[95] note 55p. reports guides non-classroom useof an internal revenue service provision that would...

DOCUMENT RESUME

ED 389 071 EA 027 178

TITLE Federal Tax Rules Relating to Benefit Plans forPublic Education Employees. A Resource Guide.

INSTITUTION National Education Association, Washington, D.C.Research Div.

PUB DATE [95]

NOTE 55p.

PUB TYPE Reports General (140) Guides Non-Classroom Use

(055)

EDRS PRICEDESCRIPTORS

ABSTRACT

MF01/PC03 Plus Postage.*Compensation (Remuneration); *Compliance (Legal);Elementary Secondary Education: Employee AssistancePrograms; *Fringe Benefits; Health Insurance;*Retirement Benefits; Tax Deductions; Taxes; *TeacherEmployment Benefits

This update of a report originally issued in 1990provides an overview of the federal tax rules as they pertain todifferent types of employee-benefit plans that are available tomembers of the National Education Association (NEA) through theiremployers. The report is based on the law in effect as of August 15,1994. Section 1 examines retirement and savings plans, with a focus'on deferred-compensation plans. It provides background information

end describes the basic features and special rules applicable todefeil:ed-compensation plans. Section 2 describes health,dependent-care assistance, and "cafeteria plans" including taxtreatments, benefits, limitations and requirements, and uses. Onetable is included. (LMI)

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Reproductions supplied by EDRS are the best that can be madefrom the original document.

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FederalTax Rules

Relating to Benefit Plans forPublic Education Employees

A Resource Guide

Federal Rules as of August 15, 1994

neaNATIONAL EDUCATION ASSOCIATION

Research Division

3

0 *CONTENTS

Introduction

Retirement and Savings PlansBackground

Deferred Compensation Plans in General 7

Retirement Plans vs. Savings Plans 7

Qualified Plans vs. Nonqualified PlansOrganization.of Retirement and Savings Plan Discussion 8

Deferred Compensation Plans for NEA Members 8

Basic Features of Deferred Compensation PlansDefined Benefit Pension Plans 8

Defined Contribution Plans 11

Section 403(b) Plans 13

Simplified Employee Pensions (SEPs) 14

Section 457 Plans 14

Special Types of Plans 15

Special Rules Applicable to Deferred Compensation PlansAvailability of Plan Assets for Distribution to Employees 18

Limits on Benefits and ContributionsSpecial Tax Treatment of Distributions 27

Nondiscrimination Rules 29

Vesting Rules 31

Portability 32

ERISA 34

Miscellaneous 34

Social Security TaxesAge Discrimination Rules 19

Basic Differences Among Plans 40

Elements of Deferred Compensation Plans General Summary 41

Health and Dependent Care Assistance Plans

Health PlansTax Treatment in General 41

Health Benefits Trusts 43

Health Care Continuation Rules (COBRA) 44

Retiree Health BenefitsAmericans with Disabilities Act

Dependent Care Assistance ProgramsFavorable Tax Treatment Limitations and Requirements 47

Dependent Care Credit 48

Forms of Provision 49

Cafeteria PlansExample 49

Qualified Cafeteria Plan 50

Disadvantages of a Cafeteria I'lan 52

Other Uses of Cafeteria Plans 51

4

INTRODUCTION

This report, which was originally issued in1990, provides an overview of the federal taxrules relating to the different types of retirementplans, savings plans, health plans, and dependentcare plans that are available to members of theNational Education Association (NEA) throughtheir employersstate or local governments. Thereport is intended to serve as an important first

step in the consideration of the different types ofemployee benefit plans.

More than 90 percent of NEA members arecovered by a type of retirement plan called adefined benefit pension plan, which provides aspecific periodic benefit throughout an employ-ee's retirement. This report describes how definedbenefit pension plans work, what rules andrestrictions apply, and what special tax advan-tages are available. The report also describes inthe same manner several other types of retirementand savings plans that can function effectivelyeither as a supplement to a defined benefit pen-sion plan or as an employer's only plan.

Careful attention to the rules set forth in thisreport can result in very significant savings forNEA members. On July 12, 1990, shortly beforethis report was originally issued, the Baltimore

Sun criticized the Baltimore city government in

the following terms:

City officials have failed to take advantageof an Internal Revenue Service provisionthat would allow the city to shield itsteachers from federal taxes -.)n employeecontributions to pension plans. The resultwould be an extra $365 to $824 each yearin take-home pay for city teachers.

The provision at issue is contained in Section414(h) of the Internal Revenue Code and is com-monly referred to as the "pick-up" rule.

Just recently, the lJelaware legislature, due tothe efforts of the Delaware State EducationAssociation, has passed a law to take advantageof the pick-up rule.

The pick-up rule is just one example that themore NEA members understand about the rules,the better their benefits will be and the greatertheir tax savings will be. In addition, an under-standing of these rules can help members identifypotentially harmful proposals to modify the lawat either the federal or state level. Informed mem-bers acting together can make a difference in hownew rules are shaped.

Knowledge of the rules summarized in thisreport can also prevent retirement plans main-tained for NEA members from violating InternalRevenue Service (IRS) requirements that must besatisfied to avoid adverse tax consequences.According to the Daily Tax Report published by theBureau of National Affairs, Inc., the IRS conducteda two-year investigation of Rhode Island's pensionplan and found violations of the "exclusive benefitrule" and of Section 415 of the Internal RevenueCode. Because of these violations, the state hasreportedly been subjected to certain sanctions. OnMarch 3, 1994, the Daily Tax Report reported thataccording to an official in the Rhode Island GeneralTreasurer's office, "following the agreement, IRSwrote all state pension funds in the Northeast tohighlight key IRS code requirements and theircompliance with those requirements."

Other employee benefits issues have alsoattracted IRS attention recently. On June 2, 1994,the Daily Tax Report stated:

5

IRS considers defective Section 403(b)annuities as "one of the hottest issues indeferred compensation" because of thedegree of non-compliance with the tax

5

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code [said Evelyn Petschek, who is theDirector of the IRS' Employee PlansTechnical and Actuarial Division].

On May 10, 1994, the Daily Tax Report suggest-ed that the focus on Section 403(b) plans has gener-ally been restricted to plans maintained by privatetax-exempt employers but that may change:

Given the compliance problems that havesurfaced in the exempt sector, particularlyin the area of tax-deferred annuities, simi-lar problems could exist in the publicschool sector as well, [James] McGovernsaid, suggesting that public schools maybe next [sic] target of IRS audits of Section403(b) arrangements.

James McGovern is the IRS AssistantCommissioner for Employee Plans and ExemptOrganizations.

Employee benefit plans maintained by publicemployers in which NEA members participate areexempt from many rules applicable to employeebenefit plans maintained by private employers(though such exemptions generally would not behelpful with respect to the issues described aboveas being raised by the IRS). In addition, plans thatare the product of collective bargaining, as is thecase with some plans for NEA members, receivefurther special treatment. This report incorporatesthe applicable exemptions and special rules.

This report is based on the law in effect onAugust 15, 1994. The law with respect to employeebenefit plans has been modified numerous timesin the past and it is anticipated that modificationswill continue. Accordingly, it is imperative thatNEA members seek further guidance before mak-ing any final decisions. In some cases, this reportmakes reference to proposed legislation thatwould affect a subject being discussed.

* *RETIREMENT AND SAVINGS PLANS

BackgroundDeferred Compensation Plans in General

The retirement and savings plans discussedbelow are all forms of "deferred compensationplans." Under a deferred compensation plan, theemployees receive in subsequent years certaincompensation earned currently.

Under certain types of plans, the decisionwhether to receive compensation currently or in asubsequent year is made by each employee.These types of plans are referred to in this reportas "elective plans." Under other types of plans,the amount of deferred compensation providedwith respect to any employee is determinedunder a formula that no individual employee canalter. These types of plans are referred to as "non-elective plans." There are also hybrid plans thatcombine both elective and nonelective features.

Retirement Plans vs. Savings Plans

Deferred compensation plans can be used for

one of two purposes. First, a deferred compensa-tion plan can provide an individual with incomereplacement after he or she has retired. Second, adeferred compensation plan can provide an indi-vidual with a means to save money for preretire-ment purposes (such as buying a home).

All of the deferred compensation plansdescribed below can be used to provide retire-ment income. Certain plans are more effective in

this regard than others.

Some, but not all, of the plans describedbelow can be used as preretirement savingsplans. However, certain aspects of the law con-cerning the availability of plan assets for distribu-

tion undermine the effectiveness of these plans aspreretirement savings plans.

Qualified Plans vs. Nonqualified Plans

Deferred compensation plans are oftenreferred to as "qualified" or "nonqualified." Ingeneral, only defined benefit pension plans anddefined contribution plans, both of which aredescribed below, are qualified plans. A qualifiedplan is required to satisfy certain technicalrequirements, which vary depending on the typeof qualified plan. Satisfaction of these require-ments entitles the plan and the employees bene-fiting under the plan to certain favorable taxtreatment, which is also described below. In addi-tion, under a qualified plan, an employee'sdeferred compensation is not held by the employ-er but is made more secure by placement in, forexample, a trust or annuity contract.

Nonqualified plans are not required to satisfythe technical requirements applicable to qualifiedplans. Accordingly, they are not entitled to thesame favorable tax treatment. However, if a non-qualified plan meets certain less restrictiverequirements, the plan and the employees enjoycertain tax advantages. These tax advantages donot apply, however, unless the employer holdsthe deferred compensation, subject to theemployer's creditors.

In addition, there are two types of deferredcompensation plans that are commonly viewed

as neither qualified nor nonqualified: tax-shel-tered annuity plans ("Section 403(b) plans") andsimplified employee pensions (SEPs). Because

'Although the use of the terms "qualified" and "nonqualified" is wide-

spread, they ilre not technical terms. Accordingly, they aw used by differentpeople to mean difterent thivs. This report describes the most commonit,age ot the ternb:. but it b. recontnumded that more ,pecitic termtnology be

u,rd III tOtartht negotuttnins to aeon! nit,understanittitg,.

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these plans generally resemble qualified planswith respect to the aspects discussed above, theyare referred to in this report as qualified plans.

Organization of Retirement and SavingsPlan Discussion

This report describes the basic features of thefive main types of deferred compensation plans:(1) defined benefit pension plans, (2) defined con-tribution plans, (3) Section 403(b) plans, (4) sim-plified employee pensions, and (5) nonqualifieddeferred compensation plans ("Section 457plans"). In addition, the report discusses how cer-tain plans--age-weighted plans, cash balanceplans, and floor-offset plansthat are oftenreferred to as separate types fit within the fivemain categories described above. The report alsosummarizes the special rules applicable todeferred compensation plans, including therequirements applicable to each type of plan andthe tax treatment of distributions from each.

Deferred Compensation Plans for NEAMembers

The NEA 1992 Benefits Survey shows that atleast 99.3 percent of the respondents have sometype of deferred compensation plan available tothem and at least 96.4 percent of the respondentsparticipate in such a plan. Substantially all ofthese 96.4 percent participate in a defined benefitpension plan. In addition, the survey indicatesthat 85.1 percent of the respondents are eligible toparticipate in a second plan and that 49.9 percentof all respondents participate in such a plan. Thesurvey refers to such second plans as "supple-mental plans" and notes that Section 403(b) plansand Section 457 plans are examples of such sup-plemental plans.

8

Basic Features of DeferredCompensation PlansDefined Benefit Pension Plans

A defined benefit pension plan is a qualifiedplan under Section 401(a) of the Internal RevenueCode. Under a defined benefit pension plan,employees earn, during their career with theemployer, the right to a specified amount of pen-sion payments each year during retirement.

For example, a defined benefit pension planmight provide that for each year that employeeswork for an employer, they earn 1 percent oftheir "final average compensation." Final aver-age compensation could be defined as the aver-age compensation earned during the last fiveyears of employment. Thus, assume that anemployee starts work for an employer at age 35and retires at age 65. Assume further that suchemployee's average compensation during the lastfive years of employment was $35,000. Under theplan described above, this employee would beentitled to an annual pension payment of 30 x .01x $35,000 = $10,500. (The "30" represents years ofservice; the ".01" is the 1 percent per year of ser-vice; and the $35,000 is final average compensa-tion.) Thus, starting at age 65, this employeewould receive $10,500 every year until death; typ-ically the payments would be made on a monthlybasis. (For discussion purposes, it is assumed thatthe employees are 100 percent vested in the bene-fits they have earned. Plans may, of course,impose certain requirements, such as minimumservice requirements, in order for an employee tobe 100 percent vested. Rules regarding vesting arediscussed below.)

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Source of payments

The payments made to employees under adefined benefit pension plan are typically madefrom a trust. The employer makes contributionsto this trust as the employees are working so thatwhen the employees retire there is enough moneyin the trust to make the pension payments.

In general, until all benefits earned byemployees have been paid to the employees (ortheir beneficiaries), the trust assets may only beused to make such payments or to pay adminis-trative expenses incurred by the plan.(Administrative expenses may also be paiddirectly by the employer; whether the employeror the trust makes these payments is generallydetermined pursuant to the plan or trust docu-ment.) Under certain circumstances, assets in

excess of the amount needed to provide employ-ees with their benefits (or to pay administrativeexpenses, if applicable) may revert to the employ-er. See "Special RuleMiscellaneous" below.

Elective plans vs. nonelective plans

A defined benefit pension plan can be struc-tured either as an elective plan or a nonelectiveplan. The plan described above is a nonelectiveplan. The benefit provided to any employeedepends solely on the application of the pensionformula; employees may not make any electionsthat affect the application of the formula.

The plan could be made into an elective planby requiring that employees, as a condition ofbeing in the plan in any year, contribute, forexample, 1 percent of their compensation to thetrust. If each employee is permitted to decidewhether or not to make a contribution, then theplan is elective and any contribution made by anemployee is an "after-tax" contribution.

For example, assume that employees are enti-tled to a salary of $30,000. In order to participate inthe elective plan described above, the emp:oyeesmust elect to contribute 1 percent of $30,000, i.e.,$300. That $300 would be an after-tax contribution.In other words, although the $300 would be deduct-ed from their paychecks, they would still be taxedas though they had received the full $30,000. It is asthough they received the $30,000 and then made anondeductible contribution of $300 to the trust.

A plan may be nonelective even thoughemployee contributions are required as a condi-tion of participation in the plan. For example, theemployee contributions could be required as acondition of employment. Generally, suchemployee contributions would also be after-taxcontributions. However, there is a special rulethat applies with respect to employee contribu-tions if, in general, employees do not have theright to receive the amount of the contributiondirectly, instead of having the amount con-tributed to the plan. Under this special rule,which is contained in Section 4I4(h) of theInternal Revenue Code, the employer may chooseto "pick-up" the employee contribution. Theresult of the employer picking up the employeecontribution is that, for federal income tax pur-poses, the contributions cease to be after-taxemployee contributions and become "pretax"employer contributions.'

For example, assume that the same $30,000-a-year employees described above are coveredunder a "condition of employment" plan.Assume further that the employer picks up the$300 contribution. Under a common pick-uparrangement, everything is the same as described

lit certain circioiNtatice,, ail alternative mean,. ot ilaymN noneh'i

employee contribution,: mail, ;i a pi ehix lit i imply to ile,,iNilate

a!, emploiret contribution,. I l,, (incept applies hi other lupe., of quill

if int plan,.

9

*

in the prior example except that the employeesare only taxed on $29,700. In other words, theemployer does not make any extra contributionsand the employees have the same $300 deductedfrom their paychecks, but they are taxed as if theydid not receive that $300.

Aside from elective and nonelective plans,there can also be hybrid plans under which a cer-tain benefit is provided to all eligible employeeson a nonelective basis, but higher benefits areonly available if an employee makes an electivecontribution to the trust.

The NEA 1992 Benefits Survey provides certaindata regarding employee contributions to definedbenefit pension plans.' The survey generally showsthat, based solely on employees who made contri-butions to their defined benefit pension plans, theaverage employee contribution was 5.2 percent ofcompensation. The survey does not distinguishbetween elective and nonelective plans.

