I. Overview.
On January 31, 2003, the Bush
Administration proposed two new tax-advantaged savings programs plus a
reorganization of the defined contribution plan rules. This follows the
Administration’s earlier proposal to end the double taxation of dividends.
The savings proposals, if enacted, would rewrite many of the rules under
which employers and employees save for retirement. It is not clear at
this time to which constituency the President’s proposal will be most
appealing – large financial institutions, business owners, or working
Americans to whom it is purportedly directed.
The opening statement in the
Department of the Treasury release quotes the President: “Americans
can help secure their own future by saving. Government must support policies
that promote and protect saving. And saving is the path to independence
for Americans in all phases of life, and we must encourage more Americans
to take that path.” These are great aspirations; however, in practice,
how much more can the average working American really save in excess of
the currently available annual $3,000 IRA and 401(k) $12,000 limits?
The President’s proposal includes
three new consolidated savings accounts: Lifetime Savings Accounts (LSAs),
Retirement Savings Accounts (RSAs), and Employer Retirement Savings Accounts
(ERSAs). The first two are available to individuals, and the last consolidates
many employer sponsored saving plans into a single new program. LSAs and
RSAs would be available to all Americans, regardless of age and income.
These accounts would likely be established as individual accounts at mutual
fund companies, insurance or other custodial entities.
II. Savings Vehicles.
A. Lifetime Savings Accounts.
LSAs would allow all Americans to save for any financial goal including,
but not limited to, education, real estate, and medical expenses. Initially
up to $7,500 per year could be contributed with no income or age limits
applicable, and withdrawals could be made from the account at any time
without penalty. Thus, a couple could save $15,000, regardless of whether
both work, and $30,000 per year if they have two children. Unlike traditional
IRAs, these would not be deductible. However, like Roth IRAs, the earnings
and withdrawals would be tax-free. All of the contribution limits in the
proposal are tied to cost of living adjustments, and the current option
of making “catch-up” contributions for those over age 50 is
retained.
B. Retirement Savings Accounts:
RSAs would replace IRAs and be very similar to LSAs, except that only
withdrawals after age 58 would be tax-free. RSAs would act very much for
income tax purposes like current Roth IRAs. Like LSAs, there would be
no upfront deduction for these contributions. Here also a nonworking spouse
could make a full RSA contribution. The annual contribution limit would
be $7,500 per person, as opposed to the current IRA limit of $3,000.
C. Employer Retirement Savings
Accounts. ERSAs would replace many employer sponsored plans, including
401(k) plans, 403(b) plans, SIMPLE 401(k) plans, governmental 457 plans,
Salary Reduction Simplified Employee Pension plans (SARSEPs), and SIMPLE
IRAs. Defined benefit plans would still be available, as would profit
sharing plans, but with substantially revised rules for the latter. Employee
contributions (e.g., salary deferrals) of up to $12,000 could be contributed
to the employer sponsored ERSA plan, increasing to $15,000 by 2006.
II. 401k Rules.
A. Nondiscrimination Rules.
The current nondiscrimination requirements for 401(k) plans – the ADP
and the ACP tests would be replaced with a “simplified set of rules”
and safe harbors. Plans will be nondiscriminatory if:
1. Non-highly compensated
average deferral percentage is more than six percent; or
2. Non-highly compensated average deferral percentage is six percent or
less and highly compensated average deferral percentage is less than two
hundred percent of non-highly compensated average deferral percentage.
B. Safe Harbor Rules. The
current 401(k) safe harbor plan designs will be replaced with the following
alternatives that will satisfy the nondiscrimination rules (the proposal
is silent on immediate vesting, currently required):
1. If the employer makes a
non-elective contribution on behalf of each participant in the plan equal
to 3% of the employee’s compensation;
2. If the employer makes a matching contribution equal to 50% of each
employee’s deferrals (up to 6% of compensation); or
3. If the employer makes a matching contribution that does not increase
based on the level of an employee’s deferrals and the match is equal to
the amount that would be made under a 50% match (up to 6% of compensation),
such as a match of 100% of each employee’s deferrals (up to 3% of compensation).
III. Other Rules. The following
additional changes would be made to profit sharing and other defined contribution
plans, including those with the ERSA 401k option.
