Guest Article

(From the February 10, 2003 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits. Hyperlinks within the article have been added by BenefitsLink.)

Bush Administration Issues FY 2004 Budget Proposals

President Bush issued his proposed budget for fiscal year 2004 on February 3, which includes a number of proposals relating to employment, employee benefits, and executive compensation. If enacted, these proposals could have a dramatic effect on existing tax-qualified pension plans-- particularly defined contribution plans-- and nonqualified deferred compensation plans. However, reports indicate even Congressional Republicans are raising serious doubts about many of the President's retirement savings proposals.

The budget reiterates the President's call for Congress to enact the rest of his proposed 401(k) reforms from last year. Among other things, these proposals include:

(Congress enacted new rules relating to blackout periods as part of last year's Sarbanes-Oxley Act.)

The President's budget also proposes to make permanent the pension reforms enacted as part of the Economic Growth and Tax Relief Reconciliation Act (P.L. 107-16) by repealing the Act's sunset provision. Furthermore, President Bush is proposing to simplify current rules relating to tax-qualified defined contribution plans, repeal the moratorium on Treasury guidance relating to nonqualified deferred compensation, and modify the use-it-or-lose-it rule for health FSAs offered through section 125 cafeteria plans, among other things. The budget does not address defined benefit funding issues, such as a replacement for the 30-year Treasury rate.

The following summary of the relevant tax provisions in the President's budget is based on descriptions provided in the Treasury Department's "Blue Book." The Blue Book, which includes summaries of all revenue proposals included in the President's budget, can be downloaded from the Treasury Department's Web site, at http://www.treasury.gov/press/releases/reports/bluebook2003.pdf.

Pensions and Retirement Savings

ERSAs

Summary: The President's budget proposes to consolidate 401(k), SIMPLE 401(k), Thrift, 403(b), and governmental 457 plans, as well as SIMPLE IRAs and SARSEPs, into a single retirement savings vehicle: the Employer Retirement Savings Account (ERSA). ERSAs would operate under the same rules that now apply to 401(k) plans, but many of those rules would be modified and simplified.

For example, ERSA participants would be subject to the same elective deferral, catch-up, and total contribution limits that now apply to 401(k) participants. However, the nondiscrimination rules for ERSA contributions would be greatly simplified. The actual contribution percentage (ACP) and average deferral percentage (ADP) tests would be repealed, and contributions would be subject to a single nondiscrimination test. (Specifically, the average contribution percentage of HCEs could not exceed 200 percent of NHCE's percentage if the NHCEs' average contribution percentage was 6 percent or less. In cases in which the NHCEs' average contribution percentage exceeded 6 percent, the goal of increasing contributions among NHCEs would be deemed satisfied, and no nondiscrimination testing would apply.) An employer contribution safe harbor would be available for satisfying this test.

The proposal also would change the qualification requirements for all defined contribution plans by:

The ERSA proposals would not affect defined benefit plans.

Analysis: The ERSA proposal is designed to encourage more employers to adopt retirement plans for their employees by making them less difficult (and therefore less costly) to set up and administer. Whether the proposal would actually result in more employers (particularly small employers) adopting plans is an open question, but many of the proposed changes probably would be welcomed by existing 401(k), 403(b), and 457 plan sponsors.

Nonetheless, the President's proposals almost certainly will encounter significant opposition. Like previous proposals to repeal the top-heavy rules and simplify nondiscrimination testing requirements, these probably will be attacked as potentially detrimental to participants. And the ongoing bear market may not be the best political backdrop for proposals that would further skew the tax-qualification rules in favor of defined contribution plans.

LSAs and RSAs

Summary: The President's budget proposes to replace traditional, nondeductible, and Roth IRAs with two new accounts: Lifetime Savings Accounts (LSAs) and Retirement Savings Accounts (RSAs). In general, these accounts would enjoy the same tax advantages as the current rules afford Roth IRAs. That is, contributions would be nondeductible, but earnings would accumulate tax-free and distributions (subject to certain exceptions that would apply only to RSAs) would not be taxable.

Both LSAs and RSAs would be subject to a $7,500 per year cap on contributions (indexed). LSAs could be funded with gifts and other non-wage income (including investment income), but RSAs could be funded only with wage income. No income limits would apply to LSA or RSA eligibility.

As indicated, all LSA distributions would be tax-exempt. RSA distributions in excess of the account holder's basis could be subject to income and penalty taxes, but only if made before the account owner turns 58, becomes disabled, or dies. Neither LSAs nor RSAs would be subject to minimum required distribution rules during the account owner's lifetime.

The proposal would allow existing balances in Archer Medical Savings Accounts (MSAs), Coverdell Education Savings Accounts, and Qualified State Tuition Plans to be converted to LSAs. Likewise, traditional and nondeductible IRAs could be converted to RSAs (Roth IRAs would be converted automatically). However, because MSAs and traditional IRAs are funded with deductible contributions, conversions involving these types of accounts would be taxable events.

Analysis: The LSA/RSA proposal may be vulnerable to attack on several fronts. The first is cost. Conversions of MSAs and traditional IRAs into LSAs and RSAs, respectively, will generate revenue in the short-term. But the new accounts could have significant adverse effects on government revenue in the long-term because accumulated earnings generally will not be taxed. (According to the Blue Book, the proposal would generate approximately $18.7 billion in additional revenues during the first 4 years, but lose all but about $2 billion of that gain over the following 7 years.)

