New Planning Strategies with Retirement Plans

One factor that influences the decision of an employer (particularly a small business) to adopt a retirement plan is the extent to which the business's owners will benefit. Recognizing this, Congress enacted the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), which increased the maximum annual amount that employers can contribute to a defined contribution plan, from the lesser of $35,000 or 25% of compensation in 2001 to the lesser of $40,000 or 100% of compensation in 2002. (The $40,000 threshold will be indexed in $1,000 increments.) The EGTRRA also increased the annual compensation that may be taken into account for purposes of determining contributions and benefits under a plan and for nondiscrimination testing, from $170,000 in 2001 to $200,000 in 2002. (The $200,000 threshold will be indexed in $5,000 increments.)

The above increases have drawn much attention to the fact that employees can now reach the maximum contribution level through a defined contribution plan, so that any existing money-purchase pension plan (MPPP) could be terminated in 2002 without sacrificing contribution levels.

Conversions of MPPPs are popular with plan sponsors, because they require annual contributions of a set percentage of participants' compensation. Contributions to profit-sharing plans, on the other hand, are discretionary and can be based on whether the plan sponsors can afford to make plan contributions. Given the current economic turmoil, this flexibility could prove valuable to plan sponsors. In fact, in Rev. Rul. 2002-42, the IRS clarified some of the tax issues in a merger or conversion of an MPPP into a profit-sharing plan. (For further information, see Tax Trends, "Merger of Pension Plan into Profit-Sharing Plan Is Not Partial Termination," TTA, August 2002, p. 545.)

However, little attention has been given to the change in percentage of the compensation level. The EGTRRA effectively increased this percentage from 25% in 2001 to 100% in 2002. With the family-aggregation rules repealed, closely held businesses should consider putting spouses or other family members on the payroll at $40,000 and amending their defined contribution plan to allow for contributing 100% of salary (or $40,000) to their defined contribution plan in 2002. This strategy could really benefit a number of profitable, closely held businesses with few employees who want to increase their retirement savings, while generating significant tax deductions.

From Roger W. Lusby, III, CPA, CMA, AEP, Frazier & Deeter, LLC, Atlanta, GA