OVERVIEW OF PRESENT-LAW TAX RULES

RELATING TO

QUALIFIED PENSION PLANS

Scheduled for a Public Hearing

Before the

SUBCOMMITTEE ON OVERSIGHT

of the

HOUSE COMMITTEE ON WAYS AND MEANS

on May 5, 1998

Prepared by the staff

of the

JOINT COMMITTEE ON TAXATION

May 4, 1998

JCX-30-98

CONTENTS

INTRODUCTION

I. SUMMARY

II. PRESENT-LAW RULES

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A. Overview of Qualified Plans

B. Plan Qualification Requirements

1. Coverage and nondiscrimination requirements

a. Minimum coverage rules

b. Minimum participation rule

c. Nondiscrimination in contributions or benefits

d. Nondiscrimination rules relating to qualified cash or deferred arrangements

e. Nondiscrimination rules relating to employer matching contributions and employee contributions

2. Limitations on contributions and benefits

3. Definitions

a. Highly compensated employee

b. Employer and employee

C. Treatment of Distributions

1. Uniform minimum distribution rules

2. Withdrawal rules

3. Taxation of distributions

D. Funding Rules

III. ISSUES AND ANALYSIS RELATING TO THE SIMPLIFICATION OF EMPLOYEE PENSION

BENEFITS TAX LAWS

INTRODUCTION

The Subcommittee on Oversight of the Committee on Ways & Means has scheduled a public hearing on May

5, 1998, to review the Internal Revenue Code rules relating to private pension plans.

This pamphlet,(1)prepared by the staff of the Joint Committee on Taxation, provides a description of present

law and a discussion of issues relating to simplification of the Federal income tax rules applicable to

tax-qualified retirement plans. Part I of the pamphlet is a summary. This is followed by a description of the

present-law Federal tax rules regarding tax-qualified plans (Part II), and a discussion of pension plan

simplification issues (Part III).

I. SUMMARY

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Present-law rules relating to qualified plans

A plan of deferred compensation that meets the qualification standards of the Internal Revenue Code (a

qualified plan) is accorded special tax treatment under present law. The employer maintaining the plan is

entitled to a current deduction (within limits) for contributions to a qualified plan even though an employee is

not required to include qualified plan benefits in income until the benefits are distributed from the plan. The

purpose of the tax benefits for qualified plans is to encourage employers to establish nondiscriminatory

retirement plans for their employees.

Qualified plans are broadly classified into two categories: defined contribution plans and defined benefit

pension plans. There are several different types of defined contribution plans, including money purchase

pension plans, profit-sharing plans, stock bonus plans, and employee stock ownership plans ("ESOPs"). An

increasingly popular type of defined contribution plan is a qualified cash or deferred arrangement named a

"section 401(k) plan" for the governing Code section.

One of the main purposes of the qualification standards and related rules governing qualified plans is to

ensure that qualified plans benefit an employer's rank-and-file employees as well as the employer's highly

compensated employees. The qualification standards also define minimum rights of plan participants and

beneficiaries and provide limits on the tax deferral possible under qualified plans.

The qualification rules include minimum participation rules that limit the age and service requirements an

employer can impose as a requirement of participation in a plan; coverage and nondiscrimination rules

designed to prevent qualified plans from discriminating in favor of highly compensated employees; vesting

and accrual rules which limit the period of service an employer can require before an employee earns or

becomes entitled to a benefit under a plan; limitations on the contributions made on behalf of and benefits of

a plan participant; and minimum funding rules designed to ensure the solvency of defined benefit pension

plans. The Code also contains rules regarding the taxation of qualified plan benefits; terminations of qualified

plans; and rules designed to prevent plan fiduciaries and others closely associated with a plan from misusing

plan assets.

The present-law rules governing qualified plans originated in the Employee Retirement Income Security Act

of 1974 ("ERISA"). ERISA forms the basis for the current private pension system. The rules enacted in

ERISA have been revised several times. The modifications have had a variety of purposes, including

ensuring broader pension plan coverage, providing greater benefit security for participants in defined benefit

plans, modifying the rights of plan participants, and simplification. The Small Business Job Protection Act of

1996 contained comprehensive pension simplification provisions. These provisions included significant

changes to the rules regarding taxation of distributions and nondiscrimination, including the addition of a new

type of plan for small employers (called the "SIMPLE") and a design-based safe harbor plan for cash or

deferred arrangements. The recently enacted Taxpayer Relief Act of 1997 also contained a variety of pension

simplification provisions, including provisions to simplify plan administration.

Simplification issues

The Federal laws and regulations governing employer-provided retirement benefits are recognized as among

the most complex set of rules applicable to any area of the tax law. There are several sources for this

complexity, including the interaction of retirement policy and tax policy, the volume and frequency of

employee benefits legislation, the structure of the workplace, the need to take into account the great variety of

compensation and benefit packages, the desire for certainty in the law, and transition rules.

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In analyzing any proposal to simplify the pension rules, the following issues are important: (1) the extent to

which the proposed change is consistent with the underlying policy objectives of the rule that is altered; (2)

whether a complete revision of rules that employers and plan administrators understand and use should be

made solely in the interest of simplification; (3) whether additional legislation with respect to a rule that has

already been subject to significant legislation itself creates complexity; (4) the extent to which transition rules

and grandfather rules contribute to complexity; and (5) whether any attempt to simplify the rules relating to

employer-provided pension plans should be required to be revenue neutral with respect to present law.

II. PRESENT-LAW RULES(2)

A. Overview of Qualified Plans

In general

A plan of deferred compensation that meets the qualification standards of the Internal Revenue Code (a

qualified plan) is accorded special tax treatment under present law. Employees do not include qualified plan

benefits in gross income until the benefits are distributed even though the plan is funded and the benefits are

nonforfeitable. Tax deferral is provided under qualified plans from the time contributions are made until the

time benefits are received. The employer is entitled to a current deduction (within limits) for contributions to

a qualified plan even though an employee's income inclusion is deferred. Contributions to a qualified plan are

held in a tax-exempt trust.

The special tax benefits for qualified plans and qualified plan benefits represent a significant tax expenditure.