A. Coverage. A single test
would be required to demonstrate minimum coverage, the 70% ratio-percentage
test. Under this test, the percentage of an employer’s non-highly compensated
employees covered under a plan would have to be at least 70% of the percentage
of the employer’s highly compensated employees covered under the plan.
B. No Non-Pro Rata Allocations.
Permitted disparity (social security integration), age and service weighting,
and cross-testing would all be prohibited for all defined contribution
plans.
C. Compensation Definition.
Compensation for plan purposes would be based on the amount reported on
form W-2 for wage withholding, plus the amount of ERSA deferrals.
D. Highly Compensated Employees.
Individuals with compensation over the current year’s Social Security
wage base would be “highly compensated employees.”
E. Top Heavy Repeal. The top
heavy rules would also be repealed.
F. Political Response. Several
organizations, including those not usually in agreement (such as ASPA
and the Small Business Council of America, on the one hand, and the Pension
Rights Center, on the other) are already claiming (seemingly correctly)
that the most likely users of RSAs and LSAs are the wealthy, including
business owners, who will be more enchanted with making a $15,000 (or
$30,000, if married) annual contribution to their individual accounts
rather than maintaining a plan with employee cost. That, the groups point
out, will reduce plan coverage for workers of small employers. The elimination
of cross testing and the other design options might just be the final
straw to kill plans for large employers, too, when we advise them of the
need to once again fully amend their plans. ERIC, the organization representing
the Fortune 100 in benefits matters, has described the simplicity of the
Bush plan unflatteringly as a “straightjacket.”
IV. Inequity Between Workers
and Owners.
Example: Business owner and
spouse each save $15,000 each after tax in RSA and LSA for 20 years ($30,000
a year). Assume 8% after 20 years the amount is $1,796,799 which will
produce a lifetime annuity of about $190,000 all of which is income tax
free.
Working American and spouse
salary defer $7,500 and get match or profit sharing of $7,500 each in
profit sharing plan for 20 years. Assume 8% after 20 years the amount
is $1,796,799. Retirement annuity of about $190,000 a year, but all taxable.
A good portion of the earnings
in the retirement plan will likely be dividends and capital gains, the
qualified plan for the worker has converted tax free income (dividends)
and 20% taxed capital gains to ordinary income. Those items will be income
tax-free to the owner.
The President’s two 2003 proposals
– tax-free dividends and creation of LSAs and RSAs — are part of long-range
plan of the President’s advisors to make all investment income tax free.
But the working American with an employer retirement plan would get otherwise
tax-free income converted into taxable income. And the owners of the employer
would have much less incentive to contribute for the employee than under
current rules.
Employers Scramble To Fix Cross-Tested Plans;
Dealing With Cross-Tested Plans That Are Top Heavy or Using 3% 401(k)
Safe Harbor
The new cross-testing regulations,
first effective in 2002, apply in a unique way to cross-tested plans that
are combined with 401(k) plans and that contain the 3-percent nonelective
safe harbor contribution (or are top heavy).
Reg. 1.401(a)(4)-12 defines “employee” as follows: “With
respect to a plan for a given plan year, employee means an employee (within
the meaning of §1.410(b)-9) who benefits as an employee under the
plan for the plan year (within the meaning of §1.410(b)-3).”
If the plan is not top heavy and is not a safe harbor 401k, the plan can
impose a 1,000 hour and/or last day of the year allocation requirement
for all contributions, including the gateway. (Emphasis added.)
In addition, Reg. 1.401(a)(4)-9(c)(3)(ii) prohibits using cross-testing
if a single plan is restructured into component plans. If one were to
carve out the employees who are eligible only for the 3% Safe Harbor non-elective
contribution as a separate component plan, and the rest of the employees
who benefit under the new comparability contribution as a separate component
plan, that plan would be precluded from using a cross-tested formula.
Thus, the safe harbor contribution cannot be conditioned on employment
at year-end or on crediting of a minimum number of hours of service. When
a safe harbor nonelective contribution is part of a cross tested plan,
the cross tested plan cannot apply a “last day” or “minimum
hour” provision to the required “gateway” contribution,
as explained below.
Beginning in 2002, any cross
tested plan must provide a minimum gateway allocation to any nonhighly
compensated employee (NHC) who “benefits” under the plan. This
minimum allocation is a percentage of pay equal to the lesser of: (a)
one-third of the highest allocation percentage to any highly compensated
employee, or (b) 5 percent. In most cases where the goal is to fund to
the full $40,000 limit for at least one of the HCs, in which case the
NHCs will receive an allocation of 5 percent.
