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Percent-of-Pay Changes for 2002 Will Let Some Contribute More
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By Ted Benna
Creator of the first 401(k) plan |
The Portman-Cardin Retirement Security and Pension Act
has finally been enacted as a part of President Bush's Economic Growth and Tax Relief
Reconciliation Act (EGTRRA). These important retirement-related changes were passed by
Congress during each of the past two legislative sessions but were vetoed by
then-President Clinton because they were attached to bills he didn't like.
You have undoubtedly read about the increased 401(k)
contribution limit and the new catch-up contribution provision that will take effect Jan.
1, 2002. However, you may not be aware of or understand the significance of two other
important changes.
These changes will mostly affect workers whose employers
make generous contributions to the 401(k) and/or profit-sharing plan, highly compensated
workers and their spouses, and lower-income earners who want to increase their 401(k)
contributions. Both changes deal with different "percent-of-pay" limits.
Percent-of-Pay Limit
Currently, the amount you and your employer contribute to
your 401(k), profit-sharing plan, and any other tax-qualified defined-contribution plan
you participate in may not exceed 25 percent of your pay during a plan year. This combined
limit isn't a problem for most employees because 25 percent of pay is a lot of money to
contribute to your retirement. However, it has created problems for employees who work for
companies that make very generous employer contributions. In essence, the amount they
themselves can contribute is limited.
Wilson Greatbatch LTD (WGT) is a biotech company whose
retirement program I helped revamp a few years ago. WGT currently contributes 5 percent of
each eligible employee's pay to a defined-contribution pension plan (a money purchase
plan). WGT also contributes up to 3 percent of pay as a 401(k) matching contribution, plus
an additional 8 percent to 10 percent of pay as a profit-sharing contribution. The
combined employer contribution level can be as high as 18 percent of pay.
Employees can also make contributions to the 401(k). In a
year in which WGT contributes 18 percent, the maximum employee contribution will be 7
percent (I got that limit by subtracting 18 percent from 25 percent.). Because the
profit-sharing contribution is variable, employees don't know, at the beginning of the
year, how much they will receive, and consequently how much they will be able to
contribute in order to hit the 25-percent combined maximum. As a result, those who want to
be sure to contribute the maximum must contribute a large enough percentage during the
year to get 25 percent if the profit-sharing contribution is on the low side.
For example, an employee may decide to contribute 10
percent, get the 5 percent pension contribution and the 3 percent match. If the company
has a good year and makes a 10 percent profit-sharing contribution, these employees may
receive only 7 percent of this as a plan contribution.
Removal of the 25-percent-of-pay combined employee/employer
contribution limit will enable WGT employees to contribute any amount to the 401(k),
effective Jan. 1, 2002, subject to the $11,000 pre-tax contribution limit and the special
restrictions that will still apply to highly compensated employees.
For example, an employee who earns $75,000 will be able to
contribute $11,000 during 2002 without having to worry about how much the employer
contributes. (Yes, I realize those of you who work for employers that don't make any
contributions, or make a much lower contribution, would like to have this problem.) This
change will also give those of you who work for companies that currently restrict
non-highly paid employees to lower percentages additional ammunition to push your employer
to increase the contribution percentage to the amount permitted by law.
Other Interesting Opportunities
Elimination of the 25 percent limit will also open some
other interesting opportunities for people who start saving later in life for retirement,
such as single moms and others who can't afford to save until their children are grown,
and spouses of highly compensated employees.
First, look at a single mom who starts saving late for
retirement. Assume you are a 55-year-old who has saved very little. Your annual salary is
$35,000 and you are now financially in a position where you can squeeze a $10,000 pre-tax
401(k) contribution into your budget. Currently, the maximum you can contribute is 25
percent of your salary, reduced by your employer's contributions. If your employer
contributes 5 percent of your pay, you are currently limited to a 20 percent contribution,
or $7,000. But you will be able to contribute $10,000 starting in 2002 — in fact, you
could contribute the maximum of $11,000 plus a $1,000 catch-up contribution, if you could
afford it. This assumes your employer's plan doesn't limit participant contributions to a
lower percentage.
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| "Until the mid-90s, tax-favored
retirement savings was viewed by many policy makers and members of Congress as a big black
hole sucking up lost tax revenue. The change in attitude that finally led to enactment of
these measures is certainly great." |
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| — Ted Benna, creator of the first
401(k) plan. |
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Now look at highly compensated employees, in particular
those at the lower end of the category (with annual compensation of $85,000 to $100,000).
These workers can have a difficult time accumulating enough for retirement. Their 401(k)
contributions may be severely restricted by discrimination rules. Typically they can
contribute only 6 percent to 8 percent of pay to the 401(k), and in some instances they
are limited to only 3 percent. A $6,000 annual contribution to a 401(k) by an employee who
earns $100,000 isn't sufficient to build an adequate nest egg. To add insult to injury,
this group will receive less than 20 percent of its retirement income from Social
Security. They will need enough from other sources, including their 401(k), to replace at
least 50 percent of their income.