For fiscal year 1998, the tax expenditure for the net exclusion for pension contributions and earnings is

estimated to be $73.5 billion.(3)

The policy rationale for this tax expenditure is that the tax benefits for qualified plans encourage employers

to provide retirement benefits for their employees. This reduces the need for public assistance and reduces

pressure on the social security system.

A primary purpose of the qualification standards and related rules governing qualified plans is to ensure that

qualified plans benefit an employer's rank-and-file employees as well as highly compensated employees.

They also define the rights of plan participants and beneficiaries and provide some limit on the tax benefits

for qualified plans.

Qualified plans are broadly classified into two categories based on the nature of the benefits provided:

defined contribution plans and defined benefit pension plans.

Under a defined benefit pension plan, benefit levels are specified under a plan formula. Benefits under a

defined benefit pension plan are funded by the general assets of the trust established under the plan;

individual accounts are not maintained for employees participating in the plan.(4)

Benefits under defined contribution plans are based solely on the contributions (and earnings thereon)

allocated to separate accounts maintained for each plan participant. There are several different types of

defined contribution plans, including money purchase pension plans, target benefit plans, profit-sharing

plans, stock bonus plans, and employee stock ownership plans ("ESOPs"). A profit-sharing or stock bonus

plan, a pre-ERISA money purchase pension plan, or a rural cooperative plan may include a qualified cash or

deferred arrangement (a "sec. 401(k) plan"). Under such an arrangement, an employee may elect to have the

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employer make payments as contributions to a plan on behalf of the employee, or to the employee directly in

cash. The various different types of plans are in part historical and reflect the various different ways in which

employers structure deferred compensation programs for their employees.

Sanction for failure to meet qualification rules

If a plan fails to meet the qualification standards, then the special tax benefits for qualified plans do not apply,

and benefits and contributions are taxed under normal income tax rules. In general, if a plan fails to meet the

qualification standards, then contributions to the plan are includible in the employees' gross income when

such contributions are no longer subject to a substantial risk of forfeiture (secs. 402(b) and 83). Amounts

actually distributed or made available to an employee are generally includible in income in the year

distributed or made available under the rules applicable to taxation of annuities (sec. 72). Special sanctions

apply in the case of failure to meet certain qualification rules.

An employer is generally not entitled to a deduction for contributions to a nonqualified plan until the

contributions are includible in an employee's gross income.

Because disqualification of a plan can have harsh results, in practice the Internal Revenue Service ("IRS")

generally does not disqualify a plan for failure to satisfy the qualification rules, but negotiates lesser sanctions

typically designed to correct the error. The IRS has established programs allowing plan sponsors to correct

qualification failures and thereby continue to provide their employees with retirement benefits on a

tax-favored basis. These programs include: the Administrative Policy regarding Self-Correction ("APRSC");

the Voluntary Compliance Resolution ("VCR") program; the Walk-in Closing Agreement Program ("Walk-in

CAP"); and the Audit Closing Agreement Program ("Audit CAP"). Recently, the IRS consolidated these

programs into a coordinated Employee Plans Compliance Resolution System ("EPCRS").

SIMPLE retirement plans

Under the Small Business Job Protection Act of 1996, certain small businesses can establish a simplified

retirement plan called the savings incentive match plan for employees ("SIMPLE") retirement plan. The rules

relating to SIMPLE plans were adopted to encourage small employers to adopt retirement plans by providing

a simplified retirement plan that is not subject to the complex rules applicable to tax-qualified plans. SIMPLE

plans can be adopted by employers who employ 100 or fewer employees who received at least $5,000 in

compensation during the preceding year and who do not maintain another employer-sponsored retirement

plan. A SIMPLE plan can be either an individual retirement arrangement ("IRA") for each employee or part

of a 401(k) plan. If established in IRA form, a SIMPLE plan is not subject to the nondiscrimination rules

generally applicable to qualified plans and simplified reporting requirements apply under title I or ERISA.

Within limits, contributions to a SIMPLE plan are not taxable until withdrawn.

A SIMPLE plan can also be adopted as part of a 401(k) plan. In that case, the plan does not have to satisfy

the special nondiscrimination tests applicable to 401(k) plans and is not subject to the top-heavy rules. The

other qualified plan rules continue to apply.

A SIMPLE retirement plan allows employees to make elective contributions which cannot exceed $6,000 per

year. The $6,000 dollar limit is indexed for inflation in $500 increments. The employer is required to satisfy

one of two contribution formulas. Under the matching contribution formula, the employer generally is

required to match employee elective contributions on a dollar-for-dollar basis up to 3 percent of the

employee's compensation. Under a special rule applicable to a SIMPLE IRA, the employer can elect a lower

percentage matching contribution for all employees (but not less than 1 percent of each employee's

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compensation). In addition, a lower percentage cannot be elected for more than 2 out of any 5 years.

Alternatively, for any year, an employer is permitted to elect, in lieu of making matching contributions, to

make a 2 percent of compensation nonelective contribution on behalf of each eligible employee with at least

$5,000 in compensation for such year, whether or not the employee makes an elective contribution.

In order for the employer to lower the matching percentage, (in the case of a SIMPLE IRA), or to make a

nonelective contribution for any year, the employer has to notify employees of the applicable match within a

reasonable time before the 60-day election period for the year. The 60-day election period is the period within

which each eligible employee can elect to participate in the SIMPLE plan and modify any previous elections

regarding the amount of contributions. The 60-day period is the 60-day period before the beginning of any

year or the 60-day period before an employee first becomes eligible to participate.

No contributions other than employee elective contributions, required employer matching contributions or

employer nonelective contributions can be made to a SIMPLE plan. All contributions to an employee's

SIMPLE account must be fully vested.

Contributions to a SIMPLE plan generally are deductible by the employer and excludable from the

employee's income. Early withdrawals from a SIMPLE plan generally are subject to the 10-percent early

withdrawal tax. However, in the case of a SIMPLE IRA, withdrawals of contributions during the 2-year

period beginning on the date the employee first participated in the SIMPLE IRA are subject to a 25-percent

early withdrawal tax.

