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Administration Announces Revised Savings Proposals — Changes Made to Address ASPPA’s Concerns

Summary
On February 2, the Secretary of Treasury unveiled a new version of the LSA/RSA/ERSA proposals. ASPPA’s Government Affairs Committee has met with senior Administration officials on numerous occasions to express serious concerns about the possible impact of last year’s savings proposals on small business retirement plan coverage. Significantly, many of the revisions to the proposals were made in response to the concerns raised by ASPPA. In response to the changes made by Treasury, ASPPA no longer opposes the proposals as outlined in Treasury’s budget proposal.

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Modifications to the LSA/RSA/ERSA Proposals
Following is a summary of the major changes made to the LSA/RSA/ERSA proposals. A more detailed description of the new proposals is provided below.

Lifetime Savings Accounts (LSAs)

  • Contribution limits reduced from $7,500 to $5,000 per year/per individual (indexed). No catch-up contributions (unchanged from the original proposal).
  • Family transfers now only permitted between spouses and not other family members, unlike last year’s proposal. This ensures that the limit cannot be circumvented by contributions directed through other family members.

Retirement Savings Accounts (RSAs)

  • Contribution limits also reduced from $7,500 to $5,000 per year/per individual (indexed), with no catch up contribution.
  • Revised proposal clarified that an RSA can be permitted as an add-on to an employer plan. Since there are no income limits on RSAs, this would in effect increase the contribution limit in the employer plan without impacting the employer plan contribution limits or nondiscrimination tests (i.e., similar to catch-up contributions, but without age requirements).

Employer Retirement Savings Accounts (ERSAs)

  • Treasury has agreed to retain the current-law cross-testing, average benefit percentage testing, and permitted disparity rules in place without modification.
  • The current-law top-heavy rules would also be retained.
  • Custodial account ERSA plans, similar to SIMPLE IRAs, would be permitted, but only for employers with less than ten employees.

ASPPA’s Position

ASPPA appreciates the willingness of Treasury and the rest of the Administration to consider our concerns and their desire to achieve balanced retirement policy. ASPPA applauds Treasury for materially reducing the contribution limits and for retaining the current-law nondiscrimination testing flexibility that has been so critically important to small business retirement plan formation. In response to the changes made by Treasury, ASPPA no longer opposes the proposals, provided the LSA/RSA contribution limit does not exceed $10,000. In fact, ASPPA believes that on balance the combined revised LSA/RSA/ERSA proposals, if enacted, would result in greater retirement plan coverage and consequently greater retirement savings for working Americans. We have also suggested to Treasury, with respect to the ERSA proposal, that they consider retaining the 401(k) name since it has significant public brand recognition.

ASPPA has also discussed with Treasury expanding the present-law SAVER’s credit as a supplement to the RSA and ERSA proposals. Specifically, ASPPA believes that the SAVER’s credit, which provides a tax credit for retirement savings contributions by lower income individuals, should apply to RSA and ERSA contributions, and should be expanded to cover taxpayers with slightly higher/more moderate incomes. Further, the credit should be refundable so it is also available to individuals who might not have to pay any tax in a particular year. Although the Administration has chosen not to add an expanded SAVER’s credit to their proposals at this time, ASPPA believes that adding the expanded SAVER’s credit to the proposals is an important element to ensuring that long-term retirement savings remains a priority for moderate income working families. Consequently, ASPPA will continue to work on this issue as these proposals make their way through the legislative process.

Detailed Description of Proposals

Lifetime Savings Accounts (LSAs)

Under the revised proposal, effective in 2005, individual taxpayers, regardless of their level of income or whether or not they had income, would be permitted to contribute up to $5,000 (indexed) annually to an LSA. A taxpayer could also contribute $5,000 annually to an LSA on behalf of any other individual. Like current-law Roth IRAs, contributions made to an LSA would be on an after-tax basis and distributions (including any earnings) would be tax-free. However, unlike Roth IRAs, there would be no restrictions on when you can take a distribution and no associated early withdrawal penalties. There would be no required minimum distributions until death when, as with Roth IRAs, required minimum distribution rules would apply to the beneficiary. Amounts in Medical Savings Accounts, Education Savings Accounts, and Qualified State Tuition Programs would be retained, but amounts in those accounts or programs could be converted to an LSA before 2006. Accumulated amounts in LSAs could only be transferred between spouses and not other family members, unlike last year’s proposal.

