The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), signed into law last July, provided the most significant increases in retirement savings opportunities in many years. Among them is the ability of older workers to defer an additional portion of their compensation into a qualified plan.
The idea makes sense, because older workers may not have had the foresight to begin saving for retirement when they were younger. They may need to “catch-up” on their deferrals during their remaining working years.
Conceptually, the catch-up provisions under EGTRRA seemed fairly simple. Participants age 50 and over are allowed to make additional deferrals into their retirement plans. What could be simpler than that? But recently released IRS proposed regulations illustrated that the catch-up rules are not as easy as apple pie.
The proposed regulations contain all of the details about the proper handling of catch-up contributions. This newsletter will provide the information you need to understand this new savings opportunity.
Eligibility
Catch-up contributions are not a plan requirement–they are an option that employers can choose to provide. They are only available for qualified retirement plans that allow elective salary deferrals, which include 401(k) plans, Simple IRA plans, Salary Reduction Simplified Employee Pension plans (SARSEPs), section 403(b) Tax Sheltered Annuity plans, and section 457 eligible government plans. (SARSEPs were discontinued after 1996–only pre-existing ones can remain in effect.)
Participants who are age 50 and older are eligible to make catch-up contributions. This includes participants who are projected to attain age 50 by the end of the calendar year, even if they die or terminate employment before their 50th birthday.
Catch-Up Contribution Limits
Listed below are the dollar limitations for catch-up contributions to standard 401(k) plans, SARSEPs, 403(b) plans and 457 plans:
| Year | Limit |
2002 | $1,000 |
2003 | $2,000 |
2004 | $3,000 |
2005 | $4,000 |
2006 | $5,000 |
For SIMPLE 401(k) plans and SIMPLE IRAs, the dollar limits are one-half of those shown above.
After 2006 the dollar limit will be indexed for inflation in $500 increments, calculated using the third quarter of 2005 as the base period.
Determination of Catch-Up Contributions
The new law states “catch-up contributions are elective deferrals made by a catch-up eligible participant that exceed any of the applicable limits.” In other words, a deferral will not be classified as a catch-up contribution until it exceeds one of these three applicable limits:
Statutory Limits
These limits include the annual elective deferral limit in effect for each calendar year ($11,000 for 2002) and the Internal Revenue Code (IRC) section 415 annual additions limit. For 2002, the annual additions limit for defined contribution plans increased to the lesser of 100% of compensation or $40,000. Annual additions include employee and employer contributions and forfeitures allocated to a participant’s account during the plan’s limitation year.
Employer-Provided Limit
This is a limit placed on elective deferrals under the terms of the plan, which is not required under the IRC. An example of this would be a plan provision limiting elective deferrals to 10% of compensation.
Actual Deferral Percentage (ADP) Limit
This is the limitation on deferrals by the highly compensated employees (HCEs) determined by the annual nondiscrimination testing. The limit is calculated to be the largest dollar amount that may be retained for each HCE by a plan that would fail the ADP test if it did not make corrective distributions.
Timing of Catch-Up Contribution Determination
Except for the calendar-year dollar deferral limit, the determination of the amount of any deferrals considered to be in excess of an applicable limit is determined at the end of the plan year. The determination as to deferrals in excess of the annual dollar limit is made at the time such excesses are deferred.
Catch-Up Contribution Examples
The ABC 401(k) Plan is a calendar year plan which for 2002 allows deferrals of up to 50% of compensation, limited to the $11,000 annual dollar limit. The plan was amended to allow catch-up contributions of up to $1,000 in 2002 for those age 50 and older.
Exceeding Annual Elective Deferral Limit: Jennifer is a 55-year-old participant in the ABC 401(k) Plan, earning $100,000 per year. She elects to defer $500 from each semi-monthly paycheck, for a total annual deferral of $12,000.
Since this amount exceeds the statutory annual dollar limit of $11,000 and, since Jennifer is over age 50, the additional $1,000 will be classified as a catch-up contribution. The determination will be made as of the first paycheck in December that the deferral limit has been exceeded and catch-up contributions have begun.
Exceeding Employer-Provided Limit: Mark is also a participant in the ABC 401(k) Plan. He is a 60-year-old retired police officer, receiving a full pension, who works part-time for ABC. Mark’s annual compensation is $20,000. He elects to defer $11,000 into the plan during 2002. At the end of the year, it will be determined that Mark exceeded the plan’s 50% of compensation deferral limit by $1,000. This excess will be considered a catch-up contribution.