Each participant receiving
the nonelective safe harbor contribution is treated as “benefiting”
and, therefore, must receive the minimum gateway allocation if greater
than 3% of pay. The plan cannot condition either the 3-percent nonelective
safe harbor nor the gateway cross tested allocation on being employed
on the “last day” or on being credited with any minimum hours
of service.
However, many plans (including
volume submitter plans) drafted prior to the implementation of the new
cross tested rules (applicable for plan years beginning in 2002) contained
such conditions for the cross-tested allocation. These plans must be amended
to remove those provisions for years after 2001, or risk disqualification
or contributions of more than intended, depending on the plan’s formula.
This amendment can be made up to 9-1/2 months after the close of the plan
year, as permitted under regulations for correcting a nondiscrimination
failure (Treas. Reg. 1.401(a)(4)-11(g)). Adopting an amendment to remove
the last day of the year or minimum hours of service provision as to the
gateway contribution would permit such testing and correct a nondiscrimination
failure.
Under the minimum allocation
gateway, the NHCs are only required to receive a minimum allocation gateway
(not more than 5 percent). In many cases, if not most, the plan will need
to allocate a larger contribution to the NHCs to satisfy the nondiscrimination
tests. If your client wants to minimize funding for terminated (during
the plan year in question) or part-time employees, then an amendment can
also be adopted to limit the contribution to this group to no more than
the minimum gateway contribution.
Consider a cross-tested plan
in which the NHCs must receive an allocation of 8 percent to satisfy the
year’s nondiscrimination testing. If this plan is amended to only remove
the last day or 1,000 hours of service requirement, all of the NHCs will
receive the full 8-percent allocation. Participants who terminate or have
less than 1,000 hours are only required to receive the minimum allocation
gateway (5 percent). If individuals who terminate in the plan year or
who are credited with less than 1,000 hours of service are placed in a
separate category for cross testing, their allocation can be limited to
5 percent.
Note that his same type of
problem exists in plans that are top-heavy. The minimum top heavy contribution
can be conditioned on employment on the last day of the plan year but
not 1,000 hours of service. Thus, in a top heavy cross-tested plan, if
the gateway contribution exceeds 3% of pay (as it normally does), then
those entitled only to the minimum top heavy contribution must receive
the minimum gateway contribution if greater than 3% because they are “benefiting”
under the plan.
Expansive Penalties For Late
Blackout Notices
(And Not Just for Plans with Employer Stock But Also Those Allowing Participant
Loans and Directed Investments)
I. Overview; Timing of Notice.
Congress sometimes uses a cannon to kill a fly, and that’s what happened
when it targeted a need for more employee notification prior to a “blackout
period.” The recently released final regulations on the blackout
notice retain the severe daily penalties for a late notice. Failure to
comply with these notice requirements can lead to enormous penalties.
The blackout notice must generally
be provided at least 30 days (but not more than 60 days) prior to the
last date in which participants could exercise any one of the three rights
identified below.
Late delivery of the Notice
is excused if: (a) a delay in the imposition of a blackout period would
result in a violation of ERISA’s fiduciary provisions, or (b) commencement
of the blackout period is due to events that were unforeseeable or circumstances
beyond the control of the plan administrator.
II. Blackout Period Defined.
Plan administrators of defined contribution plans must provide participants
with advance written notice of any blackout period. For purposes of these
regulations, a blackout period is any period of more than three consecutive
days during which a participant’s ability to (1) direct or diversity assets
credited to his or her account, (2) obtain a loan for a plan, or (3) obtain
a distribution for the plan is “temporarily suspended, limited or
restricted.” The last two blackout events may cause more unforeseen
problems than the first.
A. Common Blackout Causes.
A notice is required for common events occurring in many employer plans.
· When transferring
from one 401(k) provider to another.
· In cases where a plan
is in the process of shutting down or being terminated and after a specific
date no loans or distributions will be available, an advance blackout
notice is required.
· An amendment to eliminate
a loan provision from a plan would seem to require a 30-day advance notice.
· When loans are not
be available. Consider, for instance, a plan that requires that any participant
loans be coordinated through one employee identified by the employer.