Simplified employee pensions

Under a simplified employee pension ("SEP"), contributions are made to individual retirement arrangements

(IRAs) established on behalf of each participant. SEPs are not subject to the general qualification rules and

are intended to provide an employer with a retirement savings arrangement for the employer's employees that

requires a minimum of administrative work.

In general, employer contributions to a SEP are required to be made on behalf of each employee who has

attained age 21, has performed service for the employer during at least 3 of the immediately preceding 5

years, and received at least $400 (1998) in compensation from the employer for the year.

Because of the enactment of SIMPLE plans, effective for taxable years beginning after December 31, 1996,

employers can no longer establish a salary reduction SEP (SARSEP) under which the employees can elect to

have contributions made to the plan or to receive the contributions in cash (sec. 408(k)(6)). However,

employers may continue to make contributions, under the rules in effect prior to January 1, 1997, to

SARSEPs that were established before 1997. In addition, employees hired after December 31, 1996, may

participate in SARSEPs established by their employers prior to January 1, 1997.

B. Plan Qualification Requirements

1. Coverage and nondiscrimination requirements

Key among the qualification standards are coverage and nondiscrimination rules designed to ensure that

qualified plans benefit a significant number of an employer's rank-and-file employees as well as highly

compensated employees. These rules include numerical minimum coverage rules (sec. 410(b)), a minimum

participation rule requiring that a defined benefit pension plan benefit a minimum number of employees (sec.

401(a)(26)), and a general nondiscrimination requirement (sec. 401(a)(4)). Special nondiscrimination rules

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apply to qualified cash or deferred arrangements, employer matching contributions, and after-tax employee

contributions. For purposes of applying the nondiscrimination rules, the maximum amount of compensation

that may be taken into account is $160,000 (for 1998). The employer may elect to aggregate certain plans for

purposes of the nondiscrimination rules. In addition, the employer can apply the rules separately to separate

lines of business. Under present law, State and local governmental plans are exempt from the

nondiscrimination and minimum participation rule.

a. Minimum coverage rules

A plan is not a qualified plan unless the plan satisfies at least one of the following requirements: (1) the plan

benefits at least 70 percent of all nonhighly compensated employees ("percentage test"); (2) the plan benefits

a percentage of nonhighly compensated employees which is at least 70 percent of the percentage of highly

compensated employees benefitting under the plan ("ratio test"); or (3) the average benefits test. A plan meets

the average benefits test if (1) the plan benefits such employees as qualify under a classification set up by the

employer that is not discriminatory in favor of highly compensated employees ("classification test"); and (2)

the average benefit percentage for nonhighly compensated employees of the employer is at least 70 percent of

the average benefit percentage for highly compensated employees of the employer. In general, for purposes

of satisfying any of the tests, the exclusion from consideration of employees who have not satisfied certain

minimum age and service requirements is permitted.

b. Minimum participation rule

A defined benefit plan is not a qualified plan unless it benefits no fewer than the lesser of (1) 50 employees of

the employer or (2) the greater of (a) 40 percent of all employees of the employer or (b) 2 employees (1

employee if there is only 1 employee) (sec. 401(a)(26)). This requirement may not be satisfied by aggregating

comparable plans, but may be applied separately to different lines of business of the employer.

A special sanction applies to violations of the minimum participation rule. Under this sanction, if one of the

reasons a plan fails to be a qualified plan is because it fails either the coverage rules or the minimum

participation rule, then highly compensated employees are to include in income the value of their vested

accrued benefit as of the close of the year in which the plan fails to qualify. Nonhighly compensated

employees are not taxed on their benefits if the only reason a plan is not a qualified plan is a failure to satisfy

the coverage requirements or the minimum participation rule.

The minimum participation rule was enacted in the Tax Reform Act of 1986 because the Congress belied that

it was inappropriate to permit an employer to maintain multiple plans, each of which covered a very small

number of employees. Although plans that are aggregated for nondiscrimination purposes are required to

satisfy comparability requirements with respect to the amount of contributions or benefits, such an

arrangement may still discriminate in favor of highly compensated employees.

c. Nondiscrimination in contributions or benefits

A qualified plan may not discriminate in favor of highly compensated employees with respect to

contributions or benefits under the plan (sec. 401(a)(4)). This general nondiscrimination requirement applies

to all plan aspects, including those not addressed under the numerical coverage tests. Thus, it may apply not

only with respect to contributions or benefits, but also with respect to optional forms of benefit and other

benefits, rights, and plan features such as actuarial assumptions, rates of accrual methods of benefit

calculation, loans, social security supplements, and disability benefits.

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Whether or not a plan meets the general nondiscrimination test is a factual determination, based on the

relevant facts and circumstances. A plan does not fail to meet the general nondiscrimination test if

contributions or benefits bear a uniform relationship to compensation.

d. Nondiscrimination rules relating to qualified cash or deferred arrangements

In general

A profit-sharing or stock bonus plan, a pre-ERISA money purchase pension plan, or a rural cooperative plan

may include a qualified cash or deferred arrangement (sec. 401(k)). Under such an arrangement, an employee

may elect to have the employer make payments as contributions to a plan on behalf of the employee, or to the

employee directly in cash. Contributions made at the election of the employee are called elective deferrals.

The maximum annual amount of elective deferrals that can be made by an individual is $7,000 (indexed)

($10,000 for 1998). A special nondiscrimination test applies to cash or deferred arrangements.(5)

The special nondiscrimination test applicable to elective deferrals under qualified cash or deferred

arrangements is satisfied if the actual deferral percentage for eligible highly compensated employees for a

plan year is equal to or less than either (1) 125 percent of the actual deferral percentage of all nonhighly

compensated employees eligible to defer under the arrangement, or (2) the lesser of 200 percent of the actual

deferral percentage of all eligible nonhighly compensated employees or the actual deferral percentage for all

eligible nonhighly compensated employees plus 2 percentage points. The actual deferral percentage for a

group of employees is the average of the ratios (calculated separately for each employee in the group) of the

contributions paid to the plan on behalf of the employee to the employee's compensation. The maximum

permitted actual deferral percentage for highly compensated employees for a year is generally determined by

reference to the actual deferral percentage for nonhighly compensated employees for the preceding year.

