Tax Reform And Its Impact On State And Local Pensions

By JANET QUIST

A broad spectrum of retirement plans sponsored by state and municipal governments are subject to significant changes imposed by the new tax law recently signed by President Reagan.

401(k) plans:

Municipal employers will find the option of offering their employees a 401 (k) plan is now closed. Cities which have adopted 401 (k) retirement plans as of May 6, 1986 may continue to offer this option to their employees. However, the establishment of new plans is prohibited.

Other provisions of note include:

• A $7,000 (maximum) per year contribution (adjusted for inflation) may be deferred by an employee effective January 1, 1987.

• Should an employee also participate in a 403(b) or 457 plan — the combined amount of the deferred contribution per year is still $7,000.

• The total contribution for employee and employer continues at $30,000.

• Nondiscrimination rules (prohibiting discrimination against lower paid employees) have been tightened.

• Hardship withdrawals can only be made from employee deferrals not from employer contributions or the earnings on joint employer/employee contributions.

• The waiting period for plan participation can be no longer than one year following the date of hire.

403(b) Plans (Tax-Sheltered Annuities):

403(b) plans are primarily used by public schools and some tax-exempt organizations such as churches. Similar to the 401(k), employee contributions can be made in the form of salary reductions with employers often providing matching or supplemental contributions.

The most significant changes are:

• Employee deferrals are limited to $9,500 per year (not indexed for inflation) effective January 1, 1987. For the sake of measure, indexing begins when the $7,000 cap on 401 (k) plans reaches $9,500, then both caps are indexed together.

• For the first time, general nondiscrimination rules will be imposed on 403(b) plans effective January 1, 1989. Such rules are extended to employer contributions. Employers can simply offer a salary reduction which applies equally to all employees to comply.

• Withdrawal restrictions for custodial accounts are extended to 403(b) annuities.

• The doctrine of constructive receipt of income is repealed. This means, for example, that if a bonus is to be paid or is promised to be paid in December, payment may not be deferred until January.

457 Plans (Deferred Compensation Plans for State and Local Governments):

457 plans rely on employee salary deduction contributions (similar to 401(k) and 403(b) plans).

• Existing contribution limits remain at the lesser of $7,500 or 33 1/2 percent of compensation (or 25% of before employee contribution). All employee contributions to 403(b) plans count against limits imposed on 457's.

• As of January 1, 1989, two sets of uniform distribution rules become effective:

1. Distribution rules governing 401 (k) and 403(b) plans and IRA's are amended and extended to 457 plans. Benefit distribution must begin by April 1 of the year following the year in which the employee reaches age 70 1/2, regardless of whether or not the individual continues to work for the same employer. For example, Mr. Jones becomes 70 1/2 in January 1987. He must begin to receive his benefits by April 15, 1988. The payment schedule cannot exceed an annuity over the life of the employee and beneficiary or the joint life expectancy of the employee or beneficiary.

2. Distribution requirements unique to 457's. Should payments commence prior to death, for instance retirement payments, a payment schedule of at least 66 2/3 percent (or 2/3 of total projected benefits) is required to be paid to the employee. Should death Occur prior to payment of all benefits, the ensuing schedule for payment to the beneficiary must be at least as timely as it was to the employee. Benefits to a beneficiary must commence within 60 days of the close of the plan year in which the death of the participant occurred and must be distributed over a period not longer than 15 years. Payment distribution for longer than one year must be made in nonincreasing amounts annually.

Basis Recovery Rules:

The most controversial aspect of this law as it pertains to government employees regards the repeal of the three year basis recovery rule effective July 1, 1986.

Congress in its spirited effort to raise revenues, was attracted to the approximately $7.5 billion it sought to gain by tightening up these rules. The following summarizes the most significant changes in the treatment of these distributions.

• Beyond the above mentioned repeal, all distributions, regardless of whether they began before or after the annuity starting date, will be subject to the expected return rule.

• Recipients with annuity starting dates beginning January 1, 1987, can only receive back tax free the

December 1986 / Illinois Municipal Review / Page 17

amount of his or her total contribution. All subsequent contributions are taxable.

• Should the recipient die, the unrecovered portion is deductible from the individuals last taxable year.

• A grandfather clause included in the Act permits the withdrawal of pre-1987 employee contributions before retirement, without the need to apply the expected return rule, if the plan permitted the inservice withdrawal as of May 5, 1986.

Changes in Lump Sum Distribution Rules:

• Effective January 1, 1987, the ten-year average for lump sum distributions is repealed. Participants age 50 and over as of January 1, 1986 may, regardless of retirement date, continue to elect ten-year averaging. However, they must use 1986 rates.

• The Act imposes a six year phaseout of capital gain treatment. Participants age 50 and over as of January 1, 1986 may continue capital gains treatment. However, they must use a 20 percent flat tax rate.

• The lump sum distribution rules have been replaced by a five year forward averaging rule. However, recipients must be over 59 1/2 years of age and the five year averaging rule can only be elected once.

Section 415 of the Internal Revenue Code — Contribution and Benefit Limit of Qualified Plans.

The government-defined benefit plans found under section 415 survived tax reform relatively unscathed. For the most part they may continue to adhere to current law standards with the exceptions listed below.

• Regardless of the age of retirement and provided they have 20 years of service, state and local police and firefighters, and members of the armed forces, will receive a maximum benefit not to be reduced below $50,000.

• Government employers and other tax exempt employers are exempt from provisions relating to normal retirement age and the elimination of the $75,000 floor for benefits beginning at age 55. (Social Security retirement age is 65 and moving up to 67.)

• The benefit limit of $90,000 applies for age 62.

• If the benefit commences prior to age 62 an actuarial reduction of $90,000 is required. However, benefits can be no lower than $75,000 for benefits paid between 55 and 62 years of age.

• For benefits paid to those over 65 there is an actuarial increase.

• The $90,000 limit will be adjusted to inflation in 1988. However, the defined contribution limit of $30,000 will remain frozen until the defined benefit limit reaches 25 percent of the defined benefit dollar limit. Following, both limits will increase but retain the 4-1 ratio.

• As of January 1, 1987, all employee after tax contributions must be included when applying the $30,000 defined contribution plan limit.

Individual Retirement Account (IRA)

Individuals wishing to make contributions to an IRA may continue to do so although some restrictions will apply with regard to those also wishing to participate in employer-maintained retirement plans. An interesting provision to this law finds an individual participating only in a 457 plan may continue to also make contributions to an IRA without restrictions.

The following are rules imposed with regard to employer-maintained pension plans and the IRA:

• single taxpayer: full deduction if adjusted gross income is below $25,000; partial deduction between $25,000 and $35,000; and no deduction at or above $35,000.

• married taxpayer filing jointly: full deduction if AGI is below $40,000; partial deduction between $40,000 and $50,000; and no deduction at or above $50,000.

• married taxpayers filing separately: full deduction if AGI is $0; partial deduction between $0 and $10,000; and no deduction at or above $10,000.

With an eye on revenue raising, Congress targeted both public and private retirement plans as a way to tighten tax "loopholes" (tax credits, deductions and exclusions) and as a result, the positive trend toward increased individual savings and investment for a financially sound retirement has been reduced.

The reduction or elimination of favorable tax provisions governing various pension plans offered by employers has served to reduce employee deducibility for IRA's, 403(b) and 401 (k) plans and reduces the tax benefits of plan distributions. The long term significance of these revisions is yet to be seen. •

Page 18 / Illinois Municipal Review / December 1986