It would appear that if that individual went on vacation and, as a result
of that person’s absence, there is a period of more than three days when
participants couldn’t process a loan, a blackout notice is triggered.
The notice, unless it met one of the reasons that permits a shorter notice
period, needs to be provided 30 days prior to the start of the employee’s
vacation period.
Thus, under circumstances described
above, the employer would be required to distribute a notice to participants
(and beneficiaries, if they may borrow from the plan) of the employee’s
approaching vacation date. Were such an individual merely sick or if he
or she quit and, as a result, the plan was unable to coordinate the loan
provisions, then it appears that you might be eligible for a shorter advance
notice period because the reason why loans cannot be processed is beyond
the employer’s control.
To avoid such issues, make
sure that an alternate person can process a loan. Then be sure that they
do not take consecutive vacations or get sick at the same time if their
sickness is to last more than three days.
B. Events Not Constituting
a “Blackout.” The following suspensions, limitations or restrictions
are not “blackouts” under the regulations and Notice to participants
is not required:
“Regularly Scheduled”
Restrictions. Preexisting and regularly scheduled restrictions, if they
have been previously disclosed, are not considered “blackouts”
under the regulations. Prior notice of such restrictions may be furnished
via summary plan descriptions, summary of material modifications, enrollment
forms, materials describing the plan’s investment alternatives, and other
similar documents pursuant to which the plan is established or operated.
The DOL specifically stated that quarterly freezes on the trading of employer
securities that are timed to coincide with earnings reports and intended
to prevent insider trading are covered by this exception if appropriately
disclosed in SPDs, prospectuses or other documents.
QDRO-related Restrictions.
Restrictions on a participant’s account in connection with a QDRO or during
the period when the plan administrator is considering whether a domestic
relations order is a QDRO are not considered “blackouts” under
the regulations.
Individual Participant or
Third-Party Actions. Restrictions on the account of a particular participant
triggered by the actions or omissions of the participant or a third party
are excluded from the Notice requirement. Examples include a tax levy,
a dispute over a deceased participant’s account among putative beneficiaries,
failure by the participant to obtain a PIN number, and allegations that
the participant committed a fiduciary breach or crime involving the plan.
Permanent Restrictions. Permanent
restrictions are not blackouts. However, if some rights are temporarily
suspended in connection with a permanent restriction (e.g., if the deletion
of a fund requires a temporary restriction on investments to the remaining
funds), Notice of the temporary restrictions is required.
Restrictions on Investment-Education
Services. Permanent or temporary restrictions on investment education,
investment advice, retirement counseling, and financial planning services
do not constitute a blackout.
Third Party Caused Blackouts.
The regulations specify that where the inability to exercise participant’s
rights is caused by a third party, the employer has not blackout notice
responsibility. Thus, employers with participant directed plans that have
arrangements with their brokers where the broker establishes a brokerage
account for each participant’s account in the name of the plan, and then
allow for participants to direct the investment of those accounts. The
individual will then contact the broker directly, typically by phone,
to make a buy or a sell within his or her account. It would therefore
appear that where such a broker is on vacation or not able to coordinate
such a change in the participant’s investments for three days, an advance
blackout notice is not required because this delay is caused by a third
party.
C. Common Blackout Events. A notice is required for common events occurring
in many employer plans.
· When transferring
from one 401(k) provider to another.
· In cases where a plan is in the process of shutting down or being
terminated and after a specific date no loans or distributions will be
available, an advance blackout notice is required.
· An amendment to eliminate a loan provision from a plan would
seem to require a 30-day advance notice.
· When loans are not be available. Consider, for instance, a plan
that requires that any participant loans be coordinated through one employee
identified by the employer. It would appear that if that individual went
on vacation and, as a result of that person’s absence, there is a period
of more than three days when participants couldn’t process a loan, a blackout
notice is triggered. The notice, unless it met one of the reasons that
permits a shorter notice period, needs to be provided 30 days prior to
the start of the employee’s vacation period.
Thus, under circumstances described
above, the employer would be required to distribute a notice to participants
(and beneficiaries, if they may borrow from the plan) of the employee’s
approaching vacation date. Were such an individual merely sick or if he
or she quit and, as a result, the plan was unable to coordinate the loan
provisions, then it appears that you might be eligible for a shorter advance
notice period because the reason why loans cannot be processed is beyond
the employer’s control.
