Frequently Asked Questions Regarding the LSA/RSA and ERSA Proposals

LSA/RSA Provisions

I have been contributing to IRAs for years. Will I have to stop?

After 2003, you will no longer be able to contribute to an IRA. However, your ability to contribute to both an LSA and an RSA will give you much more flexibility to save for your future. You will be able to save up to $7,500 (indexed in the future for inflation) in an LSA plus up to $7,500 (indexed in the future for inflation) in an RSA for a total of $15,000 in tax-preferred savings. In addition, you will have much more flexibility to take distributions for what you deem appropriate when you deem it appropriate.

Will there be any income limitations on making contributions to LSAs or RSAs?

There are no income limitations on making contributions to LSAs. You can make a contribution to an LSA even if you have no wage income. Thus, you can make contributions on behalf of your children or other family members, in order to help them save for home ownership, health emergencies, education, retirement, or other future costs. While there are no maximum income limitations on making contributions to RSAs, you may not contribute more than your compensation (wages) income to an RSA.

What tax benefits do I receive if contributions are not deductible?

While all contributions to LSAs and RSAs will be nondeductible, all distributions from LSAs and RSAs (except for RSA distributions prior to age 58, death or disability) will be excludible from taxable income. As a result, all investment earnings can be distributed tax free. This is the same tax treatment as current law Roth-IRAs.

Which tax treatment would be better for me: an old-style deductible IRA or a new Roth-style RSA?

For the vast majority of individuals it doesn’t make a difference: After-tax income in retirement is the same whether contributions are tax free and distributions are taxed or contributions are taxed and distributions are tax free. The only exceptions to this rule are individuals who change tax brackets after they retire. If an individual’s tax rate declines in retirement, deductible contributions are better; if an individual’s tax rate increases in retirement, Roth treatment is better.

Will I continue to be able to contribute to Archer medical savings accounts, Coverdell education savings accounts and qualified state tuition programs?

Yes. The LSA/RSA proposal will not affect your ability to contribute to MSAs, ESAs, or QSTPs. Many taxpayers may prefer the increased flexibility of the new LSAs as their tax-preferred savings vehicle.

Can I convert my existing IRAs, MSAs, ESAs, and QSTPs to an LSA or RSA?

You may convert an MSA, ESA, or QSTP to an LSA anytime before January 1, 2004. In the case of a conversion of a QSTP or ESA, no amount would be taxable in the year of the conversion while a conversion of an MSA to an LSA will result in taxation of the total amount converted in the year of the conversion.

You may convert a traditional IRA to an RSA at any time. The amount converted will be taxable except to the extent that you have basis in your IRA. If you convert prior to January 1, 2004, you will be able to spread the tax on the conversion over a four-year period. For conversions on or after January 1, 2004, the total taxable amount will be included in your gross income for the year of the conversion.

Will the Saver’s Credit still be available after the enactment of the LSA/RSA proposal?

Yes. The Saver’s Credit will be available for elective deferrals and LSA/RSA contributions made prior to 2007.

What will happen to the new deemed IRA provision? Will employer plans still be able to offer them?

Deemed IRAs will become deemed RSAs and will be subject to the rules applicable to RSAs.

Who will be able to become trustees for the LSAs and RSAs?

The rules that now apply to IRAs regarding who can be a trustee will apply to LSAs and RSAs. Thus, the trustee will have to be a bank or another person who demonstrates to the IRS that the manner in which they will administer the trust will be consistent with the rules applicable to LSAs and IRAs.

Will LSAs and RSAs be permitted to be held in the form of an annuity?

Yes. LSAs and RSAs may be held in the form of a nontransferable annuity contract issued by an insurance company that meets the rules that currently apply to individual retirement annuities.

Can I make LSA or RSA contributions on behalf of other persons, such as my children or spouse?

Yes, you may make LSA or RSA contributions on behalf of any other individual. However, total contributions made on behalf of an individual may not exceed $7,500 for LSAs and $7,500 (or compensation income, if less) for RSAs. In the case of a married couple filing jointly, RSA contributions up to $7,500 can be made for each spouse (including, for example, a homemaker who does not work outside the home) if the combined compensation of both spouses is at least equal to the contributed amount.

Will catch-up contributions be available for LSAs or RSAs?

Catch-up contributions will not be available for LSAs or RSAs, but the limits applicable to all individuals in LSAs and RSAs will be significantly greater than the existing IRA limits, even with catch-up.

