PENSION AND EMPLOYEE BENEFIT PROVISIONS

John J. McFadden and Burton T. Beam, Jr.

The new law included a few significant provisions related to pensions and employee benefits. Probably the most important was the repeal of the 15 percent excise tax on excess distributions and accumulations. Combined with other changes, this will favorably affect qualified plan design, and the defined benefit plan may be due for a revival. The new law also included many technical changes that generally simplify plan administration; a few of the most significant of these technical changes are covered here.

Prior Law. Until 1996, there were two separate Code provisions aimed at preventing excessive accumulations in qualified plans for an individual participant. A 15 percent excise tax was imposed on annual distributions from qualified plans, 403(b) plans, and IRAs if the distribution exceeded an indexed threshold level (1997: $160,000). A corresponding tax was imposed on estates of decedents who died holding accumulated amounts from such plans. In addition, Code Section 415 (enacted as part of ERISA in 1974) provides limits on annual additions to a defined contribution plan (the lesser of 25 percent of compensation or $30,000, as indexed) and limits on benefit under a defined benefit plan (the lesser of 100% of average compensation or $120,000, as indexed). Under Section 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.

In 1996, Congress apparently determined that the existence of both of the provisions described above constituted overkill. As a result, the Small Business Act of 1996 repealed the combination fraction computation of Section 415(e), effective after 1999. To provide relief during the interim period, the 15 percent excess distribution tax (but not the excess accumulation tax) was suspended for years beginning after December 31, 1996, and before January 1, 2000.

New Law. The new law simply repeals Code Section 4980A (containing the excess distribution and excess accumulation tax provisions) leaving intact last year’s repeal of Code Section 415(e) effective after 1999.

Commentary. The effect of the 1996 and 1997 legislation represents a potentially significant new-millennium bonus for those in a position to maximize qualified plan accumulations. Under the law as now applicable, after 1999 plan participants may be able to combine defined-benefit and defined-contribution coverage in newly advantageous ways. The old Section 415 combined-plan limits will not be a factor in plan design, although existing limitations on deductions under Code Section 404(a)(7) will have a restraining effect. But distributions and accumulations will be free of the 15 percent excise tax, which otherwise would have significantly reduced any large accumulations. Combined/maximized plans could become very popular particularly for small closely held companies and professional corporations where owner-employees can dictate the design of qualified plan provisions. Because 10 years of plan participation is generally required to receive full benefits under a defined-benefit plan, some employers should investigate immediate adoption of a defined-benefit plan, in anticipation of the post-1999 rules.

Because of the repeal of the 15 percent tax retroactive to the beginning of 1997, the discussion of the moratorium in chapter 5 of Financial Planning 2000 is no longer applicable. However, individuals with substantial qualified accumulations must still weigh the advantages and disadvantages of taking distributions and paying income taxes, or accumulating and incurring future estate taxes. Except for very large accumulations, the 15 percent tax often was not a major factor in such planning and the repeal therefore may have relatively little impact in many cases.

Increase in Involuntary Cashout Limit

Prior Law: In order to simplify administration of qualified plans and Section 457 plans, the law permitted the plan administrator to pay out benefits valued at $3,500 or less upon the participant’s termination of participation, even if the participant did not consent to the immediate distribution.

New Law: This amount is raised to $5,000.

Annuity Rule for Recovery of Basis in Qualified Plan (Joint Lives)

Prior Law: The 1996 Small Business Act replaced the former annuity rules for recovery of basis from qualified plans with a simplified table. Under this rule, the total basis is to be divided by a number from a prescribed table, and the resultant amount is the amount of each monthly payment that is nontaxable. The table is as follows:

Only a single-life table was provided.

New Law: The new law provides an additional table for annuities paid over the life of more than one individual. The table is as follows:

Prior law. Prohibited transactions between an IRA or qualified plan and a disqualified person (for example, a lease of property between a qualified plan and the employer sponsor of the plan) were subject to a two-tier tax. The first-tier tax was 10 percent of the amount in question, followed by a 100 percent tax if the transaction was not undone.

