ERSAs Bear Major Changes for Plan Sponsors

January 31, 2003 ( - Come Monday plan sponsors - and participants - will have some new retirement plan options to consider, and perhaps a few less to deal with.

The Treasury Department today announced that President Bush’s 2004 Budget proposal to Congress would include two new expanded savings proposals, what have been termed Lifetime Savings Accounts (LSAs) and Retirement Savings Accounts, (RSAs).

However, of most immediate interest to plan sponsors is the Employer Retirement Savings Accounts (ERSAs), a new type of plan that is designed to “promote and vastly simplify employer sponsored retirement plans.”   It accomplishes this by consolidating a wide variety of defined contribution alternatives – 401(k), SIMPLE 401(k), 403(b), and governmental 457 accounts – into a single type of plan (The ERSA would not replace nongovernmental 457 plans).  

However, while ERSAs will replace 401(k)s beginning next year under the proposal, employers will not have to terminate their existing plans, according to the Treasury.   Additionally, SIMPLEs, SARSEPs, 403(b) plans, and governmental 457 plans may continue in existence indefinitely, but may not accept any future contributions after 2004.

ERSAs will follow the existing rules for 401(k) plans, but these rules will be simplified.   According to a press release from the Treasury Department, both the definition of compensation and the minimum coverage requirement will be simplified and the top-heavy rules will be repealed.

Definitions, Tests Streamlined

There would be a uniform definition of compensation for all purposes for defined contribution plans:   the amount reported on form W-2 for wage withholding, plus the amount of ERSA deferrals.   Additionally, a simplified definition of highly compensated employee would be adopted under which all individuals with compensation for the prior year above the Social Security wage base for that year would be considered to be highly compensated employees.

Nondiscrimination requirements for ERSA contributions will be satisfied by a single test. Essentially, an ERSA will satisfy the nondiscriminatory benefit requirements if the average contribution percentage (ACP) for nonhighly compensated employees (NHCEs) is greater than 6%.   However, if the ACP is less than 6%, then the average contribution percentage for highly compensated employees must not exceed 200% of the ACP of the NHCEs.  

Employers can also satisfy the nondiscrimination test by adopting a safe harbor provision design.

State and local government plans are exempt from the nondiscrimination requirement, and ERSAs covering only workers of a charitable organization are subject only if the plan allows after tax contributions.

As currently allowed under 401(k)s, 403(b)s, SARSEPs and a 457 plan employees will be able to defer $12,000 under an ERSA (increasing to $15,000 in 2006).   That is, however, greater than the contributions currently permitted under a SIMPLE 401(k) or SIMPLE IRA.   Additionally, once the employee reaches age 50, a catch-up contribution of $2,000 is allowed (increasing to $5,000 in 2006).

After tax contributions will be permitted to an ERSA, and accounts attributable to such contributions made after 2003 will be treated much like the new RSAs, with distributions generally exempt from taxation, and accounts not subject to minimum distribution rules.

Coverage Tests  

ERSAs will have a single test to show that the plan meets the nondiscrimination rules with respect to coverage - ratio-percentage coverage. Under this test, the percentage of an employer's nonhighly compensated employees covered under a plan would have to be at least 70% of the percentage of the employer's highly compensated employees covered under the plan. The other coverage testing alternatives would be repealed, according to the Treasury announcement.

Permitted disparity and cross-testing would be prohibited for defined contribution plans, and top-heavy rules would be repealed for defined contribution plans.  

The ERSA proposal would reportedly have no effect on other types of defined contribution plans, including "pure" profit sharing plans, stock bonus plans, and money purchase pension plans - other than the simplifications relating to definitions of compensation, highly compensated workers and coverage.   It also has no impact on the rules applicable to defined benefit plans.

The  Saver's Credit will still be available for elective deferrals and LSA/RSA contributions made prior to 2007, while deemed IRAs (see  IRS Issues "Deemed IRA" Guidance ) will become deemed RSAs and will be subject to the rules applicable to RSAs.

In addition to employer-sponsored savings alternatives, Treasury said that new Lifetime Savings Accounts (LSAs) can be used by workers for any type of saving, including children's education, a new home, healthcare needs, or to even to start their own business. The new LSA works like current law Roth IRAs, but with no income limits, and an increased annual contribution limit of $7,500.   As with a Roth, LSA contributions are not deductible, but earnings will accumulate tax-free, and distributions will be tax free as well.  

Furthermore, prior to January 1, 2004, individuals may convert balances in an Archer Medical Savings Account (MSA), Coverdell Education Savings Account, and Qualified State Tuition Plan to LSAs - but while balances in these accounts may not be converted to LSAs after 2003, taxpayers can continue to contribute to those accounts.

Retirement Alternatives

Retirement Savings Accounts (RSAs) can be used only for retirement saving, and allow for the consolidation of traditional IRAs, nondeductible IRAs and Roth IRAs, each of which has a confusing and different set of rules regarding eligibility and tax treatment.   Individuals can set aside up to $7,500/year (indexed for inflation in future years) in an RSA - in addition to amounts contributed to an LSA.   RSAs will have rules similar to current law Roth IRAs:

  • contributions will not be deductible
  • earnings will accumulate tax free and
  • distributions after age 58 (or death or disability) will be tax-free.

Additionally, individuals will not be required to take minimum distributions from the accounts during their lifetime.

Existing Roth IRAs will be unaffected (except that they will be renamed RSAs), while existing traditional and nondeductible IRAs may, but do not have to be, converted into RSAs.   However, those not converted to RSAs could not accept any new contributions (other than rollover contributions).

Treasury notes that complex eligibility restrictions for IRAs under current law confuse taxpayers and cause some to avoid contributing to IRAs, even if they are eligible to contribute.

Catch-up contributions will not be available for LSAs or RSAs, however the new contribution limits exceed the current IRA limits, even with catch-up.