**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

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CONTENTS
INTRODUCTION	

I.	SUMMARY	

II.	PRESENT-LAW RULES	

	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
**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.

	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 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 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 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.

	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.

	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 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 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.

**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.

	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.

	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 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.

	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

	Although employers and practitioners often complain about the complexity of the rulesrelating to employer-provided 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.

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.

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).**************