Form of payment

A common form of payment under a definedbenefit pension plan is a life annuity, that is, a setamount per year starting at retirement and con-tinuing until the employee's death.

One common variation would be a joint andsurvivor annuity based on the lives of theemployees and their beneficiaries. Such an annu-ity might operate in the same manner as a lifeannuity during the employees' lifetime, then pro-vide a second life annuity to the employees' bene-ficiaries. The second life annuity might be equal

'Ow ,itriwit dor, not actitalth reto to dettuird bt'nefit pen,4on plans, 1,111rather refers to -ba,ic plans" las opposed to -supplemental plan.4-1.1/0ietTer, WICe the basic plan for substantially all WA members is a Ilefinol!loft pensuott ;OH, the ..;111Tey data lire proVided here with nr:pect ft tettitedbenefit pension plans.

in annual payments to the employees' life annu-ity or it may be a percentage of the employees'life annuity. For example, employees mightreceive $10,000 a year during their retirement andtheir beneficiary might receive half that amount($5,000) a year during the period between theemployee's death and the beneficiary's death.Employees whose benefits are paid in the form ofa joint and survivor annuity generally receive lessduring their lifetime than do employees whoreceive an annuity only for their own life.

Another common form of payment is a lifeannuity with a "term certain." Under such anannuity, payments for a specified number ofyears (the term certain) are made even ; theemployees and their beneficiaries die befr e thatpoint (with the extra payments made tc contin-gent beneficiaries).

The amount paid annually under the annu-ities described above may be subject to cost-of-living adjustments (COLAs). Such COLAs maybe automatic, ad hoc, or contingent on specifiedevents (such as trust earnings).

A defined benefit pension plan may alsoallow an employee to choose to receive, instead ofan annuity, a single lump sum payment equal tothe present value of the available annuity pay-ments. In fact, a plan might require an employeeto receive a lump sum payment at least undercertain circumstances, for example, if the employ-ee terminates employment prior to retirement agewith a small vested benefit under the plan.

A defined benefit pension plan may also pro-vide a combination of an annuity and a lumpsum payment. For example, a plan may permitemployees to choose to receive the benefit attrib-utable to their own employee contributions in alump sum and to receive their benefit derivedfrom employer contributions in an annuity form.

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The forms of distribution described above areamong the more common ones.

General tax treatment

Employees are not taxed when employer con-tributions are made to a trust under a definedbenefit pension plan. A distribution from the trustis taxable income to the recipient, however,except to the extent that the distribution is "rolledover" or is considered to be a return of theemployee's after-tax contributions.

Subsequent sections of this report providefurther guidance with respect to (1) deferring tax-ation of a distribution by rolling over the distrib-ution into certain other deferred compensationplans or into an individual retirement account(IRA); (2) determining the portion of any distrib-ution that consists of an employee's after-tax con-tributions; (3) penalty taxes that apply to certaindistributions; and (4) special means of reducingthe rate at which a distribution is taxed.

In general, neither contributions (other thanafter-tax contributions) to the trust nor distribu-tions from it are subject to the Social Security tax(even if such tax generally applies to an NEAmember).4However, a pick-up contribution issubject to the Social Security tax (if such tax gen-erally applies) to the extent that the contributionis made pursuant to a salary reduction agree-ment. For this purpose, a salary reduction agree-ment need not be in writing. Trust earnings aregenerally exempt from taxation.

Defined Contribution Plans

Like a defined benefit pension plan, a definedcontribution plan is a qualified plan under

' References in this report to Hu Social Sec.nrini lax include the InNqIal

Insurance lay as as the abi-age survivors, anti disabillty Insurance laA

Section 401(a) of the Internal Revenue Code.However, under a defined contribution plan, eachparticipating employee has an account in theplan. Contributions are made to that account bythe employer and/or by the employee. The earn-ings attributable to those contributions are alsocredited to the employee's account. Thus, definedcontribution plans function like bank accounts.

The primary difference between a definedcontribution plan and a defined benefit pensionplan is that in the former the employer only com-mits to a certain level of contributions.Accordingly, unlike a defined benefit pensionplan, the amount of assets available to theemployee for retirement (or preretirement pur-poses) is, in all cases, solely a function of the con-tributions to the trust and the earnings generatedby those contributions.

There are two types of defined contributionplans that are relevant for NEA members: moneypurchase pension plans and profit-sharing plans.Until the Tax Reform Act of 1986, there was somequestion as to whether a public employer couldmaintain a profit-sharing plan since it did nothave profits in the traditional sense. The TaxReform Act of 1986 provided, however, that anemployer could maintain a profit-sharing planex!rtrt if it did not have profits. In effect, althoughthe name "profit-sharing plan" remained, theexistence of profits became irrelevant.Accordingly, it became clear that public employ-ers could maintain a profit-sharing plan.

Although private employers typically retaindiscretion on a year-to-year basis as to whether tomake a contribution to a profit-sharing plan, thatis not a necessary component of a profit-sharingplan. An employer can be required under a Profit-sharing plan (or a collective bargaining agree-ment) to make a specified level of contributionsto a profit-sharing plan.

I/

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Accordingly, there are few differences forNEA members between money pui chase pensionplans and profit-sharing plans. In fact, the differ-ences that do exist favor the adoption of a profit-sharing plan. Except as specifically noted, thediscussions below of defined contribution plansapply both to money purchase pension plans andto profit-sharing plans.

Although the term "profit-sharing plan" is theterm used in the Internal Revenue Code, anemployer that adopts a profit-sharing plan hasdiscretion with respect to whether to include theterm in the actual name of the plan. For example,a public employer that finds the term inappropri-ate might refer to a profit-sharing plan as a retire-ment plan, a supplemental retirement plan, or asavings plan.

Source of payments

The payment source is the same as in definedbenefit pension plans described above, exceptthat in almost all cases, all employer and employ-ee contributions (and the income earned by suchcontributions) are allocated to employees'accounts and are thus payable to the employees(or their beneficiaries) (net of the administrativeexpenses charged to the plan). However, employ-ees are not entitled to more than that amountunless the employer has failed to make requiredcontributions. .


A defined contribution plan may be structuredas an elective plan, a nonelective plan, or a hybrid.An example of a nonelective plan would be a planunder which the employer contributes on behalf ofeach eligible employee an amount equal to 5 per-cent of such employee's compensation.

12

The following is an example of an electiveplan. Under the plan, employees may electwhether to contribute to the trust any amount upto 3 percent of their compensation. In addition,for every dollar contributed by the employee, theemployer will also contribute a dollar (or a differ-ent figure, such as fifty cents or two dollars). Theemployee may also have the option of makingadditional contributions to the plan that are not"matched" by the employer. Alternatively, a planmay be structured so that an employee may electwhether to make contributions, but none of suchcontributions are matched by the employer.

In general, employee contributions to a definedcontribution plan must be after-tax contributions.In order for an employee contribution to be madeon a pretax basis, it must either (1) be made under apick-up arrangement, which is nonelective asdescribed above (in which case the contribution istreated as an employer contribUtion) or (2) be madeunder a special type of elective plan commonlyreferred to as a "401(k) plan."

The general rule, however, is that a state orlocal government may not maintain a 401(k) plan.Under an exception to this rule, a state or localgovernment that had adopted a 401(k) planbefore May 6, 1986, may maintain a 401(k) planon behalf of any of its employees, includingemployees not covered before May 6, 1986.

Forms of payment

Payments made from a defined contributionplan may be made in the same forms describedabove with respect to defined benefit pensionplans. However, lump-sum payments are morecommon with respect to defined contributionplans. In addition, installment payments madeover a specified number of years are not uncom-mon in defined contribution plans. If a defined

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contribution plan does make a distribution in anannuity form, it is done by using the employee'saccount to purchase an annuity contract from aninsurance company.


The tax treatment of defined contributionplans is the same as with defined benefit pensionplans described above, except that pretaxemployee contributions under a 401(k) plan aresubject to the Social Security tax (if otherwiseapplicable).

Section 403(b) Plans

All Section 403(b) plans are structured eitheras defined benefit pension plans or defined con-tribution plans. The reason that Section 403(b)plans merit separate discussion in this report isthat Section 403(b) plans are subject to their ownspecial rules. (Section 403(b) plans may only bemaintained by an employer that is either a publiceducational organization or a certain type of pri-vate nonprofit organization.)

This report discusses Section 403(b) plans inthe context of defined contribution plans. This isdone primarily because Section 403(b) plans aremuch more frequently structured as such. Therules outlined with respect to defined contribu-tion Section 403(b) plans, however, generally alsoapply to defined benefit Section 403(b) plans.

Source of payments

In general, contributions by an employer oremployee under a Section 403(b) plan must beeither (1) used to purchase an annuity contract for

the employee or (2) paid into a custodial account'and invested in regulated investment company

stock (that is, mutual funds) on behalf of theemployee. (Thus, there is no trust.) Both arrange-ments function like a defined contribution plan:the employee is entitled to the contributions andto the earnings attributable to those contributionsthat are generated by the annuity contract or cus-todial account.


The discussion above of elective and nonelec-tive defined contribution plans applies to Section403(b) plans with two important exceptions. First,employee contributions under a Section 403(b)plan may be made on a pretax basis regardless ofwhether they are elective or nonelecti .. In fact,elective pretax employee contributions are themost common form of contribution under aSection 403(b) plan. Second, the pick-up rules donot apply.

The NEA 1992 Benefits Survey provides infor-mation regarding employer and employee contri-butions to supplemental plans, which appear tobe predominantly Section 403(b) plans andSection 457 plans, but which may also includesome defined contribution plans. The surveyshows that the average employee contributionmade by respondents contributing to their sup-plemental plan was 5.3 percent of compensation.Respondents participating in supplemental plansestimated that the average employer contributionwas 1.3 percent of compensation.

Forms of payment

Benefit payments made under a Section403(b) plan are the same as defined contributionplans described above.

A custodial account is Netwrally an at count estabhhed with a bank or

smular institution in which Se( non 4(L3(b) f und,: wan be held.

313

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The tax treatment of 403(b) plans is the sameas defined benefit pension plans described above,except that (1) the special means of reducing thetax rate applicable to a distribution do not apply,(2) pretax employee contributions are subject tothe Social Security tax (if otherwise applicable),and (3) as noted, the pick-up rules do not apply.

Simplified Employee Pensions (SEPs)

A SEP is, in effect, a special type of definedcontribution plan that is established underSection 408(k) of the Internal Revenue Code.Under a SEP, the employer makes contributionsto IRAs established on behalf of all the eligibleemployees.

Source of payments

Under a SEP, all payments to employees (ortheir beneficiaries) are made from the employee'sIRA.

Nonelective plan

Only nonelective employer contributions maybe made to a SEP maintained by a state or localgovernment.

Forms of payment

Benefit payments under a SEP are made in thesame form as defined contribution plansdescribed above.

14


The tax treatment of contributions to and dis-tributions from a SEP is the same as defined bene-fit pension plans described above, except that (1)the special means of reducing the tax rate applica-ble to a distribution do not apply, and (2) therules relating to employee contributions do notapply because there are no employee contribu-tions.

Section 457 Plans

In general, deferred compensation plans thatdo not "qualify" as defined benefit pension plans,defined contribution plans, Section 403(b) plans,or SEPs are nonqualified deferred compensationplans. (The basic standards that deferred compen-sation pthns must satisfy to "qualify" are dis-cussed below under "Special Rules.")Nonqualified deferred compensation plans fallinto two categories: Section 457(a) plans andSection 457(f) plans. The difference between thetwo categories is that Section 457(a) plans meetcertain requirements and thereby qualify formore favorable tax treatment.

Section 457(f) plans essentially include anydeferred compensation plan maintained by astate or local government that does not (1) qualifyas a Section 457(a) plan, (2) fall within one of theother categories of plans described above, or (3)fit within certain narrow exceptions.° The taxtreatment of Section 457(0 plans is generallyunfavorable. The primary unfavorable aspect isthat employees are generally taxed on thedeferred compensation provided under a Section457(f) plan when their rights to such compensa-tion become substantially vested, even thoughthey may not at that time have received the

There are except wns for bona ride vacation leaoe. swk leave. compensato-ry time, severance_pay. Ill:ability pay, or death benefit Maw.. There arealso certam tranqinkluleN tor tertam plans in existence in 1987 or 1988.

* * * *

deferred compensation in current cash. Becauseof the unfavorable treatment of Section 457(f)plans, this report does not discuss these plans fur-ther and references to deferred compensationplans are intended to be references to plans otherthan Section 457(f) plans.

Although Section 457(a) plans can be struc-tured either like defined benefit pension plans ordefined contribution plans, the latter are muchmore common and, accordingly, this report dis-cusses Section 457(a) plans in that context. (Therules outlined with respect to defined contribu-tion Section 457(a) plans generally also apply todefined benefit Section 457(a) plans.)

Source of payments

Under a Section 457(a) plan, the employersimply promises to make certain payments toemployees at a subsequent time. There may ormay not be a trust, annuity contract, or custodialaccount to which contributions are made. Even if

a trust, etc., is established, the assets placed in thetrust may not be restricted to make paymentsunder the Section 457(a) plan, but rather must beavailable to the employer's general creditors.

The absence of a trust does not mean that anemployee is not credited with contributions andearnings on those contributions. Contributions onbehalf of an employee, whether made by theemployer or the employee, are credited to theemployee and are generally held by the employeras part of its general assets. The employee is alsocredited with earnings based either on a statedrate of return established by the employer (suchas 6 percent) or based on the actual rate of returnearned bv the employer with respect to invest-ments made with the employee's deferred corn-pensa tion.

Elective or nonelective plan

A Section 457(a) plan may be elective, non-elective, or a hybrid, as in the case of a definedcontribution plan. However, most typically it is apurely elective plan, that is, only elective employ-ee contributions are made. Although it is unclearwhether after-tax employee contributions to aSection 457(a) plan are permitted, the issue ismoot because all employee contributions to sucha plan can and should be made on a pretax basis.

Form of payment

Benefit payments under a 457(a) plan aremade in the same way as in the defined contribu-tion plans described above.


The tax treatment of contributions to and dis-tributions from a 457(a) plan are the same as inthe defined benefit pension plans describedabove, except that (1) all distributions from aSection 457(a) plan are taxable (because there areno after-tax employee contributions or rollovers);(2) under certain circumstances, an employeewho has a right to receive a distribution from aSection 457(a) plan upon demand is taxable onthe amount available, even if not distributed; (3)

Section 457(a) plans are not subject to the penaltytaxes, special lower tax rates, or pick-up rulesapplicable to defined benefit pension plans; and(4) a contribution to a Section 457(a) plan is sub-ject to the Social Security tax (if otherwise applic-able) when the contribution is vested.

Special Types of Plans

The terminology used with respect todeferred compensation plans is often a source of

15

* * *

confusion. For example, there are certain plansthat are often referred to as separate types ofplans but actually fit within one of the five cate-gories listed above.

Age-weighted plans

There has been considerable publicity recent-ly regarding "age-Weighted plans." In almost allcases, these plans are nonelective defined contri-bution plans or Section 403(b) plans. (Age-weighted plans are discussed below in thecontext of defined contribution plans rather thanSection 403(b) plans; this is done for convenienceof presentation since the same principles apply inboth cases.) What is distinctive about an age-weighted plan is the way contributions are allo-cated among the employees.

Under a conventional nonelective definedcontribution plan, each employee's account iscredited with the same employer contribution,measured as a percentage of the employee's com-pensation. For example, each employee might becredited with a contribution equal to 5 percent ofsuch employee's compensation. Under a commonvariation, the percent of compensation mayincrease with respect to compensation in excess ofthe Social Security wage base.

Under one type of age-weighted plan, theemployer's nonelective contribution is allocatedamong employees based on a formula that takesinto account both age and compensation, with theolder employees receiving much larger contribu-tions (again measured as a percentage of compen-sation). For example, younger employees mightreceive contributions equal to 3 percent of com-pensation while older employees are creditedwith 15 percent or more.