If a cash or deferred arrangement satisfies the special nondiscrimination test, it is treated as satisfying the

general nondiscrimination rules (sec. 401(a)(4)) with respect to the amount of elective deferrals. However,

the group of employees eligible to participate in the arrangement is still required to satisfy the minimum

coverage test (sec. 410(b)).

Excess contributions

If the special nondiscrimination rules are not satisfied for any year, the qualified cash or deferred arrangement

will not be disqualified if the excess contributions (plus income allocable to the excess contributions) are

distributed before the close of the following plan year. In addition, under Treasury regulations, instead of

receiving an actual distribution of excess contributions, an employee may elect to have the excess

contributions treated as an amount distributed to the employee and then contributed by the employee to the

plan on an after-tax basis.

Excise tax on excess contributions

An excise tax is imposed on the employer making excess contributions to a qualified cash or deferred

arrangement (sec. 4979). The tax is equal to 10 percent of the excess contributions (but not earnings on those

contributions) under the arrangement for the plan year ending in the taxable year. However, the tax does not

apply to any excess contributions that, together with income allocable to the excess contributions, are

distributed or, in accordance with Treasury regulations, recharacterized as after-tax employee contributions

no later than 2-1/2 months after the close of the plan year to which the excess contributions relate.

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Design-based safe harbor

Effective for years beginning after December 31, 1998, as an alternative to the special nondiscrimination test,

a cash or deferred arrangement may satisfy a designed-based safe harbor.

The designed-based safe harbor was added by the Small Business Job Protection Act of 1996. The Congress

believed that the complexity of the special nondiscrimination test was not justified by the marginal additional

participation of rank-and-file employees that might be achieved by the operation of the rule, particularly

given the dollar limit on elective deferrals. It was believed that the result the nondiscrimination test was

intended to produce could also be achieved by creating an incentive for employers to providing certain

matching contributions or nonelective contributions on behalf of rank-and-file employees. It was also hoped

that the significant reduction in administrative burdens under a design-based test would encourage more

employers, particularly small employers, to adopt a plan. Critics of the design-based safe harbor are

concerned that it will significantly reduce participation by rank-and-file employees.

Under the safe harbor rule, a plan satisfies the contribution requirements for a cash or deferred arrangement if

the employer either (1) satisfies certain matching contribution requirements or (2) makes a nonelective

contributions to a defined contribution plan of at least 3 percent of an employee's compensation on behalf of

each nonhighly compensated employee who is eligible to participate in the arrangement without regard to

whether the employee makes elective contributions under the arrangement. In addition, under the safe harbor

rule, the plan must satisfy a notice requirement. The notice requirement is satisfied if each employee eligible

to participate in the cash or deferred arrangement is given written notice, within a reasonable period before

any year, of the employee's rights and obligations under the arrangement.

e. Nondiscrimination rules relating to employer matching contributions and employee contributions

In general

A special nondiscrimination test is applied to employer matching contributions and employee contributions

under qualified defined contribution plans (sec. 401(m)).(6)

This special nondiscrimination test is similar to the special nondiscrimination test applicable to qualified cash

or deferred arrangements. Contributions which satisfy the special nondiscrimination test are treated as

satisfying the general nondiscrimination rules (sec. 401(a)(4)) with respect to the amount of contributions.

The term "employer matching contributions" means any employer contribution made on account of (1) an

employee contribution or (2) an elective deferral under a qualified cash or deferred arrangement.

The special nondiscrimination test is satisfied for a plan year if the contribution percentage for eligible highly

compensated employees does not exceed the greater of (1) 125 percent of the contribution percentage for all

other eligible employees, or (2) the lesser of 200 percent of the contribution percentage for all other eligible

employees, or such percentage plus 2 percentage points. The contribution percentage for a group of

employees for a plan year is the average of the ratios (calculated separately for each employee in the group)

of the sum of matching and employee contributions on behalf of each such employee to the employee's

compensation for the year.

Effective for years beginning after December 31, 1998, as an alternative to the special nondiscrimination test

applicable to employer matching contributions, a plan may satisfy a designed-based safe harbor. Under the

safe harbor, a plan is treated as meeting the special nondiscrimination test if (1) the plan meets the

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contribution and notice requirements applicable under the safe harbor method of satisfying the special

nondiscrimination requirement for qualified cash or deferred arrangements, and (2) the plan satisfies a special

limitation on matching contributions.

Treatment of excess aggregate contributions

As under the rules relating to qualified cash or deferred arrangements, if the special nondiscrimination test is

not satisfied for any year, the plan will not be disqualified if the excess aggregate contributions (plus income

allocable to such excess aggregate contributions) are distributed before the close of the following plan year.

Generally, the amount of excess aggregate contributions and their allocation to highly compensated

employees is determined in the same manner as with respect to excess deferrals.

Excise tax on excess aggregate contributions

An excise tax is imposed on the employer with respect to excess aggregate contributions (sec. 4979). The tax

is equal to 10 percent of the excess aggregate contributions (but not earnings on those contributions) under

the plan for the plan year ending in the taxable year for which the contributions are made.

However, the tax does not apply to any excess aggregate contributions that, together with income allocable to

the excess aggregate contributions, are distributed (or, if nonvested, forfeited) no later than 2-1/2 months after

the close of the plan year in which the excess aggregate contributions arose.

2. Limitations on contributions and benefits

In general

Under present law, overall limits are provided on contributions and benefits under qualified plans based on

the type of plan (sec. 415). The overall limits apply to all such contributions and benefits provided to an

individual by any private or public employer. Certain special rules apply to governmental plans which allow

higher benefits to be paid under governmental defined benefit plans.

Defined contribution plans

Under a defined contribution plan, the qualification rules limit the annual additions to the plan with respect to

each plan participant to the lesser of (1) 25 percent of compensation or (2) $30,000 (sec. 415(c)). Annual

additions are the sum of employer contributions, employee contributions, and forfeitures with respect to an

individual under all defined contribution plans of the same employer. The $30,000 limit is indexed for

cost-of-living adjustments. Compensation for these purposes generally includes all compensation includible

in gross income. Elective deferrals to section 401(k) plans and similar arrangements, elective contributions to

nonqualified deferred compensation plans of tax-exempt employers and State and local government plans

(sec. 457 plans), and salary reduction contributions to a cafeteria plan are also considered compensation.

