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what they really mean

Finally, legislators say
what they really mean

On Aug. 20, 1996, President Clinton signed into law the Small Business Job Protection Act. This act contains numerous “pension-simplification” provisions and represents the most significant pension legislation since the Tax Reform Act of 1986.
In a pleasant change from recent tax legislation, the pension-simplification provisions of the act will, in fact, really simplify many aspects of retirement plans.
The most significant changes have been made to so-called 401(k) plans. Generally, 401(k) plans permit employees to direct that a portion of their salary be placed in the plan as opposed to being paid directly to them. Such deferrals occur on a pretax basis, so that the participating employee’s taxable income for the year is reduced by the amount contributed to the plan.
Under the act, for the first time in recent history, such plans also will be available for tax-exempt employers (other than governmental employers).
Generally, 401(k) plans have been required to undergo complex yearly testing to ensure that highly compensated employees (“HCEs”) are not deferring at a significantly greater rate than all other employees. These plans also often offer “matching contributions” to entice employees to participate (i.e., the employer makes a contribution equal to a percentage of the employee deferrals). Such matching contributions have been subject to similar discrimination tests.
This testing has constituted a complex and costly burden, frequently requiring 401(k)-plan sponsors to dedicate significant staff time and to hire outside consultants to ensure that the tests are met.
Beginning in 1999, the new law provides several safe harbors that will eliminate the need for such testing. In addition, the new law offers simplified testing methods that can provide significant relief starting next year.
Presently, employers are required to perform the annual non-discrimination testing based upon the contributions for the current year. This generally results in considerable year-end administrative scrambling, sometimes including the return to HCEs of some of their contribution.
The new law permits employers to test on the basis of the prior year’s contributions. These new rules become effective for years beginning after Dec. 31, 1996, and should permit employers to notify HCEs early in the plan year as to the percentage that they will be permitted to contribute for that year.
Starting in 1999, employers may choose from two safe harbors. However, both require certain minimum employer contributions. In order to take advantage of either option, the employer must provide employees with advance notice of their rights and obligations under the safe-harbor plan.
Safe harbor No. 1: No testing is required if employer contributions are made on behalf of all eligible non-HCEs equal to at least 3 percent of their compensation.
Safe harbor No. 2: No testing is required if matching contributions are made on behalf of each non-HCE on a dollar-for-dollar basis up to the first 3 percent of compensation deferred plus an additional 50 percent of each dollar on deferrals between 3 percent and 5 percent of compensation.
In order to take advantage of either of the above safe harbors, the additional employer contributions (either matching or non-elective) must be 100 percent vested at all times.
An additional safe harbor exists with regard to matching contributions. Generally, this safe harbor is met if one of the above deferral safe harbors is used and the employer match is level for all participants and capped at no more than 6 percent of an employee’s compensation.
Employers are not required to follow one of the safe harbors; where they believe the “old rules” are more advantageous, they can continue to use them. To decide which course to follow, employers must weigh the costs of providing additional fully vested contributions against the costs and administrative burden of annual testing. Those choosing a safe harbor, however, will significantly reduce the administrative burden they now face in testing their 401(k) plans.
As one can see from the discussion above, the concept of who is an HCE is crucial to a number of the non-discrimination tests. Unfortunately, the definition of HCE historically has been extraordinarily complex. The new law attempts to remedy this with a simplified definition of HCEs.
Now, only 5 percent owners (during the current or prior year) or individuals receiving compensation in excess of $80,000 (indexed) in the prior year will be considered HCEs. This test may be used by any employer. However, alternative, more complex tests also are available.
Under the new law, small employers wishing to offer a salary-deferral arrangement now are given the option of adopting simplified plans as opposed to full-blown 401(k) plans. Beginning Jan. 1, 1997, a new “savings incentive match plan for employees”–a SIMPLE plan–may be adopted by employers with 100 or fewer employees.
The SIMPLE plans may be in the form of individual retirement accounts or may be part of a 401(k) plan. In general, these plans will shift significant administrative burdens from employers to sponsoring organizations such as banks and insurance companies.
Before adopting a SIMPLE 401(k), an employer must consider several unique requirements that distinguish such plans from traditional 401(k) plans.
First, the annual limit on deferrals is $6,000 (indexed) per participant (the limit for traditional 401(k) plans is $9,500). Second, the employer must not maintain another qualified plan benefiting its employees. In addition, the employer must make certain fully vested contributions. Such contributions may be in the form of either matching contributions up to 3 percent of compensation or a flat 2 percent contribution for all participants.
Unlike a traditional 401(k) plan, no other contributions may be made beyond those outlined above.
As one can see, SIMPLE plans are somewhat more restrictive than traditional 401(k) plans. In general, they provide for a significantly lower level of deferrals and lock an employer into a fixed contribution that may not be exceeded. However, they also may provide a significant new opportunity for small employers reluctant to undertake the burdens of a traditional 401(k) plan.
The act also effected significant changes to plan-distribution rules. Of particular interest to many participants: the temporary suspension of the 15 percent excess-distribution tax (the so-called “success tax”), as well as the elimination of special five-year averaging.
The benefits and burdens of these changes are beyond the scope of this article, but I will discuss them in detail in a subsequent column.
The act provided for several other potentially significant changes as well. Most are technical in nature and of primary interest to pension practitioners. For example, family-aggregation rules were repealed, and some of the contribution and benefits tests were eased.
For once, the term “legislative simplification” holds true. While most of these rules will primarily benefit employers sponsoring 401(k) plans, Congress certainly is moving in the right direction. One can only hope that simplified testing and safe harbors in the 401(k) context will lead the way for further initiatives to simplify this Byzantine area of the law.
(Michael McEvoy is a partner in the law firm of Harter, Secrest & Emery, where he concentrates his practice on tax matters. His associates, Paul Holloway and Mark Wilson, who concentrate on employee benefits, assisted with this article.)


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