The formula that determines how much the

16

different employees are credited with is derivedfrom the IRS's nondiscrimination rules, which arediscussed below under "Special Rules." Theserules establish a special method of nondiscrimi-nation testingreferred to as "cross-testing"under which small contributions for youngeremployees can be considered to be equivalent tolarger contributions for older employees. Underthis special rule, the contributions are "cross-test-ed" based on the life annuity that could be pur-chased for the employee at normal retirementage. For younger employees, a contribution hasmany more years prior to normal retirement agein which to earn income. Accordingly, a verysmall contribut:in for a 25-year-old and a verylarge contribution for a 64-year-old could pur-chase the same life annuity starting at age 65 andthus would be considered equivalent for purpos-es of the nondiscrimination rules.

Many private employers find cross-testing tobe attractiVe because it allows them to providetheir older employeeswho are often more high-ly compensatedwith larger retirement benefitswithout running afoul of the nondiscriminationrules. Generally, this same favoring of olderemployees could be achieved through a definedbenefit pension plan, since defined benefit planbenefits are generally expressed as life annuitiesstarting at normal retirement age. However,many private employers, particularly small ones,find the administrative costs and burdens ofdefined benefit pension plans to be prohibitive.

The nondiscrimination rules generally havelittle effect on defined contribution plans main-tained for NEA members. Moreover, there is gen-erally no desire to favor higher paid NEAmembers over lower paid NEA members.

The Treasury L)epar I in I'll 1 has inoposed legtslotion to curb the us otiros.-testing to atisfy the noudiscrimivation rub's. : of August 15. 19Q1,/to suCh legistatton has 17(vti

Accordingly, the primary rationale for NEA mem-bers to seek coverage under an age-weightedplan is to provide larger contributions to olderemployees, not because they tend to be highlycompensated employees but because they arecloser to retirement.

Cash balance plans

Cash balance plans, which were generally cre-ated in the 1980s, are defined benefit pensionplans. What is distinctive about cash balanceplans is the benefit formula.

As discussed above, defined benefit pensionplans often use benefit formulas that provide aset percentage of an employee's "final averagecompensation" multiplied by the employee'syears of service. For example, a defined benefitpension plan might provide a benefit equal to 1

percent of final average compensation multipliedby an employee's number of years of service.

A cash balance plan, on the other hand, has abenefit formula that resembles the formula of adefined contribution plan. A cash balance plangenerally provides that each employee is to have

a hypothetical account within the plan. Theemployee's account will be credited with adeemed contribution each year, such as 5 percentof the employee's compensation. (The deemedcontribution could also be age-weighted or variedin any other way used with respect to definedcontribution plans.) In addition, the account bal-

ance will be credited with interest at a stated rate.

At first blush, cash balance plans seem morelike defined contribution plans than defined ben-efit pension plans. There are, however, criticalfactors that make them defined benefit pensionplans. The key factor is that there is a guaranteedinterest rate. Thus, even if the plan's actual assets

sustain a loss, each employee's hypotheticalaccount will still be credited with the stated inter-est rate. This element alone is technically suffi-cient to make the plan a defined benefit pensionplan. Another important aspect of a cash balanceplan is that the employer is not required to makeannual contributions equal to the deemed contri-butions. The employer may choose, within cer-tain limits, to overfund or underfund the plan fora period of time, provided that there should besufficient assets in the plan in order to pay thebenefits when due.

Cash balance plans are adopted for a varietyof reasons. Some employers switch from a con-ventional defined benefit pension plan to a cashbalance plan because they believe that the benefitformulas under conventional defined benefit pen-sion plans are too complicated for employees tounderstand or appreciate. Cash balance plansoffer a simple-to-understand alternative. Otheremployers who make the switch believe that con-ventional defined benefit pension plans inappro-priately favor older workers over youngerworkers because of the use of final average com-pensation in the benefit formula. One way to sub-stantially increase the benefits of youngerworkers is to adopt a cash balance plan that pro-vides a deemed contribution that is an equal per-centage of every employee's compensation.

Compared to a defined contribution plan,cash balance plans can appeal to employees wholike the guaranteed interest rate that is not avail-

able under a def;ned contribution plan. On theother hand, thc benefits of favorable investmentexperience flow to the employer under a cash bal-

ance plan (through reduced future plan contribu-tions), an aspect that can be attractive foremployers.

As noted above, cash balance plans are rela-

tively new and several issues as to how they

* * *

should be structured remain unsettled. Moreover,the IRS has repeatedly indicated that it plans inthe near future to issue new guidance clarifyingthe rules with respect to cash balance plans.Although the new guidance may focus primarilyon nondiscrimination issueswhich may be ofless concern to NEA membersother significantissues may also be addressed by the IRS.

Floor-offset plans

A floor-offset plan is a defined benefit pensionplan with one distinctive characteristic. The bene-fits provided under the defined benefit pensionplan are offset by the value of benefits providedunder another plan of the same employer, typi-cally a defined contribution plan. For example, adefined benefit pension plan might provide anemployee with a benefit equal to 1 percent offinal average compensation multiplied by theemployee's years of service, offset by the lifeannuity starting at normal retirement age thatcould be purchased with the employee's accountbalance under a defined contribution plan.

A floor-offset plan can be used to address avariety of needs. For example, an employer mightuse a defined contribution plan as its primarysource of retirement benefits. In order to ensure acertain minimum retirement benefit, the employ-er might add a floor-offset plan. The floor-offsetplan would protect employees from unfavorableinvestment experience in the defined contributionplan. The floor-offset plan would also protect theinterests of employees who join the work force atan older age; defined contribution plans, particu-larly those that are not age-weighted, generallydo not provide an adequate retirement benefit forsuch employees.

18

Special Rules Applicableto DeferredCompensation Plans

The tax treatment described above for quali-fied deferred compensation plans is very favor-able. For example, under general tax principles,individuals are taxable on amounts paid into atrust on their behalf by their employer if andwhen such amounts become substantially vested,even if they have not at that time received thedeferred compensation in current cash compensa-tion. Also under general tax principles, theincome earned by such a trust is subject toincome tax. The more favorable tax treatment ofqualified plans is, however, conditioned on theplan's meeting the applicable standards for quali-fication? These rules are summarized below.

With respect to nonqualified deferred com-pensation plans, a Section 457(a) plan is treatedfavorably as compared to a Section 457(f) plan, asdiscussed above. Such treatment is conditionedon the Section 457(a) plan's meeting certainrequirements, which are also discussed below.

In addition, this section of the reportdescribes certain special rules with respect to thetax treatment of distributions from deferred com-pensation plans.

Availability of Plan Assets forDistribution to Employees

Prohibitions on availability

In order to qualify for favorable tax treatment,

The IRS has stated, iunvever, that pending further review. it will no! hal-lenge the tax-evempt qtatus of trusts maintained in conneitim, with theretirement phni ()t a state Or lorai giaTrIllneat.

* * *

a deferred compensation plan must restrict anemployee's ability to receive assets from the planprior to the occurrence of certain events.

A plan may be more restrictive than isrequired by law. For example, even if the lawwould permit a certain type of plan to make dis-tributions to an employee prior to termination ofemployment, the plan may by its terms prohibitsuch distributions.

Defined benefit pension plans

A defined benefit pension plan may not makea distribution to an employee of benefits fundedby the employer until the employee has terminat-ed employment, become .disabled, attained nor-mal retirement age under the plan, or died, oruntil the plan has terminated.

After-tax employee contributions and theincome attributable to such contributions are,however, subject to different rules. If no employ-er-funded benefit is conditioned on an after-taxemployee contribution, a defined benefit pensionplan may allow such contribution and the incomeattributable to such contribution to be withdrawnby the employee at any time. lf, however, anemployer-funded benefit has been conditioned onthe after-tax employee contribution, such contri-bution and the income thereon appear to be sub-ject to the same restrictions applicable toemployer-funded benefits, with very limitedexceptions.

Defined contribution plans

Distributions from a money purchase pensionplan are subject to the same restrictions applica-ble to a defined benefit pension plan.

9

The rules with respect to distributions from aprofit-sharing plan are much more liberal thanthose applicable to defined benefit pension plans.A profit-sharing plan generally may distribute toan employee any employer contributions and theincome attributable to such contributions if (1)the assets to be distributed have been in the trustfor at least two years; (2) the employee hasattained an age specified in the plan (which neednot be normal retirement age); (3) an event hasoccurred with respect to the employee (such aslayoff, hardship, illness, disability, retirement,death, or severance of employment); (4) the planterminates; or (5) the employee has participatedin the plan for at least five years.

A 401(k) plan, which is generally a type ofprofit-sharing plan, is, however, subject to restric-tions on distributions of pretax employee contri-butions (and certain employer contributions) andthe income thereon that are more restrictive thanthose applicable to other profit-sharing plans (butnot as restrictive as those applicable to definedbenefit pension plans).

After-tax employee contributions to profit-sharing plans are subject to the most liberal distri-bution rules. If no employer contribution isconditioned on an after-tax employee contribu-tion, a profit-sharing plan may provide that theemployee contribution and the income attribut-able thereto may be withdrawn by the employeeat any time.

If an employer contribution has been condi-tioned on the employee contribution, the planmay allow employees to have this same freedomof withdrawal, except that the plan has to providea mechanism for, in effect, limiting the exercise ofthese withdrawal rights. Such a limitation mightrequire, for example, that the amount withdrawnhave been in the plan for a certain minimum peri-od (such as two years). If employees wish to exer-

19

*

cise their withdrawal rights prior to the expira-tion of such period, an alternative limitationmight be the suspension of the employee's rightto make or receive contributions for six monthsfollowing exercise of the withdrawal rights.

Section 403(17) plans

Under a Section 403(b) plan, amounts that areused to purchase annuity contracts generally maybe distributed at any time. This rule, however,does not apply to elective pretax employee contri-butions and the income attributable to such con-tributions. Such pretax employee contributionsmay not be distributed until the employee attainsage 591/2, separates. from service, dies, becomesdisabled, or incurs a hardship. The same restric-tions apply to the income earned on elective pre-tax employee contributions except that thehardship rule does not apply.

Under a "grandfather rule," the restrictionson distribution of elective pretax employee con-tributions (and the income thereon) do not applyto amounts that were in the plan as of the end ofthe last plan year beginning before 1989. (Therestrictions do apply, however, to the earnings onthe grandfathered amounts).

All amounts in a Section 403(b) plan that areheld in a custodial account are subject to the samedistribution restrictions applicable to elective pre-tax employee contributions used to purchase anannuity contract, except that the grandfather ruledoes not apply.

SEPs

Distributions from a SEP may be made at anytime.

20

Section 457 plans

Under a Section 457(a) plan, distributionswith respect to an employee may not be madeuntil the employee separates from service or hasan enforceable emergency (which is a narrowercategory than "hardship").

Ten percent early distribution penalty tax

Even if a deferred compensation plan maymake a distribution under the rules describedabove without jeopardizing its favorable tax treat-ment, a 10 percent penalty tax will apply to therecipient of a taxable distribution unless the distrib-ution is made for one of the following reasons:

(i) made on or after the date theemployee attains 591/2

(ii) made on or after the employee'sdeath

(iii) attributable to the employee beingdisabled

(iv) made in the form of a life annuity, ajoint and survivor annuity, or a simi-lar form, provided that the pay-

ments begin after the employeeseparates from service

(v) made after the employee separatesfrom service, provided that theemployee does so during or after thecalendar year in which he/sheattained age 55

(vi) not in excess of the employee'sdeductible medical expenses for theyear (or the amount that would bedeductible if the employee itemizeddeductions)

(vii) made to a family member of theemployee's (or former family mem-ber) under a state court domesticrelations order

* * * 0

These rules apply to all deferred compensa-tion plans except that (1) the exceptions describedin clauses (v), (vi), and arguably (vii) do notapply to SEPs; (2) the requirement in clause (iv)that the employee have separated from servicedoes not apply to SEPs; and (3) distributionsunder Section 457(a) plans are not subject to the10 percent penalf- fax in any case.

Plan loans

Employees may generally be permitted toborrow plan assets from a defined benefit pen-sion plan, defined contribution plan, or Section403(b) plan without jeopardizing the plan's favor-able tax treatment. (As a practical matter, loansfrom the latter two types of plan are much morecommon than loans from defined benefit pensionplans.) Such loans are not permitted with respectto SEPs. In the case of a Section 457(a) plan, anyloan to an employee would technically be treatedas a loan from the employer and thus would notbe subject to any special rules.

A loan from a defined benefit pension plan,defined contribution plan, or Section 403(b) planis generally treated as a loan, rather than as a dis-tribution, and thus is not subject to income taxesor penalty taxes. However, some or all of a planloan will be treated as a distribution for such pur-poses if the loan violates certain requirements.Very generally, those requirements are as follows.

Limitation oll amount

The sum of all outstanding loans to anemployee from all plans of an employer may notexceed the lesser of $50,000 or the greater of$10,000 or 50 percent of the value of the employ-ee's vested benefits under the plans.

In addition, very generally, the $50,000 maxi-mum is reduced by the amount of loan principalpaid by the employee during the prior 12 months.

Repayment period

In general, a plan loan must be required to berepaid within five years and must, in fact, be repaidwithin five years. There is an exception from thisrule for loans used to acquire the employee's prin-cipal residence. There is no official guidance as towhat repayment period is permissible with respectto a principal residence loan.

Quarterly payments

Plan loans must be repaid in substantiallyequal payments that are made at least quarterly.Of course, the loan may also be repaid or acceler-ated prior to the end of the stated term.

Pledges

For purposes of the requirements listedabove, employees who pledge or assign any por-tion of their plan benefits shall be treated as hav-ing received a plan loan of the amount pledged orassigned.

Effect on the plan

Even if a loan is treated as a distributionbecause it does not satisfy the rules describedabove, it is not necessarily treated as a distribu-tion for purposes of the prohibitions on distribu-tions. A loan generally will be treated as adistribution for those purposes only if it is not abona fide loan, that is, there was no real intentthat the loan would be repaid.

1 21

* *

Minimum distribution rules

In general, a deferred compensation plan doesnot qualify for favorable tax treatment unless theplan requires that employees begin receiving dis-tributions from the plan by no later than April 1of the year immediately following the later of (1 )the year the employee attains age 70V: or (2) theyear the employee retires. The year the employeeretires does not.apply to a SEP. In addition, thecommencement of distribution of amounts thatwere in a Section 403(b) plan as of December 31,1986, may be delayed beyond the dates describedabove, but generally not beyond age 75.

Limits on Benefits and Contributions

In order to qualify for favorable tax treatment,a deferred compensation plan must limit the con-tributions or benefits that it provides to eachemployee.

The limits discussed below are in certain cir-cumstances a function of an employee's, compen-sation. For a discussion of an issue affecting theamount of compensation an employee is treatedas receiving for these purposes, see "Pretaxemployee contributions," page 37.


In general, under Section 415 of the Internal.Revenue Code, employees may not be entitled toan annual benefit attributable to employer contri-butions under a defined benefit pension plan inexcess of the lesser of $118,800 (indexed) or theemployees' average compensation over the three-consecutive-year period in which their compensa-tion was the highest (indexed in years after theemployee separates from service).

?I

Under proposed legislation, the "averagecompensation" rule described above would beinapplicable to any defined benefit pension planmaintained by a state or local government (or bythe federal government).

Both the $118,800 (indexed) figure and theaverage compensation limit may be reduced withrespect to an employee who is (or has been) aparticipant in a defined contribution plan or aSEP maintained by the same employer. Thisreduction applies under Section 415(e) and can incertain circumstances have a very significanteffect on the amount of annual benefits permittedwith respect to a participant. If a participant in adefined 'uonefit pension plan also participates in aSection 403(b) plan maintained by the samemployer, rather than a defined contribution plan

or SEP, the reduction under Section 415(e) onlyapplies in limited, avoidable circumstances.'Accordingly, for an employer with a defined ben-efit pension plan that is considering adopting asupplemental qualified plan, Section 403(b) planshave this advantage.

