SIMPLES: Will They Fly?
David A. Littell

What Was the Situation Before?

Since their inception in the early 1980s 401(k) plans have experienced phenomenal growth in popularity. However, much of the boom has been limited to the large- and medium-sized plan market.¹ To bolster plan participation in smaller markets, Congress instituted salary reduction simplified employee pensions (SARSEPs), but these plans did not provide employer matching contributions and required significant annual discrimination testing, so they never really caught on in a big way.

1. The focus of this section will be on the small plan market.

What Is the Nature of the Change?

Under the recently passed Small Business Job Protection Act, Congress made a second attempt to fit a 401(k) knockoff into the small plan market. The new plan is called a SIMPLE—derived from the acronym for the phrase savings incentive match plan for employees. SIMPLEs are administratively convenient salary deferral plans that also allow employer matching or nonelective contributions. Employers can begin sponsoring SIMPLEs in 1997, and after December 31, 1996, employers will no longer be able to establish a new SARSEP (although existing SARSEPs were grandfathered).

Congress actually provided for two new plans, both of which are referred to as SIMPLEs. One type of plan is a SIMPLE that is funded with IRAs, making it similar to the SEP. This version is referred to as either a SIMPLE or SIMPLE IRA—and most experts expect this to be the one that employers will use most commonly. However, the law also allows traditional 401(k) plans to avoid certain requirements by adopting certain SIMPLE provisions. This is generally referred to as a 401(k) SIMPLE. Except where specifically noted, the term SIMPLE below describes the IRA-funded plan. Later in the discussion, the 401(k) SIMPLE will be described and contrasted.

The tax advantages for the SIMPLE are essentially the same as for a 401(k) plan. Employee salary deferral contributions are not subject to income tax, even though they are subject to FICA and FUTA taxes. Employer contributions are not subject to any taxes at the time they are contributed to the plan. Trust income is not taxed, and employees are taxed on their benefits only at the time of distribution.

Eligible Employers. Any type of organization, including any nonprofit organization or state or local government, can establish a SIMPLE. However, in the prior year, the entity cannot have had more than 100 employees with $5,000 or more of compensation. If the employer grows beyond the 100-employee limit, the law does allow the employer to sponsor the plan for an additional 2-year grace period. Note that that the 100-employee rule is determined by taking into consideration all employers that are required to be aggregated under controlled group, affiliated service, and leased employee rules of Code Secs. 414(b), (c), (m) and (n).

Also note that to be eligible, the sponsoring employer cannot maintain any other qualified plan, 403(b), or SEP during any part of a plan year that it maintains a SIMPLE. In other words, the SIMPLE must be the sponsor’s only tax-sheltered retirement plan. The IRS has clarified that sponsoring an inactive or frozen plan (meaning a plan in which no benefits are currently accruing²) will not disqualify the sponsor from maintaining a SIMPLE.

2. IRS Notice 97-6 clarifies that a defined-contribution plan is not disqualifying if no contributions are allocated to participants. Transfers, rollovers, and even reallocated forfeitures are not treated as allocated contributions. A defined-benefit plan is not disqualifying if no participant receives a benefit accrual for the year.

Contributions. In a SIMPLE, all eligible employees have the opportunity to make elective pretax contributions of up to $6,000 (subject to cost-of-living adjustments). Unlike the 401(k) plan (or the old SARSEP), there is no nondiscrimination testing, so highly compensated employees can make contributions without regard to the salary deferral elections of the nonhighly compensated employees. Similarly the SIMPLE is not subject to the Code Sec. 415 limits (which limit contributions to the lesser of 25 percent of compensation or $30,000). This means that an employee can defer up to 100 percent of his or her compensation. The only other limit that can apply occurs if an individual participates both in a SIMPLE and in a salary-reduction-type retirement plan (401(k), SARSEP, SIMPLE, or 403(b) plan) with an unrelated employer. In this case the $9,500 salary deferral limit applies to all pretax salary deferral type contributions.

In addition to the employee elective deferrals, a SIMPLE sponsor is required to make a mandatory employer contribution. This contribution can be made in one of two ways:

• The employer can make a dollar-for-dollar matching contribution on the first 3 percent of compensation that the individual elects to defer.
• The employer can make a 2 percent nonelective contribution for all eligible employees.

If the employer elects the matching contribution, it has one other option. Periodically the employer can elect a lower match as long as the matching contribution is not less than one percent of compensation and participants are notified 60 days before the beginning of the plan year. The employer can elect the lower percentage for up to 2 years in any 5-year period, which can even include the first 2 years that the plan is in force.

The employer contribution amount just described is both the minimum required and the maximum employer contribution allowed. In other words, if the employer elects the matching contribution, 3 percent is the maximum match, and nonelective contributions are not allowed. If the employer elects the nonelective contributions, then the 2 percent contribution is the maximum, and matching contributions are not allowed. This means that the maximum amount that can be contributed for an owner or other highly compensated employee in a SIMPLE is $12,000 (table 5-1). This amount includes the $6,000 salary deferral and $6,000 for the dollar-for-dollar match, up to 3 percent of compensation. To contribute the full $12,000, the employee must earn $200,000 of compensation or more (3 percent of $200,000 equals $6,000). For the individual earning less, the maximum matching contribution is limited by the 3 percent rule (see table 5-1). As you can see, the 3 percent matching contribution—unlike in qualified plans or SEPs—is not subject to the $160,000 (in 1997) compensation cap. However, the compensation cap does apply if the employer elects the 2 percent nonelective contribution. This means that the 2 percent nonelective contribution for an individual who earns $160,000 or more is limited to $3,200.

