Order Code 97-863 EPW
Updated February 9, 2001
CRS Report for Congress
Received through the CRS Web
Retirement Saving Plans: Answers to
Frequently Asked Questions
James R. Storey
Updated by Celinda Franco
Specialist in Social Legislation
Domestic Social Policy Division
Summary
Individuals who participate in retirement saving plans sponsored by their employers
or have savings in individual retirement accounts (IRAs) frequently raise questions about
the federal laws and regulations that govern their plans. Individual account plans are
particularly affected by the federal income tax code, which has grown considerably more
complex over the past two decades. The retirement saving provisions of the tax code
have been written in pursuit of three major policy goals: (1) to implement in tax law the
standards for employee benefit plans set forth in the Employee Retirement Income
Security Act (ERISA) of 1974; (2) to assure that employer-sponsored retirement plans
benefit a broad spectrum of a firm’s work force in a fair and nondiscriminatory manner;
and (3) to encourage retirement saving while limiting the federal income tax revenue
foregone through deferred taxation on plan contributions and earnings. Pursuit of these
goals by Congress has led to a complicated web of rules with which plan sponsors and
participants must comply. This report provides answers to 10 of the most frequently
asked questions about these rules. It will be updated when laws and regulations change.
Frequently Asked Questions About Individual Account Retirement
Plans
The following questions address federal rules for the types of retirement plans that
allow participants to make contributions and accumulate investment earnings in individual
accounts on a tax-advantaged basis. Except for individual retirement accounts (IRAs),
which can be started independently by an employee and a financial institution, these
retirement savings plans are sponsored by employers for the benefit of their employees.
Three of these plan types are known by the section number of the Internal Revenue Code
which authorizes them: §401(k) salary deferral plans; §403(b) tax-deferred annuities; and
§457 nonqualified deferred compensation plans. Other employer-sponsored arrangements
use IRAs to accumulate assets for employees in
simplified
employee
pensions (SEP plans)
and
savings
incentive
match
plans for
employees of small employers (SIMPLE plans).
SIMPLE plans also can be established as §401(k) plans.
Congressional Research Service ˜ The Library of Congress
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The questions answered below are often raised by individual participants who seek
an explanation of federal law, regulation, or congressional intent. They deal with limits
on contributions, options for withdrawals, applicable taxes, and information disclosure.
(For a more complete discussion of the federal rules for retirement plans, see: CRS Report
for Congress 98-171,
Retirement Plans With Individual Accounts: Federal Rules and
Limits.)
1. Why does my plan limit contributions to less than the maximum
allowed by federal law? Employers offer retirement plans to their employees
voluntarily. There is no federal requirement that plans be offered, or that plan offerings
meet a minimum threshold of generosity. Thus, plan sponsors can set limits of their own
choosing on contributions to their plans so long as those limits do not exceed the limits set
in federal law.
Section 415 of the tax code limits the sum of annual contributions from employer and
employee to the lesser of 25% of annual pay or $35,000 (adjusted for inflation in $5,000
intervals). In addition, a $10,500 limit (inflation-adjusted in $500 intervals) applies to an
employee’s annual elective salary deferrals. Other limits may apply because of
nondiscrimination tests that federal law applies to elective salary deferrals and employer
matching contributions. (These tests are discussed in answering question #2 below.) A
plan may set more stringent limits on contributions. The federal limits are only
ceilings
that plans cannot allow to be exceeded, not required contribution levels. Any
contributions made in excess of these limits are immediately taxable and generally must be
distributed by the plan to participants as taxable income within a certain time period after
the end of the plan year.
2. Why are the contribution limits for highly paid employees and
owners more restrictive than for other employees? Tax-qualified retirement
plans sponsored by employers must provide benefits to a broad sector of workers in a fair,
nondiscriminatory manner. To enforce this standard in plans that accept voluntary elective
salary deferrals, Congress has adopted what pension experts term “nondiscrimination
tests” that limit the deferrals of the highly paid and “5% owners”1 based on the level of
deferrals by other covered workers. This test, known as the “actual deferral percentage”
or ADP test, compares the average salary deferral as a percent of salary for the highly
compensated group to the corresponding average for the nonhighly compensated group.
The ADP for the highly paid for the plan year cannot exceed the lesser of: (1) two times
the ADP for the nonhighly paid; or (2) the greater of (a) 125% of the ADP for the
nonhighly paid, or (b) the ADP for the nonhighly paid plus 2 percentage points. For
example, if the ADP for the nonhighly paid is 1%, the ADP for the highly paid must not
exceed twice that amount (2%). If the ADP for the nonhighly paid is 6%, the ADP for the
highly paid is limited to 8% or less (6% plus 2%). If the ADP for the nonhighly paid is
12%, the ADP for the highly paid cannot exceed 15% (125% of 12%). These same
mathematical relationships are applied to employer matching of elective deferrals to
prevent this source of funds from bestowing excessive benefits on the highly paid.