Employee contributions

The benefit attributable to after-tax employeecontributions to a defined benefit pension plan isnot subject to the limit described above. Instead,for purposes of the Section 415 limits, employeecontributions to a defined benefit pension planare generally treated as contributions to a definedcontribution plan.

It appears, though it is far from clear, that the

Iii circumstances in which the Section 415(0 reduction would otherwiseapply to the annual benefit limit described above. an emphmer mint chooseto hace the i (qui bon apply instead to the defined contribution hssitil (whitapplies to Section 40 plans and SI:Ps, as well as to defined contribution

,INcussed below. Because of the manner in which Section 415(0applies, however, it is getwrally advisable to have the mluetion apply to theannual benefit limit described above.

r;

benefit attributable to pick-up contributions to adefined benefit pension plan is subject to the limit

described above.

Ancillary benefits

If employees are entitled to certain types of

ancillary benefits, such as payments after theirdeath other than as a life annuity to their spouse,the ancillary benefits must be converted into a lifeannuity of equivalent value (for testing purposesonly), added to the employee's regular benefit,and the total then tested against the limitdescribed above. An example of an ancillary ben-efit that need not be valued and tested is a prere-tirernent disability benefit.

Under proposed legislation, all disability anddeath benefits provided under a governmentaldefined benefit pension plan would be disregard-ed in applying the Section 415 limit and thusneed not be valued and added to an employee'sregular benefit.

Early or late retirement

If an employee's benefits under the plan beginbefore age 62, the $118,800 (indexed) figure must beactuarially reduced with respect to that employeeto reflect the fact that benefits are commencingbefore age 62. However, if the benefit begins at or

after age 55, the actuarial reduction shall not reduce$118,800 (indexed) to an amount lower than$75,000 (not indexed). If the benefit begins before

age 55, the limit is the greater of (1) the actuarialequivalent of a $118,800 (indexed) benefit com-mencing at age 62, or (2) the actuarial equivalent of

a $75,000 benefit commencing at age 55.

Since the $75,000 figure is not indexed, these

actuarial reductions will become increasinglyimportant in the future. The reductions couldbecome particularly important if NEA memberscontinue their preference for early retirement. TheNEA 1992 Benefits Survey found that 11.9 percentof the respondents plan to retire by age 54 and43.8 percent by age 59.

If an employee's benefit begins after age 65,

the $118,800 (indexed) figure is actuariallyincreased to reflect the commencement of benefits

after age 65.

$10,000 benefit permitted

A special rule allows a defined benefit pen-sion plan to provide an annual benefit of $10,000

or less to an employee, even if that benefit wouldotherwise exceed the limit described above. Thisspecial rule only applies, however, if the employ-

ee has never been covered under a defined contri-bution plan or SEP (or in certain circumstances aSection 403(b) plan) maintained by the sameemployer.

Adjustment of limit based on years of service or

participation

The $118,800 (indexed) limit is reduced pro-portionately for an employee who has less thanten years of participation in the plan. For exam-ple, if employees have only been participants fortwo years, their benefit could not exceed 20 per-

cent of $118,800 (indexed), or $23,760 (indexed).

The average compensation limit and the spe-cial $10,000 amount are reduced in a similar fash-ion but based on years of servic9 with theemployer rather than years of participation in the

plan.

2 3 23

Collective bargaining exemption

There is a narrow exemption from the averagecompensation limit for collectively bargained plansthat meet a series of requirements, including, forexample: (1) employees must be eligible to partici-pate in the plan after not more than 60 days of ser-vice; (2) employees are 100 percent vested in theirbenefits after no more than four years of service;and (3) an employee's benefits are not determinedby reference to the employee's compensation. Evenif a plan meets the requirements, the exemptiongenerally applies only to employees whose com-pensation is less than the average compensation ofemployees covered under the plan.

In general, the defined benefit pension plansin which NEA members participate are not collec-tively bargained, so that this exemption will gen-erally be inapplicable.

Plan aggregation and disaggregation

For purposes of the limit described above, alldefined benefit pension plans maintained at anytime by an employer are treated as a single plan,that is, are "aggregated." Thus, if the benefitsearned by an employee under two plans main-tained by the same employer exceed the applica-ble limit in total, the limit is considered exceeded.

In addition, for purposes of the limitdescribed above, related employers are treated asa single employer. (There is little guidance withrespect to the circumstances in which publicemployers are considered to be related.)

If a single plan is maintained by two or moreunrelafril employers, the benefit earned under theplan by an NEA member is, for purposes ofapplying the limit described above, generallydivided into separate benefits based on the bene-fits earned from each employer.

14

Special electioli

Congress has provided a special election tostate and local government employers. If anemployer makes this election, the limit describedabove is deemed satisfied with respect to. anemployee of such employer if the employee'sbenefit under the employer's plan does notexceed the amount that would be payable underthe plan without regard to any plan amendmentsadopted after October 14, 1987. However, thisfavorable treatment only applies to employeeswho first became participants in the plan beforeJanuary 1, 1990.

There is a significant condition attached tothis election. If an employer makes this election,employees ineligible for the favorable treatmentgenerally become subject to the version of thelimit that applies to taxable employers. Underthat version, the $118,800 (indexed) figure is actu-arially reduced kor increased) if benefits beginbefore (or after) an employee's qocial Securityretirement age (which is between 65 and 67,depending on the employee's current age). Inaddition, the $75,000 .1-ul described above doesnot apply. In comparison with the rules describedabove, this version of the dollar limit is muchlower for employees who retire early and beginreceiving their benefit.

The election must have been made by the endof the first plan year beginning after 1989.

Additional proposed kwislation

Under proposed legislation, a governmentalplan could provide benefits in excess of theSection 415 limits, provided that under the excessarrangement, no election is provided to anemployee (directly or indirectly) to defer compen-sation. Very generally, the proposal would allow

* 0 * *

such additional benefits to be taxable to employ-ees only upon their receipt of such benefits andwould allow income earned by the benefits priorto distribution to be nontaxable to the employer(or to a separate trust holding the benefits). In all

other ways, the excess portion of the plan wouldnot be treated as a qualified plan.

The proposed legislation would also deem allgovernmental plans to be in compliance withSection 415 for all taxable years beginning beforethe date the legislation is enacted.

Because of the favorable legislative proposalsdescribed in this and other sections, the "specialelection" described above may no longer beadvantageous. Accordingly, the proposed legisla-tion also provides employers that have made theelection with the option to revoke it.


In general, under Section 415 of the InternalRevenue Code, the sum of the employer andemployee contributions made on behalf of anemployee to defined contribution plans in a yearmay not exceed the lesser of $30,000 (indexed ona delayed basis) or 25 percent of the employee'scompensation. For this purpose, any amount thatis forfeited by one employee in a defined contri-bution plan and is allocated to a second employeeis treated as a contribution on behalf of the sec-ond employee.

"Rollover contributions" and "transfers,"both of which are discussed below, are not treatedas contributions for purposes of the limitdescribed above.

As in the case of defined benefit pe )siOnplans, all defined contribution plans maintainedby an employer are treated as a single defined

contribution plan for purposes of the applicablelimit. The rules with respect to related employersand with respect to a defined benefit pension planmaintained by two or more unrelated employersalso apply to defined contribution plans.

Section 403(b) plans

Contributions made on behalf of an employeeto a Section 403(b) plan are generally subject totwo limits. First, such contributions are subject tothe limit applicable to defined contribution plansunder Section 415. However, unless an employeemakes one of the elections referred to below,Section 403(b) plans are not aggregated withdefined contribution plans for purposes of thislimit.

Second, employer contributions and pretaxemployee contributions on behalf of an employeein a year may not exceed the "exclusionallowance" established under Section 403(b)itself. The exclusion allowance is generally theexcess of 20 percent of the employee's taxablecompensation for the year, multiplied by years ofservice with the employer, over the total of thenontaxable employer contributions and pretaxemployee contributions made by or with respectto the same employer to Section 403(b) plans,defined benefit pension plans, defined contribu-tion plans, Section 457(a) plans, or certain 457(0plans on behalf of the employee for all prioryears.

There are special rules that under certain cir-cumstances provide more liberal limits than thosedescribed above. Each employee may elect which,if any, of the special rules to use:

25

* * * 0 * * *

SEPs

For purposes of the Section 415 limits describedabove, a SEP is treated as a defined contributionplan. In addition, under Section 402(h) of theInternal Revenue Code, contributions to a SEP onbehalf of an employee may not exceed the lesser of15 percent of the employee's taxable compensationor $30,000 (indexed on a delayed basis) reduced bya certain amount in the case of SEPs that providelarger contributions for "highly compensatedemployees" than for "nonhighly compensatedemployees" (as a percentage of compensation). See"Nondiscrimination Rules" below for a definitionof "highly compensated employee."

Section 457 plans

In general, under Section 457 itself, the limiton the amount that may be deferred on behalf ofan employee in a year under a Section 457(a) planis the lesser of $7,500 or one third of the employ-ee's taxable compensation. There is also a specialrule that provides a higher limit (up to $15,000)during an employee's last three years before nor-mal retirement age. In addition, the $7,500 limit(or higher limit) is, in effect, reduced by (1)amounts deferred under other Section 457(a)plans on behalf of the same employee; (2)amounts contributed on behalf of the employeeunder a Section 403(b) plan; and (3) pretaxemployee contributions made on behalf of theemployee under a 401(k) plan.

Under proposed legislation, the $7,500 figurereferred to above would be indexed.

2(1

Special limit on elective pretax employeecontributions

Elective pretax employee contributions are sub-ject to the general limits described above and, inaddition, they are subject to a special separate limitunder Section 402(g) of the Internal Revenue Code.Generally, under this special limit an employeemay not make more than $9,240 (indexed) of elec-tive pretax employee contributions during a calen-dar year to all deferred compensation plans (otherthan Section 457(a) plans). However, with respect toelective pretax employee contributions to Section403(b) plans, the limit is the higher of $9,240(indexed) or $9,500 (not indexed). Accordingly, inthe near future, when the $9,240 is indexed to exceed$9,500, there will be no special Section 403(b) limit.

For employees who have at least 15 years ofservice, the limit on elective pretax employee con-tributions to Section 403(b) plans is raised pursuantto a formula, with a maximum increase of $3,000.

Pick-up contributions are not subject to thisspecial limit.

Penalty tax on excess distributions andexcess accumulations

There is a 15 percent penalty tax that applies, inaddition to the generally applicable income tax, toindividuals who receive "excess distributions." Forthis purpose, very generally, individuals have anexcess distribution if in a calendar year they receivefrom all deferred compensation plans (other thanSection 457(a) plans) and IRAs taxable distributionsin excess of the greater of $148,500 (indexed) or$150,000 (not indexed). In addition, a comparable 15percent tax applies to individuals who die withvery large accumulations of assets in deferred com-pensation plans (other than Section 457(a) plans)and IRAs.

Special Tax Treatment of Distributions

Distribution rolled over to another plan or


If a distribution from a defined benefit pen-sion plan is "rolled over" (that is, contributedunder certain circumstances described below) toanother defined benefit pension plan, a definedcontribution plan, or an IRA, the amount rolledover is not taxable at that time to the employee.

Very generally, all distributions may be rolledover with the following exceptions: (1) periodicpayments made over the life of the employee (or

over the lives of the employees and their benefi-ciaries); (2) periodic installment payments madeover a period of at least ten years; (3) the mini-mum amount required to be distributed underthe rules described above; (4) any amount of adistribution that is not taxable to the recipient (forexample, because it is a return of after-taxemployee contributions); and (5) certain miscella-neous, less common types of distributions (suchas a distribution to cure a violation of Section415). Distributions that may be rolled over arereferred to as "eligible rollover distributions."

There are generally two types of rollovers:rollovers made by the employee-recipient anddirect rollovers. In the former case, the employeereceives an eligible rollover distribution from adefined benefit pension plan. In order to roll overthe eligible rollover distribution, the employeemust, within 60 days of the distribution, con-tribute the distribution lo another defined benefitpension plan, a defined contribution plan, or an

for a discussion of another WOWS' of InOVing assets from one deferredcompensation plan to another without taxation, see "Asset Portability,"below.

IRA. The employee may roll over all or only aportion of the eligible rollover distribution.

A defined benefit plan that makes an eligiblerollover distribution available to an employee gen-erally must also make available to the employeethe option of a "direct rollover." A direct rollover isa direct transfer of some or all of the eligiblerollover distribution to a defined contribution planor an IRA designated by the employee. (A directrollover may not be made to a defined benefit pen-sion plan.) As in the case of a rollover made by anemployee, the amount of the direct rollover is nottaxable to the employee at the time it is made.

The law also includes an incentive for employ-ees to elect a direct rollover. Generally, any portionof an eligible rollover distribution that is receivedby the employee rather than directly rolled over issubject to mandatory 20 percent withholding.

The administrator of a defined benefit pen-sion plan must provide a written explanation ofthe rollover and withholding rules (and, if applic-able, the rules regarding the special tax ratesdescribed below) to an employee within a certainperiod before an eligible rollover distributionbecomes payable.

All of the rules described above regardingrollovers apply not only to employees but also todistributions to a deceased employee's survivingspouse and distributions to a spouse or formerspouse pursuant to a domestic relations order.However, rollovers with respect to a survivingspouse may only be made to an IRA, not to adefined contribution plan.


Same as defined benefit pension plansdescribel above.

2727

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Section 403(7) plans

The same rules applicable to defined benefitpension plans apply to Section 4030) plansexcept that rollovers from Section 403(b) plansmay only be made to other Section 403(b) plansor to IRAs.

SEPs

SEPs are generally subject to the samerollover rules applicable to IRAs. Thus, any SEPdistribution is eligible to be rolled over but onlyto an IRA. In addition, there is no mandatory 20percent withholding and no requirement that adirect rollover option be provided. Finally, onlyone IRA distribution may be rolled over during a12-month period though this limitation does notapply to direct transfers between IRAs.

Section 457 plans

Distributions from Section 457(a) plans maynot be rolled over to any other type of plan.However, amounts to which an employee is enti-tled may be transferred directly from one Section457(a) plan to another Section 457(a) plan.

Distribution of after-tax contributions

As discussed above, in general, a distributionfrom a deferred compensation plan is taxable tothe recipient except to the extent that the distribu-tion is considered to be a return of the employee'safter-tax contributions. Thus, in the case of plansthat permit after-tax employee contributions, it isnecessary to determine the amount of a distribu-tion that is considered to consist of after-taxemployee distributions.

28

Prior to the Tax Reform Act of 1986, the lawpermitted, under certain circumstances, the firstdistributions from a deferred compensation planto be considered to be after-tax employee contri,butions. Thus, employees could generally receiveon a nontaxable basis all of their after-taxemployee contributions prior to receiving anytaxable amounts. (One of the rules that permittedsuch tax treatment was often referred to as the "3-year basis recovery rule.")

However, the Tax Reform Act of 1986 generallyprovided that each distribution will be treated asconsisting partially of a nontaxable return ofafter-tax employee contributions and partially oftaxable amounts. (There are "grandfather" rulespreserving the old system for certain distribu-tions.) Very generally, the proportions of nontax-able and taxable amounts will be based on thetotal amount of each to which the employee isentitled under the plan.

Special tax rates applicable to lump sumdistributions

In general, a lump sum distribution from adefined benefit pension plan or defined contribu-tion plan is eligible for taxation at lower rates ifno part of the distribution is rolled over. A lumpsum distribution is generally a single distributionof all amounts that an employee is .entitled tounder the plan (and under certain other plansmaintained by the emplo);er). In addition, to be alump sum distribution, a distribution must bemade (1) on account of the employee's death, (2)after the employee attains age 591/2, or (3) onaccount of the employee's separation from ser-vice.