Which types of employer-sponsored plans would be replaced by the new ERSA?

The ERSA would replace all types of funded plans with employee contributions. Thus, ERSAs would replace 401(k) plans, SIMPLE 401(k) plans, 403(b) plans, governmental 457 plans, salary reductions simplified employee pensions (SARSEPs), and SIMPLE IRAs. The ERSA would not replace nongovernmental 457 plans.

Are there any types of employers who would not be able to sponsor an ERSA?

No. Any employer would be able to sponsor an ERSA.

Will the ERSA proposal have any effect on the amount that an employee will be able to defer under existing law?

The amount that an employee will be able to defer under an ERSA will be $12,000 (increasing to $15,000 in 2006) plus, once the employee reaches age 50, a catch-up contribution of $2,000 (increasing to $5,000 in 2006). This is the same that an employee may defer under a regular 401(k) plan, a 403(b) plan, a SARSEP or a 457 plan, but it is greater than the amount permitted under a SIMPLE 401(k) or SIMPLE IRA.

Will after-tax contributions be permitted under an ERSA?

Yes. 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. Distributions from such accounts will generally be exempt from taxation and the accounts will not be subject to the required minimum distribution rules until after the death of the participant.

Will governments with grandfathered 401(k) plans and public schools with 403(b) plans still be able to allow deferrals up to the maximum under a 403(b) or 401(k) plan as well as the maximum under a 457 plan?

No. Once ERSAs are in place, all covered employees will be able to defer only the maximum applicable to ERSAs.

Will employers have to terminate their existing plans and transfer the assets to an ERSA?

No. Beginning in 2004, all 401(k) plans will become ERSAs. SIMPLEs, SARSEPs, 403(b) plans, and governmental 457 plans may continue in existence indefinitely, but may not accept any future contributions after 2004.

What nondiscrimination tests will apply to ERSAs?

The same simplified nondiscriminatory coverage requirement will apply to ERSAs (other than those covering only state and local government employees) that will apply to all other defined contribution plans. (See Q&A below). An ERSA will satisfy the nondiscriminatory benefit requirements if the average contribution percentage for nonhighly compensated employees is no greater than 6% and the average contribution percentage for highly compensated employees does not exceed 200% of the average contribution percentage for nonhighly compensated employees. If the average contribution percentage for nonhighly compensated employees is greater than 6%, then the average contribution percentage for highly compensated employees may be any amount.

Will state and local governments and charitable organizations be subject to the nondiscriminatory benefit requirement?

ERSAs covering only employees of state and local governments will be exempt from the nondiscriminatory benefit requirement. An ERSA covering only employees of a charitable organization will be subject to the nondiscriminatory benefit requirement only if it allows after tax contributions. In any event, an ERSA covering employees of a charitable organization will be subject to a universal availability requirement regarding the ability of employees to make deferrals under the plan. That is, all employees of the organization must be permitted to elect to make deferrals of more than $200.

Is there a safe-harbor design under which an employer will not be required to apply the general nondiscriminatory benefit rule described above?

Yes. A plan can satisfy the nondiscriminatory benefit rule through any one of the following safe harbor employer contribution designs: 1. The employer makes a nonelective contribution on behalf of each participant in the plan equal to 3% of the employee’s compensation, 2. The employer makes a matching contribution equal to 50% of each employee’s deferrals (up to 6% of compensation), or 3. The employer makes a matching contribution that does not increase based on the level of an employee’s deferrals and the match is equal to the amount that would be made under a 50% match (up to 6% of compensation), such as a match of 100% of each employee’s deferrals (up to 3% of compensation).

Does the budget proposal related to ERSAs affect any other defined contribution plans?

Yes. The proposal includes the following provisions that would greatly simplify the administration of all defined contribution plans: 1. There would be 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. 2. Permitted disparity and cross-testing would be prohibited for defined contribution plans. 3. The top heavy rules would be repealed for defined contribution plans. 4. 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. 5. 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.

Does the ERSA proposal have any effect on defined contribution plans that do not involve employee deferrals or employee after-tax contributions? In other words, does the proposal affect pure profit sharing plans, stock bonus plans, and money purchase pension plans?

Other than the simplifications discussed in the preceding question, the ERSA proposal would not affect the rules applicable to employer contributions to defined contribution plans, other than safe harbor nonelective contributions or matching contributions.

Does the ERSA proposal have any effect on defined benefit plans?

No, the proposal would not affect the rules applicable to defined benefit plans.

[Source: The White House]