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Instability in the financial markets is unsettling to individuals trying to accumulate assets for retirement. However,
even before the terrorist attack it was evident that assumptions of Americans regarding investment returns
were being dismantled.

Events signaling the end of the long business expansion in this country were in motion before the attack on
the World Trade Center. The dot com sector meltdown and over capacity in the telecommunications sector led
the downturn in business spending. This downturn in capital spending has reduced the growth rate in the US
economy, leading to declining corporate earnings and large losses for stockholders. The main factor preventing
the US from falling into recession was the spending of individuals, both for consumption items and housing.
Analysts were amazed at how well consumer confidence held up in the face of declining stock market levels.

The events associated with the September 11th attack on the WTC kicked out the last prop holding up this
market. The speed in which the decline in airline traffic has led to layoffs in industries that depend on air traffic
has been stunning (hotels, leisure, and aircraft manufacturing). Beyond the direct impact on these industries, a
larger risk exists if a decline in employment affects the financial stocks. The financial sector in Japan has been
in trouble for over a decade and their economy has suffered. It should be clear to all that the difference between
a growing economy and a stagnant one is very slight and can be affected by events beyond our control. The collateral
damage to the economy from terrorism is magnified by the amount of debt sloshing around the system.

The cherished assumption that is under fire is that asset appreciation in stock and home values will make up for
a poor savings rate. The savings rate in this country recently was hovering around zero as Americans continued
to borrow at a rate faster than the economy was growing. The belief that consumers could continue this indefi-
nitely and support economic growth was just wishful thinking. We have now been treated to the spectacle of
politicians exhorting over leveraged consumers to keep spending to support the economy in the face of rising
unemployment. How does one support savings and consumption simultaneously? The last time this was tried
was during the Vietnam War, and it set the stage for the inflation during the next two decades.

A continuation of the “borrow and spend” economy seems odd in light of previous capital calls on our national
income. Consider the resources directed towards the Marshall Plan in Europe and the subsequent 45-year cold
war. The West German economy is still groaning under the load of trying to unify with East Germany. With
hindsight it is obvious that just using the military to overpower Iraq did not do the job. Now the bill has come
due. Call it the reverse peace dividend.

How will individuals respond to these developments? Borrow and spend attitudes will likely be out and figuring
out how to service debt and fund retirement savings will be in. This newsletter will focus on explaining new
savings opportunities in the 2001 act so that businesses can change their pension plans to take advantage of the
new tax law changes and individuals can plan their savings accordingly.

Revisiting the 2001 Tax Act

The retirement savings provisions of the 2001 tax act look like they were prescient in helping savers restock
retirement plans in response to a bear market. The yack in the media focused on decreases in tax rates and the
benefits received by taxpayers at different income levels, but the significant parts of the act focused in two main
areas:

  • Increased opportunities for tax advantaged retirement saving, and
  • Increases in the amounts of assets not subject to estate taxes.

The coupling of these two things makes sense. How are we going to encourage people to save if those assets
may be subject to estate taxes if they die prematurely? People will engage in belt tightening if they have an
incentive to do so through a combination of investment returns and tax savings. They are not inclined to defer
consumption if there is likely that their savings will be subject to estate taxes. America has a culture of consumption,
and it seems that we have to be properly motivated to practice thrift and restraint.

2001 law changes that promote retirement savings

  1. Increases in the amount of IRA contributions are scheduled.

    Contribution amounts, having been capped at $2,000 since 1982, are scheduled to increase from $3,000 in 2002
    to $5,000 in 2008. The contribution amounts will not be inflation adjusted after 2008, so it will still take an
    act of Congress to allow individuals to keep increase their retirement saving amounts in line with the declining
    value of the dollar.

  2. Bonus IRA contributions will be allowed for older taxpayers.

    The 2001 act calls these “catch-up contributions,” but this is a misnomer. A better term for these would be bonus
    contributions because these additional contributions are allowed to individuals age 50 or older regardless of
    their prior contribution history. The additional bonus contributions start at $500 in 2002 and increase to $1,000
    in 2006.

  3. Increases in annual limits for elective employee deferrals are scheduled.

    Maximum elective deferrals under 401(k) plans started at $7,000 and have been inflation indexed, so that by
    2001 they had increased to a $10,500. The deductible amount of these contributions has always been limited by
    non-discrimination calculations. Depending on the features of the employerʼs plan, employees can make nondeductible
    contributions for amounts in excess of the deductible amount up to the maximum deferral per year.

    Starting in 1998, employers were allowed to created SIMPLE IRA plans that allowed employees to make up to
    $6,000 in elective deferrals. For 2001 the maximum contribution amount had been increased to $6,500 by inflation
    indexing.

    There is an overall limit on elective deferrals by an individual equal to the limit under 401(k) plans. Regardless
    of the number of employee plans in which an individual participates (401(k)ʼs and Simple IRAʼs), the annual
    limit applies to the total of wages deferred. The annual limit on 401(k) plan elective deferrals is being increased
    from $11,000 in 2002 to $15,000 in 2006. The annual limit will be inflation indexed starting in 2007. The limit
    on SIMPLE IRA deferrals is being increased from $7,000 in 2002 to $10,000 in 2005. The annual limit will be
    inflation indexed starting in 2006.