New law. The first-tier tax is raised to 15 percent; the 100 percent tax remains unchanged.

401(k) and SIMPLE Matching Contributions for Self-Employed

Prior law: In the case of a self-employed individual (partner or proprietor) participating in a 401(k) plan or SIMPLE, matching contributions by the employer were often not practical since such contributions were treated as additional elective deferrals by the participant subject to the $9,500 limit ($6,000 for SIMPLEs).

New law. Matching contributions are not to be treated as elective deferrals, thus treating the self-employed the same as regular (nonowner) employees.

Elimination of SPD Filing Requirement

Prior law. The ERISA reporting and disclosure provisions required that employee benefit plans, including certain nonqualified deferred compensation plans, furnish a Summary Plan Description (SPD) to plan participants and to the Department of Labor. Modifications of the plan required similar filings of a Summary of Material Modifications (SMM).

New law. The requirement for Department of Labor filing of SPDs and SMMs has been eliminated. These documents, however, must still be furnished to participants as before.

Commentary. The new law eliminates what even the government viewed as pointless paperwork. However, note that SPDs and SMMs must still be prepared and furnished to employees. In some cases the requirement of DOL filings acted as an incentive to timely prepare and distribute these documents, and this incentive no longer exists. These documents can be critical in the event of disputes and litigation, and employers must continue to make sure they are properly prepared and distributed when required.

Increase in 403(b) Exclusion Allowance for Salary Reductions

Prior law. Under Section 403(b) plans (tax-deferred annuity plans available to certain tax-exempt organizations), the starting point in determining the maximum annual tax-deferred contribution amount is an amount referred to as the "exclusion allowance," which is equal to 20 percent of the participant’s "includible compensation" multiplied by his years of service, less prior contributions to the plan. Under prior law, includible compensation was in effect taxable compensation, so that if the employee made elective deferrals under the 403(b) plan or other such plan, his includible compensation was reduced for purposes of the exclusion allowance.

For example, for an employee earning $30,000 with one year of service and no prior plan contributions, the exclusion allowance for an elective deferral (salary reduction) contribution was $5,000 (20 percent of $25,000) rather than 20 percent of $30,000, since the includible compensation had to be reduced by $5,000 (the amount of the elective deferral).

New law. For purposes of the exclusion allowance, the includible compensation is grossed up to include elective deferrals under 403(b) plans, 401(k) plans, Section 125 cafeteria plans, and Section 457 governmental plans. Using the example above, under the new law the participant is entitled to an exclusion allowance of $6,000 (20 percent of the full grossed-up salary of $30,000) and can contribute $6,000 to the 403(b) plan by salary reduction.

Commentary. This provision will make 403(b) calculations simpler and may increase the amount that some employees can contribute. However, it does not change the $9,500 (indexed) maximum for salary reductions, so it will not affect highly compensated employees who already contribute the maximum amount.

Full Funding Limit for Defined-Benefit Plans

Prior law. Deductions for contributions to a defined-benefit plan were limited by a full funding limitation that was generally 150 percent of the plan’s "current liability." This provision often operated to obstruct the rational funding of defined-benefit plans by arbitrarily denying a deduction for certain years.

New law. The full funding limitation is raised to 170 percent for plan years beginning in 2005 or later, in a series of steps beginning with 155 percent in 1999 and 2000.

Commentary. This provision will tend to make defined-benefit plans more attractive by allowing greater current deductible contributions in some cases.

10% Limit on Investment of 401(k) Elective Deferrals in Employer Stock

Prior law. A qualified pension plan may not invest more than 10 percent of its assets in stock or other securities of the employer corporation and employer real estate. However, this limit does not apply to "individual account plans," which includes profit sharing and 401(k) plans. Under prior law there were no special provisions for accounts based on employee elective deferrals.

