until paid or made available. 299 Section 457 applies both to arrangements that permit employees to elect whether to defer compensation or receive it currently and those that do not permit such an election; many section 457 plans take an elective deferral approach. Over time, the rules relating to section 457 plans of State and local governments and of tax-exempt entities have diverged. Presently, section 457 plans of State and local governments operate in many cases similar to section 401(k) or other qualified retirement plans and some of the rules relating to governmental section 457 plans mirror those relating to qualified retirement plans. For example, assets under a governmental section 457 plan are required to be placed in a trust for the exclusive benefit of plan participants,300 similar to the requirements applicable to qualified retirement plans. In contrast, section 457 plans of tax-exempt organizations (like nonqualified deferred compensation plans of private companies) cannot be funded. As another example, the general rule for taxation of distributions from governmental section 457 plans (i.e., that amounts are not taxable until paid) parallels the rule applicable to qualified plans, whereas the rule applicable to distributions from 457 plans of tax-exempt employers does not. In addition, rollovers between governmental section 457 plans and other tax-favored retirement arrangements are permitted (subject to certain separate accounting requirements), whereas rollovers between 457 plans of tax-exempt employers and other types of plans are not. Reasons for Change The early withdrawal tax reflects the concern that the tax incentives for retirement savings are inappropriate unless the savings generally are not diverted to nonretirement uses. The early withdrawal tax discourages early withdrawals and also recaptures a measure of the tax benefits that have been provided. Governmental section 457 plans currently provide benefits similar to those under qualified retirement plans, thus, the same rationale for applying the early withdrawal tax to qualified retirement plans applies to governmental section 457 plans. Description of Proposal Under the proposal, the early withdrawal tax applicable to qualified retirement plans is extended to section 457 plans of State and local governments. Effective Date The proposal is effective for distributions in taxable years beginning after the date of enactment. Discussion The proposal would provide parity between the treatment of qualified retirement plans and governmental section 457 plans with respect to the early withdrawal tax. This change is consistent with other recent changes to governmental section 457 plans, including the addition of the requirement that the trust be funded and the taxation of distributions. As is the case with qualified plans, imposition of the early withdrawal tax may prevent erosion of governmental 457 plan benefits prior to when they are needed for retirement by the individuals. The proposal would also be a step toward simplification with respect to rollovers between governmental section 457 plans and other types of arrangements, by eliminating a reason for the separate accounting requirement. Imposition of the early withdrawal tax will increase the tax liability of plan participants to whom the tax applies compared with present law to the extent that participants take early withdrawals. In some cases, however, the early withdrawal tax may serve as an incentive to leave benefits in the section 457 plan until a later date, thus serving the purpose of the tax. G. Modify Prohibited Transaction Rules for Individual Retirement Arrangements ("IRAS") to Reduce Tax Shelter Transactions Present Law Roth IRAs Individuals with adjusted gross income below certain levels may make nondeductible contributions to Roth IRAS.301 The maximum annual contribution that may be made to a Roth IRA is the lesser of a certain dollar amount ($4,000 for 2005)302 or the individual's compensation for the year. An individual who has attained age 50 before the end of the taxable year may also make catch-up contributions to a Roth IRA up to a certain dollar amount ($500 for 2005).3 304 The contribution limit is reduced to the extent an individual makes contributions to any other IRA for the same taxable year. In the case of married individuals, a contribution of up to the dollar limit for each spouse may be made to a Roth IRA provided the combined compensation of the spouses is at least equal to the contributed amount. The maximum annual contribution that can be made to a Roth IRA is phased out for taxpayers with adjusted gross income over certain levels. Unlike the case with traditional IRAs, contributions to a Roth IRA may be made even after the account owner has attained age 70-2. Amounts held in a Roth IRA which are withdrawn as qualified distributions are not includible in income. A qualified distribution is a distribution that (1) is made after the fivetaxable year period beginning with the first taxable year for which the individual made a contribution to a Roth IRA; and (2) is made after attainment of age 59-1⁄2, on account of death or disability, or is made for first-time homebuyer expenses of up to $10,000. 301 Sec. 408A. 302 The Economic Growth and Tax Relief Reconciliation Act of 2001 (“EGTRRA”) increased the dollar limit on IRA contributions to $4,000 for 2005 through 2007 and $5,000 for 2008. After 2008, the limit is adjusted for inflation in $500 increments. The provisions of EGTRRA generally do not apply for years beginning after December 31, 2010. Thus, the dollar limit on annual IRA contributions returns to $2,000 in 2011. 303 Under EGTRRA, the additional amount permitted for catch-up contributions to an IRA is $500 for 2005 and $1,000 for 2006 and thereafter. As a result of the general sunset provision of EGTRRA, catch-up contributions are not permitted after 2010. 