Human Resources: IRS Issues Sample Amendments for New Tax Law

From The 401(k) Handbook, Â©Thompson Publishing Group, Inc.

The IRS has recently released guidance and sample amendments for implementing the changes in the Economic Growth and Tax Relief Reconciliation Act (EGTRRA). IRS Notice 2001-56 shows sponsors of 401(k) and other qualified plans how to comply with the new law´s effective dates, and Notice 2001-57 provides sample amendments to implement new features and limits.

New Hardship Distribution Rules
IRS regulations allow certain "deemed" hardship distributions from the plan without requiring financial information disclosures under specifically identified circumstances. But the participant´s elective contributions and employer matching contributions are suspended for at least 12 months after the distribution. EGTRRA requires the IRS to reduce this suspension period to six months. Notice 2001-56 provides that the revised regulations will be effective for calendar years beginning after Dec. 31, 2001, and will not be limited to hardship distributions received after that time, but can be applied to hardship distributions made before this date. According to the notice, a plan can be amended "to provide that an employee who receives a hardship distribution in 2001 is prohibited from making elective deferrals and employee contributions for six months after receipt of the distribution (or until January 1, 2002, if later)."

Plans generally do not have to take advantage of the revised regulations regarding hardship distributions. However, plans that use safe harbors for matching contributions or non-elective (3 percent) contributions to satisfy the 401(k) nondiscrimination tests must shorten the suspension period after a hardship distribution. Notice 2001-56 requires these plans to shorten their suspension periods from 12 months to six months to continue taking advantage of the matching contribution safe harbor for calendar years beginning after 2001. The safe-harbor plans have the option of applying the six-month suspension only to hardship distributions that occurred after Dec. 31, 2001.

Top-Heavy Plans
Top-heavy plans require faster vesting and increased employer contributions. A 401(k) plan is top-heavy if the total combined value of accounts held by all "key employees" is greater than 60 percent of the total value of all plan accounts. The critical definition in this determination is that of the "key employee." Beginning with the 2002 plan year, EGTRRA makes several favorable changes to the "key employee" definition. However, because top-heavy status for 2002 will be determined on the last day of the 2001 plan year, it was unclear if plans would have to wait until 2003 to take advantage of the new rules. Notice 2001-56 determines the 401(k) plan´s top-heavy status for the 2002 plan year, and the plan need not use the old law´s four-year look-back rule to determine key employees. For the 2002 plan year, key employees will be only those individuals who, in the 2001 plan year were: (1) officers who earned $130,000 or more; (2) 5-percent owners; and (3) 1-percent owners earning more than $150,000. No more than 50 people will be treated as officers, and the number may be less in certain situations.

Covered Compensation
EGTRRA also increased the tax code´s limit on the amount of compensation that can be considered in making deferrals or contributions to any tax qualified plan. The limit will be raised from $170,000 in 2001 to $200,000 for plan years beginning in 2002. Also increased is the percentage limit from 25 percent of total compensation to 100 percent for plan years after 2001. There were questions whether the new limits could be used for contributions or benefit accruals being calculated in the 2002 plan year and thereafter, if the contributions and accruals were actually based on the compensation earned in years prior to 2002. While this question primarily arises in defined benefit plans calculations, it is also connected with certain 401(k) plans. For example, a profit sharing allocation in connection with a 401(k) plan (although not technically considered part of the 401(k) plan) might base contributions made in 2002 on the compensation earned in 2001.

Notice 2001-56 gives plans the option to use the higher 2002 amount, although the examples in the notice involve only defined benefit plans. However, the notice specifically refers to accruals or allocations. A plan that uses annual compensation earned prior to the 2002 plan year to determine accruals or allocations for a plan year that begins on or after Jan. 1, 2002 may "provide that the $200,000 compensation limit applies to annual compensation for such prior periods in determining such accruals or allocations."

For example, assume that Ellen, a profit sharing plan participant, earned $210,000 in 2001. The profit sharing plan makes its contribution for the 2002 plan year based on 2 percent of the prior year´s compensation. If the plan elects to use the higher covered compensation limit under the law in 2002 of $200,000, Ellen will receive $4,000 (2 percent of $200,000) as her 2002 contribution. If the plan elects to use the old limit in effect in 2001, she would receive only $3,400 (2 percent of $170,000).

Sample Plan Amendments
Because so many of the EGTRRA changes are optional, such as the reduction in the suspension of plan contributions after a hardship withdrawal, rapid adoption of plan amendments is important. Additionally, IRS Notice 2001-42 announced a remedial period running at least through the 2005 plan year for the adoption of any needed retroactive remedial EGTRRA amendments. But such a remedial period will be available only for those plans that made a good faith effort to timely adopt any plan amendments for: (1) changes required by EGTRRA (such as faster 401(k) matching contribution vesting); or (2) optional changes the plan sponsor elects to make if the plan language is not consistent with the operation of the plan.

An amendment will be considered a "good faith EGTRRA amendment" if the language shows a reasonable effort to take into account all EGTRRA requirements for the relevant provision and does not reflect an unreasonable or inconsistent interpretation of the provision.

Fortunately, Notice 2001-57 provides sample amendments for most of the provisions affecting 401(k) plans. Adoption of the relevant sample amendments provided in the notice in a timely fashion will be deemed to be a "good faith EGTRRA amendment." The amendments need not be adopted verbatim, and reasonable changes for consistency with the plan document are permitted. The sample amendments are also designed to be used with both individually designed and pre-approved plans.

Check Plan Language, Even If No Changes Anticipated
Most of EGTRRA´s changes for 401(k) plans, with the exception of faster vesting for matching contributions, are optional. Nevertheless, even plan sponsors that do not intend to adopt some of the optional provisions should review plan documents and summary plan descriptions (see related story, p. 1). If these documents contain references to current law citing specific sections of the Internal Revenue Code or use such phrases as "the maximum amount permitted by law," the plan will be bound by that language and the plan sponsor will have adopted the new law regardless of its intentions. For example, if the plan does not intend to permit employees to defer 100 percent of compensation to the 401(k) plan, but references Section 415(c) of the Internal Revenue Code, then the plan will have inadvertently adopted the 100-percent-of-compensation limit for plan years beginning after Dec. 31, 2001. Such language is relatively rare, but a review of the plan now could save trouble and prevent controversy - not to mention embarrassment - later.

More Guidance in October
The IRS recognizes that many of the issues and questions on EGTRRA changes are not resolved by the sample amendments. Additional amendments may be required as the IRS releases more guidance over the next few months.

The IRS is expected to release more EGTRRA guidance by this month. Of special interest will be rules for tracking the 401(k) catch-up provisions for plan participants who will be age 50 or older as of the end of the 2002 plan year. IRS is well aware that whether plan sponsors choose to offer plan participants this important additional retirement savings advantage will depend largely on how easy it is to administer. If the IRS imposes several reporting and tracking requirements, sponsors are not likely to offer the catch-up opportunity. Plan sponsors and benefits professionals are urging IRS to keep the catch-up requirements as simple as possible.

Martha Priddy Patterson is the director of employee benefits policy analysis with Deloitte & Touche LLP´s Human Capital Advisory Services in Washington, D.C. Patterson is the contributing editor of The 401(k) Handbook.