Administering Qualified Retirement Plans in the Wake of This Year’s Tax Law

From Employee Benefits Alert

December 1996

The tax laws passed by Congress and signed by President Clinton earlier this year included a number of changes to the qualified retirement plan rules that will take effect during the next three plan years of most qualified retirement plans. In this edition we summarize a number of the recent amendments with current effective dates and those taking effect in 1997, and discuss their implications on plan administration. Amendments adopting the new rules need not be made until the first plan year beginning after January 1, 1998, but plans must be administered in accordance with the rules beginning on their effective dates.

New Minimum Distribution Rules

Under the new minimum distribution rule, employees (other than 5% owners) who continue working after reaching age 70½ are not required to commence plan distributions until April 1 of the calendar year following the year in which they retire. 5% owners continue to be subject to the requirement that they begin receiving distributions by April 1 of the calendar year following the year in which they reach age 70½. There is no guidance concerning the application of this rule when an employee reduces his hours but does not retire. Plan administrators may (but are not required to) permit employees who began receiving distributions under the current rule, but who are not required to receive distributions under the new rule, to defer distributions that would otherwise be made after December 31, 1996 until after retirement. Distributions cannot be deferred without the consent of the participant. Employee communications must be revised to include this change, and participants who are receiving distributions while still in employment should be notified of their right to discontinue distributions if the plan administrator determines to permit deferrals by participants who are receiving required minimum distributions under the current rule.

Revised definition of Highly Compensated Employee

Under the new rule, an employee is a highly compensated employee ("HCE") for a plan year if he (i) is a 5% owner of the employer during that plan year or the preceding plan year, or (ii) had compensation in excess of $80,000 (adjusted for inflation after 1996) for the preceding plan year (and, if the employer elects, was in the top 20% of employees by compensation for the preceding plan year). This change will reduce the number of HCEs and make it easier to determine which employees are HCEs for the current plan year, because the determination will be based on prior plan year data. Employers with a large percentage of employees paid in excess of the $80,000 threshold should elect to restrict the HCEs to the top 20%. Although the new rule is effective for plan years beginning after 1996, when testing HCE status for 1997 employees who earned more than $80,000 during 1996 would be included.

Repeal of Family Aggregation Rules

The family aggregation rule, which grouped together certain highly paid employees or 5% owners with their family members for purposes of nondiscrimination testing, has been repealed. This change should permit greater contributions on behalf of owners of closely held businesses whose family members also work for the company.

Simplified 401(k) Discrimination Test

The 401(k) ADP and ACP tests may now be applied by reference to the ADP and ACP for non-highly compensated employees for the prior plan year. Employers may also elect to use current year data. If an election is made to use current year data, however, that election can only be changed in the manner to be set forth in future regulations. Use of prior year data will permit plan administrators to determine at the beginning of the plan year the amount that highly compensated employees may contribute without exceeding the limitations. Use of prior year data also will permit plan administrators to limit HCE contributions during the plan year to the ADP limit and avoid the need for year end testing and distributions of excess contributions. It is not clear how the new rules are to be applied to non-highly compensated employees who did not make any contributions during the prior year.

Distributions of Excess 401(k) Contributions

A 401(k) plan that has received excess contributions from HCEs may correct the problem by making timely distributions to the HCEs. Under the new rule, excess contributions must be distributed first to the HCE who has the largest dollar amount of contributions, rather than to those who have the greatest ADP. This will result in the highest paid employees receiving distributions, rather than the lower paid HCEs as often occurred under the present law.

Revised Minimum Participation Rules

The minimum participation rule has been repealed for defined contribution plans and revised for defined benefit plans. Under the revised rule, a defined benefit plan must benefit the lesser of (i) 50 employees, or (ii) the greater of 40% of all employees or 2 employees (1 employee if there is only 1 employee). This change will make it easier for employers to adopt defined contribution plans for small divisions or separate groups of employees that require a different plan.

Notice Requirements for Joint and Survivors Annuities

The new law codifies the rule adopted by temporary Treasury Regulations which permits participants and their spouses to waive the 30-day waiting period that is generally required before distribution of benefits can begin. Under the new rule, distributions may begin eight days after the plan administrator has given the participant the written notice regarding the qualified joint and survivor annuity if the participant waives the 30-day explanation period requirement (with spousal consent when necessary).

New Language for Spousal Consent Forms and Qualified Domestic Relations Orders

The new law requires the IRS to develop model language by January 1, 1997 for inclusion in spousal consent forms and qualified domestic relations orders ("QDROs"). In general, defined benefit, money purchase, certain profit sharing and stock bonus plans are required to obtain the consent of a participant's spouse before making a distribution in a form other than a qualified joint and survivor annuity or before accepting a designation of a beneficiary other than the participant's spouse. Once the IRS issues the model spousal consent language, plan administrators should modify their forms to include the model language. The model QDRO provisions should reduce the difficulties that have been experienced by those drafting and reviewing QDROs.