Eligibility Requirements. The SIMPLE has eligibility requirements that are different from those of both the SEP and the qualified plan. The plan must cover any employee who earned $5,000 in any 2 previous years and is reasonably expected to earn $5,000 again in the current year. Employees subject to a collectively bargained agreement do not have to be covered (however, they do have to be counted when determining whether the employer has 100 or fewer employees). Eligible employees must be given the right to make the salary deferral and receive either an employer matching or nonelective contribution. For determining eligibility, compensation is essentially taxable income plus pretax salary deferrals. For a self-employed person, compensation is net earnings (not reduced by salary deferral elections). SIMPLEs can be maintained only on a calendar-year basis, and all employees become eligible to participate as of January 1.

The plan can have less restrictive eligibility provisions—for example, allowing immediate eligibility, reducing the number of years required prior to entry, or reducing the $5,000 compensation requirement. These options are clearly identified in the IRS model plan document, IRS Form 5304-SIMPLE.

Funding Vehicles. Like SEPs and SARSEPs, the SIMPLE plan is funded with individual retirement accounts, which means that the following requirements apply to the SIMPLE:

• Participants must be fully vested in all benefits at all times.
• Assets cannot be invested in life insurance or collectibles.
• No participant loans are allowed.
• No limitations can be placed on participant withdrawals.

Even though these accounts are essentially IRAs, accounts established under a SIMPLE will be referred to as SIMPLE IRAs and will differ from regular IRAs in one regard discussed further below. Due to a special 25 percent early distribution penalty tax that applies to distributions in the first 2 years of participation, there is a prohibition on the transfer out of a SIMPLE IRA and into a regular IRA in the first 2 years of participation. Otherwise, participants can circumvent the 25 percent tax.

Adopting a Plan. Although a plan must be maintained on a calendar-year basis, a plan can be established beginning on any date between January 1 and October 1 of the year, with two exceptions. First, if an employer previously sponsored a SIMPLE, then the effective date for the new plan can only be January 1. Second, if a new business entity is formed after October 1, it can establish a plan as soon as the entity is formed.

The adopting employer can establish a plan by adopting one of two IRS-provided model documents, Form 5305 SIMPLE or IRS Form 5304 SIMPLE. These documents do not need an IRS approval letter and are only two pages long. In addition, a SIMPLE IRA must be established for each participating employee before the date of the first required contribution. IRS form 5305-S can be used to establish a trust account, and form 5305-SA can be used to establish a custodial account.

Form 5305 SIMPLE is used when the plan has what is referred to as a designated financial institution. This is a financial institution (bank, insurance company, or mutual fund group) that agrees to be the sole recipient of all plan contributions. At first blush it might seem that most financial services providers would want to have this status so that they would be the exclusive agent for all IRA accounts. However, in reality most will probably not want this status. The problem is that if an entity is a designated financial institution, it must give participants the right to freely transfer their benefits to another SIMPLE IRA, or after 2 years of participation to any IRA, without cost or penalty. Even though the IRS has provided guidance allowing the institution to limit when such transfers can occur, it has defined the term cost or penalty broadly to include any liquidation, transaction, redemption, or termination fee; any commission, load (whether front-end or back-end), or surrender charge; or similar fee or charge imposed with respect to the balance being transferred. However, it is permissible for a designated financial institution to charge such transaction fees to the employer.

Because of this penalty most plans will probably be established with Form 5304 SIMPLE. Since this form does not require a designated financial institution, the SIMPLE IRA trustee or custodian will not have to be concerned about the "no charge or penalty" provision if a participant wants to transfer assets to another trustee. The IRS has clarified that the plan sponsor can still work with one primary service provider, as long as participants are made aware of their right to establish a SIMPLE IRA with another trustee.

Plan Operations. After establishing a plan, the sponsoring employer must notify participants that they have the 60-day election period just prior to the calendar year to make a salary deferral election or modify a previous election for the following year. This means that once the plan is operational, the election period is November 2 to December 31. For a new plan the first election period can be somewhat later and can comprise any 60-day period that includes either the day of or the day before the effective date of the plan. For example, if the plan begins on July 1, 1997, the election period can be June 30, 1997, to August 29, 1997. After the election period is over, employees who have made a salary deferral election must still be given the option to stop making deferrals at any time during the year. The sponsor can require that the participant wait until the following year to elect back in, or it may have a more liberal election modification provision—for example, allowing participants to modify their election at any time.

Every year, prior to the 60-day election period, the trustee (or custodian) must prepare and the employer must distribute a summary plan description (SPD) that includes employer-identifying data, a description of eligibility under the plan, benefits provided, terms of the salary election, and description of the procedures for and effects (tax results) of making a withdrawal. Also 30 days after the calendar year ends, the trustee must give participants a statement of the year’s activity and the closing account balance.³

3. Code Sec. 408(l).

The clear and precise disclosure requirements are accompanied by clear penalties for failure to comply. The trustee is fined $50 a day for late distribution of participant statements or the annual summary plan description, and the employer is fined $50 a day for late notification to participants of their right to make salary deferral elections.⁴ The disclosure requirements and penalty system were probably deemed necessary, since there is no direct incentive for the employer to encourage SIMPLE participation (unlike the 401(k) plan, in which highly compensated contribution levels are tied to nonhighly compensated contributions under the ADP nondiscrimination test).