New law. Congress viewed the unlimited investment of 401(k) elective deferral accounts in employer securities or real estate, without the participant’s consent, as potentially abusive. Under the new law elective deferral accounts (including earnings on elective deferrals) are treated as a separate plan subject to a 10 percent limit on investment in employer securities and real estate. This new provision applies where the plan or any person other than the participant can direct more than 1 percent of the participant’s elective deferral account investments in employer securities or real estate.

Commentary. The new provision is a limited reform, applicable only to investments of elective deferral accounts without the participant’s consent. The following are still permitted:

• investment by the participant of more than 10 percent of his or her account in employer stock under a directed investment provision
• investment of employer contributions under a 401(k) or profit sharing plan in employer stock without limit
• ESOP plans with a 401(k) salary reduction feature, sometimes referred to as KSOPs

Combining SIMPLES and Collectively Bargained Plans

Prior law. An employer could not adopt a SIMPLE if it maintained any other qualified plan.

New law. If an employer has no qualified plan except a plan that covers only employees in a collective bargaining unit, it may adopt a SIMPLE for the non-collective bargaining employees.

Increase in Self-Employed Health Insurance Deduction

Prior Law: Self-employed persons (partners and proprietors) may deduct a percentage of health insurance costs incurred for themselves, and their spouses and dependents. This percentage was scheduled to increase to 80 percent for 2006 and thereafter.

New Law: The scheduled increase has been accelerated, beginning with 40 percent in 1997 and increasing to 100 percent for 2007 and thereafter.

Extension of Employer-Provided Educational Assistance Plans

Present Law: An employer can provide tax-free educational assistance benefits to an employee. Tuition, fees, and related expenses are eligible up to $5,250 annually per employee. Graduate-level courses are ineligible for this benefit. The provision was scheduled to expire May 31, 1997.

New Law: This provision has been extended to cover courses beginning before June 1, 2000.

New Coverage Rules for Group Health Plans

Prior Law: Until the adoption of the COBRA portability provisions, there were no specific requirements in the Internal Revenue Code that regulated coverage and benefits of an employer’s health plan. The COBRA provisions required certain portability provisions for terminating employees subject to a $100 per day excise tax for noncompliance. In 1996, two new requirements were added, subject to the same penalty: limited exclusions for preexisting conditions, and a limitation on exclusions for health status.

New Law: The new law adds two more requirements, also subject to the $100 per day excise tax for noncompliance. First, health plans can’t limit postbirth hospital stays to less than 48 hours. Second, limits on benefits for mental illness must be no more restrictive than those for medical/surgical benefits. However, nothing in the new law requires plans to provide either hospital benefits for maternity or mental health benefits. And, for that matter, there continues to be no law that requires an employer to maintain any health benefit plan for employees.

Commentary: While the failure of Clinton’s health insurance plan demonstrated that there is no support for massive federally mandated change in health plans, there has been considerable support for incremental provisions like these and this trend may continue. Since these provisions increase the cost of health plans, they may contribute to the continuing erosion of employer-provided health coverage.

Chapter 7 of Financial Planning 2000 should be read with these changes in mind.

Medical Savings Accounts

New Law: The following changes are made to eligibility for medical savings accounts:

• Persons who have medicare supplement policies are not eligible to establish medical savings accounts.
• A person eligible for medicare may establish a medical savings account beginning in 1999. The basic concept is that the secretary of health and human services would pay the premium of the high deductible policy purchased by such a person and then make a contribution to the person’s MSA equal to the difference between the insurance premium and a specified medicare capitation amount. This is only one of several changes that will allow beneficiaries to have several choices in addition to traditional medicare coverage. However, numerous regulations still must be issued before these changes can be fully implemented.

Commentary: Chapter 7 of Financial Planning 2000 should be read with these changes in mind.

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