2001 Tax Act Retirement Plan Changes
     By David E. Grein
Although the 2001 Tax Act's tax rate cuts and estate and gift tax changes received most of the media attention, retirement plan changes in the new law deserve equal attention. Virtually every important contribution limit has been increased. The result is that next year employers will be able to change retirement plans to increase contributions to employees.

The following is a summary of some of the important changes the 2001 Tax Act made to retirement plan rules.

INCREASE IN COMPENSATION CAP
There is a dollar limit on how much of an employee's compensation can be taken into account when figuring contributions to retirement plans. This year the limit is $170,000, but next year it will be $200,000.

Example: A corporation's profit sharing plan contributes 10% of each participating employee's salary to his or her plan account. One of its employees earns $250,000. This year, the corporation can contribute $17,000 to his account (10% of $170,000). Next year, its contribution for the employee will be $20,000 (10% of $200,000).

INCREASE IN TOTAL CONTRIBUTION CAP AND DEDUCTIBILITY LIMIT
Two important annual limits apply to profit sharing plans. One restricts the total amount of contributions that can be contributed by the employer and employee to each plan participant's account, and the other restricts the amount of the contribution that can be deducted. This year the maximum amount that can be contributed to each participant's account is 25% of compensation, or, if less, $35,000. The maximum deductible contribution is 15% of the compensation paid to all employees covered by the plan.

Next year the maximum amount that can be contributed to each participant's account is 100% of compensation up to a maximum of $40,000. The maximum deductible contribution will be 25% of the compensation paid to all employees covered by the plan.

Example: An architect has an incorporated practice that maintains a profit sharing plan. He is the only employee and his annual compensation is $160,000. This year the practice may contribute $35,000 to the architect's account, but it may deduct only $24,000 of the contribution (15% of $160,000). Next year the practice may contribute $40,000 and it can deduct $40,000 (25% of $160,000).

401(k) ARRANGEMENTS
The changes for 401(k) arrangements are also significant. There are four major changes:

1. There's a limit on how much employees can defer each year. This year, the maximum is $10,500, but it will rise to $11,000 in 2002, and then rise in $1000 annual increments until it reaches $15,000 in 2006.

2. Employees who are age 50 or older may make additional annual deferrals of pre-tax dollars. The maximum additional contribution for 401(k) arrangements will be $1,000 for 2002, $2,000 for 2003, $3,000 for 2004, $4,000 for 2005, and $5,000 for 2006 and later years. As a bonus, the additional contribution will not be subject to the various limitations and requirements that normally apply to elective deferrals.

Example: A company's 401(k) arrangement allows employees to make elective deferrals up to 10% of compensation or the annual dollar limit, whichever is less. An employee, age 51, makes $70,000 a year. Next year, that employee can make a regular elective deferral of $7,000, plus an additional elective deferral of $1,000. For 2006, the employee can make an additional elective deferral of $5,000.

3. Beginning next year elective deferrals (as well as an employee's elective set-asides in a cafeteria plan) will be treated as "compensation" for purposes of applying the deduction limits that apply to profit sharing. This year these deferrals are not treated as "compensation."

Example: A company maintains a profit sharing plan. It also has a 401(k) plan that allows employees to make elective deferrals up to 6% of salary. One of its employees earns $50,000 and makes a maximum 401(k) elective deferral of $3,000. Beginning next year, the company can deduct up to $12,500 for (1) contributions to the employee's profit sharing account, plus (2) matching contributions to her 401(k) account ($12,500 is 25% of $50,000). This year, the company can deduct no more than $7,050 in profit sharing and matching 401(k) contributions ($7,050 is 15% of [$50,000 minus $3,000 elective contribution]).

4. Any matching contributions that employers make to employees' 401(k) accounts will have to vest at a faster pace. Currently, employees must be 100% vested in matching contributions after (1) five years of service, or (2) after seven years, if employees are 20% vested after three years, plus an additional 20% for each subsequent year. For the next year's contributions, employees must be 100% vested in matching contributions after (1) three years of service, or (2) after six years (20% vested after two years, plus an additional 20% for each subsequent year).

One effect of the 2001 Tax Act is to make retirement plans more attractive for many owners of small businesses. Employers who do not currently sponsor retirement plans may want to take a fresh look.