4. Code Sec. 6693(c)(1).

Administrative costs for a SIMPLE should be quite low. At the present time, no annual reporting with the IRS or DOL is required. Also, unlike the 401(k) plan, no ADP test or other nondiscrimination tests must be performed.

Withdrawals. Like SEPs, the plan cannot put any limitations on participant withdrawals, which means that participants have access to funds at any time to spend them or roll them over into another IRA. If an individual takes a distribution, the entire amount of the distribution will be subject to income tax as ordinary income. If the participant is under age 59 1/2, the distribution will also be subject to the 10 percent early-distribution excise tax (unless one of the exceptions applicable to IRAs applies). Since participants have such easy access to funds, Congress decided to add an additional penalty. The 10 percent penalty tax becomes 25 percent for amounts withdrawn within 2 years of the date of first participation.

This special rule complicates SIMPLE IRA rollovers somewhat. The general rule is that amounts in a SIMPLE IRA can be rolled over (or transferred) to either another SIMPLE IRA or regular IRA under the rollover rules that apply to regular IRAs. However, individuals in the first 2 years of SIMPLE participation can only roll a distribution into another SIMPLE IRA.

401(k) SIMPLE. The new SIMPLE described above is sometimes referred to as the IRA SIMPLE, since the Small Business Job Protection Act of 1996 also allows for a similar alternative for 401(k) plans, which is referred to as a 401(k) SIMPLE. A 401(k) plan that adopts the principal provisions of the IRA SIMPLE will not be required to satisfy the ADP or ACP test (for matching contributions). Equally as important is that such a plan will not have to satisfy the qualified plan top-heavy requirements.

In order for the employer to sponsor a 401(k) SIMPLE, it cannot have more than 100 employees (applying the same rules that apply to SIMPLEs). Similarly state and local government organizations that cannot sponsor a 401(k) plan cannot sponsor a 401(k) SIMPLE.

In order for a 401(k) plan to be treated as a 401(k) SIMPLE, the 401(k) plan must meet the following requirements:

• It must be maintained on a calendar year.
• Employee pretax salary deferrals cannot exceed $6,000.
• Employer contributions must be limited to either a 3 percent matching contribution for eligible employees or a 2 percent nonelective contribution for all eligible employees who earn more than $5,000 for the year.
• It must provide for full and immediate vesting.
• It must prohibit contributions for participants in the 401(k) SIMPLE from receiving contributions to any other qualified plan, SEP, SIMPLE, or 403(b) plan sponsored by the employer.

Note that in contrast to the SIMPLE IRA, in this plan if the employer makes the 3 percent matching contribution, the $160,000 compensation cap does apply. Consequently the maximum matching contribution for an individual earning $160,000 or more is $4,800.

Beginning in 1997, any 401(k) plan that is currently maintained can be converted to a 401(k) SIMPLE by adopting the model amendment provided in Rev. Proc. 97-9. To adopt the SIMPLE provisions for the year, the amendment and participant notification must occur more than 60 days prior to the beginning of the plan year. Also employees must be given a 60-day election period in which to make salary deferral elections in the following year. For 1997, however, the amendment can be adopted any time before July 1, 1997, as long as certain requirements are satisfied.

To fully understand the 401(k) SIMPLE, it is important to understand that except for the special requirements described above, this plan is still a 401(k) plan, so it is subject to the flexible qualified plan coverage requirements and the plan must file annual Form 5500s and meet other reporting and disclosure requirements. All qualified plan contribution limits and distribution requirements apply as well.

What Should Be Done?

All eligible plan sponsors (employers with 100 or fewer employees that do not sponsor another retirement plan) should consider their new options under the Small Business Job Opportunity Act of 1996. Under the new law beginning in 1997, the private for-profit employer interested in a tax-advantaged salary savings plan now has three choices: the traditional 401(k) plan, the 401(k) SIMPLE, or the SIMPLE funded with IRA accounts. First we will compare the traditional 401(k) to the SIMPLE and then discuss the uses of the 401(k) SIMPLE.

For those employers familiar and comfortable with the 401(k) plan, the SIMPLE appears incredibly rigid. With strict contribution requirements, the single plan requirement, and limited tax-shelter potential, at first glance it seems hard to see why an employer would choose a SIMPLE over the 401(k) plan. Feature by feature, the advantage almost always goes to 401(k) plans, which are better for maximizing contributions and skewing employer contributions to a targeted group of employees—typically two common goals of small-plan sponsors. In addition, a 401(k) plan is much more flexible. The plan can be limited to part of the workforce as long as the minimum coverage requirements are met, and matching and profit-sharing contributions can be designed to meet a variety of goals. Finally, employer contributions can increase or decrease over time. The features that make the 401(k) plan the more useful retirement planning vehicle are as follows:

• Salary deferrals—The maximum salary deferral amount of $9,500 is substantially higher than in the SIMPLE.
• Maximum tax shelter—The total maximum contribution on behalf of a highly compensated employee is $12,000 in a SIMPLE and as high as $30,000 in a 401(k) plan.
• Matching contributions—The matching contribution in a 401(k) plan can match both the employer’s goals and the budget. Matching contributions can be subject to a vesting schedule and may even be made on a discretionary basis.
• Profit-sharing contributions—Nonelective contributions can be allocated using a cross-testing method in which the lion’s share of the contribution is on behalf of the highly compensated employees.
• Coverage—The qualified plan coverage requirements are more flexible and allow the employer to keep part-time employees out of the plan. 
• Loans—Participant loan programs are an important feature in the 401(k) plan. Participants are less reluctant to make salary deferral contributions if they feel that they will have access to these funds without adverse tax consequences.

