2001 Tax Act Provides Great Opportunities for Employees to Save for Retirement

On Oct. 17, 2001, Len Carusi, a consultant with Watson Wyatt & Company, presented a technical session on the 2001 Economic Growth and Tax Relief Reconciliation Act for the New York State Society of Certified Public Accountants’ Employee Benefits Committee at their company offices in New York City. Carusi and his colleagues, Valerie Wise, a communications consultant, and Matthew Eilenberg, an attorney, focused on the planning opportunities for defined contribution plans associated with the act.

According to the discussion, the tax legislation’s planning opportunities will make it much more favorable for employees, staff and management to save for retirement while taking advantage of enhanced tax benefits. The act provides significant changes to defined contribution plans, such as the 401(k) plan, which remains unprecedented since 1981, when the plans quickly grew to become the most popular retirement vehicle for both plan sponsors and plan participants.

The new tax law highlights, particularly as they relate to 401(k) plans, include: a salary limit increase, a higher elective deferral limit, a special catch-up provision for employees age 50 and older, a tax credit for lower-paid employees, a faster vesting schedule and a shorter hardship withdrawal suspension period. The tax act changes will take effect on Jan. 1, 2002, and will expire on Dec. 31, 2010. Plans will then be governed in accordance with current ERISA (Employee Retirement Income Security Act) regulations as plans were prior to the new legislation.

Under the new tax law the salary limit for the purposes of determining benefits under the 401(k) plan will increase from $170,000 to $200,000. The $200,000 salary limit will allow employees who make more than $170,000 but less than $200,000 to contribute more to the plan while receiving higher employer matching contributions. The salary limit will be indexed in $5,000 increments after 2002.

The elective deferral limit will increase from $10,500 to $11,000 in 2002 and should please higher-paid employees because they can save more for retirement while enjoying a larger match of employer contributions and taking advantage of the greater tax benefits. The pre-tax elective deferral limit will increase by $1,000 increments from 2003 up to $15,000 in 2006 and indexing in $500 increments after 2006.

The pre-tax catch-up provision of the act will benefit all employees age 50 and older, which will allow them to contribute an additional $1,000 in excess of the revised elective deferral limit of $11,000 per year. Unlike the current tax provisions, which do not provide for any type of catch-up contribution, the catch-up contribution schedule will apply in the same manner as the increased elective deferral limit that will start with an additional $1,000 in 2002 and end with an additional $5,000 in 2006. Therefore, an employee age 50 or older can contribute a maximum of $12,000 to his or her 401(k) plan for 2002. After 2006, the pre-tax catch-up contributions will be indexed in $500 increments.

According to Carusi, “Employees who were born on or before Dec. 31, 1952, can make a catch-up contribution at any time during 2002.

“For example,” he said, “if an employee turns age 50 in December 2002, he or she could make catch-up contributions at the beginning of the year.”

The primary reason for this provision is to allow older employees, especially the baby boomers, to more quickly save for retirement and to make up for the years they could not save for retirement due to a lack of disposable income or employer-sponsored plans. This provision also gives females a chance to catch up on their 401(k) contributions that were missed when they took a break from work or entered into the workforce late because of parental obligations.

As indicated, the tax act will benefit all employees, including those with small incomes. Effective Jan. 1, 2002, a married employee making $30,000 can earn an income tax credit of $1,000 for a $2,000 contribution to a 401(k) plan. However, the tax savings will vary based on annual income and the amount an employee contributes to the plan. This tax provision is designed to increase participation of the non-highly compensated employees.

The new tax act will expedite the vesting of employer matching contributions. The current schedule varies from a “five-year cliff vesting,” where employees do not vest until after five years with the plan, or the “seven-year graduated” vesting schedule, where the employee vests in 20% increments over a three- to seven-year period. The new law requires employer-matching contributions under the 401(k) plan to vest fully in three years or in 20% increments over a two- to six-year vesting period. This is another provision of the tax act that should encourage employees to participate in the plan, because they can realize faster savings in a shorter period of time.

The ability to withdraw money from a 401(k) plan under its hardship withdrawal feature is still another provision revised under the new tax law. Under the new law, the suspension period for hardship withdrawals will decrease from 12 months to six months, effective after Dec. 31, 2001. If employees need to take money from their 401(k) plans under the hardship feature, they can resume making contributions after just six months. This will greatly assist those employees who struggle to save for retirement, while facing economic hardships.

President Bush signed the tax act into law to address pressing concerns of an aging workforce and the lack of planning and saving for retirement. The act untangles a web of regulations that hamper employees’ efforts to save for retirement and eliminates nightmares for plan administrators. The law allows greater flexibility in managing 401(k) plans as well as providing advantageous tax benefits to all employees. Starting in 2002, employees can take advantage of the tax law changes like the increased deferral limit, catch-up contributions and shorter vesting periods. Plan administrators should see an increase in retirement savings.