  4. Bonus elective salary deferrals under 401(k) and SIMPLE IRA plans are available for older taxpayers.
    As with IRAʼs, additional elective deferrals are available for individual to aged 50 or over. Bonus 401(k) deferrals start at $1,000 in 2002 and increase to $5,000 in 2006.

    Bonus SIMPLE IRA deferrals start at $500 in 2002
    and increase to $2,500 in 2006. These amounts will be inflation indexed starting in 2007.

  5. Percentage of income limitations on elective 401(k) deferrals by employees are eliminated starting in 2002

    Elective 401(k) salary deferrals previously were subject to a limit of 15% of qualified compensation. Starting
    in 2002 there will effectively be no percentage limitation on 401(k) elective deferrals. These can equal 100%
    of wages up to the annual dollar limit on elective deferrals. This puts the contribution options of employees
    in 401(k) plans on the same footing as those covered by SIMPLE IRAʼs, which have had the 100% limit since
    enactment in 1997.

  6. Percentage limits on employer pension contributions have been decoupled from elective employee
    deferrals.

    Previously, elective employee deferrals were deemed to be employer contributions for the purpose of applying
    percentage limitations on employer pension contributions. Under certain circumstances this could have resulted
    in employer contributions reducing employee deferrals dollar for dollar. For example, if the employer maintained
    a profit sharing plan with a 15% employer contribution rate, effectively no elective salary deferrals would
    have been allowed.

    Starting in 2002 elective deferrals are not deemed to be employer contributions for the purpose of applying the
    percentage limitations. Employees will able to defer the lesser of their wages or the annual dollar limit regardless
    of what their employer contributes to a plan. (However, the amount of 401(k) elective deferrals that is deductible
    continues to be governed by existing non-discrimination formulas. The increase in deferral limits does
    not automatically guarantee that additional salary deferrals will be deductible.)

    This effect of this change is best illustrated by the following graphs. The first shows the maximum possible
    deferred compensation under pension law that applies through 2001. The maximum percentage tops out at less
    than 25% of wages and is relatively insensitive to changes in wages levels.

    The next chart shows the potentially large amount of income that employees could receive free of income taxes
    under the 2001 tax act. Employees can conceivably receive 125% of wages free of income taxes for the first
    $11,000 of wages. Although the amount available for deferral as a percentage of wages declines as wage levels
    increase, the percentage remains above 40% through $80,000 of wages. The likely winners here are working spouses and individuals in second careers that want to keep working at modest income levels. There is a good chance that many individuals in these groups may have the resources available from sources other than their wage income to meet living expenses so that a high wage deferral strategy is workable from a cash flow perspective. The typical overextended consumer will not be able to defer these large amounts because of debt service requirements.

    Deferred Compensation

    Deferred Compensation

    Businesses using part time employees will also be winners. One can envision classes of employees that may not be interested in working without these generous income deferral programs. There will likely be a strong relationship between the type of deferred compensation programs that a business offers and its ability to hire.

  7. The dollar limit for additions to an employeeʼs pension account has been increased, and the inflation-indexing formula has been liberalized.
    There has been a $30,000 per year limit on account additions to an employeeʼs account since 1982. Account additions
    can come from employer contributions, employee deferrals, or allocation of forfeitures from non-vested participants.
    This is a limitation that is applied to individuals for each employer, not to individuals over different
    employers. You can have as many annual limits as you have employers.

    The limit was supposed to be inflation adjusted, but indexing was first postponed and then allowed in $5,000
    increments. This meant that the annual limit was not changed as long as the total change was less than $5,000,
    and it would take several years before any contribution limit would catch up with inflation. Only in 2001 did
    inflation indexing increase the annual contribution from $30,000 to $35,000.

    Starting in 2002 the annual defined contribution limit will increase $40,000, and inflation indexing will occur in
    $1,000 increments starting in 2003.

  8. The percentage limitation on profit sharing plans has been increased from 15% to 25%.

    The overall limitation on contributions to defined contribution plans was (and remains) 25% of covered compensation.
    However, profit sharing plans were always subject to a lower 15% limitation. Profit sharing plans
    include cash or deferred arrangements (401(k)ʼs), and Simplified Employee Pensions (SEPʼs) in addition to
    regular employer contributory profit sharing plans.

    A benefit of profit sharing plans is that employer contributions are made at the discretion of the employer. Unlike Money Purchase pension plans where annual contributions are required as a condition of tax qualification,
    profit sharing contributions can be skipped if required by the financial objectives and financial condition of the
    employer. This flexibility has been a reason for employers to prefer profit-sharing plans to Money Purchase
    plans that have higher funding limits. A popular alternative has been to adopt a profit sharing in conjunction
    with a 10% Money Purchase plan. This allowed the employer to reach the 25% defined contribution limit while
    maintaining some funding flexibility.