In order to qualify for taxation at lower rates,the lump sum distribution must meet the follow-ing requirements. First, the distribution generally

* * *

must be received after the employee has attainedage 594. Second, the employee generally may nothave used the special lower tax rates with respectto any prior lump sum distribution. Third, theemployee must have been a participant in the dis-tributing plan for at least five years prior to the

year of distribution.

In general, the special lower tax rates areachieved through a rule called "5-year averaging.".

This is one of the areas where the treatment ofmoney purchase pension plans differs from thatof profit-sharing plans. In general, in determiningwhether a distribution constitutes a lump sumdistribution for purposes of the special tax rates,a money purchase pension plan is aggregatedwith a defined benefit pension plan. Accordingly,if an employee is entitled to benefits under both a

money purchase pension plan and a defined ben-efit pension plan and such employee receives atotal distribution from the former but not fromthe latter, the distribution does not constitute alump sum distribution (because it was not a totaldistribution from the combined plans). lf, howev-er, in this example, the former plan were a profit-sharing plan rather than a money purchasepension plan, the distribution described in theprevious sentence would constitute a lump sumdistribution.

The special lower tax rates do not apply toSection 403(b) plans, SEPs, or Section 457(a) plans.

Proposed legislation would eliminate the spe-cial lower tax rates, subject to an exception for indi-

viduals who were age 50 prior to January 1, 1986.

Nondiscrimination Rules

Section 457(a) plans) not favor an employer'shighly compensated employees over the employ-er's nonhighly compensated employees. SeeSections 401(a)(4), 401(k), 401(m), 403(b)(12),410(b), and 410(c) of the Internal Revenue Code.Another aspect of the nondiscrimination rules,which is contained in Section 401(a)(26) of theInternal Revenue Code, generally requires that allsuch plans cover at least the lesser of 50 employ-ees or 40 percent of the employer's employees.(Although this aspect of the rules does not applyto SEPs, typically more restrictive rules apply toSEPs under Section 408(k) of the InternalRevenue Code.)

The IRS has, with certain exceptions, suspend-ed the application of all nondiscrimination rules topublic plans until 1996 at the earliest. The excep-tions are SEPs and the part of a Section 403(b) plan

that accepts elective pretax employee contributions.

During the period prior to 1996, the IRS maywell establish special rules for public plans thattake into account their unique circumstances.When the nondiscrimination rules do becomeapplicable to public plans, it is also possible thatthey will not immediately apply to public plansthat are maintained pursuant to a collective bar-gaining agreement ratified prior to the date thatthe IRS establishes such special rules. It is alsopossible that the period during which the nondis-crimination rules do not apply to public planswill be extended beyond 1995.

Even if the nondiscrimination rules were to bemade applicable without any additional specialrules for public plans, in certain cases describedbelow the nondiscrimination rules would nothave much effect on NEA members.

Plans without highly compensated employeesNondiscrimination rules generally require

that deferred compensation plans (other than First, if NEA members are covered by their

23 29

* *

own plan and none of those members are highlycompensated employees, then with certain limitedexceptions, the plan automatically satisfies thenondiscrimination rules. Those exceptions are gen-erally SEPs and the part of a Section 403(b) planthat accepts elective pretax employee contributions.

In this regard, the following provides a verygeneral summary of the definition of a highlycompensated employee as it will apply to mostpublic educational institutions." A highly com-pensated employee includes any employee whoin the preceding year received compensation inexcess of $66,000 (indexed) or was an officer ofthe employer and received compensation inexcess of $59,400 (indexed).' Employees are alsohighly compensated if they meet one of theserequirements the current year and are in the top100 employees of the employer by compensation.Finally, if, in a year, no employee of the employermeets one of the above requirements, the highestpaid employee is considered highly compensat-ed.'

Rti les relating to employees who receive compensation in CRT:4S of575,000 fint1exedl or who are in the top 20 percent of the einployer'simiployees by compensation are not described because they rarely /wve apractical effect on public emphmers. A rule relating to employees who ownmore tluni 5 percent of the emphmer is also omitted. Technically, the defini-tion of "highly compensated employee" described in the text and in thisfootnote, which is contained in section 414(0 of the Internal Revenue Code,does not apply for purposes of we of tlw nondiscrimination tests applicableto defined benefit pension plans mid defined contribution plans. The deter-mination of highly compensated employees for purposes of that test is basedOlt all the facts and circumstances. However, it may well be reasonable touse the more precise section 414(0 definition under Ihe facts and circum-stances.

The figures set forth in the text are for 1994. The 1993 figures, which arealso rehTont for determining highly compensated employee status in 1994,an. 564,245 and 557,821, respectively. There are limits on the number ofenrployee, who must be treated as officers.

The definition of "highly compensated employee" set forth in the te.vtwould be slightly altered by pension simplification bills currently ,,endingin Congress.

Special rules for collectively bargainedplans

The second situation in which the nondis-crimination rules would not have much effect onNEA members is if the plan in which the mem-bers participate is maintained pursuant to a col-lective bargaining agreement. In general, based inpart on proposed new IRS regulations, there is astrong argument that if a collectively bargainedplan for NEA members benefits at least the lesserof 50 employees or 40 percent of the NEA mem-bers covered by the collective bargaining agree-ment, the plan automatically satisfies thenondiscrimination rules. (In fact, if a collectivelybargained plan covers NEA members employedby more than one employer, the "50 employ-ees/40 percent" rule does not apply to coverageof the NEA members.)

The most significant exceptions to this generalrule are SEPs, Section 401(k) plans with respect tothe availability and amount of pretax employeecontributions, and the part of a Section 403(b)plan that accepts elective pretax employee contri-butions. In addition, this general rule does notapply to the extent that employees of the plan orof NEA itself are covered under the plan.

Generally, defined benefit pension plans inwhich NEA members participate are not collec-tively bargained, but rather are determined bystate law. On the other hand, other types ofdeferred compensation plans maintained forNEA members are generally the product of col-lective bargaining. Because these other types ofplans are generally collectively bargained, thepotential nondiscrimination problems for NEAmembers with respect to such plans are generallylimited to SEPs and elective pretax employee con-tributions to Section 403(b) plans. Moreover, thesepotential problems can be avoided by treating allemployees in the same manner under the plan.

30

* 0

With respect to such collectively bargainedplans, eligibility requirements (such as age, service,or job classification requirements) for participationin a plan for NEA members may generally be deter-mined without regard to the nondiscriminationrules. The same is also true of the eligibility require-ments for specific levels of benefits under the plan.

Rules for noncollectively bargained plans

As noted above, the defined benefit pensionplans in which NEA members participate are gen-erally not collectively bargained and thus, if theycover any .highly compensated employee, maybecome subject to the full range of nondiscrimi-nation rules.

It is difficult to generalize with respect to theeffect of the nondiscrimination rules on suchdefined benefit pension plans. The nondiscrimi-nation rules, as they currently exist, are long,complex, and not necessarily intuitive in all cases.For example, if a plan treats all employees inexactly the same manner, one might think that thenondiscrimination rules would not raise an issue.However, that is not necessarily true. Such a planmight fail to satisfy the nondiscrimination rulesbecause of different options elected by employ-ees.

Because (1) it is difficult to generalize aboutthe nondiscrimination rules, (2) the rules may befurther delayed with respect to governmentalplans, and (3) extensive special rules may beissued with respect to governmental plans, thisreport does not discuss the nondiscriminationrules any further. It is enough to say that if theserules apply to governmental plans without signif-icant modifications, achieving and demonstratingcompliance may be quite burdensome and take asignificant amount of time. Accordingly, this is anarea that warrants monitoring.

Compensation limits

Only $150,000 (indexed) of an employee's com-pensation can be taken into account under anydeferred compensation plan other than a Section457(a) plan and possibly the part of a Section 403(b)plan that accepts elective pretax employee contribu-tions. However, this rule does not apply to publicplans until 1996 at the earliest; there is also a delayfor collectively bargained plans that could in certaincircumstances render the rule inapplicable until1997. Even when the rule begins to apply, certainemployees will be permanently exempted from itsapplication. (The application to SEPs of the delayedeffective dates described above, other than the col-lectively bargained plan provision, is unclear.)

Vesting Rules

Defined benefit pension plans and definedcontribution plans

The vesting rules applicable to defined benefitpension plans and defined contribution plansmaintained by private employers do not apply tosuch plans as maintained by state or local govern-ments. There are, however, certain vesting rulesthat do apply to public plans. First, if a plan is ter-minated or there has been a complete discontinu-ance of contributions under the plan, employees'benefits under the plan must be 100 percent vest-ed to the extent there are sufficient assets in theplan. For purposes of this rule, a "termination"includes both a partial termination and a completetermination of a plan. A partial termination mayoccur, for example, when a substantial group ofemployees who were covered by the plan areexcluded by reason of a plan amendment or byreason of being discharged by the employer. Apartial termination may also occur if the plan'sbenefits are reduced or the plan's requirements foreligibility or vesting are made more stringent.

31.3/

Under a second vesting rule, the application ofthe plan's vesting schedule must not result in dis-crimination in favor of higher paid employees.Such discrimination may occur, for example, if therate of turnover among lower paid employees issignificantly higher than the rate of turnoveramong higher paid employees. If an employeradopts a rapid vesting schedule," however, theemployer generally avoids the risk of such a find-ing of discrimination (unless the employer engagesin abusive practices such as firing employeesimmediately before they become vested).

It appears, though not clearly, that the appli-cation of this vesting nondiscrimination rule topublic plans is suspended until at least 1996under the generally applicable suspension ofnondiscrimination rules described above.

It also appears, though not clearly; that a planmaintained by a state or local government mustprovide that an employee's benefit will be 100percent vested when the employee attains theplan's normal retirement age and satisfies otherrequirements applicable under the plan such aswith respect to service for the employer oremployment with a subsequent employer. In thecase of a profit-sharing plan, the normal require-ment age provision does not apply.

If an employee does not become 100 percentvested in the benefit and thus forfeits the unvest-ed portion, the forfeited amount generally must

omeimmlim" 'Ehe following is an emple of such a rapid sclu.dule:

Completed yearsof employment Vested percentage

4

5

1011 or more

32

40'445'450`;

70';80'490.;100'4

be treated, in effect, as an employer contributionto the plan, thus decreasing the amount theemployer actually has to contribute. In the case ofa defined contribution plan, hdWever, an employ-ee's forfeiture may alternatively be used toincrease the benefits of other employees.

Section 403(b) plans

Although Section 403(b) plans are typically100 percent vested at all times, they are notrequired to be. Section 403(b) plans appear to besubject only to the vesting nondiscrimination rule(which, as noted, may not apply until at least1996).

SEPs

Contributions to SEPs must be 100 percentvested at all times.

Section 457(a) plans

There are no vesting rules applicable toSection 457(a) plans.

Portability

In general, the concept of portability relates toemployees' ability to preserve their deferred com-pensation benefits when they move to a newemployer. Discussion of this concept is dividedbelow into two general topics: asset portabilityand service portability.

Asset portability

The term "asset portability" is used in thisreport to refer to an employee's ability to move

32

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retirement benefits from a former employer'splan to a new employer's plan or to an IRA.

There are two ways to move retirement bene-fits from one plan to another plan or to an IRA.One way is by a rollover. The rollover rules aredescribed above. It should be noted, however,that a rollover to a plan (as opposed to an IRA) isonly possible if the recipient plan acceptsrollovers (which not all plans do).

The second way of moving retirement benefitsis by a direct transfer from one plan to another planor IRA. (A transfer pursuant to an employee's elec-tion of a direct rollover is not a direct transfer forthis purpose.) Transfers are permitted fromdefined contribution plans to other defined contri-bution plans or to defined benefit pension plans.Transfers from defined benefit plans to otherdefined benefit plans or to defined contributionplans are permitted, but, in certain cases, only onthe condition that the transferor plan has been ter-minated, thus triggering 100 percent vesting.Transfers between Section 403(b) plans are permit-ted, as are transfers between Section 457(a) plans.Finally, SEPs are composed of IRAs, and transfersbetween IRAs are permitted.'

The transfers described above generally mayconsist of all or a portion of an employee's bene-fits under the transferor plan. However, in certaincases, restrictions on the employee's benefits thatapply under the transferor plan (such as with-drawal restrictions described above) must applyto the transferred benefits in the transferee plan.In addition, a transfer is only possible if it is per-mitted by both the transferor and transferee plan.

1111111MNIMMIMThe transfers described above are the most common. Under certain

ctonNtances, transfers not described above may also be permitted.

Service portability

The concept of service portability is generallyrelevant only to defined benefit pension plans. Anemployee's benefits under a defined benefit pen-sion plan are generally determined based on theemployee's number of years of service and com-pensation history with the employer. However, anemployer's defined benefit pension plan is gener-ally not prohibited from giving one or moreemployees credit for years of service for and/orcompensation from another employer or class ofemployers. (Some public plans may currently pro-vide credit for other governmental service withinthe same state; probably no public plan credits ser-vice for a public employer in another state.) Suchcredit would remove a significant impediment tochanging jobs. (lf, however, an employer providessuch credit to an employee under its defined bene-fit pension plan, the employer may also wish toinclude-a provision in the plan under which theemployee's benefits are reduced by the benefitsearned by the employee from the employer withrespect to which credit is being given.)

Although as noted there is no flat prohibitionagainsfsuch credit, the amount of credit a partic-ular employee may receive may be limited. Asnoted above, the $118,800 (indexed) limit general-ly is phased in over ten years of participation inthe current employer's defined benefit pensionplan; thus, employees with one year of participa-tion in such plan are limited to 51-1,880 (indexed),regardless of their years of participation in anoth-er employer's plan. Also as noted above, theaverage compensation limit is subject to a similarphase-in except that it is based on years of servicewith the current employer. Moreover, the averagecompensation limit is based on compensationfrom the current employer, without regard tocompensation from another employer.

The limit problems described in the prior

33

paragraph do not apply if the employers arerelated and thus are treated as a single employerfor the purposes of the limit. The limit problemsalso might not apply if an employee's benefitunder a prior employer's plan is transferred tothe new employer's plan; that might permit thenew employer's plan to take into account serviceand compensation with the prior employer forpurposes of the limit.

ERISA

Deferred compensation plans maintained bystate and local governments are exempt from thenon-tax rules of the Employee Retirement IncomeSecurity Act of 1974 (ERISA). Thus, such plansare exempt from the federal fiduciary rules thatgovern matters such as how trust assets areinvested. Of course, any fiduciary standardsunder state law would apply. In addition, theInternal Revenue Code requires, as a condition ofthe favorable tax treatment described above, that(1) defined benefit pension plans and definedcontribution plans be maintained for the "exclu-sive benefit" of the employer's employees (andtheir beneficiaries) and (2) transactions betweenthe employer and such plans be fair to the plan.These rules would be violated if, for example, thetrust assets are used not for the benefit of theemployees but rather for the employer's ownpurposes. Thus, the investment of trust assets, aswell as other aspects of plan operation, are sub-ject to tax rules protecting the interests of theemployees.

Due to their exemption from ERISA, govern-mental defined benefit pension plans are notinsured by the Pension Benefit GuarantyCorporation (PBGC) and, accordingly, need notpay premiums to the PBGC.

34

Miscellaneous

Advance determinations from the IRS

The IRS has established a special procedurethat employers can use to apply for an IRS deter-mination that a defined benefit pension plan ordefined contribution plan satisfies the require-ments under the Internal Revenue Code for thefavorable tax treatment, that is, a determinationthat the plan is qualified. Technically, a favorabledetermination letter does not ensure that the IRSwill not later claim that the plan is retroactivelydisqualified. However, generally, the IRS willonly do so if there has been a change in the law orin the relevant facts, the employer did not dis-close all the relevant facts in its application, or theplan was not operated in accordance with the lawand the documents submitted by the employer.

The special procedure referred to above doesnot apply to Section 403(b) plans, SEPs, or Section457(a) plans. However, employers may generallyobtain a similar letter from the IRS with respect tothese plans by submitting an application for a"private letter ruling."