Retirement Savings Accounts (RSAs)

In addition to contributions to an LSA, effective in 2005, individual taxpayers would also be permitted to contribute another $5,000 (indexed) annually to an RSA. Unlike current-law traditional or Roth IRAs, the ability to contribute to an RSA would not be subject to any income limits. However, the amount of the annual contribution to an RSA would be limited to the taxpayer’s wage income (i.e., the taxpayer would have to earn at least $5,000 in wages to contribute the maximum $5,000 to an RSA). Contributions made to an RSA would be on an after-tax basis and distributions (including any earnings) would be tax-free if made after age 58 or upon death or disability. Early distributions would be subject to income tax (after basis is exhausted) and a penalty tax. As with LSAs, there would be no required minimum distribution rules until death.

The revised proposal would clarify that RSAs can be an add-on to an employer-based retirement plan. This would effectively increase the contribution limit to a salary reduction plan without impacting the plan contribution limits or nondiscrimination tests (i.e., similar to catch-up contributions, but without age requirements). Existing Roth IRAs would automatically be converted to RSAs. Beginning in 2005, deductible contributions could no longer be made to traditional IRAs. However, a traditional IRA could still be created to accept rollover contributions. Prior to January 1, 2006, an existing traditional IRA could be converted to an RSA and would be subject to a four year income tax spread. After 2006, conversions would still be permitted, but the full amount of the conversion would be subject to income tax in the current year.

Employer Retirement Security Accounts (ERSAs)

As with last year’s proposal, ERSAs would replace existing 401(k), 403(b), governmental 457, SIMPLE, and grand-fathered SARSEP plans with a single plan available to all employers with rules essentially similar to existing rules governing 401(k) plans.(1) In other words, the plan (except as provided below) would still have to satisfy the qualified plan (and trust) rules and would still be subject to ERISA’s various requirements. Thus, among other things, an ERSA would still be subject to the Section 402(g) limit [annual employee contribution limit ($13,000 in 2004)], plus catch-up if applicable ($3,000 in 2004), the Section 401(a)(17) annual compensation limit ($205,000 in 2004), the current law restrictions on distributions, and the current law minimum required distribution rules.(2) Importantly, under the revised proposal the existing nondiscrimination rules, other that the 401(k) nondiscrimination tests, would remain in place. Thus, cross-testing, the average benefit percentage test, the permitted disparity rules, and the top-heavy rules would not be eliminated. Further, the revised proposal would not change the definition of compensation or the definition of highly compensated employee, just like last year’s proposal.

There would still be significant changes, however. Under the proposal, the ADP/ACP nondiscrimination tests would be repealed and replaced with a less onerous nondiscrimination test. Under this proposed new test, if the average deferral percentage for non-highly compensated employees is greater than 6 percent, there would be no restrictions on the deferral percentages of highly compensated employees. If the average deferral percentage of non-highly compensated employees is equal to or less than 6 percent, then the average deferral percentage for highly compensated employees may not exceed two times the deferral percentage for non-highly compensated employees. For this purpose, qualified nonelective contributions would be permitted as under current law. Further, the proposal would provide for two safe harbors in order to avoid any nondiscrimination testing. The first safe harbor would be the same as the current law safe harbor exempting the plan from nondiscrimination testing if it provides a 3 percent of pay contribution to participants regardless of whether they save on their own. The alternative safe harbor would exempt the plan from nondiscrimination testing if a 50 percent match on employee contributions up to 6 percent of pay (or a more generous formula) is provided. This is a significantly less expensive matching contribution than the current law matching contribution safe harbor which requires a 100 percent match on employee contributions up to 3 percent of pay and an additional 50 percent match on subsequent employee contributions up to an additional 2 percent of pay. As under current law, safe harbor contributions would have to be 100 percent vested. Further, there would no longer be a specific matching contribution test. Matching contributions would need only to satisfy the Section 401(a)(4) nondiscrimination rules.

