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New Law Puts the Brakes on Inflation Adjustments to Qualified Plan Limits

Winter 1995

Twice during the past several years, Congress has yielded to the temptation to raise revenue by "reforming" the country's pension laws. In 1992, increases in federal unemployment insurance benefits were funded by changes in the pension laws. The changes imposed mandatory 20% federal income tax withholding on distri-butions from qualified retirement plans that were not rolled over directly into other retirement arrangements. Last year, projected revenue losses caused by tariff reductions under the General Agreement on Tariffs and Trade were offset by pension law changes enacted under the Retirement Protection Act of 1994 (the "Act") affecting defined benefit and defined contribution plans alike.

The primary purpose of the Act is to stiffen the funding requirements for defined benefit pension plans. In addition, it changes the way that cost-of-living adjustments are made to certain annual dollar limitations which apply to all types of qualified retirement plans. As a result, these adjust-ments will increase more slowly over time. The following is a brief summary of these new rules.

Cost-of-living adjustments to maximum salary reductions under 401(k) plans and SARSEPs.
The new rules provide that the annual dollar limitation on salary reduction contributions under 401(k) plans and SARSEPs (salary reduction simplified employee pension plans) may be adjusted only in $500 increments, and increases in the limitation will be rounded down to the next nearest multiple of $500. As a result, the maximum salary reduction contribution that a participant may make under his or her 401(k) plan or SARSEP for 1995 is $9,240, the same limit that was in effect for 1994. Under the new rules, that limit will not change until cost-of-living increases raise it to at least $9,500.

Cost-of-living adjustments to the maximum amount of compensation taken into account for qualified plan purposes.
The law currently limits the amount of annual compensation that may be taken into account for purposes of determining contribu-tions or benefits under a qualified retirement plan to $150,000, as adjusted for cost-of-living increases. The Act provides that for plan years beginning after 1994, the $150,000 limit may be adjusted only in increments of $10,000, with increases in the limit rounded down to the next lowest multiple of $10,000. Although the IRS intends to continue issuing yearly cost-of-living adjustments, they will not be reflected in the $150,000 limit until the sum of those adjust-ments is at least $10,000.

Cost-of-living adjustments to limitations on maximum annual additions and benefits.
Before the Act, the law provided that the $30,000 limitation on annual additions to a partici-pant's account under a defined contribution plan (such as a profit-sharing, money purchase, or 401(k) plan) would be increased to 25% of the dollar limitation on annual benefits under a defined benefit plan once the latter limitation reached $120,000 (which will happen this year). However, under the Act's new rules, adjustments to the $30,000 defined contribu-tion limitation are no longer tied to the defined benefit dollar limitation. Instead, the $30,000 limitation will be adjusted for cost-of-living increases, but only in $5,000 increments. As a result, the $30,000 limitation will increase again only when cost-of-living increases raise it to $35,000 or more.

The Act further provides that the defined benefit dollar limitation also will be adjusted only in $5,000 incre-ments. The adjusted limit for these plans is $120,000 for 1995. That figure will not change until cost-of-living increases raise it to at least $125,000.

Cost-of-living adjustment for eligibility under a SEP.
An individual's eligibility to participate in a SEP (simplified employee pension plan) is partly based upon how much he or she earns in a given year. Under prior law, anyone who was at least 21 years old, worked for his or her employer during at least three of the five preceding years, and earned at least $396 per year could participate in a SEP. The Act provides that this dollar limit will be adjusted only in increments of $50. As a result, the dollar figure for 1995 is $400, and it will not increase until cost-of-living adjustments raise it to at least $450.

Finally, under the new rules, the IRS will announce the cost-of-living adjustments to the indexed qualified plan dollar limitations in October or November of the year prior to the year for which the adjustments are effective. (Under the old rules, the IRS announced the adjustments in January of the year for which they were effective.) Consequently, due to the change to the new system, the 1995 indexed amounts reflect only nine months' worth of the 1994 cost-of-living increase.

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