Changes in Retirement Plans for 1997

INTRODUCTION.

In 1996 the United States Congress enacted several pieces of legislation impacting the use of retirement plans. The outline below summarizes several of the changes that are effective as of January 1, 1997.

1. INDIVIDUAL RETIREMENT ACCOUNTS (IRAs):
   1. Penalty Free Withdrawals for Medical Expenses. Distributions taken before age 59 1/2 will not be subject to the 10% federal excise tax on early distributions if they are made to pay for medical expenses of a taxpayer, their spouse or dependents. The expenses must exceed 7.5% of the taxpayer's adjusted gross income for the exemption from the penalty tax to apply. Note that the exemption is only for the excise tax. The withdrawal will still be subject to regular income tax.
   2. Penalty Free Withdrawals for Medical Insurance. Early distributions can be made penalty free for purpose of paying for medical insurance for the taxpayer, spouse or dependents if the taxpayer has received unemployment compensation for at least 12 weeks and the distribution is made in the year the unemployment compensation is received or the following year.

      Contributions for Non-working spouses. Deductible contributions of up to $2,000 can now be made for each spouse, including a homemaker who does not work outside the home. Previously, the aggregate was $2,250. Note that for participants in qualified retirement plan deductibility remains contingent upon meeting certain income limitations.

2. SAVINGS INCENTIVE MATCH PLAN FOR EMPLOYEES.

   The Act establishes a simplified retirement plan for businesses called the Savings Incentive Match Plan for Employees (SIMPLE). SIMPLE plans may be adopted by employers with 100 or fewer employees who do not maintain another employer sponsored retirement plan. There is a two year grace period for employers to continue the plan once they exceed the 100 employee limit. Key rules governing SIMPLE plans are:

   1. No discrimination testing is required if the employer matches employees' contributions dollar for dollar up to 3% of compensation or makes a contribution of 2% of compensation for all employees.
   2. Employees are permitted to contribute up to $6,000. (Note that this is less than the 401(k) limit of $9,500).
   3. The funding vehicle can either be an IRA or a qualified plan trust. Use of an IRA will eliminate the potential for fiduciary liability that many employers seek to avoid.
   4. Employees who receive at least $5,000 in compensation from the employer in two previous years and are expected to receive that amount during the present year are eligible for the plan. (Note that this may include part-time employees who do not otherwise receive employer sponsored benefits.)
   5. All contributions to the employees' SIMPLE accounts must be fully vested.
   6. Distributions from SIMPLE accounts are generally taxed like IRAs and are includable in income when withdrawn. Tax free rollovers can be made from a SIMPLE account to a different SIMPLE account or to an IRA. Early withdrawals are subject to an excise tax similar to IRAs except that withdrawals made within the first two years an employee participates in the plan are subject to a 25% (rather than a 10%) withdrawal tax.
   7. The IRS has provided a model SIMPLE plan for adoption by employers.

3. CHANGES FOR 401(K) PLANS.
   1. Non-profit sponsorship of plans. Effective 1/1/97 non-profit organizations will be permitted to establish 401(k) plans. Previously such organizations were limited to specialized plans for governmental units and non-profits called 403(b) or 457 plans. Note that governmental bodies are still precluded from adopting 401(k)s.
   2. Distribution of Excess Contributions. If a plan fails any of the discrimination tests imposed by the IRS it is frequently forced to distribute back to its highly compensated employees a portion of their elective deferrals. In the past, the distribution was made on the basis of the percentage of contribution elected. Thus a person who elected to contribute 15% would receive dollars back while a person who contributed 10% might not. Many times this had the effect of penalizing middle management who frequently contributed more on a percentage basis but less on an actual dollar basis. Effective for years beginning after 12/31/96, distributions must be made on the basis of actual dollars contributed.
4. WAIVER OF EXCESS DISTRIBUTION TAX. The Internal Revenue Code contains a provision subjecting any taxpayer withdrawing more than $155,000 per year from a qualified plan to an excess distributions tax of 15%. The excise tax will be waived for the years 1997, 1998 and 1999. A similar 15% excise tax applicable to excess accumulations in estates has not been waived. Thus, an estate planning technique for older persons or those in medical crisis may be to withdraw retirement fund assets to avoid the excess accumulations tax on death. Note that the withdrawals will be subject to regular income tax. Therefore, consideration must be given to whether continued tax deferred growth outweighs the savings in excise tax.
5. MINIMUM DISTRIBUTION RULES. For employees who are covered by a qualified plan, minimum required distributions must begin by the later of the April 1 following the year the employee attains age 70 1/2 or the year of retirement. Previously distributions had to commence on the basis of age regardless of employment status. Note that this change does not apply to IRA holders or to persons who are 5% owners of the sponsoring company. These people still must commence distributions by the April following age 70 1/2. A plan can permit an employee who is receiving benefits but is not required to under the new rules to stop receiving distributions BUT PLANS ARE NOT REQUIRED TO DO SO.
6. NEW DEFINITION OF HIGHLY COMPENSATED EMPLOYEE. Prior multi-level test is replaced with a two part test. For years beginning after 12/31/96 a highly compensated employee is defined as:
   1. a 5% owner at any time during the year or any preceding year;
   2. an employee who either (i) earned $80,000 and was in the top 20% of employees ranked by compensation for the year or (ii) earned $80,000 (the employer can choose between the two rules).

      This will simplify one of the many complex components of discrimination testing required under the Internal Revenue Code.

7. MISCELLANEOUS CHANGES.
   1. Family aggregation testing is repealed for plan years beginning after 12/21/96. Under the family aggregation rules spouses and certain other family members had been treated as a single person for purposes of determining maximum benefit accruals.
   2. Normal retirement age for testing purposes is changed to be Social Security retirement age rather than simple age 65 for plan years beginning after 12/21/96.