Also, some have expressed concern that LSAs and RSAs, as proposed, would discourage small employers from establishing retirement plans for their employees. The reason is a married small business owner could save up to $30,000 per year in LSAs and RSAs (more if he/she has kids) without incurring the expense associated with setting up a tax-qualified retirement plan. (The Administration counters this by arguing the complexity of the tax-qualified plan system is the primary barrier to entry for small business owners.)

Executive Compensation

Summary: Since 1978, the Treasury Department has been subject to a statutory moratorium on new regulations or other guidance on many aspects of nonqualified deferred compensation arrangements. (The moratorium is codified as section 132 of the Revenue Act of 1978.) According to the Blue Book, "Section 132 restricts the ability of Treasury and the IRS to respond effectively to arrangements designed to allow individuals to avoid current income for compensation that is, in practice, readily accessible or sheltered from the employer's creditors." The President's budget calls for repeal of section 132.

Analysis: There appears to be substantial bipartisan support for repealing section 132. If Congress repeals section 132, Treasury likely will issue regulations that would severely limit the ability of executives to delay taxation of nonqualified deferred compensation amounts.

Health and Welfare Benefits

Health FSAs

Summary: Under current rules, section 125 cafeteria plans may not allow health FSA participants to carry over unused account balances from one plan year to the next (the so-called "use-it-or-lose-it rule"). The President's budget includes two proposed modifications to the use-it-or-lose-it rule. The first would permit health FSAs to allow participants to carry over up to $500 in unused amounts to the next plan year. The second would permit health FSAs, at the participant's election, to distribute up to $500 in unused amounts in cash or contribute such amounts to a 401(k) plan, 403(b) plan, governmental 457(b) plan, SARSEP, SIMPLE IRA, or MSA. Any amounts so distributed would be subject to income tax withholding and employment taxes.

Analysis: These proposals are designed to encourage more employees to use health FSAs and to discourage health FSA participants from incurring "unnecessary" medical expenses at the end of the year to avoid forfeiting benefits. Several Members of Congress have introduced similar proposals to modify or repeal the use-it-or-lose-it rule.

Archer MSAs

Summary: The President's budget proposes to make Archer Medical Savings Accounts (MSAs) permanent, eliminate the cap on the number of Archer MSAs that can be established, and eliminate the restrictions on who may establish Archer MSAs, among other things. The definition of high deductible health plan would be modified to permit an annual deductible as low as $1,000 for individual coverage and $2,000 in all other cases. Such plans also would be permitted to provide, without counting against the deductible, up to $100 of coverage for allowable preventive services per covered individual each year. In addition, the proposal would allow Archer MSAs to be funded with employee contributions through a section 125 cafeteria plan.

Analysis: Republicans have long championed Archer MSAs as a flexible alternative to traditional health insurance arrangements-- particularly to managed care arrangements-- and as a market-based approach to extending health coverage to some uninsured Americans. Democrats generally dismiss Archer MSAs as tax shelters for the healthiest and wealthiest Americans. As a result of this disagreement, Republicans so far have been successful only in extending the original MSA demonstration project, which was originally scheduled to expire on December 31, 2000. The number of Archer MSAs has never come close to exceeding the 750,000 limit provided for under current law.

Health Insurance Tax Credit

Summary: The President's budget would create a refundable income tax credit for the cost of health insurance purchased by individuals under age 65, subject to certain adjusted gross income limits. The maximum credit would be $1,000 per adult and $500 per child (for up to two children). Thus, a married couple with two children and a modified adjusted gross income of $25,000 or less would be eligible for a credit of up to $3,000.

Under the proposal, eligible individuals would be allowed to claim the credit at the time they purchase insurance, and the health insurer would be responsible for seeking reimbursement from the Treasury Department. Eligibility for the advance credit would be based on the individual's prior year tax return.

Individuals participating in public or employer-provided health plans generally would not be eligible for the tax credit.

Analysis: It is not clear from the proposal if the credit could be used to offset COBRA premiums.

Long-Term Care Insurance Premium Deduction

Summary: The President's budget would create an above-the-line deduction for qualified long-term care insurance premiums, up to certain age-based annual dollar limitations. (This deduction already is available to self-employed individuals.) Employees that purchase long-term care insurance through their employers generally would be eligible for the deduction, but only if the employees pay at least 50 percent of the cost of such coverage.

Analysis: The advantage to an above-the-line deduction is that all eligible taxpayers, including those that do not itemize deductions, can take it. If this proposal is enacted, it could help increase participation in employer-sponsored long-term care insurance programs.

Other Employment-Related Proposals

Telecommuting: The President's budget proposes to create an income exclusion for the value of employer-provided computers, software, or other office equipment if necessary for an employee to perform work for the employer at home. The purpose of the proposal is to encourage telecommuting.

Welfare-to-Work and Work Opportunity Tax Credits: The President's budget proposes to combine the Welfare-to-Work and Work Opportunity tax credits into a single credit, and simplify the rules for computing the credit amount.

The information in this Washington Bulletin is general information only and not intended to provide advice or guidance for specific situations. Contact your Deloitte advisor for information regarding your specific circumstances. If you have questions or need additional information about this article and you do not have a Deloitte advisor, please contact Martha Priddy Patterson (202.879.5634) or Robert B. Davis (202.879.3094). Human Capital Advisory Services, Deloitte LLP, 555 12th Street NW, Suite 500, Washington, DC 20004-1207. Copyright 2003, Deloitte.