1 The restricted group consists of owners with at least a 5% interest in the firm and employees
whose annual compensation exceeds $85,000 (adjusted for inflation in $5,000 intervals). The
group with pay above $85,000 can be narrowed by applying an optional rule that they must also
fall within the top 20% of the firm’s employees ranked by pay.
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An ADP test first appeared in law when §401(k) was added to the tax code in 1978
by P.L. 95-600. The allowable gap in ADP between the two employee groups was
narrowed in 1984 by P.L. 98-369 and in 1986 by P.L. 99-514. SIMPLE §401(k) plans are
exempt from the ADP test. Also, the 1996 law (P.L. 104-188) that authorized SIMPLE
plans allows a waiver of the ADP test beginning in 1999 for §401(k) plans that meet a
“safe harbor” plan design with respect to employer contributions. A §401(k) plan that
receives employer funding at rates at least as generous as those called for in the safe harbor
design options will be regarded as having met the nondiscrimination tests.2
3. How long can a plan sponsor take to release my money after I leave
a plan? An employer-sponsored retirement plan is required by ERISA to distribute funds
to participants no later than the 60th day after the latest of: (1) the date that the participant
attains the earlier of age 65 or the plan’s normal retirement age; (2) completion of 10 years
of plan participation; or (3) separation from service. Thus, plans are not required to
distribute funds to a separated employee until 60 days after the later of normal retirement
age or completion of 10 years of service in most cases. However, most §401(k) plans do
provide for distribution soon after an employee’s separation at any age.
Once a participant is eligible to receive a distribution and has initiated action to do
so, the plan sponsor is obligated to act on that request in a timely manner. However,
federal law does not specify a definite time limit within which a plan sponsor must
complete action on a distribution to a participant.
4. Why was 59½ selected as the age for penalty-free withdrawals of
retirement savings? In creating tax-advantaged opportunities for individual retirement
saving, Congress wanted to assure that the tax benefits conferred on these accounts were
in fact mainly supporting individual saving for retirement. Thus, Congress placed a
restriction on pre-retirement use of these funds. A primary decision in this regard was to
establish an age beyond which the use of tax-deferred retirement savings would be
presumed to be for the purpose of providing retirement income. Age 60 was selected as
the appropriate minimum age for this policy. Because the insurance industry played a
prominent role in the drafting of the first law in 1962 (P.L. 87-792) that implemented such
a policy, a custom of insurance companies to apply an “insurance age” to policyholders in
determining age-related premiums was adopted in the legislation. A person’s insurance
age is determined by the birthdate that is within 6 months of the present date. Thus, a
person’s insurance age first becomes 60 when age 59½ is attained.
5. Under what circumstances can I withdraw money from my retirement
plan without a penalty before age 59½? A 10% excise tax generally applies to
premature withdrawals of retirement funds that are subject to the income tax when
distributed.3 This excise tax is additional to any income tax owed on the withdrawn
2 There are two safe harbor designs for §401(k) employer contributions. The first requires the
employer to contribute at least 3% of pay for every eligible nonhighly compensated employee. The
second requires the employer to match employee salary deferrals at a rate at least as generous as
the following: 100% of the first 3% of salary deferred, plus 50% of the next 2% of salary deferred.
3 The early withdrawal penalty is 25% for withdrawals from SIMPLE retirement accounts within
the accountholder’s first 2 years of plan participation. There is no early withdrawal allowed from
(continued...)
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amount. The penalty tax applies to withdrawals from §401(k) and §403(b) plans before
age 59½ with the following exceptions: (1) upon the accountholder’s death; (2) in case
of permanent disability; (3) in the event of early retirement after age 55; (4) to pay medical
expenses large enough to qualify for itemized deduction treatment under the federal
income tax; or (5) if withdrawals are received in the form of a lifetime annuity.
Penalty-free withdrawals are allowed before 59½ from IRAs if the accountholder:
(1) dies; (2) becomes permanently disabled; (3) pays medical expenses large enough to
qualify for itemized deduction treatment under the federal income tax; (4) makes
withdrawals in the form of a lifetime annuity; (5) pays health insurance premiums while
unemployed at least 12 weeks; (6) pays higher education expenses for him(her)self or a
family member; or (7) purchases a home. (Qualified withdrawals for home purchase are
subject to a lifetime limit of $10,000 and can be used only by persons with no
homeownership interest in the prior 2 years.)