There are, however, a few clear advantages to the SIMPLE. First, establishing and maintaining a SIMPLE is considerably less complicated than a 401(k) plan. The plan document is short and easy to read, and no IRS determination letter is involved. The employer’s responsibilities are limited to establishing the plan, giving participants the opportunity to make a salary deferral election, distributing the trustee-provided summary plan document, and directing contributions to the IRA trustee. The sponsor does not even have to reach out to any specific service provider; it can require that the participants take the step of establishing their own SIMPLE IRA. The employer does not have to worry about annual administrative tasks, such as completing annual Form 5500s, nondiscrimination testing, or calculating the various contribution limits that apply to 401(k) plans. In those plans, the paperwork involved in distribution planning has become quite complicated. Spousal elections, mandatory withholding, and direct transfer options are costly. In the SIMPLE, none of these is a concern. Distributions can occur at any time and require no involvement by a plan administrator. The distribution transaction is between the participant, the trustee, and the tax collector. All these factors translate into significantly lower operating costs than for a 401(k) plan. In addition, less administration means less exposure to plan noncompliance problems that can have a negative impact for the sponsor, service providers, and/or plan participants.

For the employer looking to contribute the smallest amount to the plan, the advantage in most cases will go to the SIMPLE. Theoretically, a small employer-sponsored 401(k) plan can provide for employee salary deferral contributions only. When this is the case, the employer’s only cost is for administration (and some of those costs can be passed on to the participants). However, if the plan is top-heavy ⁵—which is often the case for the small-employer plan—the employer is required to make a 3 percent contribution for nonkey employees.⁶ Unfortunately, the top-heavy contribution requirement generally cannot be satisfied with matching contributions, so the employer who has a match must still make the additional 3 percent contribution. In comparison, the 3 percent SIMPLE contribution only has to be made for those employees who make salary deferral elections. If the employer is on a tight budget and expects full participation, then the employer can elect the 2 percent nonelective contribution instead or periodically lower the matching contribution to as low as 1 percent. Even when comparing the SIMPLE to a non-top-heavy 401(k) plan, the sponsor with a small budget is still going to be more interested in spending its limited plan dollars on employee benefits and not on administrative expenses.

5. In top-heavy plans the aggregate of the accounts of key employees under the plan exceeds 60 percent of the aggregate of the accounts of all employees.

6. IRC Sec. 416(c). Note that most employers required to make a 3 percent contribution for nonkey employees will end up choosing to contribute the same amount for key employees as well.

The strengths of the SIMPLE make it an interesting option for the small employer with a small benefit budget that is shopping for its first retirement plan. It’s hard to imagine that the employer currently maintaining a 401(k) plan will want to give up its design flexibility. But to the small employer, the SIMPLE is an inexpensive, easy-to-administer plan that can give the company a competitive edge by providing a 401(k) lookalike retirement program. It’s too early to tell how well this plan will catch on, and its success will depend in part on the types of products service providers make available and the aggressiveness with which the SIMPLE is marketed. But if the SIMPLE does become popular, this should be good news for employees and for employee benefits service providers. Hopefully the SIMPLE will open up a whole new market of retirement plan sponsors.

Remember that the SIMPLE can also be sponsored by nonprofit organizations and government entities, but governments will not be adopting them because they have other retirement plans. On the other hand, the nonprofit sector could be the largest potential market for the SIMPLE because many nonprofit organizations fit the appropriate profile: fewer than one hundred employees, no current retirement plan, a small budget, and a concern for the retirement security of employees. For these organizations, if the employer can afford the contribution, the SIMPLE can look quite attractive. Low administrative expenses mean that most of the money spent goes towards providing benefits. Even 501(c)(3) organizations that are eligible to sponsor 403(b) plans should consider the SIMPLE. The 403(b) plan is generally the appropriate choice if the employer does not make any contributions (salary deferral only), since this type of plan is generally exempt from ERISA and many of the income tax rules as well. However, if the employer is going to make a modest contribution, maintaining a 403(b) plan becomes almost as complex as a 401(k) plan. Here the employer should seriously consider the SIMPLE.

For example, a small nonprofit organization with 10 employees has an interest in sponsoring a retirement plan. They have a budget of 3 percent of compensation and also want to allow employee pretax salary deferrals. They have already explored the 403(b) and 401(k) options and are discouraged by the administrative costs of maintaining either plan. For them the SIMPLE is by far the superior choice, and they are excited about setting one up as soon as possible.

