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First: Compensation of up to $200,000 may now be counted for benefit plan purposes. For 2001, the maximum amount of compensation that could be counted was $170,000. For example, a professional person earns $200,000 plus per year and who has one employee on salary at $30,000 per year. In 2001, without permitted disparity, a maximum defined contribution allocation to the professional would have been $35,000, and would have required $6,176 to be allocated to the employee. For 2002, the same contribution would yield $35,805 to the professional and $5,371 to the employee.

Also Note: Due to cost of living increases the $35,000 limit for annual additions to a participant’s account have been increased from $35,000 to $40,000 for 2002. So in the example above the professional could now contribute $40,000 to his own account and another $6,000 to the employee.

Profit Sharing and 401(k) Plans

Profit sharing plans that do not include 401(k) accounts should consider adding them for 2002, for several reasons:

A. HIGHER CONTRIBUTIONS TO PROFIT SHARING PLANS

Previously, under a profit sharing plan an employer could contribute up to 15% of total payroll. With 401(k) accounts employees could defer a portion of their salary into the plan, but the employee contributions reduced the amount of profit sharing contributions the employer could make. For 2002, employers can contribute up to 25% of payroll to a profit sharing plan, and employees’ 401(k) contributions will not reduce the employer’s profit sharing contribution.

For example, assume a company has total payroll of $500,000 and has a profit sharing plan with a 401(k) feature. The graphic below shows the additional benefits of this rule change. Note that the employer can contribute more than $100,000 extra in 2002!

Old Rule New Rule

Total Salaries 500,000 500,000

Deferrals 50,000 50,000

Salary Limitation 450,000 500,000

Plan Limit 15% 25%

Maximum Total Contribution 67,500 125,000

Less Deferrals -50,000 N/A

Net Employer

Contribution 17,500 125,000
 

This leads to an opportunity and a problem: The employer may contribute much more to the plan but will those additional contributions benefit the employees desired? To make sure that they do, it is imperative that profit sharing plans use the best tools for their allocations. This may mean age weighting, permitted disparity or cross-testing. Such tools permit favoring of older employees, more highly compensated employees or a combination thereof. Using state of the art planning will allow the employer to benefit the key employees appropriately.

B. HIGHER CONTRIBUTIONS TO 401(k)

The applicable contribution limit for employee deferrals contributions has increased to $11,000 for participants in 401(k), 403(b), SEP or 457 plans, an increase of $500 for 401(k) and $2,500 for 457 plans.

C. CATCH-UP CONTRIBUTIONS FOR 401(k)

In addition to the higher contribution limit for employee deferrals, an additional “catch-up” contribution of $1,000 for 2002 is permitted for participants age 50 and above to 401(k), 403(b), SEP or 457 plans. (SIMPLE plans permit an additional $500.) For 2002, therefore, a 50 year-old participant in a 401(k) plan could defer up to $12,000, while a participant under age 50 is limited to $11,000.

Current proposed IRS regulations indicate that catch-up contributions will not be taken into account for non-discrimination testing for either highly-compensated or non-highly compensated employees.

D. SAVER’S CREDIT

Another new benefit available to participants this year is the “Saver´s Credit”, an income tax credit for qualifying taxpayers with adjusted gross income below $50,000. It is equal to a specified percentage of eligible employee contributions made to an eligible employer-sponsored retirement plan or to an IRA for 2002. The following arrangements are eligible for the credit: 401(k) plan, SIMPLE 401(k), a 403(b) plan, a 457 plan, a SIMPLE plan or a SARSEP. Finally, the Saver´s Credit is also available for contributions to a traditional or Roth IRA.

IRS Announcement 2001-106 indicates that (unlike catch-up contributions) contributions eligible for Saver’s Credit treatment are taken into account for nondiscrimination testing purposes.

Money Purchase Plans

Money purchase plans are obsolete! Previously money purchase pension plans were needed for a company to make a maximum contribution of up to 25% of salary. However, for 2002, profit sharing plans alone now permit deductions of up to 25% of compensation as an elective rather than a fixed contribution.

Fixed contribution money purchase pension plans should generally be converted to profit sharing plans, or terminated and the assets transferred to a profit sharing plan to take advantage of the greater flexibility.

Defined Benefit Plans

The retirement age in defined benefit plans has been reduced to 62 and the maximum annual benefit has been increased from $140,000 to $160,000. This means that employers may be able to make tax-deductible contributions of $200,000 or more to a defined benefit plan with the bulk of the contributions going to the benefit of selected older employees.

It should also be noted that a couple of years ago, Congress repealed the combined plan limit (called the 1.0 or 1.4 Rule) which limited benefits under a defined benefit plan when combined with a defined contribution plan. So it is now possible to stack a defined benefit plan on top of a defined contribution plan to increase the amount of deduction considerably.