Defined benefit pension plans

In general

Under present law, the limit on the annual benefit payable by a defined benefit pension plan is generally the

lesser of (1) 100 percent of average compensation, or (2) $130,000 for 1998 (sec. 415(b)).(7)

The dollar limit is adjusted annually for cost-of-living increases. The dollar limit is reduced proportionately

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for individuals with less than 10 years of participation in the plan.

The dollar limit on annual benefits is reduced if benefits under the plan begin before the social security

retirement age so that the limit is actuarially equivalent to a benefit beginning at the social security retirement

age. If retirement benefits provided by a defined benefit pension plan begin after the social security

retirement age, the dollar limit is increased so that it is the actuarial equivalent of the dollar limit applicable to

a benefit beginning at the social security retirement age.

Present law provides that a minimum benefit can be paid even if the benefit exceeds the normally applicable

benefit limitations. Thus, the overall limits on benefits are deemed to be satisfied if the retirement benefit of a

participant under all defined benefit pension plans of the employer does not exceed $10,000 for a year or any

prior year, and the participant has not participated in a defined contribution plan of the employer. The

$10,000 limit is reduced for participants with less than 10 years of participation in the plan.

Combined plan limitation

An additional limitation applies if an employee participates in a defined benefit pension plan and a defined

contribution plan maintained by the same employer. This combined plan limitation prevents avoidance of the

separate plan limits through the creation of different types of plans. The limit permits an employee to obtain

benefits greater than the single-plan limitation, but precludes an individual from obtaining the maximum

possible benefits from both a defined contribution plan and a defined benefit pension plan of the same

employer. Effective for years beginning after December 31, 1999, the combined plan limitation is repealed.

3. Definitions

a. Highly compensated employee

In general

For purposes of the qualification rules, an employee, including a self-employed individual, is treated as

highly compensated with respect to a year if, the employee (1) was a 5-percent owner of the employer at any

time during the year or the preceding year or (2) either (a) had compensation for the preceding year in excess

of $80,000 (indexed for inflation) or (b) at the election of the employer had compensation in excess of

$80,000 (indexed for inflation) and was in the top 20 percent of employees by compensation for such year.

Treatment of family members

Prior to 1997, a special rule applied with respect to the treatment of family members of certain highly

compensated employees. Under the special rule, if an employee was a family member of either a 5-percent

owner or 1 of the top 10 highly compensated employees by compensation, then any compensation paid to

such family member and any contribution or benefit under the plan on behalf of such family member was

aggregated with the compensation paid and contributions or benefits on behalf of the 5-percent owner or the

highly compensated employee in the top 10 employees by compensation. Therefore, such family member and

employee were treated as a single highly compensated employee. Effective for years beginning after 1996,

the family aggregation rules have been repealed. The rules were repealed by the Small Business Job

Protection Act of 1986 because the Congress believe the rules imposed an undue restriction on the ability of

family members to obtain retirement benefits. In addition, the complexity of the calculations required under

the rules appeared unnecessary in light of the numerous other provisions that ensured that pension plans do

not unduly benefit highly compensated employees.

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b. Employer and employee

In general

For purposes of plan qualification requirements, all employees of certain entities must be aggregated and

treated as though employed by a single employer. Under these rules, all employees are considered employed

by the same entity to the extent they are employed by corporations that are members of a controlled group

(sec. 414(b)), trades or businesses under common control (e.g., related partnerships) (sec. 414(c)), or

members of an affiliated service group (sec. 414(m)). In addition, individuals are treated as employees to the

extent they are leased employees (sec. 414(n)). The Secretary of the Treasury is authorized to prescribe by

regulations such additional aggregation rules as are necessary to prevent the avoidance of the qualification

rules through the use of separate organizations, employee leasing, or other arrangements (sec. 414(o)).

Leased employees

An individual (a leased employee) who performs services for another person (the recipient) may be treated as

the recipient's employee if the services are performed pursuant to an agreement between the recipient and a

third person (the leasing organization) who is otherwise treated as the individual's employer. The individual is

to be treated as the recipient's employee only if the individual has performed services for the recipient on a

substantially full-time basis (i.e., at least 1500 hours) for a period of at least 12 months, and the services are

of a type historically performed by employees in the recipient's business field.

An individual who otherwise would be treated as a recipient's leased employee will not be treated as such an

employee if the individual participates in a safe harbor plan maintained by the leasing organization. A plan is

a safe harbor plan if it is a money purchase pension plan and if it provides that (1) an individual is a plan

participant on the first day on which the individual becomes an employee of an employer maintaining the

plan, (2) each employee's rights to or derived from employer contributions under the plan are nonforfeitable

at the time the contributions are made, and (3) amounts are to be contributed by the employer on behalf of an

employee at a rate not less than 10 percent of the employee's compensation for the year (the 10 percent

contribution is not to be reduced by integration with social security).

Each leased employee is to be treated as an employee of the recipient, regardless of the existence of a

safe-harbor plan, if more than 20 percent of an employer's nonhighly compensated workforce are leased

employees.

C. Treatment of Distributions

1. Uniform minimum distribution rules

Present law provides uniform minimum distribution rules generally applicable to all types of tax-favored

retirement vehicles, including qualified plans and annuities, certain individual retirement arrangements

(IRAs), and tax-sheltered annuities (sec. 403(b)).

Under present law, in the case of 5-percent owners, distributions from qualified plans are required to begin no

later than the participant's required beginning date (sec. 401(a)(9)). The required beginning date means the

April 1 of the calendar year following the later of (1) the calendar year in which the employee attains age

70-1/2, or (2) the calendar year in which the employee retires. In the case of an employee who is a 5-percent

owner (as defined in section 416), the required beginning date is the April 1 of the calendar year following

the calendar year the employee attains age 70-1/2.