6. Why can’t I roll over money from my §457 plan to my new employer’s
plan or my IRA? The tax code generally allows tax-deferred transfers, or “rollovers,”
of retirement funds from one employer-sponsored plan to another, from an employer plan
to an IRA, or from one IRA to another. The statutory language on rollover eligibility for
employer plans limits rollovers to funds held in “qualified plans.” Qualified plans are plans
that the Internal Revenue Service (IRS) has determined to be in compliance with federal
laws regarding coverage, vesting, funding, nondiscrimination, reporting, and disclosure.
Section 457 plans are not qualified plans because they are not subject to the
aforementioned rules. In fact, contributions to §457 plans would be immediately taxable
except for the exemption granted to plans that meet the specifications of §457 of the tax
code. When Congress first established §457 (P.L. 95-600), it did not choose to impose
the requirements of plan qualification on §457 plans, nor did it choose to extend the
concept of tax-deferred rollovers to nonqualified plans such as §457 plans.
7. Why do I have to withdraw funds from my retirement plan after age
70½? The tax code requires that minimum annual withdrawals begin after the later of:
(1) separation from employment; or (2) attainment of age 70½.4 This minimum required
withdrawal must be large enough to use up the account balance over the expected
remaining lifetime(s) of accountholder and beneficiary deemed to be 10 years younger,
unless the beneficiary is a spouse who is more than 10 years younger. It must begin by
April 1 of the calendar year following the calendar year in which the triggering event
occurs.
A minimum required withdrawal provision was first put into law in 1962 with the
beginning of Keogh plans for the self-employed (P.L. 87-792). Its purpose is to assure
that tax-deferred savings and the associated investment earnings are subject to taxation as
income when the accountholder is retired and/or reaches old age. The rationale for the
3 (...continued)
§457 plans and, hence, no early withdrawal penalty. Withdrawals from §457 plans are allowed
upon separation from employment, attainment of age 70½, “unforeseeable emergencies,” or death.
4 Accountholders must begin IRA withdrawals after attaining age 70½ regardless of their
employment status. The option to delay withdrawals until actual retirement, authorized by P.L.
104-188, applies only to employer-sponsored plans.
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tax-deferred status accorded retirement saving is to help workers accumulate retirement
assets for later use as a source of income. It is not intended as a means to realize a lifetime
tax exemption for assets that are held until death and bequeathed to the accountholder’s
heirs.
8. Why must contributions to my IRA come only from earned income?
The public policy purpose of the IRA is to assure that all workers have some opportunity
for tax-advantaged retirement saving. It is not the intent of the IRA to facilitate asset
accumulation for the future income needs of persons who already live on asset income or
who depend on public income transfer payments. Annual contributions to IRAs are limited
to the lesser of: (1) $2,000; or (2) the current year’s earnings.
There are two exceptions to the rule that IRA contributions must come from current
wage, salary, or self-employment income. First, a nonworking spouse can contribute to
an IRA, the annual limit being the lesser of: (1) $2,000; or (2) the filing unit’s combined
earnings, reduced by the working spouse’s IRA contribution. Second, an IRA
contribution can be made from alimony income received under a court-ordered divorce
settlement.
9. How can I get information about my retirement plan? Questions about
particular provisions of your employer’s plan may be answered by reference to the
Summary Plan Description (SPD) each plan is required to submit to the IRS. The
employer is supposed to distribute the SPD to participants. Information on a plan’s
financial transactions is filed regularly with the IRS on Form 5500 and must be made
available to participants upon request. The status of a participant’s benefit account must
be reported annually by the plan to each participant who requests a report. More frequent
reports may be made at the plan’s discretion. An IRA accountholder can obtain
documentation regarding the rules governing the IRA and its investment performance from
the financial institution that holds the account in trust.
10. Where should I seek help if I think I may have a problem with my
retirement plan? The U.S. Department of Labor (DoL) is responsible for enforcing the
plan requirements set forth in ERISA. An individual may contact DoL at the following
address:
U.S. Department of Labor
Pension and Welfare Benefits Administration
Division of Technical Assistance and Inquiries
200 Constitution Avenue N.W.
Washington, DC 20210-0999
This office may be reached by telephone at (202) 219-8776. The agency has an internet
home page at the following address:
[http://www.dol.gov/dol/pwba/]
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The office responsible for enforcing tax code requirements for retirement plans is:
U.S. Department of the Treasury
Internal Revenue Service
Employee Plans and Technical and Actuarial Division
1111 Constitution Avenue N.W.
Washington, DC 20224
Telephone assistance regarding tax-related problems plans may be obtained by calling the
Taxpayers’ Assistance Service at (202) 283-9516. The IRS internet address is:
[http://www.irs.gov/]