The spouse of an employee in this category is penalized if
he or she works because around 50 percent of what the spouse earns goes to pay taxes, if
you include federal income tax, Social Security tax, state tax and local wage taxes. A
spouse who earns $30,000 and loses half of it to taxes probably doesn't feel adequately
rewarded. Another painful reality for these workers is that they get badly shortchanged by
Social Security. They pay the full Social Security tax of $3,060, in this instance, but
will receive very little (if any) additional benefit compared to the spousal benefit they
would receive without paying any Social Security taxes.
You may be wondering how the change in the percent-of-pay
limit will help this couple. Here's how: The spouse who earns $30,000 will now be able to
contribute $11,000 to a 401(k) plus the catch-up contribution if over age 50, and receive
any amount of employer match, without having to worry about the 25-percent maximum limit.
This will help overcome the adverse impact of the contribution restriction on the highly
compensated spouse. This change will enable a spouse who returns to the workforce in this
type of situation to make a substantial contribution to the family's future financial
security.
It should be noted that this strategy won't work if both
people work for the same employer and one spouse owns at least 5 percent of the company.
In this case, both spouses will be included in the highly compensated group because the
ownership is attributed to both spouses. But, if the non-owner spouse earns a salary,
however modest, and is eligible for the 401(k) plan but doesn't actually contribute to it,
the owner spouse can contribute double the percentage of pay allowed.
Here's an example:
Assume you:
- own a business,
- earn $100,000,
- can contribute only $6,000 due to the discrimination test
limits.
Further assume your spouse provides some services to the
business but doesn't receive any pay. Now, suppose you pay your spouse a modest salary
such as $5,000 a year. If your spouse is eligible for the 401(k) but doesn't contribute,
you will now be able to contribute 12 percent instead of only 6 percent because your
non-participating spouse will be included when the discrimination tests are run. This
works because both spouses are included in the discrimination tests as highly paid
employees. A zero contribution by the low-paid, non-participating spouse doubles the
percentage of pay that the higher-paid spouse is permitted to contribute.
How the New Limit Affects You
Because of the new rules, your employer must amend its plan
so that you can begin contributing a larger percentage of your pay effective Jan. 1, 2002.
The new legal limit is 100 percent of your pay, but you
can't really contribute this much because you must pay Social Security taxes and you may
have to pay some state and local taxes on the amount you contribute to your 401(k). You
may also have deductions from your pay for other benefits such as health insurance or a
Section 125 cafeteria plan. The actual maximum you contribute must be adjusted to allow
for these other deductions.
Unfortunately, it will still be necessary to impose a much
lower percentage limit for highly compensated employees, but somewhat larger contributions
by the non-highly paid employees will allow the highly paid employees to contribute more.
The fact that catch-up contributions are not subject to the discrimination tests will also
help highly paid employees who are over age 50.
Employer Deductible Contribution Limit
A second percent-of-pay limit will also be raised under the
new law. Your employer gets a tax deduction on the contributions it makes to your
defined-contribution plans. The current limit is 15 percent of eligible payroll for a
profit-sharing plan and 25 percent when the employer has both a profit-sharing and
defined-contribution pension plan. Eligible payroll is the amount of compensation paid to
eligible employees during the plan year that is included for plan contribution purposes.
The employer deduction limit for profit-sharing plans is complicated by the fact that a
401(k) comes under the rules for profit-sharing plans. As a result, employee pre-tax
contributions made to a 401(k) must be included in the 15 percent limit for the employer.
(This is not done on an individual basis; it is an average for all employees.)
This 15 percent limit has also been a problem when
employers make generous contributions. For example, when an employer contributes 6 percent
of pay to the 401(k), this leaves room for only 9 percent to be contributed pre-tax by
employees. Because this limit is applied to eligible employees in the aggregate rather
than individually, some employees can contribute more than 9 percent if others contribute
less. However, employees who work for companies with really generous employers have been
totally prevented from contributing to their 401(k). This has been the case at SAS
Institute, the world's largest privately owned software company. SAS historically
contributed 15 percent of eligible pay to a profit-sharing plan. Due to the 15 percent
employer-deduction limit, SAS employees have been prevented from having a 401(k). Any
amount an employer contributes over the 15 percent limit is not deductible in the current
year by the employer.
One way around this limit is to establish a money purchase
plan as a second plan. This is what WGT did when I helped them restructure their plans.
This increases the maximum employer deduction limit from 15 percent, plus the amount of
the contribution to the money purchase pension plan. But establishing a second plan is an
additional expense for the employer. Another unattractive feature of this strategy is that
the contribution to the money purchase plan is fixed rather than variable.
The 15-percent employer-deduction limit for profit-sharing
plans will be increased to 25 percent effective Jan. 1, 2002, and employee pre-tax
earnings contributed to the plan will no longer be counted. This will enable employers
like WGT to go back to a single plan if they wish. It will also enable employers that
currently have profit-sharing plans with a 15-percent employer-contribution level to add a
401(k) feature to the existing plan so employees can also contribute. There aren't many of
these companies around, but there are some.
These changes will be very useful in the limited situations
where they apply. Perhaps more importantly, the entire Portman-Cardin bill is an important
reaffirmation of the need to encourage retirement savings by workers. Until the mid-90s,
tax-favored retirement savings was viewed by many policy makers and members of Congress as
a big black hole sucking up lost tax revenue.
The change in attitude that finally led to enactment of
these measures is certainly great.
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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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