To avoid such issues, make
sure that an alternate person can process a loan. Then be sure that they
do not take consecutive vacations or get sick at the same time if their
sickness is to last more than three days.
III. Penalties. Failure to provide the Notice may result in a DOL-imposed
civil penalty of up to $100 a day, calculated from the date of the failure
(i.e., the latest date the Notice could have been provided) to the date
the blackout period ends. Each affected participant to whom the Notice
was not provided constitutes a separate violation. Liability for the penalty
is imposed on all persons responsible as plan administrators.
Thus, failure to provide the
blackout notice at least 30 days prior to the start of the blackout period
triggers a full penalty. That is, the full penalty applies, even if the
notice is only one day late. Consider a plan for which the blackout period
is expected to last for 21 days beginning on March 31. If the notice is
not provided by March 1, the penalty is calculated based on both the 30
days prior to March 31 and the 21 days after March 30. That is, the $100
a day penalty is based on 51 days or $5,100 for each participant or beneficiary
affected by the blackout period.
If you give the notice to all
but one participant by March 1 and that one participant receives the notice
on March 2, the penalty will be $5,100. If you miss giving it to 10 participants
or affected beneficiaries, the penalty would be $51,000, assuming that
the blackout period is not extended.
IV. Furnishing Notice. The
Notice may be provided together with other materials if the blackout information
is prominently identified. In addition to first class mail and electronic
transmission, the Notice may be furnished by overnight, certified or express
mail, or private delivery services. Sending the Notice to the last known
address of a participant is acceptable. Interoffice mail is considered
to be the same as hand delivery; thus the Notice is not “furnished”
until received in these cases.
DOL MODEL BLACKOUT NOTICE
Important Notice Concerning Your Rights Under The [Enter Name of Individual
Account Plan]
[Enter date of notice]
1. This notice is to inform you that the [enter name of plan] will be
[enter reasons for blackout period, as appropriate: changing investment
options, changing recordkeepers, etc.].
2. As a result of these changes, you temporarily will be unable to [enter
as appropriate: direct or diversify investments in your individual accounts
(if only specific investments are subject to the blackout, those investments
should be specifically identified), obtain a loan from the plan, or obtain
a distribution from the plan]. This period, during which you will be unable
to exercise these rights otherwise available under the plan, is called
a “blackout period.” Whether or not you are planning retirement
in the near future, we encourage you to carefully consider how this blackout
period may affect your retirement planning, as well as your overall financial
plan.
3. The blackout period for the plan [enter the following as appropriate:
is expected to begin on [enter date] and end [enter date]/is expected
to begin during the week of [enter date] and end during the week of [enter
date]. During these weeks, you can determine whether the blackout period
has started or ended by [enter instructions for use toll-free number or
accessing web site].
4. [In the case of investments affected by the blackout period, add the
following: During blackout period you will be unable to direct or diversify
the assets held in your plan account. For this reason, it is very important
that you review and consider the appropriateness of your current investments
in light of your inability to direct or diversify those investments during
the blackout period. For your long-term retirement security, you should
give careful consideration to the importance of a well-balanced and diversified
investment portfolio, taking into account all your assets, income and
investments.] [If the plan permits investments in individual securities,
add the following: You should be aware that there is a risk to holding
substantial portions of your assets in the securities of any one company,
as individual securities tend to have wider price swings, up and down,
in short periods of time, than investments in diversified funds. Stocks
that have wide price swings might have a large loss during the blackout
period, and you would not be able to direct the sale of such stocks from
your account during the blackout period.]
5. [If timely notice cannot be provided (see paragraph (b)(1)(v) of this
section) enter: (A) Federal law generally requires that you be furnished
notice of a blackout period at least 30 days in advance of the last date
on which you could exercise your affected rights immediately before the
commencement of any blackout period in order to provide you with sufficient
time to consider the effect of the blackout period on your retirement
and financial plans. (b) [Enter explanation of reasons for inability to
furnish 30 days advance notice.]]
6. If you have any questions concerning this notice, you should contact
[enter name, address and telephone number of the plan administrator or
other contact responsible for answering questions about the blackout period].
Alson R. Martin
Shook, Hardy & Bacon L.L.P
10801 Mastin,
Overland Park, KS 6621-1671,