In contrast to the SIMPLE, the 401(k) SIMPLE is a whole different story. Here, it is hard to see just who will benefit from this plan design option. The employer is subject to the rigid design restrictions of the SIMPLE without the benefit of significant simplification. The 401(k) SIMPLE does eliminate nondiscrimination testing as well as the top-heavy problem, but the employer must adopt and maintain a 401(k) plan document, meet qualified plan reporting and disclosure requirements, and comply with the various distribution requirements. This option might make sense for the employer who is already sponsoring a 401(k) plan but has been frustrated by either the top-heavy test or has had to significantly limit contributions for highly compensated employees because of the nondiscrimination tests. This employer might be interested in sponsoring a SIMPLE, but making a transition would require terminating the 401(k) plan, distributing benefits, and establishing the SIMPLE with individual IRAs. Instead, the employer could amend the plan into a 401(k) SIMPLE, while retaining the same funding vehicle and avoiding the plan termination. Also if the company later outgrows the 401(k) SIMPLE, the SIMPLE provisions can be revoked, allowing a seamless transition into a more complex 401(k) plan design.

Other features that can make the 401(k) SIMPLE more attractive than the SIMPLE with IRAs include

• participant loans—Like other 401(k) plans this plan can offer a participant loan program.
• flexible coverage requirements—One advantage of the qualified plan rules that is helpful to the employer with a large number of part-time employees is the ability to exclude employees with fewer than 1,000 hours of service.
• other plans—Even though employees in the 401(k) SIMPLE cannot be covered in another retirement plan, the sponsor can maintain another plan for other employees. This might be helpful if the employer has, for example, two work sites and wants a different plan for each group.

At the present time, no one knows whether the SIMPLE (or the 401(k) SIMPLE) will be a hit, or like the SARSEP, another flop. The SIMPLE solves some of the SARSEP’s problems but also sets up some new roadblocks for the sponsor. The benefits professional who is turned off by the lack of flexibility should stay open to the possibility that this plan may look good to the small, struggling business or nonprofit organization. To this group a plan that is easy to understand, explain, and administer may look quite attractive—spawning a whole new generation of retirement plan sponsors.

Where Can I Find Out More?

• HS 326 Planning for Retirement Needs. The American College.
• HS 341 Selected Retirement Plan Topics. The American College.
• GS 814 Advanced Pension and Retirement Planning I. The American College.
• IRS Model SIMPLE plan documents. Form 5305-SIMPLE, to be used with a designated financial adviser, and Form 5304-SIMPLE, to be used when there is not a designated financial adviser.
• IRS Model SIMPLE IRA forms. Form 5305-S: SIMPLE individual retirement trust account and Form 5305-SA: SIMPLE individual retirement custodial account.
• IRS Notice 97-6, which provides guidance in a question-and-answer format regarding SIMPLEs.
• IRS Rev. Proc. 97-9, which contains a model amendment for 401(k) plan sponsors that want to adopt the 401(k) SIMPLE provisions.
• Internal Revenue Code Sec. 408(p), which lists the SIMPLE requirements.

401(k) Plans after the Small Business Job Protection Act of 1996
David A. Littell

What Was the Situation Before?

In the 1990s, 401(k) plans have taken the pension market by storm. In 1995, for example, 70 percent of all newly adopted qualified plans were 401(k) plans. The Profit Sharing/401(k) Council of America’s 1995 survey showed that the average 401(k) participation level was 86 percent and that the average participant account balance stood at $65,294. This represents an increase from 80 percent in 1994, and a doubling of the 1990 account figure of $31,246. The primary dissatisfaction with these plans has been their administrative complexity. Also as workers have become used to—and attached to—their 401(k) plans, nonprofit organizations, which couldn’t sponsor 401(k)s, were at a competitive disadvantage with for-profit organizations.

What Is the Nature of the Change?

The Small Job Protection Act of 1996 responded to both these concerns by expanding access to the 401(k) plan and by simplifying plan administration. Some simplification provisions directly focused on 401(k) concerns, while others had an impact on a broader spectrum of plans.

Broader Access. Beginning in 1997, nonprofit organizations (and Indian tribal governments) can now sponsor 401(k) plans.⁷ This should be very good news for those nonprofit organizations that have not been eligible to sponsor either 401(k) or 403(b) plans (organizations that are not 501(c)(3) nonprofit organizations). These employers—which include business associations, private clubs, labor unions, credit unions, and civic leagues—could not previously sponsor any type of tax-sheltered plan. Under the new law, 501(c)(3) charitable organizations are now able to choose between 401(k) and 403(b). Even though the 403(b) plan is still the appropriate choice in most situations, some employers will want the ability to have a vesting schedule or to invest in a broader range of investments than is afforded by the 401(k) plan.

7. This extension does not apply to state and local government entities, which are still prohibited from maintaining 401(k) plans.

Changes to ADP and ACP Testing. 401(k) plans continue to have to satisfy a nondiscrimination test for employee elective salary deferrals (called the ADP test) and a nondiscrimination test for employer-matching contributions as well as participant after-tax contributions (called the ACP test). In most ways the methodology remains the same, and the objective of the tests remains the same, as well—to limit contributions for the highly compensated employees (HCEs) based on the level of contributions made for the nonhighly compensated employees (NHCEs). However, there are several welcome changes that will make it easier to perform and satisfy the tests. One change is the timing of the testing. Under the prior law, the maximum average deferral percentage for the HCEs for the current plan year was based on the average deferrals of the NHCEs for the current year, so it could not be determined with certainty how much the HCEs could contribute to the plan until the close of the plan year.