Neither determination letters nor private let-ter rulings are required in order for a plan to beentitled to favorable tax treatment. However, thegreat majority of private sector employers applyfor such a letter or ruling in order to decrease thechances that the IRS will subsequently assert thatthe plan did not meet the applicable requirementsunder the Internal Revenue Code for favorabletax treatment. It is less common for governmentalemployers to seek a letter or ruling.

Programs to address rule violations

If a deferred compensation plan that isintended to satisfy the requirements for qualified

status is found to have violated those requirements,the effect can be significantly adverse. For example,employees would become taxable on amounts paidinto a trust on their behalf if and when suchamounts become substantially vested, even if theyhave not at that time received the deferred com-pensation in cash. The draconian nature of theeffects of "disqualification" has led the IRS inrecent years to develop alternative means ofaddressing violations of the qualification rules.

One of those alternative means is theVoluntary Compliance Resolution (VCR) pro-gram. The VCR program only applies to definedbenefit pension plans and defined contributionplans that have received an IRS determination let-

ter that reflects a review of the plan under lawsenacted through 1984. Moreover, it only appliesto operational violations of the qualification rules;a violation contained in a plan document is noteligible for the VCR program. Also ineligible forthe VCR program are egregious violations and"exclusive benefit violations."

Under the VCR program, an employer (1)admits in writing to the IRS that its plan has opera-tionally violated the qualification rules, (2) correctsthe violation retroactively and prospectively in amanner that satisfies the National Office of the IRS,and (3) pays a compliance fee to the IRS that variesfrom $350 to $10,000 based on a number of factors.The admission described in (1) must be madebefore the employer has been notified of an IRSexamination of the plan. If the employer and theIRS cannot agree On a method of correction, theIRS may pursue disqualification of the plan. In the

case of certain violations, the IRS has publishedmethods of correction that are acceptable, thoughnot the only acceptable methods.

The VCR program was scheduled to expireJanuary 1, 1995, but there have been informalreports that it may be made permanent.

Another alternative sanction system is theClosing Agreements Program (CAP), which, likethe VCR program, is limited to defined benefitpension plans and defined contribution plans.However, all qualification violations, includingdocumentary violations, are eligible for the CAPexcept violations involving significant discrimi-nation in favor of highly compensated employ-ees; exclusive benefit violations; and repeated,deliberate, or flagrant violations. The CAP canapply without regard to whether (1) a plan isalready under IRS examination, (2) the IRS dis-covers the violation (as opposed to the employeridentifying the issue for the IRS), or (3) the planhas a determination letter. Under the CAP, theemployer must correct the violation retroactivelyand prospectively, as in the case of the VCR pro-gram. In addition, the employer is subject to amonetary penalty that is negotiable with the IRSbut is generally based on an agreed-upon per-centage of the total taxes that would be due if theplan were disqualified. The CAP is administeredby the IRS key district offices, which are to con-sult with the IRS National Office with respect tolarge cases.

There is also a special voluntary CAP foremployers that do not qualify for the VCR pro-gram (for example, they do not have'a determina-tion letter), but who identify the violation for theIRS before being notified of an IRS examination ofthe plan. All CAP rules apply except (1) repeated,deliberate, or flagrant violations are eligible and(2) the monetary sanction is limited, though itmay still be a large number.

Finally, there is the Administrative PolicyRegarding Sanctions (APRS), which, like theother programs, only applies to defined benefitpension plans and defined contribution plans. Ingeneral, the AIRS is limited to operational viola-tions (other than exclusive benefit violations) thatmeet certain specific de mininus standards and

35 ,35

*

that are corrected as soon as they are discovered.Where the APRS applies, there is no monetarysanction, compliance fee, or other type of pay-ment to the government.

There have been informal reports that the IRSmay develop at least one set of alternative sanc-tions for Section 403(b) plans. A June article in theDaily Tax Report (published by the Bureau ofNational Affairs, Inc.) indicates that, according toa senior IRS official, the alternative system willnot be an expansion of the VCR program or theCAP, but rather will be tailored to the uniquecharacteristics of Section 403(b) plans.

Excess assets

A trust maintained in connection with adefined benefit pension plan may have assets inexcess of the amount necessary to pay out all ben-efits to which employees are entitled. (This is gen-erally not true of the other types of deferredcompensation plans because in those plans allcontributions and income generated by the con-tributions are generally allocated to the accountsof the employees.) An employer may include aclause in a plan entitling the employer to receivethe excess assets as a "reversion" if the plan is ter-minated at a time when there are excess assets.However, employees may bargain for a plan pro-vision entitling them to part or all of the excessassets.

Although a tax of up to 50 percent generallyapplies to reversions, it is generally not applicablein the case of a state or local government.

As noted above, an employer can have accessto excess assets in a defined benefit pension planwhen that plan is terminated. Prior to terminationof the plan, however, an employer is generallyprohibited by Section 401(a)(2) of the Internal

36

Revenue Code from withdrawing any of theexcess assets or generally from using any of theplan's assets for any purpose other than for theexclusive benefit of employees covered by theplan or their beneficiaries. (This "exclusive bene-fit rule," which is referred to in several placesthroughout this report, also applies to definedcontribution plans.)

The exclusive benefit rule, which was report-edly a problem for the Rhode Island pension plan(as discussed in the Introduction), can be helpfulto NEA members in that it can prevent a state orlocal government from using plan assets for itsown purposes. NEA members should be aware,however, that there is a technique that employerscan use to gain access to excess assets, assumingno contrary provision in the plan, collective bar-gaining agreement, or applicable state or locallaw. Under this technique, an employer can ter-minate a defined benefit pension plan, recoverthe excess assets, and instantaneously reestablishthe same plan. This may seem to be an elevationof form over substance, but it has been expresslypermitted by the IRS.

There are, however, conditions that the IRSplaces on use of the above technique. Essentially,those conditions are that the termination be treat-ed as a real one. Thus, for example, all plan bene-fits must be fully vested. Although the conditionsare generally beneficial to plan participants, NEAmembers may still have an interest in preventingstate or local governments from depleting aplan's excess assets. A plan without excess assetsmay easily become underfunded due to unfavor-able investment experience or even the aging ofthe covered employees. Underfunding, in turn,can jeopardize future benefit improvements andpossibly accrued benefit payments themselves.Accordingly, it may be in the interest of NEAmembers to prohibit state or local governments'access to excess assets, through, for example, spe-

3 11

* *

cific plan provisions and/or state legislation.

Actuarial assumptions

Generally, an employee's benefit under adefined benefit pension plan is stated in terms of

an amount, determined under the plan's formula,payable in a certain annuity form. However, asdiscussed above, the employees may receive theirbenefit in a different form, possibly in the form of a

lump sum. This requires the plan to establish thevalue of the employee's benefit in the basic formand to determine the amount that must be paid inthe different form so that the employee receives anequivalent value. This "equivalent value determi-nation" is based on certain actuarial assumptions,such as interest rates. These assumptions, whichgenerally must be specified in a defined benefitpension plan, can have a very significant effect onwhether the amount paid in the different formactually has an equivalent value.

Pretax employee contributions

Most nonelective contributions or benefitsprovided by an employer are based on anemployee's compensation. It is important to con-sider the effect of pretax employee contributionson the definition of compensation that is used forthis purpose. For example, an elective contribu-tion by an employee under a Section 457(a) planmight result in a smaller amount of compensationtaken into account under an employer's definedbenefit pension plan, with the result that theemployee's benefit under the defined benefit pen-sion plan is smaller.

Employees may he able to negotiate for a defi-nition of compensation that takes into accountpretax employee contributions (unless the defini-tion is fixed by state statute, for example).

However, for purposes of the limits on contribu-tions or benefits discussed above, compensationdoes not include pretax employee contributions,nor does it include any employer contributions(such as Section 414(h) pick-up contributions).Thus, even if there Is a favorable definition ofcompensation under a plan, the favorable defini-tion will not apply for purposes of the limitsdescribed above.

Proposed legislation would modify theserules. Under the proposal, elective pretaxemployee contributions to a defined contributionplan, Section 403(b) plan, Section 457 plan, orcafeteria plan would be included in the definitionof compensation for purposes of the limits oncontributions and benefits.

Social Security Taxes

Participation by an NEA member in a deferredcompensation plan can affect the applicability ofSocial Security taxes with respect to such member.

The Social Security tax has two components:(1) a tax of 6.2 percent of wages, which is for old-

age, survivors, and disability insurance (OASDI),and (2) a tax of 1.45 percent of wages, which is forhospital insurance. Each component applies toboth the employer and the employee, so that thetotal OASDI tax is 12.4 percent of wages and thetotal hospital insurance tax is 2.9 percent ofwages. Solely for purposes of the OASDI tax, nomore than $60,600 (indexed) of compensation istreated as wages subject to the tax.

The general rule is that the Social Security taxdoes not apply to employees of a state or localgovernment. There are, however, exceptions tothis general rule. First, a state or local govern-ment employee is subject to the Social Securitytax if there is in effect with respect to the service

3 7 37

performed by such employee an agreemententered into between the state and the Secretaryof Health and Human Services pursuant toSection 218 of the Social Security Act. If such anagreemenf is in existence with respect to anemployee, then the remaining portions of this dis-cussion of the applicability of Social Securitytaxes are not relevant for such an employee.

A second exception to the general rule set forthabove applies solely to the HI tax. Very generally,the hospital insurance tax applies to all state orlocal government employees other than those whowere performing "substantial and regular services"for their current employer prior to April 1, 1986.

It is the third exception that relates todeferred compensation plans. Generally, effectiveJuly 1, 1991, state or local government employeesare subject to the Social Security tax unless theyare members of a state or local government"retirement system."

Any of the deferred compensation plans dis-cussed in this reportdefined benefit pensionplans, defined contribution plans, Section 403(b)plans, SEPs, Section 457(a) plans, and Section457(f) planscan qualify as a retirement system ifthey satisfy the applicable requirements. In gener-al, with respect to an employee of a state or localgovernment, a retirement system must providebenefits that are comparable to the benefits thatwould be provided, based solely on the employ-ee's seryice for the state or local government,under the old-age portion of the OASDI programof Social Security. This determination is made onan employee-by-employee basis.

In the case of a deferred compensation planthat has a defined.contribution structure, the gen-eral "comparability to Social Security" ruledescribed above is interpreted to mean that theallocation to an employee's account must equal at

38

least 7.5 percent of the employee's compensation.(For all purposes under these rules, compensationmay be limited to base pay, and compensation inexcess of $60,600 (indexed) may be disregarded.)The law allows a deferred compensation planwith a defined benefit structure to satisfy the gen-eral "comparability to Social Security" rule in anyway, that is, the law does not establish a specificminimum benefit that is required, as in the case ofdefined contribution structures.

The law does, however, provide certain safeharbor methods of satisfying the general compa-rability rule. In general, one such safe harbor is abenefit equal to 1.5 percent multiplied by anemployee's average compensation for the lastthree years of service multiplied by years of ::er-vice. Generally, early retirement subsidies are nottaken into account in determining whether planswith a defined benefit structure satisfy the rule.For purposes of both the defined contributionand defined benefit rules, both employer andemployee contributions may be taken intoaccount.

In the case of a part-time, seasonal, or tempo-rary employees, a deferred compensation plandoes not qualify as a retirement system unless therules described above are satisfied and the planprovides such employee with a fully vested bene-fit. Generally, however, the "fully vested" require-ment is deemed to be satisfieC if, regardless ofwhether the plan has a defined benefit or adefined contribution structure, the part-time, sea-sonal, or temporary employees are entitled to abenefit that has a value at least equal to thecumulative amount the employees would be enti-tled to if they had received the defined contribu-tion minimum for each year of service (that is, 7.5percent of compensation for each year of serviceplus interest on such amount. If the plan has adefined benefit structure, the defined benefit ruledescribed above also applies.) Thus, if this 7.5

0 *

percent rule is satisfied, it is permissible for addi-tional benefits to be forfeitable.

Of course, to the extent that employees are sub-ject to the Social Security tax, their service is alsogenerally taken into account in determining theireligibility for Social Security and Medicare benefits.

Age Discrimination Rules

In 1990, Congress enacted the Older WorkersBenefit Protection Act (OWBPA) in reaction to theSupreme Court's decision in Public EmployeesRetirement System of Ohio v. Betts.

The Betts decision provided employers withbroad protection against age discrilnination suitsbased on the structure or operation of an employ-ee benefit plan. In Betts, the Supreme Court heldthat an employee benefit plan could be main-tained in a manner that discriminated againstolder employees provided that the plan was notused as a subterfuge to discriminate against olderemployees with respect to non-plan matters suchas hiring and termination of employment.

OWBPA, which amended the AgeDiscriminati:m in Employment Act of 1967(ADEA), overturned the Betts decision and alsoprovided a number of specific rules. First,OWBPA provided generally that employee bene-fits are independently subject to the age discrimi-nation prohibition contained in ADEA. OWBPAwent on to provide that discrimination under anemployee benefit plan will not be considered toexist where the "actual amount of payment madeor cost incurred on behalf of an older worker isno less than that made or incurred on behalf of ayounger worker." OWBPA cross-referenced cer-tain regulations that set forth such an equal bene-fit or equal cost standard and further providedthat the employer has the burden of prov;ng anequal benefit or equal cost justification for what

would otherwise be discrimination against olderworkers.

OWBPA also generally permitted other prac-tices without regard to whether they satisfy theequal benefit or equal cost test. Among thesepractices are (1) voluntary early retirement incen-tive plans that are consistent with the relevantpurposes of ADEA, (2) minimum age require-ments for eligibility for norrnal or early retire-ment benefits, (3) subsidized early retirementbenefits under a deferred compensation planwith a defined benefit structure, and (4) SocialSecurity supplements under a deferred compen-sation plan "with a defined benefit structure (thatis, benefits that do not exceed Social Security old-age insurance benefits and that are only payableto retirees before they become eligible for reducedor unreduced Social Security benefits).

OWBPA also generally permits certain bene-fits to reduce severance pay otherwise payable asthe result of a contingent event unrelated to age(such as the closing of a school). Specifically, thebenefits that can reduce severance pay are (1)some or, in certain circumstances, all of the retireehealth benefits received by an individual eligiblefor an immediate pension and (2) additional pen-sion benefits made available as a result of a con-tingent event unrelated to age, following whichthe individual is eligible for an immediate andunreduced pension benefit.

Under OWBPA, there is no age discriminationsolely because benefits under an employer'slong-term disability plan are reduced by pensionbenefits (other than those attributable to employ-ee contributions) that are paid to an individualwho has voluntarily elected to receive such pen-sion benefits or payable to an individual who hasattained the later of age 62 or normal retirementage under the pension plan and who is eligiblefor such pension benefits.

39

*

The OWBPA rules do not affect the continuedapplication of the ADEA rules adopted in 1986.Very generally, the latter rules provide that bene-fit accruals or allocations under a deferred com-pensation plan may not be reduced or eliminatedbecause of attainment of a specified age (such asnormal retirement age).

The new OWBPA rules do not apply to aseries of benefit payments that began prior to theOWBPA effective date (which was generallyOctober 16, 1992, for state and local governments)and that continued after the effective date with-out a substantial modification made to evade thepurposes of OWBPA.

Finally, OWBPA provides that an individualmay not waive any right under ADEA unless thewaiver is knowing and voluntary. OWBPA setsout a list of detailed minimum requirements thatmust be satisfied in order for a waiver to beknowing and voluntary, including a requirementthat the waiver not apply to rights or claims thatarise after the date of the waiver.

Basic Differences Among Plans

The following chart provides a very generalsummary of the basic elements of the five typesof deferred compensation plans. The informationprovided in the chart is subject to numerousexceptions that have been discussed above;accordingly, the chart should not be relied uponas the only guidance on any question. Except asotherwise noted below, references to taxation arereferences to the income tax, as opposed to theSocial Security tax.