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Under present law, the sanction for failure to make a minimum required distribution to an employee (or other

payee) under a qualified retirement plan is a 50-percent nondeductible excise tax on the excess in any taxable

year of the amount required to have been distributed under the minimum distribution rules, over the amount

that actually was distributed (sec. 4974). The tax is imposed on the individual required to take the

distribution. However, a plan will not satisfy the applicable qualification requirements unless it expressly

provides that, in all events, distributions under the plan are to satisfy the minimum distribution requirements.

2. Withdrawal rules

Present law limits the circumstances under which plan participants may obtain preretirement withdrawals

from a qualified plan. In general, these restrictions recognize that qualified plans are intended to provide

retirement income.

The least restrictive withdrawal rules apply to profit-sharing and stock bonus plans. Amounts may generally

be withdrawn from such plans after they have been in the plan for 2 years. Distributions before the expiration

of such 2-year period may also be made in the event of retirement, death, disability, other separation from

service, or hardship.

Distributions from qualified pension plans (i.e., defined benefit pension plans and money purchase pension

plans) may generally be made only in the event of retirement, death, disability, or other separation from

service.

Special rules apply to qualified cash or deferred arrangements (sec. 401(k)). Elective deferrals under a

qualified cash or deferred arrangement (and earnings thereon) may only be distributed on account of

separation from service, death, or disability, or attainment of age 59-1/2. Elective deferrals (but not earnings

thereon) may also be distributed on account of a hardship of the employee.

3. Taxation of distributions

In general

Under present law, a distribution of benefits from a tax-favored retirement arrangement generally is

includible in gross income in the year it is paid or distributed under the rules relating to taxation of annuities,

unless the amount distributed represents the employee's investment in the contract (i.e., basis) (secs. 72 and

402). Special rules apply in the case of lump-sum distributions from a qualified plan,(8) distributions that are

rolled over to an IRA or another qualified plan and distributions of employer securities.

Early distributions from qualified plans and other tax-favored retirement vehicles are subject to an additional

10-percent income tax (sec. 72(t)).

Rollovers

Under present law, an "eligible rollover distribution" may be rolled over tax free to certain IRAs or another

qualified plan or annuity. An "eligible rollover distribution" means any distribution to an employee of all or

any portion of the balance to the credit of the employee in a qualified trust, except the term does not include

(1) any distribution which is one of a series of substantially equal periodic payments made (a) for the life (or

life expectancy) of the employee or the joint lives (or joint life expectancies) of the employee and the

employee's designated beneficiary, or (b) for a specified period of 10 years or more, and (2) any distribution

to the extent such distribution is required under the section 401(a)(9) minimum distribution rules.

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The maximum amount of a distribution that can be rolled over is the amount of the distribution that is

taxable. That is, employee contributions cannot be rolled over. The rollover must be made within 60 days

after the distribution was received.

A plan must provide that employees have the option to elect to have an eligible rollover distribution

transferred directly to an IRA or another qualified plan. If the employee elects not to make such a transfer,

then the distribution is subject to withholding at a flat rate of 20 percent.

The rollover rules are designed to encourage individuals to preserve their qualified plan benefits in a

tax-favored vehicle until retirement.

Deferral of tax on net unrealized appreciation

Under present law, a taxpayer is not required to include in gross income amounts received in the form of a

lump-sum distribution to the extent that the amounts are attributable to net unrealized appreciation in

employer securities. Such unrealized appreciation is includible in gross income when the securities are sold

or exchanged.

In addition, gross income does not include net unrealized appreciation on employer securities attributable to

employee contributions, regardless of whether the securities are received in a lump-sum distribution. Such

appreciation is includible in income when the securities are disposed of.

D. Funding Rules

Under the Code, certain defined benefit pension plans and money purchase pension plans are required to

meet a minimum funding standard for each plan year (sec. 412). The minimum funding standards are

designed to ensure that pension plans have sufficient assets to pay benefits.

In the case of a money purchase pension plan, the contribution required by the minimum funding standard is

generally the contribution rate specified by the plan. Defined benefit pension plans are funded on an actuarial

basis. A special funding rule that requires faster funding applies to underfunded single-employer defined

benefit pension plans.

No contribution is required or permitted under the minimum funding rules to the extent the plan is at the full

funding limitation. In addition, under present law, subject to certain limitations, an employer may make

deductible contributions to a defined benefit pension plan up to the full funding limitation. The full funding

limitation is generally defined as the excess, if any, of (1) the lesser of (a) the accrued liability under the plan

(including normal cost) or (b) 150 percent(9) of the plan's current liability, over (2) the lesser of (a) the fair

market value of the plan's assets, or (b) the actuarial value of the plan's assets (sec. 412(c)(7)).

III. ISSUES AND ANALYSIS RELATING TO THE SIMPLIFICATION OF EMPLOYEE PENSION

BENEFITS TAX LAWS

In general

There are three potential sources of income for an individual after retirement--social security benefits,

employer-provided pension plan benefits, and personal savings. These three sources of retirement income

have traditionally been referred to as the "three-legged stool" providing retirement income security. Taken

together, these three sources of income ideally should provide an adequate replacement for preretirement

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income.

An employer's decision to establish or continue a pension plan for employees is voluntary. The Federal tax

laws provide favorable tax treatment for amounts contributed to an employer-provided pension plan to

encourage the establishment and continuance of such plans.

The Federal laws and regulations governing employer-provided retirement benefits are recognized as among

the most complex set of rules applicable to any area of the tax law. Some have argued that this complexity

has made it difficult, if not impossible, for employers, particularly small employers, to comply with the law.

In addition, it is asserted that this complexity deters employers from establishing pension plans or forces the

termination of such plans. If this assertion is accurate, then the complexity of the employee benefits laws is

reducing the number of employees covered under employer-provided plans. Such a result then forces social

security and personal savings to assume more of the burden of replacing preretirement income.

Others assert that the complexity of employee benefits laws and regulations is a necessary by-product of

attempts (1) to ensure that retirement benefits are delivered to more than just the most highly compensated

employees of an employer, (2) to provide employers, particularly large employers, with the flexibility needed

to recognize the differences in the way that employers do business; and (3) to ensure that retirement benefits

generally are used for retirement purposes.