    The change to allow contributions to profit sharing plans up to 25% is designed to encourage higher employer
    contributions while allowing tax simplification. There should be a dramatic decline in the use of Money Purchase
    plans starting in 2002 when this change takes effect as the need to have paired plans disappears.

  9. The maximum amount of qualifying wages has been increased to $200,000.

    The maximum compensation considered in limitation formulas was originally $150,000, but has been inflation
    indexed to $170,000 for 2001. Effective for 2002, the limit on qualifying wages is increased to $200,000. This
    allows employers to reach the maximum defined contribution limit without having to adopt the maximum 25%
    rate. For example, employees with wages of $200,000 or more can reach the $40,000 maximum contribution
    for 2002 at a 20% contribution rate.

  10. This change also allows employers more flexibility in structuring compensation arrangements with employees.
    Larger contributions with lower contribution percentages will allow higher compensated employees to increase
    pension contributions without increasing compensation costs to lower compensated employees.

  11. Elective after tax salary deferrals can be made to Roth IRA accounts.

    Starting in 2006, employers can set up what is termed a “Qualified Roth Contribution Program.” This would allow
    employees to designate any elective after tax deferrals to an account that would have all the tax advantages
    of a Roth IRA. The key benefits of Roth accounts are that no lifetime distributions are required and the income
    earned from the account is exempt from tax (not just tax deferred).

    The knock on Roth IRAʼs has always been that the income limit on contributions prevents participation by the
    persons who have the cash flow to take advantage of the program. No contributions have been allowed if Adjusted
    Gross Income of joint filers exceeded $160,000 ($95,000 for single filers). Under this new program there
    is no phaseout of contributions based on income level.

  12. Pre tax salary deferrals will no longer reduce qualified compensation in the calculation of employer
    contributions.

    Previously taxable W-2 wages were considered in applying contribution percentages in computing employer
    pension contributions. The 2001 tax act allows that pre tax elective contributions under Section 401(k) and
    SIMPLE IRA contributions will not reduce qualified compensation. This has the effect of increasing employer
    contributions under most circumstances. This change takes effect in 2002.

  13. Retirement savings tax credits are allowed for low-income taxpayers that make retirement plan contributions.
    This tax credit program is designed to make retirement savings programs so lucrative that even taxpayers in
    lower brackets will find the returns impossible to ignore. There is a complex set of rules that determine when
    IRA contributions are tax deductible. The factors that determine deductibility are pension coverage by an
    employer and income level. For 2001 married taxpayers with Adjusted Gross Income below $63,000 that have
    pension coverage cannot deduct IRA contributions. The income limit for single filers with pension coverage is
    $35,000.

The government was concerned about the lack of IRA participation by lower income taxpayers, so a new tax
credit has been enacted that is in addition to the tax deduction. There is no choice between the tax deduction
and the tax credit. You get both benefits if you qualify.

The tax credit is 50% for married taxpayers whose Adjusted Gross Income is $30,000 or less. The credit is
reduced to 20% until AGI reaches $32,500, and is 10% until AGI reaches $50,000. There are reduced dollar
thresholds for credit reduction for single filers. A low-income taxpayer could conceivably get a 65% rate of
return from an IRA contribution.

All pre tax and after tax elective employee deferrals and all IRA contributions (deductible and non-deductible)
can generate these tax credits as long as the income limits are met. The maximum amount of qualifying contributions
is $2,000/year for each individual. The program is experimental and is in effect from 2002 through
2006. A person must be 18 by the end of the tax year to qualify.

ACTION REQUIRED – INDIVIDUALS

  1. Individuals should do cash flow planning and assess their ability to take advantage of these expanded
    retirement savings opportunities.
  2. Individuals should understand the tax benefits from different retirement savings options (deductible,
    Roth and non-deductible contributions, availability of tax credits).
  3. Individuals should revisit their spending priorities to determine the appropriate mix of savings and
    consumption.
  4. Employees should investigate how their employers are adapting to these law changes and make the
    appropriate retirement savings elections for calendar year 2001.

ACTION REQUIRED – BUSINESSES

  1. Businesses should review their compensation arrangements with employees, looking to get the best
    mix of cash and deferred compensation especially for the type of employee that the business is interested
    in hiring.
  2. With higher pension benefit levels, businesses should make special efforts to communicate the value
    to non-cash compensation to employees and potential hires.
  3. Businesses should amend profit-sharing plans to provide for –

    • increases in contributions up to 25% of qualified compensation, and
    • a change the definition of compensation in plan documents to be consistent with the new definitions under the 2001 tax act. (Qualified compensation now includes elective employee deferrals.)
  4. Businesses that do not have 401(k) or SIMPLE IRA plans in place should consider adoption of one of
    these types of plans to allow for elective employee contributions.
  5. Businesses should considering terminating Money Purchase plans now that profit sharing plans can
    provide the maximum contribution.

Conclusion

The 2001 tax act dramatically expanded the retirement saving opportunities for individuals. Now it is up to employers
to make these programs available, and for employees to plan their cash flow to have the money to take
advantage of the opportunities