and SIMPLE plans-- the most basic type of retirement arrangements - runs to 80 pages, exclusive of appendices. Similarly, the distinctions between what types of employers can adopt what types of plans, and the separate rules on eligibility and participation for each category of plan, are unnecessarily complex. So, to the extent that the administration's reform proposals remove the complexity from salary deferral savings arrangements, they are to be applauded.

A few "reality checks" are in order, however:

• First, only 5% of American taxpayers are currently maxing out on their salary deferral limits. Many Americans wouldn't save for retirement at all if their salary deferrals weren't tax-deductible, and often matched by employers. (Statistics show that 74% of workers take part in employer-sponsored retirement plans, versus an IRA participation rate of 4.3% by workers in the same income level. These participation levels were recorded, respectively, by Fidelity in 2000 and by the Employee Benefits Research Institute in 1998. The studies are summarized in an article dated February 3, 2003 by ASPA Executive Director Brian H. Graff, Esq.)
  • For this very large segment of the population, it is hard to see how the RSA/LSA/ERSA scheme will better encourage them to save for the future.
  • Based on existing trends, it is also likely that those who do contribute to an LSA will withdraw funds for non-emergencies, thus depleting their savings. Those who are already withdrawing money from an LSA are unlikely to be able to put money towards retirement into a separate RSA.
• Second, the RSA/LSA/ERSA scheme will disconnect taxpayers from the bargaining power and economies of scale that they enjoyed while participants in an employer-sponsored retirement plan, and they will have to deal one-on-one with brokers and asset managers. It is likely under such a scenario that higher investment and service fees will erode their potential retirement savings.
• Third, many taxpayers who currently claim certain tax deductions (e.g. for student loan interest payments or college costs) will lose eligibility to do so under the new arrangement. That is because RSA/LSA/ERSA contributions are after-tax and hence do not reduce "AGI," or adjusted gross income, to the levels needed to qualify for the deductions.
• Lastly, the potential future revenue loss due to Bush's reform package is estimated to be $1.46 trillion in 10 years. This lost revenue will be due to untaxed earnings on retirement savings, as well as revenue loss due to the tax cuts that Congress enacted in 2001.

Conclusion

A heated debate over the Bush Administration's proposals is already underway. As of this writing, House Republican leaders are opposing the new measures as too sweeping and too sudden, and in response White House representatives are soft-pedaling retirement reform proposals in hope of passing the rest of the budget package. Hopefully what will emerge will be a workable compromise that enacts needed simplification (and possibly some increases in salary deferral limits) without overlooking the degree to which employer-sponsored retirement plans have successfully enabled workers to save for retirement.

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Copyright 2003, Christine P. Roberts. All rights reserved.

Christine P. Roberts
Mullen & Henzell, LLP
112 E. Victoria St.
Santa Barbara, California 93101
(805) 966-1501
fax (805) 966-9204
croberts@mullenlaw.com

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