Simplified Rules for Taxing Annuity Distributions

Effective for annuities starting after November 18, 1996, a new method of calculating the amount of taxable annuity payments is in effect. The new method makes it simpler to calculate the taxable portion of each annuity payment, but results in an acceleration of taxable income. Under the new method, the nontaxable portion of a monthly annuity payment is determined by dividing the amount of the participant's investment in the annuity (i.e., the after-tax contributions to the annuity) by a fixed number of payments depending upon the participant's age when the distributions begin. The following table provides the number of payments at each age:

Exclusion of Death Benefits

Under prior law, death benefits of up to $5,000 provided by an employer could be excluded from income. This applied to distributions from qualified plans and 403(b) annuities as will as nonqualified plans. Effective for plan participants who die after August 20, 1996, this exclusion no longer applies. This provision should simplify the determination of taxable income on a distribution. Plan administrators should ensure that death benefits paid after the effective date are reported as taxable income.

Treatment of Leased Employees

Under the new rule, a leased employee must be treated as an employee for benefits purposes if (i) the services are performed under an agreement between the recipient organization and a leasing organization that is treated as the individual's employer; (ii) the individual performs services for the recipient on a substantially full-time basis for a year; and (iii) the leased employee is under the primary direction and control of the organization for which he or she is performing services. The third test replaces the requirement of current law that the services performed by the leased employee be of a type historically performed by employees in the recipient's industry. Remember that this does not require that the leased employees be given benefits under the recipient organization's plans, only that they be included in testing the plans for nondiscrimination.

Correction of GATT Interest and Mortality Provisions

The 1994 GATT legislation adopted certain rules regarding interest and mortality rates to be used in calculating the present value of plan benefits and the section 415 benefit limitations. The new law has revised the GATT rules, retroactive to December 8, 1994, applicable to the section 415 limitations. Under new rules, the GATT interest and mortality assumptions that would have been required for purposes of determining the maximum amount of a benefit payable as an early retirement benefit or in a form other than the normal form of benefit, and which would reduce benefits payable to some participants, may be disregarded by plans in existence on December 8, 1994 before the earlier of (i) the adoption or effective date (whichever is later) of the applicable plan amendment, or (ii) the first plan year beginning after December 31, 1999. Plan sponsors that have already adopted an amendment implementing the GATT interest and mortality assumptions may repeal the amendment by August 20, 1997. This change permits the GATT interest and mortality rates to be implemented for purposes of section 415 and section 417(e)(3) (e.g., determining present value of a lump sum distribution) in the same plan year.

Contributions for Disabled Employees

Employers may continue making contributions to defined contribution plans for an employee who is permanently and totally disabled if the employee was not an owner or officer before becoming disabled. The new rule eliminates the need for the employer to make a special election and permits contributions to disabled highly compensated employees if the plan requires continued contributions for all disabled employees.

Tax-Exempt Organizations May Adopt 401(k) Plans

Tax-exempt organizations (other than state and local governments) will be permitted to adopt 401(k) plans with respect to their employees. This change will permit tax-exempt organizations, which formerly were limited to 403(b) plans, to adopt the more common form of defined contribution plan.

Change in Uniform Retirement Age

The uniform retirement age used for nondiscrimination testing is currently 65. Under the new rule, the Social Security retirement age will be considered the uniform retirement age. The Social Security retirement age is scheduled to increase above age 65 over the next few years.

New Penalty Rules for Reporting Violations

Penalties for failing to file information returns or provide payee statements with respect to pension plan distributions will be subject to the general penalty provision for failing to provide information reports. The new rules apply to information returns and payee statement the due date for which is after December 31, 1996. The penalty is $50 with respect to each failure, up to a maximum of $100,000.

Increased Excise Tax for Prohibited Transactions

The initial excise tax for prohibited transactions has increased to 10% effective for transactions occurring after August 20, 1996. As under prior law, the tax increases to 100% of the amount involved if the prohibited transaction is not corrected on a timely basis.

Repeal of Interest Exclusion on ESOP Loans

For loans made after August 20, 1996, the 50% interest exclusion available to commercial lenders on loans to employee stock ownership plans was repealed.

To learn more about the new tax laws and their effect on qualified retirement plans or other issues relating to employee benefits and executive compensation, please contact Paul J. Powers, Jr. or Kirk H. O'Ferrall at our New York office.