Under the new law, determining the maximum average deferral percentage for the HCEs for the current year is based on the previous year’s results for the NHCEs, which means that the employer knows for certain at (or near) the beginning of the year how much the HCEs can elect to defer. Now it is much more likely that the plan will satisfy the ADP test. This new methodology applies to the ACP test as well.

The IRS has clarified⁸ that the new law really means using the deferral percentages for the NHCEs for the previous year, applying law in effect during that year and deferral percentages for that year. For example, this means that in 1997, the NHCE percentage is the same as was used to calculate the 1996 ADP test. Also note that the law provides that for the first year that the plan allows employee salary deferrals, the deferral percentage for the NHCEs is deemed to be 3 percent (meaning that the ADP for the HCEs can be up to 5 percent).

8. IRS Notice 97-2.

The new law also gives the employer the right to elect to continue performing the tests using current-year numbers—as under the old rules. The IRS has clarified that for 1997, no special election needs to be made in order to elect the current-year numbers in 1997 and that an employer electing to use the current-year numbers in 1997 can elect back in 1998. The IRS has not yet provided guidance on the ability to go back and forth between the two methods for years after 1997. In the average case, employers will welcome the new law and will not make the election. However, the decision to use current-year salary ADP will be made in situations where NHCE deferral contributions tend to be volatile from year to year.

Highly Compensated Employees. Another welcome change under the new law is a simplified definition of highly compensated employee. Beginning in 1997, highly compensated employees include only individuals who are 5 percent owners during the current or previous year and individuals who in the previous year earned at least $80,000 (as indexed in 1997). The employer has the option to limit the second category to only those employees who are in the top-paid group. The top-paid group includes those employees whose earning are in the highest-paid 20 percent of the employees. IRS has not yet provided any guidance regarding top-paid group election.

Under the old rules, the highly compensated employee determination was quite complex, and employees with compensation as low as $66,000 (in 1996) could be considered highly compensated. Also under the old rules, the highest-paid officer was considered an HCE regardless of salary. Under the new rules, the floor is raised, the determination is less complicated, and the one-officer rule no longer applies.

There are few complications under the new rules. Still note that certain attribution rules apply for determining 5 percent ownership. A participant is considered owning any stock owned by his or her spouse, children, parents, and grandparents. It’s also interesting to note that under the new rules, newly hired executives (who are not 5 percent owners) may not become highly compensated employees for several years. For example, take an individual hired at a company with a calendar plan year. The employee is hired on July 1, 1997, with an annualized salary of $100,000 but earns only $50,000 in 1997. This individual does not become highly compensated until 1999.

Employers with more than 20 percent of the workforce earning more than $80,000 (such as law firms and medical practices) will have to decide whether or not to make the "top-paid group" election. Unfortunately, no general rule can be given; the decision will be based upon the specific facts and objectives of the employer.

Family Aggregation Rules. Under the old law, the family aggregation rules significantly complicated 401(k) administration. The old law actually had two aggregation rules. One treated all members of one family (parents, grandparents, children, and grandchildren) as one highly compensated employee. This treatment particularly had an impact when performing the ADP test. The second—and more onerous—rule limited compensation to a total of $150,000 (the compensation cap in 1996) for married couples and children under age 19 when one partner was either a 5 percent owner or one of the 10 highest-compensated employees. Effective for plan years beginning in 1997, both of these rules were repealed. Now families are no longer penalized, and performing the tests is less complicated.

New Correction Method for Plans That Fail the ADP Test. Under the old rules, if a plan did not satisfy the ADP or ACP test at the end of the year, the plan had to take corrective action. This meant distributing or recharacterizing salary deferrals of specified HCEs. Under the old rules, the HCEs with the highest deferral were the first to have their deferral amounts reduced. However, the individuals with the highest deferral percentages were often the lowest-paid HCEs. In most cases, employers would prefer to have the owners or others with the highest contributions be corrected first.⁹ Effective for 1997, the law requires that the HCE with the largest dollar deferral be corrected first. Hopefully, however, correction of failed tests will occur much less often under the new testing rules.

9. IRS Notice 97-2 provides a specific methodology for making correction calculations.

Special Testing Rules for 401(k) Plans That Allow Early Participation. Under previous law, Code Sec. 410(b) allowed plans that included individuals who did not meet the statutory minimum age and service requirements (one year of service and age 21) to separately test whether that group of employees satisfied the minimum coverage requirements. The rule was intended to make sure that plans were not punished for including those individuals. Although there was no similar statutory provision under the ADP and ACP tests for 401(k) plans, IRS guidance had permitted separating this group and testing it separately under both tests. The new statutory provision goes a bit further. Now, in any case where the employer separately tests such employees for coverage under the minimum coverage requirements, when performing either the ADP or ACP test, such individuals (except highly compensated employees) can simply be removed from the testing group. Note that this law does not go into effect until plan years that begin in 1999.