40L. 0

* * *

Elements of Deferred Compensation Plans General Summary

Element

Definedbenefitpension

plans(Section401(a))

Plan pays employees retirement benefit

based on formula Yes

Definedcontribution

plans Section SE1's Section

(Section 403(b) (Section 457(a)

401(a)) plans 408(k)) plans

Plan pays employees the contributionscredited to their account, plus actualearnings on those contributions No

Trust for plan assets Yes

No taxation of any person until benefits

are distributed Yes

Distributions not rolled over are taxedto recipients except to extent of after-tax

employee contributions Yes

Under Section 414(h), pick-up contri-butions not taxed to employee Yes

Elective pretax employee contributionspermitted No

Elective after-tax employee contribu-tions permitted Yes

Social Security tax on No (except employee

contribution (if contributions and

otherwise applicable pick-up)

Social Security tax on distribution (if

otherwise applicable) No

Distributions permitted prior totermination of employment No

Distributions permitted prior totermination of employment or hardship No

Certain non-annuity disifibutions be'oreage 591/2subject to UN penalty tax Yes

Loans from plan to ernployee per-mitted, subject to limits Yes

No No No No

Yes Yes Yes Yes

Yes No Yes No

Yes Yes Yes Yes

Yes Yes Yes Yes

Yes No No No

No Yes No Yes

Yes Yes No No

No ( exceptemployee

contributionsand pick-up) Yes No Yes

No No No No

Yes Yes Yes Yes

Yes No Yes No

Yes Yes Yes No

Yes Yes No NA

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Elements of Deferred Compensation Plans General Summary (cont.)

Element

Definedbenefitpensionplans

(Section401(a))

Definedcontribution

plans(Section401(a))

Section403(b)plans

SEPs(Section408(k))

Section457(a)plans

Lesser or $118,800(indexed)

or employee'sAnnual limit on benefits 3-year average(Section 415())) compensation NA NA NA NA

Same asLesser of $30,000 Same as defined defined Lesser of

(delayed indexing) contribution plans contribution $7,500 orof 257( of plus additional plans plus 331A ofAnnual limit on contributions (Section

employee's limitation may additional 'employee's415(c) except in case of 457(a) plan) NA compensation aPPly limitation compensationIf maintained as supplement to definedbenefit pmsion plan, overall limit oncontributions and benefits applicable(Section 415(e)) NA Yes No Yes No

Limit on elective pretax Higher of $9,500or $9,240

Same asoveralllimitemployee contributions NA NA (indexed) NA above

Rollover of distribution to IRA permittedwithout taxation Yes Yes Yes Yes NoSpecial lower tax rates applicable tolump-sum distributions (5-yearaveraging) Yes Yes No No NoNondiscrimination rules applicableprior to 1996/afier 1995 No/Yes No/Yes No/Yes Yes/Yes No/No

4 242

*HEALTH AND DEPENDENT CAREASSISTANCE PLANS

Health PlansTax Treatment in General

In te NEA 1992 Benefits Survey, 89.6 percentof all respondents participated in a health planoffered by their employer. The survey also indi-cated that with respect to 95.4 percent of theseparticipants, the employer made at least a partialpayment toward the cost of health insurance. Theissue then is: What is the tax treatment of suchemployer payments and of the correspondinghealth insurance benefit payments?

The general rule is that health insurance cov-erage provided by an employer to an employee isnot taxable to the employee, regardless ofwhether the employer buys the coverage from athird party (such as a commercial insurer or anHMO) or "self-insures" by paying employees'claims out of its own assets. In addition, the reim-bursements or services that the employee receivesunder the coverage are also not taxable.

The nontaxability of health insurance cover-age and of the corresponding reimbursements orservices also applies for purposes of the SocialSecurity tax (even if this tax generally applies toan NBA member).

The one significant exception to the generalrule of nontaxability is that, under Section 105(h)

of the Internal Revenue Code, if a self-insuredhealth plan is discriminatory, "highly compensat-ed individuals" are taxable on at least a portion ofthe reimbursements provided under the plan.

For purposes of this nondiscrimination rule,a highly compensated individual is generallydefined as any employee who is among the top25 percent of the employer's employees by corn-

pensation. Thus, if no NEA member is a highlycompensated individual with respect to anemployer, the nondiscrimination rule does nothave any effect on the NEA members employedby that employer.

Even if one or more NEA members are highlycompensated individuals, the nondiscriminationrule may have no effect on a self-insured healthplan maintained for NEA members if the healthplan is maintained pursuant to a collective, bar-gaining agreement. There are arguments that col-lectively bargained health plans are or will bemade exempt from the nondiscrimination rule.

Health Benefits Trusts

In some cases, it may be desirable for NEAmembers to have health benefits providedthrough a trust to which the employer makescontributions. This type of arrangement is mostoften desirable when the employer is providinghealth benefits to retired employees. If anemployer does not make advance contributionsto a trus.t, there is a risk that the employer will nothave sufficient assets to provide retirees with thehealth benefits that were promised.

If a trust is established, it is, of course, desir-able that the trust be exempt from tax. This maybe accomplished in three principal ways. First;the employer may establish a voluntary employ-ees' beneficiary association (VEBA). A VEBA isgenerally a tax-exempt trust that provides certainbenefits such as health insurance coverage toemployees and/or retired employees. It may beadvantageous under certain circumstances for theVEBA to cover NEA members employed by morethan one employer. The advantage of such anarrangement is that the cost of group healthinsurance generally decreases as the number of

et 3 43

* * * *

covered individuals increases. The primary diffi-culty in creating such an arrangement is coordi-nating the rights and obligations of the differentemployers contributing to the VEBA.

The second means of creating a tax-exempttrust to provide health benefits is through the useof a special account within a defined benefit pen-sion plan or money purchase pension plan. Thisaccount, referred to as a Section 401(h) account,can only be used to provide health benefits toretirees and their families. In addition, contribu-tions to such an account are generally limited to25 percent of the total contributions to the pen-sion plan (other than contributions for past ser-vice) determined on a cumulative rather thanannual basis.

The third means is for the employer to form aseparate organization the sole function of whichis to receive employer and possibly employeecontributions and to provide employee andretiree health benefits. If the employer is a state ora political subdivision of a state, such an organi-zation can be structured to be tax-exempt underSection 115(1) because it is performing essentialgovernmental functions.

Health Care Continuation Rules(COBRA)

State and local governments are, with certainexceptions (generally, the District of Columbiaand employers with less than 20 employees), sub-ject to the health care continuation rules, whichare commonly referred to as "COBRA." (Thename is derived from the Act in which the healthcare continuation rules were adopted, the"Consolidated Omnibus Budget ReconciliationAct of 1985.") Under COBRA, employees oremployees' family members who lose health cov-erage from the employer due to a "qualifying

44

event" are entitled to continue to receive the cov-erage ("COBRA coverage") at their own expense(plus an extra 2 percent of the premium cost) for acertain period. That period begins with the quali-fying event and generally ends 36 months later.

Qualifying events include the following:

(a) the employee's termination ofemployment (other than by reason ofthe employee's gross misconduct) orreduction in hours of employment

(b) the employee's death(c) the divorce or legal separation of the

employee from the employee'sspouse

(d) the employee becoming entitled toMedicare benefits

(e) the employee's dependent child ceas-ing to be a dependent child for pur-poses of the employer's healthcoverage

In the case of a qualifying event described in(a), the period of COBRA coverage is generallyonly 18 months, rather than 36 months. However,generally, under the Revenue Reconciliation Actof 1989, the 18-month period is extended to 29months in the case of an individual who is deter-mined, under title II or XVI of the Social SecurityAct, to have been disabled at the time of the qual-ifying event described in (a). There are also cer-tain other situations in which the period ofCOBRA coverage varies from the 36-month/18-month rules described above.

There are also events that can cut short anindividual's right to COBRA coverage prior to themaximum 36-month/18-month, etc., periodsdescribed above. The most common such eventsare (1) the individual receiving group health cov-erage from another source if such covenv does notcontain any exclusion or limitation with respect to any

11 4

* *

preexisting condition of such individual or (2) theindividual becoming entitled to Medicare bene-fits. (The language in italics was added by theRevenue Reconciliation Act of 1989.)

An employer may be obligated, under statelaw or a collective bargaining agreement, to paysome or all of the cost of the health coverage foran individual following a qualifying event.Generally, the period during which the employerpays for the health coverage counts toward themaximum period during which the employermust offer COBRA coverage. Thus, for example,if an employer provides two months of continuedhealth coverage at no cost to an employee whohas terminated employment, such employer is

only obligated to offer COBRA coverage at theemployee's expense for an additional 16 months.

Retiree Health Benefits

NEA bargaining representatives may wish tobargain for health benefits to be provided tomembers after their retirement. In this regard,there are a number of points to consider.

First, it should be made clear in the bargain-ing agreement and in the plan documents that theemployer shall not have the power to modify theplan with respect to individuals who havealready retired. (Alternatively, the employershould have specific limited powers to modify ifthat is the result of negotiations.) Employers'ability to modify retirees' health benefits is a con-stant source of dispute and litigation as employ-ers search for ways to reduce health costs.

Second, NEA bargaining representativesshould consider bargaining for a trust to be estab-lished to which the employer makes bargained-for contributions. As discussed above, if this doesnot occur, the employer may not have sufficient

assets to provide the bargained-for benefits.

Third, NEA bargaining representatives maywish to consider structuring retiree health bene-fits so that longer-service members are rewardedwith more generous benefits. For example,retirees with less than a certain number of yearsof service may be required to pay a larger amountto receive retiree health coverage.

Americans with Disabilities Act

The Americans with Disabilities Act (ADA),passed in July 1990 and currently effective foremployers with at least 15 employees, generallyprohibits disability-based discrimination in theterms, conditions, and privileges of employment.The specific implications of the ADA for employ-ee benefit plans, particularly health plans, remainunclear. A recent notice from the EqualEmployment Opportunity Commission (EEOC)provides preliminary guidance on the applicationof the ADA to health plans, but the ultimateimpact on these and other benefit plans will prob-ably be determined by the courts.

In addition to prohibiting direct acts of dis-crimination, the ADA forbids an employer fromparticipating in any arrangement with a benefitprovider that subjects an employee to disability-based discrimination; thus, the ADA applies to anemployer's relations with an insurance company,health maintenance organization, or plan admin-istrator. The ADA also forbids an employer fromdenying benefits to an employee because of aknown disability of someone with whom theemployee has a known relationship and imposessignificant limitations on medical examinationsand inquiries by employers.

Section 501(c) of the ADA sets out qualifica-tions to the general rule of the Act that are signifi-

4 5 45

* * *

cant for health plans. That section indicates that(1) an insurer, hospital, or medical service compa-ny, health maintenance organization, or anyagent, or entity that administers benefit plans, orany similar organizations, may underwrite risks,classify risks, or administer such risks that arebased on or not inconsistent with state law; (2) anemployer may establish, sponsor, observe, oradminister the terms of a bona fide benefit planthat are based on underwriting risks, classifyingrisks, or administering such risks that are basedon or not inconsistent with state law; and (3) anemployer may establish, sponsor, observe, oradminister the terms of a bona fide benefit planthat is not subject to state insurance laws. Section501(c) also provides, however, that these qualifi-cations may not be used as a "subterfuge" toevade the ADA.

EEOC regulations provide little guidance onthe application of the ADA to employee benefitplans, and courts have only begun to address theissue. However, EEOC Notice N-915.002, issuedJune 8, 1993, provides the first official interpreta-tion of the interaction of the ADA and employeehealth plans.

The notice, issued as a directive to EEOC fieldoffices, specifies several consequences of the ADAfor health plans: (1) a disability-based distinctionin an employee health plan is permissible only ifit satisfies Section 501(c) of the ADA; (2) decisionsabout the employment of a disabled individualcannot be motivated by concerns about theimpact of the individual's disability on theemployer's health plan; (3) disabled employeesmust have equal access, to the health insuranceprovided to employees without disabilities; and(4) decisions about the employment of an individ-ual who has a relationship with a disabled personcannot be motivated by concerns about theimpact of that person's disability on the employ-er's health plan.

46

The EEOC Notice addresses only the first ofthese indetail. It indicates that if a term in ahealth plan (whether applicable to an employeeor to an employee's dependent) is a "disability-based distinction," the employer must show thatthe health plan' is bona fide and that the chal-lenged term is not a subterfuge to evade theADA.

According to the notice, a health plan term isa "disability-based distinction" if it singles out aparticular disability (such as deafness, AIDS, orschizophrenia), a discrete group of disabilities(such as cancers, muscular dystrophy, or kidneydiseases), or disabilities in general. However,health plan provisions that are not based on a dis-ability and that are applied equally to all employ-ees do not violate the ADAeven if thoseprovisions have a disparate impact on employeeswith disabilities.

Thus, blanket pre-existing condition clauses,universal limits on or exclusions from coverage ofall elective surgery or experimental drugs ortreatments, coverage limits on medical proce-dures that are not exclusively (or nearly exclu-sively) used for the treatment of a particulardisability (such as limitations on the number ofblood transfusions or X-rays), lower benefit levelsfor mental or nervous conditions than for physi-cal conditions, and lower benefit levels for healthservices defined so broadly (such as "eye care")as to apply to the treatment of many dissimilarconditions and to apply to employees with andwithout disabilities are not disability-based dis-ti_ :tions and do not violate the ADA.

Under the notice, if a health plan term is adisability-based distinction, the employer mustdemonstrate that the plan is bona fide and thatthe challenged term is not a subterfuge to evadethe ADA. A plan is a bona fide plan if, in the caseof an insured plan, it exists, pays benefits, has

* * * *

been communicated to employees, and is consis-tent with state law or if, in the case of a self-insured plan, it exists, pays benefits, and has beencommunicated to employees. A "subterfuge" is adisability-based distinction that is not justified bythe risks or costs associated with the disability.

Justifications for disability-based distinctionsthat are not subterfuges include proof (1) that theemployer has not engaged in the alleged discrim-ination; (2) that the distinction is justified by legit-imate actuarial data or by actual or reasonablyanticipated experience and that conditions withcomparable actuarial data or experience are treat-ed in the same fashion; (3) that the distinction isnecessary to ensure that the health plan satisfiescommonly accepted or legally required standardsfor fiscal soundness; (4) that.the distinction is nec-essary to prevent an unacceptable change in thecoverage of the plan or in the premiums chargedfor the plan; or (5) in the case of a distinction thatdenied coverage for a specific treatment, that thetreatment has no medical value.

Dependent CueAssistance Programs

In general, dependent care assistance provid-ed by an employer to an employee under a quali-fied program is not taxable to the employee for

purposes of either the income tax or the SocialSecurity tax. This is true regardless of whether theassistance is provided in the form of reimburse-ment of the employee's dependent care expensesor in the form of a dependent care facility provid-ed by the employer.

Favorable Tax Treatment Limitations andRequirements

In order to qualify for the favorable tax treat-ment described above, employer-provideddependent care assistance must meet certainrequirements. First, the assistance must relate toexpenses for the care of dependents of theemployee who are either under age 13 or unableto take care of themselves. (The expenses mayalso be for ordinary household services if per-formed by the same person caring for the depen-dent.) Second, such care must enable theemployee to work; that is, but for the care thatthe employees obtain, they would have to give uptheir work to care for the dependent. Third,except with respect to dependents under age 13,the care generally must either take place in theemployee's household or relate to a dependentwho lives in the household. Fourth, the care maynot be provided at an overnight camp.

Employer-provided dependent care assistancein excess of specified limits is taxable to theemployee. The basic limit is $5,000 per year($2,500 in the case of a married individual filing a

separate return). However, if the employee or theemployee's spouse earns less than $5,000 (or$2,500) during the year, the limit is reduced to theamount of earnings of the lower-earning spouse.Thus, generally, if an employee's spouse does notwork, all employer-provided dependent careassistance is taxable to the employee.

The limit applies to the amount of expensesan employee incurs during a year that are subjectto reimbursement, not to the actual reimburse-ments.

