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Make Hay While the Sun Shines

Financial Planning

July 2001

Make Hay While the Sun Shines

In last month’s newsletter, we touched on some of the provisions of the new tax law signed by President Bush. Most of the provisions in the law “sunset” on December 31, 2010. As a result, it will take careful planning to take the maximum advantage of the provisions of the new law before their expiration.

Some of the more important provisions to many of us will be the retirement provisions. This article will discuss the new retirement plan rules to help you make the best use of the new law’s provisions before the “Sun Sets.”

Contribution Limits

New law will allow a maximum of $40,000 or 25% of compensation to be added to defined contribution plans for years beginning after December 31, 2001. Further, this maximum amount will increase by $1,000 each year the rate of inflation is sufficient to warrant the increase. Prior law limited annual additions to $35,000 (in 2001) with the maximum increasing in $5,000 increments based on inflation.

For those whose employers offer arrangements that include “elective deferrals” the percentage benefit is even greater. The present $10,500 maximum will increase to $11,000 in 2002; $12,000 in 2003; $13,000 in 2004; $14,000 in 2005; $15,000 in 2006 and thereafter. As it is now, the maximum amount will be indexed for inflation in increments of $500 per year after 2006. The types of plans these limits will affect are 401(k) plans, 403(b) annuities for not-for-profit organization employees, 408(k) salary reduction SEPs and 457 tax-exempt organization and state or local government plans.

If your employer has established a SIMPLE plan to which you contribute, your maximum annual additions will increase also. The present $6,500 maximum will increase to $7,000 in 2002; $8,000 in 2003; $9,000 in 2004; $10,000 in 2005 in 2005 and thereafter. As it is now, the maximum amount will be indexed for inflation in increments of $500 per year after 2005.

In addition to the above limitations, for the three years prior to retirement, participants in a 457 plan will be able to contribute twice the otherwise applicable dollar limitation.

Deductibility of Employer Contributions

In applying the amount an employer may deduct, the maximum compensation will increase to $200,000, up from the prior law amount of $170,000. Like the prior law, this amount will be indexed for inflation but in lower increments of $5,000 and not $10,000.

This increased amount will also apply in testing to see if the plan is discriminatory.

Benefit limits under Defined Contribution Plans

The law as it existed in the past, limited the annual benefit payable at retirement to 100% of average compensation or $140,000. There was also a reduction to this maximum amount if benefits began prior to the social security normal retirement age. The annual compensation that could be taken into account in determining benefits, employer contribution deductibility and nondiscrimination testing was similar to that of defined contribution plans.

Under the new law, the annual benefit limit is increased to $160,000 beginning after December 31, 2001. The $160,000 is indexed to account for inflation adjustments in increments of $5,000. Beginning in 2002, the compensation limit for the various discrimination tests and employer deduction limitations is $200,000. This amount is again indexed to account for inflation adjustments in increments of $5,000.

Catch-up Contributions

Under prior law, participants in Code Section 457 plans for state and local governmental employees could make catch-up contributions during the last three years before retirement. Under the new law, eligible employees are able to make catch-up contributions in addition to other allowed contributions. To be eligible, employees must be 50-years-old or older before the end of the plan year.

The amount that can be added to the employee's regular contributions depends on the type of plan. For any plan other than a SIMPLE plan, the applicable limit starts at $1,000 in 2002 and increases $1,000 per year until it reaches $5,000 in 2006. For SIMPLE plans, the amount that can be contributed starts at $500 in 2002 and increases $500 per year until it reaches $2,500 in 2006. Thereafter, both plans additional contribution amounts are indexed for inflation adjustments in increments of $500.

If a participant's compensation, less other elective deferrals, is less than the amounts above, the participant can elect to defer all of their compensation.

As an added bonus, the participant's employer can make matching contributions based on the catch-up contributions, subject to the normally applicable rules.


Under prior law, for the plan to be considered "qualified," there were two periods under which the participant's right to 100% of employer matching contributions could be vested. One method would provide for 100% vesting in five years and the other would allow for 100% vesting over seven years.

Under the new law, there are still two alternatives. However, the periods of vesting are shortened to three years and six years. It is important to note that this provision applies only to employer matching contributions. Accordingly, for defined benefit plans and contributions that are not contingent on the participant's elective deferrals, the five and seven year periods remain in effect.

Qualified After-Tax Roth Contributions

Individuals who participate in a 401(k) or 403(b) plan will now have the option to designate part or all of their elective deferrals as designated Roth contributions, assuming the plan will allow for such designation alternatives. In effect, this means if B. A. Taxpayer is eligible to defer $15,000 in any year beginning after December 31, 2005, B. A. can designate anywhere from $0 to $15,000 as a Roth contribution. If, for instance, B. A. made $10,000 in pre-tax contributions, he would be limited to designating $5,000 as after tax Roth contributions.

This new plan feature will create additional burdens on employers due to the need to keep separate records on the Roth amounts and, therefore, it isn't a foregone conclusion many employers will offer this feature. Additionally, there are strict contribution limitations and excess contribution penalties. Accordingly, care will need to be exercised in applying this provision.

Plan loans

In general, prior law did not allow small business owners to borrow from their plan accounts like other employees could. The new law eliminates this prohibition for years beginning after December 31, 2001.

Individual Retirement Accounts

The IRA maximums under prior law were $2,000 for each husband and wife, limited to earned income. Had the amounts established in 1981 increased with inflation, the current maximum would be $5,000. The $2,000 maximum will increase to $3,000 for the years 2002 - 2004, $4,000 for 2005-2007 and $5,000 for 2008 and thereafter. Contributions will still be limited to an individual's earned income. As with other qualified plans, the limitations will be indexed for inflation in $500 increments.

Catch-up provisions will apply to IRA owners 50 years old and older also beginning in 2002. For the years 2002-2005, the catch-up amount will be limited to $500 and for 2006 and after the limit will be $1,000.


With the advent of the higher limits for elective deferrals, combined with the faster vesting schedule, Congress has given middle and low income taxpayers a powerful incentive to participate in some sort of retirement savings plan. At present, however, these provisions sunset in 2010. Accordingly, you should review your own situation and determine if you can take advantage of some of the new provisions.

It will not be an easy decision to determine if it is more advantageous to put more into Roth plans, when available, and forego the tax savings in the short run or if designating all of your contributions as pre-tax. It will be, in the end, a numbers-crunching task, tempered by realistic expectations of future investment earnings. If you are at all uncertain as to what your best alternative is, give us a call. We are here for you and we are here to help.

Have a Happy July 4th.

These articles are intended to provide general resources for the tax and accounting needs of small businesses and individuals. Service2Client LLC is the author, but is not engaged in rendering specific legal, accounting, financial or professional advice. Service2Client LLC makes no representation that the recommendations of Service2Client LLC will achieve any result. The NSAD has not reviewed any of the Service2Client LLC content. Readers are encouraged to contact their CPA regarding the topics in these articles.

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