304 The contribution limits for IRAs are coordinated so that the maximum annual contribution that can be made to all of an individual's IRAs is the lesser of the dollar limit or the individual's compensation for the year. Distributions from a Roth IRA that are not qualified distributions are includible in income to the extent attributable to earnings. 305 The amount which is includible in income is also subject to an additional 10-percent early withdrawal tax unless the withdrawal made after attainment of age 59-1⁄2 is due to death or disability, is made in the form of certain periodic payments or another exception to the tax applies. Traditional IRAs 306 Annual contributions to traditional IRAS are subject to the same dollar limit ($4,000 for 2005) as contributions to Roth IRAs. 307 As under the rules relating to Roth IRAs, an annual contribution of up to the dollar limit for each spouse may be made to a traditional IRA provided the combined compensation of the spouses is at least equal to the contributed amount. An individual who has attained age 50 before the end of the taxable year may also make catch-up contributions to a traditional IRA up to a certain dollar amount ($500 for 2005). An individual may make deductible contributions to a traditional IRA up to the IRA contribution limit if neither the individual nor the individual's spouse is an active participant in an employer-sponsored retirement plan. If an individual (or the individual's spouse) is an active participant in an employer-sponsored retirement plan, the deduction is phased out for taxpayers with adjusted gross income over certain levels. 308 To the extent an individual cannot or does not make deductible contributions to an IRA or contributions to a Roth IRA, the individual may make nondeductible contributions to a traditional IRA, subject to the same limits as deductible contributions. An individual who has attained age 70-1⁄2 prior to the close of a year is not permitted to make contributions to a traditional IRA. Amounts held in a traditional IRA are includible in income when withdrawn, except to the extent the withdrawal is a return of nondeductible contributions. Additionally, amounts withdrawn prior to attainment of age 59-2 ("early withdrawals") from a traditional IRA 305 To determine the amount includible in income, a distribution that is not a qualified distribution is treated as made in the following order: (1) regular Roth IRA contributions; (2) contributions attributable to conversions of traditional IRAs (on a first-in, first-out basis); and (3) earnings. 308 Sec. 408. For 2005, the deduction phase-out ranges are as follows: (1) for single taxpayers, the range is $50,000-$60,000; (2) for married taxpayers filing jointly, the range is $70,000-$80,000; and (3) for married taxpayers filing a separate return, the range is $0-$10,000. If the individual is not an active participant in an employer-sponsored retirement plan, but the individual's spouse is, the deduction is phased out for taxpayers with adjusted gross income between $150,000 and $160,000. generally are subject to the same additional 10-percent early withdrawal tax applicable to taxable distributions from a Roth IRA unless an exception applies. Prohibited transactions 310 309 The Code prohibits certain transactions between certain tax-preferred retirement plans and a disqualified person. Traditional and Roth IRAs are subject to the prohibited transaction rules,311 312 Under the Code, if a prohibited transaction occurs, the disqualified person is subject to a two-tier excise tax. The first level tax is 15 percent of the amount involved in the transaction. The second level tax is imposed if the prohibited transaction is not corrected within a certain period and is 100 percent of the amount involved. Amount involved generally means the greater of the amount of money and the fair market value of the other property given or the amount of money and the fair market value of the other property received." 313 Prohibited transactions include certain direct or indirect transactions between a plan and a disqualified person: (1) the sale, exchange, or leasing of property; (2) the lending of money or other extension of credit; and (3) the furnishing of goods, services or facilities. Prohibited transactions also include any direct or indirect: (1) transfer to, or use by or for the benefit of a disqualified person of the income or assets of the plan; (2) in the case of a fiduciary, an act that deals with the plan's income or assets for the fiduciary's own interest or account; and (3) the receipt by a fiduciary of any consideration for the fiduciary's own personal account from any party dealing with the plan in connection with a transaction involving the income or assets of the plan. In general, “disqualified person" means: (1) a fiduciary; (2) a person providing services to the plan; (3) an employer any of whose employees are covered by the plan; (4) an employee organization any of whose members are covered by the plan; (5) a direct or indirect owner of a specified interest in such an employer or employee organization; (6) a member of the family of an individual which meets certain definitions of a disqualified person; (7) a corporation, partnership, or trust or estate of which (or in which) a specified interest is owned by certain other 311 The prohibited transaction rules under the Code also apply to other tax-favored savings vehicles, including qualified retirement plans, health savings accounts (sec. 223), medical savings accounts (sec. 220), and Coverdell education savings accounts (sec. 530). Under ERISA, similar prohibited transaction rules apply to employer-sponsored retirement plans and welfare benefit plans. In general, IRAS are not subject to ERISA. The prohibited transaction rules under the Code and ERISA do not apply to governmental plans or church plans. 312 Sec. 4975(a)-(b). 313 Sec. 4975(f)(4). |