A brief discussion follows of the reasons for complexity in the pension area.

Reasons for complexity in employee pension benefits laws

Volume and frequency of employee benefits legislation

Many employers and practitioners in the pension area have argued that the volume of legislation affecting

pension plans enacted since 1974 has contributed to complexity. In many cases, a particular substantive area

of pension law may be dealt with legislatively every year. For example, the rules relating to the form and

taxation of distributions from qualified pension plans were significantly changed by the Tax Equity and

Fiscal Responsibility Act of 1982, the Deficit Reduction Act of 1984, the Tax Reform Act of 1986, the

Unemployment Compensation Act of 1992, the Small Business Job Protection Act of 1996 and the Taxpayer

Relief Act of 1997. In many cases, changes in the rules are lobbied for by employers and practitioners.

This constant change of the law has not only contributed to complexity for the employer, plan administrator,

or practitioner who must understand the rules, but has also created problems for the IRS and Department of

Labor. Employers may not know what they must do to bring their pension plans into compliance with enacted

legislative changes because the IRS has been unable to publish adequate guidance for employers.

The amount of legislation in the pension area in recent years hinders the ability of the IRS and the

Department of Labor to monitor compliance with the law. Significant amounts of resources are required to be

expended to educate government employees with respect to changes in the law. Time that is spent reviewing

pension plan documents to determine whether they qualify under the tax laws in form takes time away from

the auditing of plans to ensure that they qualify in operation.

The level of legislative and regulatory activity in the pension area has also created problems because

inadequate time is available to consider the possible interaction of various provisions. The IRS may issue

regulations that are immediately superseded by legislation. Legislation is enacted that does not consider the

potential interaction problems created with other areas of employee benefits law.

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Some people argue that the rules relating to employer-provided pension plans should not be significantly

altered in the context of an effort to simplify the rules. This argument assumes that additional changes in the

employee benefits area will only contribute to complexity by legislating again in an area that some say has

been over legislated in the last 10 years.

On the other hand, legislative initiatives that merely repeal existing rules may not contribute to additional

complexity of the rules unless the repeal of such rules leaves uncertainty as to the rule that applies in place of

the repealed rule.

The structure of the workplace

Some argue that the complexity of the rules relating to pensions stems from a problem that is not unique to

the employee benefits area--that is, the way in which the workplace has developed has created inherent

complexities in the way that legislation is enacted. The way in which employers do business affects the

complexity of pension legislation.

Large employers tend to have complex structures. These complex structures may include the division of

employees among various subsidiaries that are engaged in different types of businesses. Rules are required to

deal with the issues that arise because a business is operated in many tiers. For example, questions arise as to

which employees are required to be taken into account in determining whether an employer is providing

pension benefits on a nondiscriminatory basis. To what extent are employees of various subsidiaries that are

engaged in completely different activities required to be aggregated? If these employees must be aggregated

for testing purposes, what kind of recordkeeping burdens are imposed on the employer? How are

headquarters employees treated and how does the treatment of such employees differ from the treatment of

subsidiary employees? If an employer retains temporary workers, to what extent are such workers required to

be taken into account? Should employees covered by collective bargaining agreements be treated differently

than other employees? Employers face these issues every day because of the way in which their businesses

are operated, rather than simply because the laws governing pension benefits are complex.

Flexibility and complexity

Employers and employees generally want to be able to tailor their compensation arrangements, including

pension benefits, to fit their particular goals and circumstances. Present law accommodates these desires by

providing for various tax-favored retirement savings vehicles, including qualified plans, individual retirement

arrangements (IRAs), simplified employee pensions (SEPs), SIMPLE plans, and tax-sheltered annuities.

There are many different types of qualified plans, different ways of funding such plans, and different ways of

providing benefits under such plans.

The number of different tax-favored retirement arrangements increases complexity in the pension rules

because different rules are needed for each type of arrangement. A great deal of simplicity could be achieved,

for example, if employers were permitted to choose from only one or two model pension plans. However, this

would also greatly reduce the flexibility provided employers and employees under present law.

To some extent, the complexity of present law is elective. For example, employers who wish to reduce

complexity can adopt a master or prototype plan. Similarly, an employer may adopt a simple profit-sharing

plan for all his employees that involves a minimum of administrative work. However, many employers

choose more complicated compensation arrangements.

Complexity and certainty

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Although employers and practitioners often complain about the complexity of the rules relating to employerprovided pension plans, some of that complexity is, in fact, attributable to the desire of employers or the

Congress to have certainty in the rules. For example, the general nondiscrimination rule relating to qualified

pension plans merely requires that a plan not discriminate in either contributions or benefits in favor of highly

compensated employees. This rule is easy to articulate; however, determining whether or not the rule is

satisfied is not a simple task. The most obvious problem is determining what the word "discriminate" means.

If it means that there can be no difference in contributions or benefits between those provided to highly

compensated employees and those provided to rank-and-file employees, then the rule may be fairly

straightforward. However, because the rules permit employers some flexibility to provide more contributions

or benefits for highly compensated employees, then it is necessary to determine how much of a difference in

the contributions or benefits is permitted.

On the other hand, rules that provide greater certainty for employers tend, on their face, to appear to be more

complex. A case in point are the nondiscrimination rules for employee benefits added in the Tax Reform Act

of 1986 (Code sec. 89).(10) Employers complained vigorously about the calculations and recordkeeping

requirements imposed by section 89. However, these rules developed during the legislative consideration of

the 1986 Act were in large measure in response to employer's complaints about the uncertainty of a general

rule prohibiting nondiscrimination in favor of highly compensated employees.

A more mechanical rule will often appear to be more complex, but will also provide more certainty to the

employers, plan administrators, and practitioners who are required to comply with the rule. Thus, any

attempts to reduce complexity of the employee benefits laws must balance the desire for simplicity against

the perceived need for certainty. In addition, it should be recognized that simplicity in legislation does not

preclude complexity in regulation.

Retirement policy vs. tax policy

A source of complexity in the development of pension laws and regulations occurs because the Federal

Government has chosen to encourage the delivery of retirement benefits by employers through the Federal

income tax system. This decision tends to create conflicts between retirement income policy and tax policy.