New Definition of Compensation under Code Sec. 415. Under the old law, compensation for purposes of determining the 25 percent or $30,000 maximum allocation limit was reduced by pretax contributions to a 401(k) or other tax-sheltered plan. Under the new rule, effective for plan years beginning after December 31, 1997, contributions to 401(k), 403(b), 457, cafeteria, and SIMPLE plans do not reduce compensation for Sec. 415 purposes. The old rule created a trap, especially for the second wage earner with low wages and high contributions to the plan. For example, an individual with $20,000 in compensation who deferred $5,000 had deferred too much. The new law removes the trap beginning in 1998. However, note that the problem still exists under the 15 percent maximum deduction rules for a profit-sharing (including 401(k)) or stock bonus plan. Here compensation is still reduced by the above-mentioned salary deferral amounts.

Other Related Changes. In addition to those rule changes mentioned above, other issues discussed in this chapter affect 401(k) plans. Because the 401(k) is a qualified plan, the distribution rule changes discussed in the Appendix apply to 401(k) distributions. Also employers eligible to sponsor a traditional 401(k) plan now have the opportunity to choose instead a SIMPLE, a 401(k) SIMPLE, or, beginning in 1999, the safe harbor 401(k) plan. The discussion of the SIMPLE in this chapter reviews the plan sponsor’s new options. See those sections for a discussion of these issues. Also review the Appendix for other issues that have an impact on qualified plans.

What Should Be Done?

The first step for the financial adviser—and those involved in plan administration—is to learn the rules. Most of the new rules are effective in 1997, and plans must administered in compliance with the new law. Generally plans need not be amended for the new law until 1998; however, the IRS has indicated that plans with family aggregation concerns should be amended to eliminate the family aggregation rules in 1997.

It’s also important to learn how the new law can help clients. The new rules repealing family aggregation and limiting the group of employees who are considered HCEs may allow the plan to better meet the objectives of the owners and the highly compensated, especially for businesses in which both spouses are working. In addition, plans that have had discrimination concerns should be relieved, because it is now easier to ensure plan compliance. Plan sponsors will want to review the new plan options to see if any of them are helpful (see discussion of SIMPLE).

Finally, consider whether the law changes can open up new markets. The most important development is the opportunity to install 401(k) plans in the nonprofit marketplace. In addition, the simplified rules, which make it easier to test and ensure compliance, may persuade more small businesses to sponsor a 401(k) plan.

Where Can I Find Out More?

• HS 326 Planning for Retirement Needs. The American College.
• GS 814 Advanced Pension and Retirement Planning I. The American College.
• IRC Secs. 401(k), 414(q), 410(a)(17)(A), 415(c)(3)(D)
• Kenn Beam Tacchino and David A Littell. Planning for Retirement Needs. Used in The American College’s HS 326 course.
• David A. Littell, Kenn Beam Tacchino, and David W. Cordell, eds. Financial Decision Making at Retirement. Used in The American College’s HS 336 course.
• David A. Littell et al. Retirement Savings Plans: Design, Regulation, and Administration of Cash or Deferred Arrangements and Retirement Savings Plans Supplement. Used in The American College’s HS 341 course.

The 15 Percent Excise Tax Moratorium—Should You Bite?
John J. McFadden

What Was the Situation Before?

Congress has long been concerned that the substantial tax incentives included in the qualified plan provisions will be used disproportionately by highly compensated employees (HCEs) who in their view need no government help in saving for retirement. Code Sec. 415 (enacted as part of ERISA in 1974) sets limits on annual additions to a defined-contribution plan (the lesser of 25 percent of compensation or $30,000, as indexed) and on benefits under a defined-benefit plan (the lesser of 100 percent of average compensation or $125,000, as indexed). Under Sec. 415(e), if a participant was covered under both a defined-benefit plan and a defined-contribution plan of the same employer, a complex computation involving a combination fraction had to be made each year to limit total benefits so that it was not possible to maximize both the defined-benefit and defined-contribution amounts.

The Tax Reform Act of 1986 added another provision aimed at preventing excessive qualified plan accumulations by HCEs, the 15 percent excess distribution tax. Under this provision, an excise tax of 15 percent is enacted on annual plan distributions exceeding $160,000 (indexed), in addition to the regular income tax. There are provisions exempting accrued benefits in excess of $562,500 as of August 1, 1986 (the grandfathered amount). There is also an additional 15 percent estate tax on excess accumulations at death.

What Is the Nature of the Change?

Congress has apparently determined that the existence of all the provisions described above constitutes overkill, and has repealed the combination-fraction computation of Section 415(e).

When Does This Change Affect Clients?

The combination-fraction repeal becomes effective after 1999. To provide relief during the interim period, the 15 percent excess distribution tax (but not the excess accumulation tax) is suspended for years beginning after December 31, 1996 and before January 1, 2000. Distributions during this period are deemed to be made first from non-grandfathered amounts.

What Should Be Done?

The repeal of Section 415(e) is welcome and will simplify administration of plans covering owners and executives, as well as open new opportunities for creative plan design after 1999. In the interim, however, the question is whether the moratorium on the 15 percent excess distribution tax should eagerly be taken advantage of.

Should clients accelerate distributions—that is, take distributions in excess of $160,000 (as indexed) each year? Note that 5-year averaging expires after 1999, seemingly adding urgency to this possibility.

However, clients should do some sober reflecting (and calculating) before rushing to withdraw more from their qualified plans than they ordinarily would. Accelerating distributions means that the benefits of deferring income taxes are lost. In fact, from the Treasury’s point of view, the suspension of excise taxes is a Trojan horse; this purported benefit to taxpayers will actually increase income tax revenues during the 3- year period as taxpayers rush to take advantage of the opportunity to pay their income taxes early.

