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New Rules Allow Higher Contributions, More Portability
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By Clifton Linton
Senior Writer, mPower |
The tax bill recently approved by
Congress contains new retirement regulations that will allow diligent savers to put even
more money into their 401(k) plans.
Under the new rules, the individual
annual pretax contribution limit for 401(k) plans will rise to $11,000 starting in 2002.
That limit will increase $1,000 a year over the next four years and in 2006 top out at $15,000.
Further increases will be indexed to inflation. SIMPLE plan annual contribution limits
will gradually rise to $10,000 a year in 2006, from the current $6,500. And further
increases to SIMPLE plans will also be indexed to inflation.
These regulations failed to pass in
Congress in 1999 and 2000. This time the losing streak was broken. President Bush signed
the bill into law on June 7, and it will take effect Jan. 1, 2002.
Most of the new regulations benefit
top wage earners and aggressive savers and simplify administrative procedures. Yet, there are
some changes that will impact the average worker. Those include:
- offering a tax credit to low-income
savers,
- eliminating the percentage of pay
limit, which often hampers the low-income worker's ability to save,
- vesting employer-matching contributions
faster,
- allowing workers to move money from a
401(k) to a 403(b) plan or 457 deferred-compensation plan when changing jobs,
- creating new rules that allow workers
to make "catch-up" contributions after age 50, and
- creating a new Roth 401(k) account to
let workers also make after-tax contributions to their plan.
Here's our rundown of the changes most
likely to affect 401(k) plan participants.
New Limits
Three limits define the amount a
worker is allowed to contribute to a 401(k) plan. The first is the annual individual,
pretax contribution limit. As stated above, the new law will raise it to $15,000 by 2006.
Even so, some workers aren't able to
make a full $10,500 annual contribution because they run into the percentage-of-pay limit.
That limit currently states that combined employee and employer contributions may not
exceed the lesser of 25 percent of pay or $35,000. The new law will raise the
percentage-of-pay limit to 100 percent of pay and the dollar limit to $40,000.
For low-income savers the latter
adjustment can be quite significant, said Martha Priddy Patterson, an analyst with the
human capital advisory services group of Deloitte & Touche. The reason is that the
percentage of pay limit can prevent them from making larger contributions even if they can
afford to.
"That (limit) tends to bite
two-earner families," she said. "In real life this happens all the time."
The final limit that will change is
the qualified compensation limit. Currently, 401(k) contributions can only be made on the
first $170,000 of compensation. That will rise to $200,000, in 2002. In the future,
increases in inflation will trigger a rise in this limit in $5,000 increments.
Faster Vesting
One of the most significant changes in
the law is that employers will have to speed up the time it takes for matching
contributions to vest, or become the employee's property. Cliff vesting, in which the
entire employer contribution vests after you have worked at your job for a certain number
of years, will be limited to three years instead of five. That means if you have four
years on the job as of January 2002, you will be immediately vested even if your employer
had a five-year cliff-vesting schedule.
Graded vesting, in which a certain
amount of the employer contribution becomes your property each year, will be limited to
six years instead of seven.
While those are the maximum limits,
federal law gives employers discretion to shorten them.
Another major change will make it
possible to roll 401(k) money directly into a 403(b) plan or 457 plan if you
change jobs. This is important to keep in mind if you are thinking about changing jobs. It
might be worth waiting until the end of the year to do so.
Included in these new portability regs
are rules that will let you roll pretax IRA contributions and earnings into your 401(k)
plan. That can really help you simplify paperwork and investment allocations. Until now,
you could only roll IRA money into a 401(k) if it came from a 401(k) at a previous
employer, and not from your own contributions directly to the IRA.
If you weren't able to make full
401(k) contributions early in your working career, you may be able to make "catch-up"
contributions under the new regulations. Workers after age 50 will be able to make a
catch-up contribution of $1,000, on top of the normal $11,000 maximum limit in 2002. This
limit will rise $1,000 a year over four years until 2006, to $5,000, and will then be
indexed to inflation.
Another benefit for low-income savers
is a non-refundable tax credit on the first $2,000 of savings to a 401(k)
plan. This credit will only be available for the 2002, 2003, 2004, 2005 and 2006 tax
years.
Here's how it will work:
- Individuals with up to $15,000 a year
in adjusted gross income (AGI) and couples filing jointly with AGI up to $30,000, will be
eligible for a 50 percent credit on $2,000 in contributions.
- Individuals with AGI between $15,001
and $16,250 and couples filing jointly with AGI between $30,001 and $32,500 will be
eligible for a 20 percent credit.
- Individuals with AGI between $16,251
and $25,000 and couples filing jointly with AGI between $32,501 and $50,000 will be
eligible for a 10 percent credit.
Discouraging Cash-outs
One issue which has drawn a great deal
of attention in Congress is the fact that many folks cash out of their 401(k) plans when
they change jobs.
Currently employers are permitted to
automatically distribute 401(k)-plan money to workers who leave their job and leave a
balance of less than $5,000. Many folks who aren't of retirement age often don't recognize
that a small amount can grow significantly over the years. The result is they take the
money, pay the taxes and penalties on it and spend it or use it to pay bills. Consequently
they often short-change their retirement future.
To discourage early cash-outs, the law
will permit employers to automatically roll your balance into an IRA account, in your
name, unless you specifically request the money. The new rules allow employers to roll
balances of $1,000 to $4,999 into a default IRA. This rule wouldn't apply to balances
under $1,000.
While some employer plans permit
workers to make after-tax contributions to their 401(k) plan, the new law will allow
workers to make after-tax savings contributions to a newly created Roth 401(k) plan.
The concept is similar to the Roth
IRA. You contribute after-tax dollars to the account but your money grows tax-deferred and
you won't have to pay any taxes on the withdrawals in retirement. Roth 401(k)
contributions would still be governed by the percentage-of-pay limits. The big advantage
of the Roth 401(k) is that you can use payroll deduction to set up an automatic savings
plan.
Trickle Down
While most of the rule changes seem to
either favor high wage earners or ease administrative burdens, ultimately average workers
could see some benefits, Patterson said.
For instance, many top wage earners
(known as "highly compensated employees") won't be able to take advantage of
these extra savings opportunities unless they encourage more employees to save, and those
saving to save more. The reason is they will need to boost rank-and-file participation so
the plan will pass its non-discrimination test. That test ensures that the 401(k) plan is
offered equitably to all employees and doesn't just become a perk for top executives. A
plan that fails its non-discrimination test can be disqualified.
One of the most effective tools
employers can use to encourage worker participation is the matching contribution. It's
possible employers might try to boost participation by offering a matching contribution if
there wasn't one previously, or to enrich an existing match, Patterson speculated.
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The information provided here is intended to help you understand the general issue and
does not constitute any tax, investment or legal advice. Consult your financial, tax or
legal advisor regarding your own unique situation and your company's benefits
representative for rules specific to your plan.
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