United States Individual Tax Site: The Pensions Tax Regime

The Pensions Tax Regime

The statutory tax treatment of pensions was formally legislated through the Revenue Act of 1921, which exempted interest income of stock bonus and profit-sharing plans from current taxation and deferred tax to employees until distribution. Statutes enacted since 1921 have permitted employers to deduct a reasonable amount in excess of the amount necessary to fund current pension liabilities (1928); made pension trusts irrevocable (1938); and established nondiscriminatory eligibility rules for pension coverage, contributions, and benefits (1942).

The tax treatment accorded to qualified plans provides incentives both for employers to establish such plans and for employees to participate in them. In general, a contribution to a qualified plan is immediately deductible in computing the employer's taxes but only becomes taxable to the employee on subsequent distribution from the plan. In the interim, investment earnings on the contributions are not subject to tax.

This preferential tax treatment is contingent on the employer's compliance with rules set out in the Employee Retirement Income Security Act of 1974 (ERISA) and administered by the US Department of the Treasury (under the IRC) and the US Department of Labor (under ERISA). Plans not meeting ERISA qualification requirements may also be used to provide retirement income. Nonqualified plans are generally governed by trust law rather than the tax code.

In a defined benefit plan, the employer agrees to provide the employee a nominal benefit amount at retirement based on a specified formula. The formula is usually one of three general types: a flat-benefit formula, a career-average formula, or a final-pay formula.

In a defined contribution plan, the employer makes provision for contributions to an account established for each participating employee. The final retirement benefit reflects the total of employer contributions, any employee contributions, and investment gains or losses. Sometimes the accumulated amount includes forfeitures resulting from employer contributions forfeited by employees who leave before becoming vested. As a result, the level of future retirement benefits cannot be calculated exactly in advance. Employer contributions to defined contribution plans are often based on a specific formula such as a percentage of participant salary or of company profits.

Pension plan rules govern requirements for reporting and disclosure of plan information, fiduciary responsibilities, employee eligibility for plan participation, vesting of benefits, form of benefit payment, and funding. In addition, qualified plans must satisfy a set of nondiscrimination rules (under IRC sec. 401(a)(4), sec. 410(b), and in some cases sec. 401(a)(26)) designed to insure that a plan does not discriminate in favor of highly compensated employees.

The nondiscrimination rules are satisfied through a series of complex rules that must be tested annually to ensure that the classification of employees who are eligible for participation (i.e., covered) is nondiscriminatory, and the proportion of eligible employees who actually participate in a plan is nondiscriminatory. In addition, the level of contributions and benefits under the plan(s) are tested to ensure that they do not disproportionately accrue to the highly compensated.

Pension plans must satisfy a variety of rules to qualify for tax-favored treatment. These rules are designed to protect employee rights and to guarantee that pension benefits will be available for employees at retirement. The rules govern requirements for reporting and disclosure of plan information, fiduciary responsibilities, employee eligibility for plan participation, vesting of benefits, form of benefit payment, and funding. In addition, qualified plans must satisfy a set of nondiscrimination rules (under IRC sec. 401(a)(4), sec. 410(b), and in some cases sec. 401(a)(26)) designed to insure that a plan does not discriminate in favor of highly compensated employees.

A highly compensated employee for a particular year is an employee who is a 5 per cent owner (or who was a 5 per cent owner in the preceding year), or any employee who in the prior year had compensation in excess of $95,000 (from 2005) and who, if the employer elects to apply the top 20 percent rule, was in the top 20 percent of employees on the basis of compensation for the prior year.

Pension plans generally offer retiring participants a choice between two payment options: an annuity, in which the benefit is paid out in a stream of regular payments, usually monthly and usually over the life of the participant (or lives of the participant and spouse) but sometimes over some other specified period; or in a lump sum. The type of distribution and when it is taken determines the tax treatment.

Benefits from a qualified plan payable in the form of an annuity are only included in the employee's income as payments are received. A portion of any after-tax employee contribution to the plan is considered a return of the contribution and therefore is not taxable. An individual computes the tax-free portion of each year's distribution by dividing the individual's contributions and other amounts previously taxed by a specified factor. This factor is generally tied to the age of the participant when the payments begin.

The rules apply to distributions from pension or 401(k) plans, as well as distributions from sec. 403(b) arrangements. These rules do not apply to distributions from IRAs.

A lump sum is commonly offered in defined contribution plans for distribution at retirement, death, or disability. Some defined contribution plans also provide an annuity option for their participants. However, if such an alternative exists and the benefit amount exceeds $3,500, the employer may not cash out the benefit unilaterally.

In 2005, the maximum contribution to a defined contribution plan increased to the lesser of 100% of compensation or $42,000 (in 2006, this was increased to $44,000). The maximum dollar amount will be adjusted upward for inflation in later years by $1,000 increments whenever cumulative inflation causes the limit to exceed the next higher $1,000.

For tax years beginning prior to January 1, 2000, a lump-sum distribution may be entitled to special tax treatment if it is a distribution of an employee's total accrued benefit from all plans that is paid within a single tax year and made on the occasion of the employee's death, attainment of age 591/2, or separation from the employer's service (separate treatment applies to money purchase plans). Self-employed individuals may receive lump-sum distribution treatment only in the case of death, disability, or the attainment of age 591/2. A distribution of an annuity contract from a trust or an annuity plan may be treated as a lump-sum distribution. The distribution must occur within one year of the qualified event.

A major overhaul of US pensions legislation was approved by the Senate in August, 2006, and signed into law by President George W. Bush later that month.

The Pension Protection Act 2006, which was approved in a 93-5 Senate vote, attempts to address the estimated $630 billion in underfunding in pension plans covering 45 million American workers and retirees, and is the first major change to America's pension laws for 30 years.

Under the bill, companies would be required to fund 100% of their projected pension obligations, an increase from the 90% requirement under current law. Companies that do not meet this obligation will be prohibited from increasing employee benefits and must make accelerated catch-up payments.

The bill strengthens disclosure to give workers and retirees more information about the status of their pension plan, and restricts 'golden parachute' executive compensation arrangements.

The bill also includes $60 billion in tax breaks that permanently extend pension and savings tax incentives that were part of the 2001 tax bill. This tax package includes increased contribution limits to Individual Retirement Accounts, 401(k) plans and a permanent saver's credit for lower income workers.

Although the approved legislation does not go as far as the White House had wanted, most lawmakers have welcomed the bill as an acceptable compromise.

"This bill that passed in both the House and the Senate includes about 95 percent of the compromise language we developed in the Conference Committee. It’s a package that will significantly strengthen pension funding rules, help curb record pension failures and better protect the retirement dreams of 45 million Americans," commented Sen. Mike Enzi, (R-Wy), Chairman of the Senate Health, Education, Labor and Pensions (HELP) Committee.

"Although we didn’t get everything we wanted in this bill, I am pleased the Congress will not leave this critical job unfinished as we adjourn for the August recess. The 45 million Americans directly affected by this bill deserve a greater sense of security about their retirements as we head into the end of summer," he added.

Senate Majority Leader Bill Frist (R-Tenn) also welcomed the bill, saying that the legislation will shield taxpayers from a possible multi-billion dollar taxpayer bailout of the federal Pension Benefit Guaranty Corporation, the institution that guarantees pension benefits for workers and retires from covered pension plans.

“Promises made to the American worker will be promises kept with the passage of this pension bill. We have protected the interests of retirees by strengthening pensions funding rules and making permanent the retirement security provisions from the 2001 tax bill, which is a major step toward making the president’s tax cuts permanent," Frist stated.

The bill is due to come into effect on January 1, 2008.