Retirement income policy has as its goal the delivery of adequate retirement benefits to the broadest possible

class of workers. Because the decision to maintain a retirement plan for employees is voluntary, retirement

income policy would argue for laws and regulations that do not unduly hinder the ability or the willingness of

an employer to establish a retirement plan. Such a policy might also encourage the delivery of more

retirement benefits to rank-and-file employees by adopting a rule that prohibits discrimination in favor of

highly compensated employees, but does not otherwise limit the amount of benefits that can be provided to

such employees. Thus, an employer whose principal objective was to provide large retirement benefits to

highly compensated employees (e.g., management) could do so as long as the employer also provided

benefits to rank-and-file employees.

On the other hand, tax policy will be concerned not only with the amount of retirement benefits being

delivered to rank-and-file employees, but also with the extent to which the Federal Government is subsidizing

the delivery of such benefits. Thus, Federal tax policy requires a balancing of the tax benefits provided to an

employer who maintains a qualified plan in relation to all other tax subsidies provided by the Federal tax

laws. This balancing has led the Congress (1) to limit the total amount of benefits that may be provided to

any one employee by a qualified plan and (2) to adopt strict nondiscrimination rules to prevent highly

compensated employees from receiving a disproportionate amount of the tax subsidy provided with respect to

qualified pension plans.

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Jurisdiction of pension legislation

When ERISA was enacted in 1974, the Congress concluded that Federal pension legislation should be

developed in a manner that limited the Federal tax subsidy of employer-provided retirement benefits and that

provided adequate safeguards for the rights of employees whose employers maintained pension plans.

Accordingly, the rules adopted in ERISA included changes in the tax laws governing qualified plans (Title II

of ERISA) and also included labor law requirements applicable to employer-provided plans (Title I of

ERISA). In many cases, these labor law requirements mirrored the requirements of the tax laws and created a

civil right of action for employees. Thus, ERISA ensured that compliance with the Federal employee benefits

laws could be monitored by the Federal Government (through the IRS and the Department of Labor) and by

employees (through their civil right of action under the labor laws).

Although many of the pension laws enacted in ERISA had mirror provisions in the labor laws and in the

Internal Revenue Code, subsequent legislation has not always followed the same form. For example, the

top-heavy rules that were enacted as part of the Tax Equity and Fiscal Responsibility Act of 1982 were only

included in the Internal Revenue Code and did not contain a corresponding provision in Title I of ERISA.

Some have argued that such a piecemeal approach to employee benefits legislation can lead to inconsistencies

between the Federal tax law and Federal labor law and can contribute to the overall complexity of the rules

governing pension plans.

In addition, the enforcement of rules relating to employer-provided pension plans is shared by the IRS and

the Department of Labor. Thus, there is no single agency of the Federal Government that is charged with the

development and implementation of regulations and with the operational enforcement of the rules relating to

pension plans.

Although the authority of each applicable agency has been clarified, complexity can occur because of the

manner in which the agencies interact. An employer must determine the agency with which it must consult on

an issue and may find that the goals of each agency are different. For example, the Pension Benefit Guaranty

Corporation (PBGC) views the funding of a defined benefit pension plan from its goal of assuring solvency

of the plan when benefit payments are due. On the other hand, the IRS is concerned that employers should

not be permitted to overfund defined benefit pension plans as a mechanism by which the employer can

shelter income from taxation. Without careful coordination of the goals of these 2 Federal agencies,

employers may receive inconsistent directives.

Transition rules

When the Congress enacts tax legislation altering the tax treatment of qualified pension plans or distributions

from such plans, transition relief is often provided to specific employers or individual taxpayers or to a class

of employers or taxpayers. Transition relief generally delays temporarily or permanently the application of

the enacted rule to the applicable taxpayer. Sometimes, transition relief will apply a modified rule that is a

compromise between present law and the enacted rule.

The adoption of transition rules for a taxpayer or a class of taxpayers contributes to the actual and perceived

complexity of employee benefits laws.

1. This pamphlet may be cited as follows: Joint Committee on Taxation, Overview of Present-Law Tax Rules

Relating to Qualified Pension Plans (JCS-30-98), May 4, 1998.

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2. This pamphlet is limited to a discussion of the Internal Revenue Code rules relating to tax-qualified

retirement plans. In addition to the rules in the Internal Revenue Code, the labor law provisions of title I of

the Employee Retirement Income Security Act of 1974 (ERISA) contain extensive rules regarding employee

benefit pension plans including rules regarding disclosure to employees and standards of conduct applicable

to plan fiduciaries. There is some overlap between provisions of the Code and title I of ERISA.

3. See Joint Committee on Taxation, Estimates of Federal Tax Expenditures for Fiscal Years 1998-2002

(JCS-22-97), December 15, 1997.

4. Individual accounts may be maintained for after-tax employee contributions made to a defined benefit

pension plan.

5. State and local governments generally are precluded from maintaining section 401(k) plans. However, they

generally can maintain other types of plans which operate in a similar manner.

6. These rules also apply to certain employee contributions to a defined benefit pension plan.

7. Annual benefits may in some cases exceed this dollar limitation under grandfather and transition rules

contained in the Tax Equity and Fiscal Responsibility Act of 1982 and other legislation.

8. Certain taxpayers may be permitted to make an election with respect to a lump-sum distribution to use

income averaging or other special tax treatment. In general, a lump-sum distribution is a distribution within

one taxable year of the balance to the credit of an employee which becomes payable to the recipient (1) on

account of the death of the employee, (2) after the employee attains age 59-1/2, (3) on account of the

employee's separation from service, or (4) in the case of self-employed individuals, on account of disability.

In addition, a distribution to an employee is treated as a lump-sum distribution only if the employee has been

a participant in the plan for at least 5 years before the year of the distribution.

9. Effective for plan years beginning after 1998, 150 percent will be increased as follows: 155 percent for

years 1999 and 2000; 160 percent for years 2001 and 2002; 165 percent for years 2003 and 2004, and 170

percent for years 2005 and thereafter.

10. The rules of section 89 were repealed in 1989. (P.L. 101-140).

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