When is it really beneficial to take distributions during the 3-year moratorium to avoid the 15 percent excess distribution tax? Apparently not very often. Consider these points:

• If the participant’s account is not large enough ever to attract any significant 15 percent excess distribution taxes, the moratorium is of no use. Account balances as large as $1 million may be subject to little or no 15 percent tax if the participant and spouse live out their normal life expectancy.
• Pension distribution software that shows various payout scenarios is indispensable in advising clients on this issue. In general, the crossover point (number of years of survival after a lump-sum distribution when deferring taxes becomes more advantageous than taking a lump sum under the moratorium) comes quite soon in most scenarios.
• For very large distributions, the crossover point comes later because the moratorium saves large amounts of 15 percent taxes. However, in one scenario run on a popular pension distribution software package, even an $8 million pension accumulation had a crossover point that came sooner than the joint life expectancy of the 70-year-old participant and spouse.
• The larger the grandfathered amount, the sooner the crossover (because the grandfathered amount itself avoids a considerable portion of the 15 percent tax).
• The crossover point depends heavily on projected rates of return and projected tax rates. These are difficult to predict with accuracy and probably are best addressed using best-case and worst-case scenarios.

In short, running the numbers with pension software provides an important reference point in making this decision, but ultimately planners and clients must use their best judgment. Factors include:

• health status of participant and spouse
• age of participant and spouse
• need for money
• charitable intentions (A charitable gift gets income/estate tax deductions but is subject to 15 percent excess distribution tax. This includes charitable remainder gifts. See chapter 15 for further discussion.)

Where Can I Find Out More?

• Stephan R. Leimberg. Pension and Excise Tax Planner software. Phone (610) 527-5216.

Qualified Plan Options for Nonprofits
John J. McFadden

What Was the Situation Before?

Nonprofit organizations (private corporations or other entities entitled to federal tax exemption under Code Sec. 501) were entitled to adopt qualified plans for their employees, except that Sec. 401(k) plans and salary reduction SEPs were not available. For organizations qualifying under Sec. 501(c)(3) (religious, charitable, educational and similar organizations) Sec. 403(b) annuity plans were available as an alternative. However, for other types of nonprofit organizations such as business leagues, lobbying organizations, and credit unions there was no way to design a practical salary-reduction (elective-deferral) plan for a broad group of regular employees. Code Sec. 457 permitted a limited form of salary-reduction deferred-compensation plan, but this was effectively available only to a select group of management or highly compensated employees.

What Is the Nature of the Change?

Repeal (as part of the Small Business Act of 1996) of the prohibition on 401(k) plans for tax-exempts expands the options for tax-advantaged salary-reduction (elective-deferral) plans for nonprofit employers. Here are the current options for salary-reduction plans, reflecting the new SIMPLE provisions and the repeal of SARSEPs:

• 501(c)(3) organizations¾ 401(k) plan, 403(b) plan, SIMPLE (if 100 or fewer employees and no other qualified plan, etc.), 457 plan for select group of management or highly compensated employees
• other 501 tax-exempts¾ 401(k) plan, SIMPLE (if 100 or fewer employees and no other qualified plan, etc.), 457 plan for select group of management or highly compensated employees

When Does This Change Affect Clients?

These provisions of the Small Business Act take effect for plan years beginning after December 31, 1996.

What Should Be Done?

For 501 organizations other than 501(c)(3)s, the new provisions will prove a boon for benefit plan design for regular employees. Many such organizations were frustrated by their inability to meet their employees’ demands for a 401(k) plan or alternative, and the new provisions will make it much easier for these organizations to provide retirement benefits that attract and retain employees.

For 501(c)(3) organizations, the new provisions will require the organization to review its current plans and in many cases choose between a 401(k) plan and a new or existing 403(b) plan. There generally is little or no advantage in maintaining both types of plan since the elective-deferral limit is $9,500 (indexed) per employee effectively on an aggregate basis—that is, having both plans does not generally allow an employee to make additional elective deferrals.

In the current state of limited experience with this issue, most practitioners believe that 403(b) plans are generally more favorable as an option. The advantages of 403(b) plans include the following:

• no ADP testing (although employer contributions are subject to 401(m) tests)
• no ERISA applicability for salary-reduction-only plans
• entire plan not disqualified for exceeding $9,500 limit for one employee
• Sec. 415 limitation more favorable (403(b) plan not aggregated with other plans)
• top-heavy rules don’t apply

By contrast, 401(k) plans have only a few advantages over 403(b) plans, including the following:

• somewhat broader investment flexibility—not limited like 403(b) plans to annuity contracts and mutual funds
• the ability to accept rollover contributions from qualified plans
• 5-year and 10-year averaging on lump-sum distributions

Because of potential complexities in actual situations, however, this choice should always be carefully studied for the individual case at issue.

Where Can I Find Out More?

• GS 814 Advanced Pension and Retirement Planning I. The American College.
• IRC Sec. 401(k)(4)
• Stephan R. Leimberg and John J. McFadden, Tools and Techniques of Employee Benefit and Retirement Planning, 5th edition, The National Underwriter Company. Phone (800) 543-0874.

Chapter 4

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Chapter 6