The Tax Reform Act of 1986 made big changes to retirement plans, making things more complicated and expensive for employers. But in 1996, the Small Business Job Protection Act was signed into law, addressing concerns and making changes to simplify 401(k) plans. One change was using data from the previous year for testing, instead of waiting until the end of the year to see if the plan passed. If it didn’t pass, the excess contributions had to be distributed quickly or the plan would face a tax penalty. The new law allows 401(k) plans to figure out how much high earners can contribute to their accounts based on the previous year’s data. This helps plan ahead and make any needed changes to make sure the plan is fair for everyone. But, if the lower earners contribute more in the current year, the high earners won’t feel the effects until the next year. Plan administrators should quickly decide if they want to use the current year’s data or the previous year’s data for this. Also, the law changes how excess contributions are handled for high earners. And now, tax-exempt organizations can also have 401(k) plans. In 1999, changes were made to the way discrimination tests applied to 401(k) plans. These tests, known as the ADP test and the ACP test, were put in place to make sure that highly compensated employees (HCEs) didn’t benefit more from the plan than non-highly compensated employees.
However, the law also allowed 401(k) plans to use a “safe harbor” contribution formula to avoid having to do these tests. This formula could involve a matching contribution from the employer, or a set contribution for non-HCEs, among other options. This made it easier for employers to offer 401(k) plans without having to worry about passing these discrimination tests. Employers can offer a 401(k) plan that meets certain requirements to ensure it is fair for all employees. They can also consider a SIMPLE plan, which is a new retirement option for businesses. This allows employees to save for retirement and the employer may make contributions to the plan. The SIMPLE plan is for small businesses with 100 or fewer employees who make at least $5,000 a year. If the business grows, they can still keep the plan for two years. Employees who make at least $5,000 and are expected to continue making that much can join the plan. The employer has to tell employees about the plan at least 60 days before it starts.
The SIMPLE-IRA is funded by both the employee and the employer. The most an employee can put in is $6,000 a year. The employer has to put in money every year too, using either a matching or percent of compensation formula.
The matching formula means the employer puts in the same amount as the employee, up to three percent of their pay. They can choose to put in less, but not less than one percent, and not for more than two out of five years. They also have to put in at least two percent of every employee’s pay. If a business chooses a SIMPLE 401(k) plan, employees can put money from their paychecks into the plan, and the business has to put in money too. The business can choose to match the first three percent of what each employee puts in, or put in two percent of every employee’s pay. The most an employee can put in each year is $6,000. All the money goes into a special account.
Small businesses might like SIMPLE plans because they’re easier to manage than other retirement plans. But there are still some downsides. For example, the business has to put money into the plan every year, which might be hard if the business doesn’t always have a lot of money. Also, all the money the business puts in belongs to the employees right away. In other plans, employees might have to work for the business for a few years before all the money is really theirs. And high-paid employees can’t put in as much money as they could with other retirement plans. Qualified plans used to require participants to start receiving payments by age 70 ½, even if they kept working. Now, most participants can wait until they retire to start receiving payments. Business owners with a significant stake in the company still have to start taking payments by age 70 ½. The plan sponsor can decide if they want to allow participants to wait until retirement to start taking payments, and participants who are already receiving payments can stop until they retire. Lump sum distributions can be taxed using special rules that help reduce the amount of tax owed. Starting in 2000, there were changes to how retirement plan distributions are taxed. For people who turned 50 before 1986, they can still choose to spread out their income over 10 years or pay capital gains taxes. Plan sponsors should tell soon-to-retire workers to talk to their advisors about how the new law will affect them.
Before 2000, all retirement plans had to pay out big benefits as joint annuities if the person died. The spouse had to agree to get a different kind of payment. There were lots of different forms for this, and they were confusing. The government was supposed to make a simple form, but it hadn’t come out yet. When it does, lots of plans might start using it. Qualified plans must wait 30 days before paying out benefits in the form of a joint annuity. However, after 1996, participants can choose to waive this waiting period and get their benefits after 7 days. Also, if a participant’s ex-spouse is entitled to part of the benefits, a legal document called a Qualified Domestic Relations Order (QDRO) is needed. The government will provide sample language for QDROs by 1997. “HCE” stands for “highly compensated employee,” and it’s a term used in retirement plans. The new definition of HCE means that fewer employees will be considered highly compensated. This could affect how the retirement plan operates.
There’s a 15% tax on large retirement plan withdrawals, but it’s been suspended for a few years starting in 1997. This could affect taxes and financial planning, so it’s important to talk to a financial advisor before making a big withdrawal. Starting in 1997, some rules for retirement plans have changed. Employers no longer have to meet a certain employee participation requirement. Family businesses also no longer have to treat certain family members as one employee. Plans have to be updated to follow these new rules by the start of the first plan year in 1998. There are also new rules for how much money nonworking spouses can contribute to an IRA. Lastly, the punishment for certain financial transactions has increased.
Source: https://www.floridabar.org/the-florida-bar-journal/pension-simplification-the-ultimate-oxymoron/
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