Governmental plans would be completely exempt from any nondiscrimination rules applicable to ERSAs. Charitable organizations would also be exempt, provided all employees are eligible to participate and the plan does not accept after-tax contributions. To the extent an ERSA accepts after-tax contributions, distributions of amounts attributable to such after-tax contributions made after 2003 would be tax-exempt as if coming from an RSA. This appears to be conceptually the same as the current law Roth 401(k) enacted as part of EGTRRA, but not yet effective.

The revised ERSA proposal would also be changed to permit employers with ten employees or fewer to maintain an ERSA plan through custodial accounts (i.e., similar to a SIMPLE IRA, for example). As compared to current law, this would mean that only these very small employers (putting aside governmental or church plans) would be able to avoid ERISA’s fiduciary, reporting, and disclosure rules. All other plans would now have to comply with such rules, which are intended to protect the rights of participants.

Retirement Policy Analysis

Small Business Retirement Coverage

ASPPA believes that the proposals as revised, looking at them as a package, will not negatively affect small business retirement plan coverage. In fact, on balance we believe the new proposals, particularly the ERSA proposals, would increase retirement plan coverage if enacted.

First, having the RSA as an add-on to the ERSA will effectively increase the elective deferral limit without any impact on the plan contribution limit or nondiscrimination rules (i.e., similar to the catch-up contribution, but without any age criteria). Thus, when the EGTRRA limit increases are fully phased in, the ERSA elective deferral limit for a 50 year old would be $25,000 (recognizing that the $5,000 RSA add-on would have to be on an after-tax basis while the remaining deferrals could be either on pre-tax or post-tax basis). Additionally, the changes to the nondiscrimination rules in ERSA could materially reduce the cost—both the administrative and employer contribution costs—of small businesses considering whether to adopt a retirement plan for their workers. For example, the proposal would reduce the matching contribution safe harbor formula from the current rules to a 50 percent match up to 6 percent of pay. Assuming a 5 percent average deferral percentage for non-highly compensated employees,(3) this would reduce the employer contribution cost of the matching contribution safe harbor by 37.5 percent.

Even for employers choosing not to utilize the safe harbor, there would likely be advantages to the new proposal. As in the example above, assume a 5 percent average deferral percentage for non-highly compensated employees. Under current rules the average deferral percentage for highly compensated employees would generally be limited to 7 percent. Under the ERSA proposal, the average deferral percentage for highly compensated employees would now be limited to 10 percent. Assuming a $15,000 elective deferral limit (i.e., EGTRRA increase fully phased in), that means that all employees with compensation in excess of $150,000 could now save the maximum. Presently, using the same example, the compensation limit (currently $205,000) would prevent all highly compensated employees from saving the maximum. The ERSA would further ease the pressure of the nondiscrimination rules, and simplify administration, by eliminating the ACP matching contribution test.

Although some may criticize these changes to the nondiscrimination rules as reducing the benefits of rank-and-file workers, the reality is that the current 401(k) nondiscrimination tests are not a major hurdle for larger firms, but they are a major burden for small businesses. Thus, the effect of the proposed changes would be directed most significantly at small businesses where the need to expand retirement plan coverage (in the majority of cases it does not exist at all) is most acute.