As noted above, employer-provided depen-dent care assistance must be provided under aqualified program in order to be nontaxable. In

order to be qualified, an employer's program

47

4> *

must satisfy three nondiscrimination rules. Allthree of these nondiscrimination rules are basedon the definition of highly compensated employ-ees described above.

First, the group of employees eligible for theprogram must satisfy a complicated set of testsdesigned to ensure that enough nonhighly com-pensated employees are eligible. These tests gen-erally should not present a problem for programsmaintained for NEA members. Second, benefitsunder the program must not be available on abasis that favors highly compensated employeesover nonhighly compensated employees. If theprogram for NEA members makes benefits avail-able on the same basis to all eligible employees,this second nondiscrimination rule is satisfied.

The third rule may present a problem for cer-tain NEA members. Under the third rule, theaverage value of the assistance actually receivedby the nonhighly compensated employees mustbe at least 55 percent of the average value of theassistance received by the highly compensatedemployees. There are certain special rules thatcan make the test easier to satisfy, but if the test isnevertheless not satisfied, all highly compensatedemployees are taxable on all employer-provideddependent care assistance that they receive.

Dependent Care Credit

For purposes of evaluating the advantages ofestablishing a dependent care assistance pro-gram, it is important to understand how thedependent care credit works and how the creditinteracts with an employer-provided program.

If individuals pay for their own dependentcare (rather than have their employer pay for it),the individuals are eligible for a tax credit. Thetax credit is generally equal to 20 percent of the

48

dependent care expenses paid by the individualfor the year. In order to be eligible for this credit,the expenses themselves must satisfy the require-ments described above relating to the definitionof dependent care assistance. (For example, theexpenses must be incurred in order to enable theindividual to work.)

In addition, the expenses eligible for the cred-it are subject to certain limits. The basic limits are$2,400 for an individual with one dependentbeing cared for and $4,800 for an individual withtwo or more dependents. This basic limit isreduced to the level of earnings of the lower-earn-ing spouse (if such spouse earns less than thebasic limit). So, again, generally, if one spousedoes not work, the credit is not available.

Finally, the rate of the credit is increased fortaxpayers with adjusted gross income (AGI) of$18,000 or less. The maximum rate is 30 percentfor taxpayers with AGI of $10,000 or less.

For every dollar of dependent care assistanceprovided by an employer to an employee under aqualified program, the amount of expenses eligi-ble for the credit is reduced by a dollar (but notbelow zero). For example, assume that anemployee with one dependent receives $3,000 ofemployer-provided dependent care assistanceunder a qualified program. The limit on expenseseligible for the credit would be reduced from$2,400 to zero. (It is assumed that the lower-earn-ing spouse rule has not already reduced rhelimit.) If, on the other hand, the employee hadtwo dependents, the limit would be reduced from$4,800 to $1,800. That would mean that theemployee could claim a credit of 20 percent (orhigher, depending on the employee's AGI) ofdependent care expenses up to $1,800.

0 * * *

Forms of Provision

Employer-provided dependent care assistanceis almost always provided in one of two forms: adependent care facility provided by the employeror a "cafeteria plan." The cafeteria planapproach, which is by far the most common, isdiscussed in the next section of this report,together with a discussion of how an employeeshould decide whether to use available employer-provided dependent care assistance or the depen-dent care credit.

Cafeteria PlansUnder proposed IRS regulations, employees

who have the choice between cash and a healthbenefit are treated for tax purposes as if they hadreceived the cash unless the choice is made undera cafeteria plan that is qualified under Section 125of the Internal Revenue Code. Thus, unless thechoice is made under a qualified cafeteria plan,the employees will be taxed on the value of thecash, even if they choose to receive the healthbenefit instead of the cash. The same rule appliesto a choice between cash and dependent careassistance or among cash, a health benefit, anddependent care assistance.

If the choices described above are made pur-suant to a qualified cafeteria plan, the employeeswho choose a health benefit or dependent careassistance are not treated as receiving the cashthey could have chosen. Moreover, the healthbenefit or dependent care assistance chosen by anemployee is treated as if it were provided by theemployer and thus is nontaxable to the extentdescribed above.

Examples

No cafeteria plan

Assume that an employee has a salary of$30,000. The employee's employer provides familyhealth insurance to the employee, but only if theemployee agrees to pay $1,000 of the $4,000 cost ofsuch insurance. The health insurance does not pro-vide coverage for dental or vision expenses, has a$250 deductible, and requires a 20 percent copay-ment by the employee up to a specified level.

Assume further that the employee agrees topay the $1,000 for the health insurance. Duringthe year, the employee incurs $500 of healthexpenses that are not reimbursable under theinsurance policy, either because they were notcovered (such as dental expenses) or because theywere subject to the deductible or copaymentrules. In addition, the employee pays $2,000 fordependent care expenses.

The employee in this example will receive aForm W-2 from the employer showing $30,000 aswages subject to income and Social Security tax(if applicable). The employee will be entitled to adependent care credit equal to 20 percent (assum-ing his/her AGI exceeds $18,000) of $2,000, for acredit of $400. It is assurned that the employee's$1,500 of health expenses ($1,000 for the insur-ance and $500 for other expenses) do not exceed7.5 percent of his/her AGI, so that no part of thehealth expenses is deductible under Section 213of the Internal Revenue Code.

Cafeteria plan established

Assume the same facts except that theemployer also establishes a qualified cafeteriaplan that allows employees to choose health ben-efits and/or dependent care assistance in lieu of a

49

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part of salary. This enables the employees tomake three elections prior to the beginning of theplan year. First, the employees could elect to giveup $1,000 of salary in exchange for the employerusing that $1,000 to pay the employees' share ofthe cost of the health insurance. This aspect of thecafeteria plan is often referred to as "premiumconversion." Second, the employees could electto forgo an additional $500 of salary in exchangefor the employer using that amount to reimbursethem for the $500 of uninsured health expensesthat they anticipate having. This election wouldbe made under a part of the cafeteria plan calleda "health flexible spending arrangement" or"health FSA."16 Third, under a "dependent careflexible spending arrangement" or "dependentcare FSA," the employees could elect to give upanother $2,000 of salary in exchange for theemployer using that $2,000 to reimburse them forthe $2,000 of dependent care expenses that theyanticipate having.

If the employees make these three elections,they will receive Form W-2s from the employershowing only $26,500 as wages subject to incometax and Social Security tax (if applicable)$30,000 - $1,000 $500 - $2,000 = $26,500. Thereduction of their wages by $3,500 from $30,000to $26,500 will save them income taxes of $3,500 x.15 = $525 if therare in the 15 percent income taxbracket ($980 if they are in the 28 percent incometax bracket). If Social Security taxes apply, thereduction will save them an additional .0765 x$3,500 =. $267.75. Thus, if Social Security taxesapply, their tax savings under the cafeteria planare $525 + $267.75 = $792.75 if they are in the 15percent tax bracket. This $792.75 is almost doublethe $400 tax credit, which is the only tax savingsthat they lost by participating in the cafeteriaplan.

A health FSA is considered a self-insured health plan subject to thenondiscrimination rule of Section 1()!alttot the Internal Revenue Code.

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A few facts regarding health insurance cover-age of NEA members may help put the aboveexample into perspective. According to the NEA1992 Benefits Survey, 49.9 percent of respondentsparticipating in an individual health plan and58.3 percent of respondents participating in afamily health plan contribute part of the premiumfor such plan. Among such contributors, the aver-age annual employee premium contribution was$1,080 and $1,488, respectively.

With respect to uninsured health expensesthe $500 figure in the above examplethe NEA1992 Benefits Survey showed that at least 37.1percent of the respondents did not have coveragefor vision care, at least 12.6 percent did not havedental coverage, and at least 9.3 percent did nothave coverage for prescription drugs. Moreover,although the survey did not ask for data regard-ing deductibles, coinsurance, and copayments, itis likely that these are being increased as employ-ers generally seek to shift a greater portion of ris-ing health costs onto employees.

Qualified Cafeteria Plan

In order to be qualified, a cafeteria plan mustgenerally satisfy certain requirements. The fol-lowing are the most significant of these require-ments: (1)employee election rule; (2)"use-it-or-lose- it" rule; (3)"employer-risk-of-loss" rule and(4)"no deferred compensation" rule. Althoughnondiscrimination rules generally must also besatisfied, collectively bargained plans for NEAmembers are generally exempt from these rules.

Employee election rule

In general, employees must make their elec-tions under a cafeteria plan prior to the beginningof the year. Thus, in the example described above,

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the employees must predict the amount of unin-sured health expenses that they will have duringthe year. If their prediction is too low (for exam-ple, if they elect $500 and actually have $750 ofexpenses), they have lost the opportunity toreduce their taxable salary by the excess ($250 inthis example). In other words, the cafeteria planstill provides them tax savings but not as much asit could have. If their prediction is too high, theyare subject to the "use-it-or-lose-it" rule describedbelow, which has a more adverse effect.

The requirement that elections must be madeprior to the beginning of the year is mitigated tosome extent by a rule that allows cafeteria plansto allow employees to change their electionsprospectively if during the year they have a"change in family status." The following areexamples of changes in family status drawndirectly from the IRS regulations: the marriage ordivorce of the employee, the death of the employ-ee's spouse or a dependent, the birth or adoptionof a child of the employee, the termination ofemployment (or commencement of employment)of the employee's spouse, the switching frompart-time to full-time employment status or fromfull-time to part-time status by the employee orthe employee's spouse, and the taking of anunpaid leave of absence by the employee or theemployee's spouse. Another example is a signifi-

cant change in the health coverage of the employ-ee or spouse attributable to the spouse'semployment.

As noted above, election changes permittedupon a change in family status must be prospec-tive only. In other words, an employee may only

change the amount of salary forgone after thechange in family status occurs. For example,assume the same facts described above, that is,that an employee elects to forgo $500 of salary inexchange for that amount being available foruninsured health expense reimbursement. A por-

tion of the' $500 is to be taken out of each pay-check on E pro rata basis. After six months, theemployee becomes divorced and wishes toreduce the election to zero. He/she can stop anyfurther reduction of salary, but cannot change theelection with respect to the $250 (6/12 of $500) bywhich salary has already been reduced. Withrespect to the effect of this inability to change anelection retroactively, see the discussion of theuse-it-or-lose-it rule below.

Also, a change in election that is made follow-ing a change in family status must be consistentwith the change in family status. For example,following the birth of a child, it might be consis-tent to increase one's election for dependent careassistance.

Finally, certain election changes are permitted ifthe premiums for the health insurance elected bythe employee change or the coverage is significant-ly modified during the year. For instance, in theexample described above, if the cost of the healthinsurance rose 10 percent, the employees' electionto forgo $1,000 could be adjusted automatically tocover their share of the extra cost. These rules onlyapply, however, if the employer purchases thehealth insurance from an independent third partysuch as an insurance company or an HMO.

The use-it-or-lose-it rule

Under the use-it-or-lose-it rule, if employeeselect to forgo salary in favor of a specified benefit,the forgone salary may only be used for that ben-efit. For example, assume the facts in the exampleabove. Assume further that the employees incurno uninsured health expenses during the year. Insuch a case, they simply lose the $500 of salarythat they gave up in exchange for the employeragreeing to reimburse them for up to $500 ofuninsured health expenses. The $500 may not be

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carried forward and be available to them in thenext year.

Employees' losses under the use-it-or-lose-itrule are forfeited to the employer. NEA represen-tatives should bargain to obligate the employer toreturn the losses to the employees. Under thecafeteria plan rules, the employer may return theemployees' losses to the employees as a group on,for example, a per capita basis or based on theamount of each employee's election, but notbased on the amount of each employee's loss.

The employer-risk-of-loss rule

The employer-risk-of-loss rule is a controver-sial proposed rule that only affects health FSAs.Under this rule, employees are entitled to reim-bursement of the full amount of their annual elec-tion even if they have not yet forgone thatamount of salary.

Assume the same facts in the example above.After 3 months, an employee has only forgone$125 of salary (3/12 of $500) with respect to unin-sured health expenses. However, if the employeewere to incur a $500 uninsured health expense atthat time, the employer would have to makeimmediate payment of the full $500.

Employers will clearly be concerned abouttheir risk of loss under this rule; the employee inthe above example might quit or change electionsafter receiving the $500. There are numerous waysfor an employer to reduce this risk, but no way toeliminate or even substantially eliminate it.

The no-deferred-compensation rule

A qualified cafeteria plan generally may notbe used to provide an employee with a benefit in

a later year. For example, employees may notreduce their salary in the current year inexchange for a benefit in the subsequent year.This prohibition does not, however, apply toemployee contributions to a defined contributionplan (or in certain cases to a defined benefit pen-sion plan), employer matching contributions to adefined contribution plan, certain group-term lifeinsurance, and reasonable premium rebates orpolicy dividends paid within 12 months of theend of the year.

Disadvantages of a Cafeteria Plan

The employee election rule and the use-it-or-lose-it rule are negative aspects of a cafeteria planfrom an employee's perspective. The followingare additional disadvantages.

Social Security

When employees forgo salary under a cafete-ria plan, they are reducing their wages for pur-poses of Social Security benefits (assuming SocialSecurity applies to them).

Employer cost saving

Cafeteria plans can, in certain situations (suchas in the example above), be advantageous foremployees. In other situations, employers can usecafeteria plans to shift more of the cost of healthinsurance to employees.

For example, assume that an employer pro-vides health insurance costing $4,000 to everyemployee without requiring any employee to payany part of the cost. Such an employer mightmodify its arrangement as follows. The employersimultaneously (1) provides all employees with a

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$4,000 employer "credit" that is in effect like asalary increase of $4,000, (2) requires employeeswho desire health insurance to pay the full cost ofsuch insurance, and (3) establishes a cafeteriaplan. Under the cafet nia plan, the employees caneither take the $4030 in cash or forego it if theywant health insurance. Thus, in the first year inwhich these modifications are effective, theemployees have not suffered any financial detri-ment. The next year, however, when the cost ofthe health insurance rises to, for example, $4,500,

the employer may decide that the amount of thecredit will remain at $4,000. Employees who wish

to receive health insurance must forego an addi-tional $500 of salary to receive the health insur-ance. The employer has thus shifted the burdenof the increased cost of the health insurance to the

employees.

Another effect of these types of electivearrangements is that they tempt lower-paidemployees to take cash instead of health insurance.

Dependent care credit

In certain circumstances, it will be advanta-geous for an employee to use the dependent carecredit rather than using the cafeteria plan toobtain dependent care assistance.

In general, the value of using the dependentcare assistance is the sum of (1) the individual'sincome tax bracket times the amount of depen-dent care expenses (up to the limit), plus (2) ifapplicable, 7.65 percent (the Social Security taxrate) of these expenses. For an individual in the15 percent bracket, this means the benefit is 15percent of the expenses if Social Security does notapply or 22.65 percent if Social Security applies.

' if only the hospital insurance tai applies, the figure N 1.45 penent,

rather tlunt 7.65 percent.

The value of the credit ranges meanwhile from 20percent to 30 percent of the expenses.Accordingly, for example, with respect to an indi-vidual in the 15 percent income tax bracket whois not subject to Social Security, use of the creditmay be advantageous.

The above analysis does not take into accountthe use-it-or-lose-it rule, the loss of Social Securitybenefits connected with the use of the cafeteriaplan, or the effect of the use of the cafeteria planon other federal tax provisions such as the earnedincome credit (which is affected because use ofthe exclision reduces AGI and thus can increasethe available earned income credit). Another rele-vant factor is the higher limit available withregard to dependent care assistance. For example,an employee with one dependent and $5,000 ofdependent care expenses effectively has a choicebetween a credit on expenses of $2,400, or depen-dent care assistance of $5,000.

Other Uses of Cafeteria Plans

Cafeteria plans may also be used by employ-ees with respect to group-term life insurance(including postretirement life insurance under anexception to the no-deferred-compensation rule).

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NATIONAL EDUCATION ASSOCIATION1201 Sixteenth Street, NW

Washington. PC 20036 3200

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