Exceeding ADP Limit: Diane is the owner of ABC Corp. and one of four HCEs in the 401(k) plan. She is 52 years of age. She elects to defer $10,000 of her $200,000 salary for the year ($200,000 is the new annual compensation limit for plan purposes as of 2002).
At the end of the year when the ADP test is performed, it is determined that the HCEs deferred more than is allowable and the test failed. The plan chooses to make corrective distributions to the four HCEs, under which the maximum deferral level the plan can retain for any HCE is $8,500. Since Diane is over age 50, $1,000 of her $1,500 excess will be reclassified as a catch-up contribution and kept in the plan. The other $500 will be distributed to her (with earnings).
Exceeding Section 415 Annual Additions Limit: Fred is the owner and only employee of the Fred Corp. He turns 50 on December 31, 2002. His salary for 2002 will be $120,000. He establishes a 401(k) profit sharing plan to which his corporation contributes $30,000 for 2002 (which equals the new 25% profit sharing deduction limit). He also defers $11,000 of his salary into the plan under the section 401(k) provisions.
Although his deferrals do not exceed the annual deferral dollar limit, it gives him total annual additions under section 415 of $41,000 for the year. This exceeds the new $40,000 annual additions dollar limit by $1,000.
The excess is allowable as a catch-up contribution since Fred is expected to reach age 50 by the end of the calendar year. The fact that his elective deferrals and employer contribution added together exceed 25% of his compensation does not create a deduction problem because as of 2002 elective deferrals are no longer part of the deduction limitation.
Treatment of Catch-Up Contributions
Plan Limits: Catch-up contributions are not taken into consideration when applying any plan contribution or deduction limitation. That’s because they are intended to supplement normal plan contributions.
ADP Testing: Elective deferrals that are classified as catch-up contributions are not included in determining a participant’s deferral percentage for the ADP nondiscrimination test. Any deferrals that are reclassified as catch-up as part of the correction process of a failed ADP test must be retained by the plan. Such deferrals are still considered to be excess contributions, and accordingly matching contributions with respect to such deferrals may be forfeited.
Top Heavy Considerations: When determining if a plan is top heavy, prior year catch-up contributions are considered as part of the total account balance calculations. However, current year catch-up contributions are not considered when determining contributions made by key employees, which affects the minimum top heavy contribution that must be provided to non-key employees in a top heavy plan.
Coverage Requirements: Current year catch-up contributions are not normally used in the average benefits test under the coverage requirements of IRC section 410(b). However, such contributions are used when the average benefits test utilizes prior year allocations.
Nondiscrimination Issues: The availability of catch-up contributions will not violate the nondiscrimination requirements of IRC section 401(a)(4), even if the only participants who are catch-up eligible happen to be HCEs.
Universal Availability: Employers who allow catch-up contributions in one plan must provide the same opportunity (with the same dollar levels) in all their applicable plans. An employer will not fail to satisfy this requirement simply because different employer-provided contribution limits apply to different groups of employees, as long as no plan provides lower contribution limits for catch-up eligible participants.
The IRS recently issued Notice 2002-4 which allows employers with multiple plans to adopt the catch-up provisions on different dates during 2002, provided that all such plans offer catch-up contributions by October 1, 2002.
The universal availability requirement does not apply to IRC section 457 eligible government plans. Nor does it apply to a plan that is maintained by the employer as a result of a merger, acquisition or similar transaction, as long as the newly acquired plan is amended to comply by the end of the transition period described in section 410(b)(6)(c). Union plans are not subject to the universal availability requirement until the end of the union contract in effect on January 1, 2002.
Multiple Plans: Special rules apply for employees who participate in more than one 401(k) plan, whether or not the plans are maintained by the same employer. In no event can the total of all catch-up contributions for an employee exceed the applicable dollar catch-up limit for the taxable year.
Coordination With State Laws
There is some concern among pension professionals that many states do not have income tax provisions that automatically coordinate with changes in the federal tax law. In such states, the tax treatment of catch-up contributions, as well as other contribution limits that were increased by EGTRRA, would be in question. States often do retroactively adopt new federal tax provisions.
Conclusion
The new catch-up contribution rules provide a valuable opportunity for participants age 50 and over to increase their retirement savings. Such contributions are defined as the excess over any one of a number of otherwise applicable limitations. Plan sponsors need to know how catch-up contributions are determined and treated for certain administrative purposes. Once procedures are established, catch-up contributions can become a viable tool for the enhancement of retirement benefits.