ASPPA also believes the addition of an expanded and refundable SAVER’s credit would enhance the effectiveness of the revised LSA/RSA/ERSA proposals in expanding small business retirement plan coverage. In effect, the credit would be a “government match” making participation in the ERSA more attractive for non-highly compensated employees, and additionally easing the pressure on the nondiscrimination rules. The addition of the expanded and refundable SAVER’s credit would also help ameliorate possible concerns that the LSAs and RSAs could affect coverage in plans designed for lower levels of contributions like SIMPLE IRAs. A government funded “matching contribution” will make it easier and more affordable for those smaller employers to establish and maintain these plans.

Finally, ASPPA believes that streamlining the rules between the various types of existing plans, particularly 401(k) and 403(b) plans, will simplify the choices faced by small employers and in the long run reduce administrative costs by eliminating issues raised due to the inconsistencies between the plans.

Long-Term Versus Short-Term Savings

Concerns have also been raised that the LSA proposal, which allows distributions without restriction, will displace participation in employer-based retirement plans by lower income workers. In other words, if the LSA is enacted, lower income workers are going to save in the LSA in lieu of saving in an employer-sponsored ERSA. The evidence suggests, in ASPPA’s view however, that such concerns are not warranted.

As you all know, employer-based retirement plans are an incredibly effective, in fact arguably the most effective method, for encouraging savings by lower income workers. According to the Employee Benefits Research Institute,(4) 77.9 percent of workers making from $30,000 to $50,000 and covered by a salary reduction plan actually saved in the plan. By contrast, only 7.1 percent of workers at the same level of income, but not covered by a salary reduction plan, saved in an individual retirement account. In other words, lower income workers are 11 times more likely to save when covered by a workplace retirement plan. The reasons for this striking dichotomy are the convenience of payroll deductions, the culture of savings fostered in the workplace, and the incentive of the matching contribution.

The enactment of an LSA will not change these reasons. If accessibility to the account were such a critical factor, lower income workers would currently choose an IRA over a contribution to an employer plan. IRAs are in effect fully accessible now, notwithstanding the early-withdrawal penalty that has many exceptions ,and as a practical matter, has little detrimental effect. Further, for complete accessibility, many moderate income workers could invest presently in a nonqualified investment and pay only a 5 percent tax on those investment earnings.(5) There is no evidence to suggest that employer plan contributions by lower income workers are dropping in response to these substantially reduced income tax rates. We seriously doubt that further reducing the tax rate from 5 percent to zero will make any additional difference in this regard.

Notwithstanding our view that concerns about a shift from employer-plan contributions to LSA contributions by lower income workers is misplaced, any such concerns would be even further lessened by enactment of an expanded and refundable SAVER’s credit that would only be available for contributions to the RSA and ERSA. Such an added “government match” on top of an already provided employer matching contribution would constitute a powerful combination of incentives, which we believe would be too enticing for the vast majority of workers to ignore. An expanded and refundable SAVER’s credit will only make the proven effectiveness of employer-sponsored plans even stronger in generating savings by lower income workers.

Footnotes

1 Beginning in 2005, all 401(k) plans will automatically become ERSAs. SIMPLEs, SARSEPs, 403(b) plans, and governmental 457 plans may continue in existence indefinitely, but would not be permitted to accept any future contributions after 2005. The ERSA would not replace nongovernmental 457 plans. The Administration is considering rules that would make it easier for existing amounts in SIMPLEs, SARSEPs, 403(b) plans, and governmental 457 plans to be transferred to ERSAs.

2 As noted in the RSA discussion, this proposal would allow an RSA as an add-on to an ERSA plan, thus effectively increasing the contribution limit for all participants by $5,000 (but after tax) without any impact on employer plan limits or nondiscrimination tests.

3 The most recent survey of the Profit Sharing/401(k) Council of America reported a 5.2 percent average deferral percentage by non-highly compensated employees among plan sponsor respondents.

4 Based on 1998 data, the most recent available.

5 The 2003 tax bill, the Jobs & Growth Act, substantially lowered tax rates on dividends and capital gains on nonqualified investments. Households making less than $56,800 in adjusted gross income are eligible for a 5 percent income tax on dividends and capital gain. This roughly represents 70 percent of American households.