Order Code RS21451
Updated January 19, 2006
CRS Report for Congress
Received through the CRS Web
Retirement Savings Accounts: President’s
Budget Proposal for FY2006
Patrick J. Purcell
Specialist in Social Legislation
Domestic Social Policy Division
The President’s proposed budget for FY2006 would establish Lifetime Savings
Accounts (LSAs) that could be used for any type of saving, and from which withdrawals
could be made at any time, and Retirement Savings Accounts (RSAs) that could be used
for retirement saving. In addition, beginning in 2006, several kinds of employersponsored retirement plans would be consolidated into Employer Retirement Savings
Accounts (ERSAs). Qualification rules in the tax code would be simplified, while other
rules governing ERSAs would conform substantially to those that apply to §401(k)
plans. This report will be updated as further legislative developments occur.
Lifetime Savings Accounts. Individuals of any age could contribute up to
$5,000 annually, indexed to inflation, to a Lifetime Savings Account (LSA), regardless of
whether they had any earnings that year. No upper income limit would apply to LSA
participants. Contributions would not be deductible, but investment earnings would
accumulate tax-free. Distributions from the account would be tax-free, regardless of the
individual’s age or the purpose for which the distribution was used. There would be no
required distributions from LSAs during the account owner’s lifetime. The annual
contribution limit of $5,000 would apply to all Lifetime Savings Accounts in an
individual’s name, but contributions over this amount could be made to accounts owned
by others. An account in a child’s name would become the child’s property upon reaching
the age of majority, as defined under applicable state law. An account owner could roll
over the balance in an LSA to an LSA owned by his or her spouse, but not to anyone else.
Balances in, Coverdell Education Savings Accounts (ESAs), and Section 529
Qualified State Tuition Plans (QSTPs) could be converted to LSAs up to December 31,
2006, subject to the following rules: Amounts could be rolled into an LSA from a QSTP
only if the individual was the beneficiary of the QSTP on December 31, 2004. The
amount that could be rolled over to an LSA from an ESA would be limited to the account
value on December 31, 2004, plus any contributions to and earnings on the accounts in
2005. The amount that could be rolled over to any LSA from a QSTP would be limited
to the sum of (1) the lesser of $50,000 or the amount in the QSTP as of December 31,
2004, plus (2) any contributions and earnings to the QSTP during 2005. Total rollovers
Congressional Research Service ˜ The Library of Congress
to an individual’s LSA attributable to 2005 contributions to the individual’s ESAs and
QSTPs could bot exceed $5,000, plus any earnings on those contributions.
Retirement Savings Accounts. Individuals of any age could contribute up to
$5,000 per year from earned income to a Retirement Savings Account (RSA). The
maximum annual contribution would be indexed to inflation. For a married couple, the
maximum contribution would be the lesser of annual earned income or $10,000, also
indexed to inflation No upper income limit would apply to RSA contributors.
Contributions to an RSA would not be tax-deductible, but qualified distributions would
be tax-free. Qualified distributions would be those made after age 58 or if the account
owner died or became disabled. All other distributions would be nonqualified
distributions. Nonqualified distributions in excess of contributions would be subject to
both the regular income tax and a 10% additional tax. Distributions would be deemed to
come from contributions first. Distributions from RSAs would not be required during the
account owner’s lifetime.
Current “Roth IRAs” would be renamed RSAs and would be subject to the rules for
RSAs. Owners of traditional IRAs could convert them to RSAs. Converted amounts in
excess of nondeductible contributions (the account “basis”) would be taxed as ordinary
income. Conversions before January 1, 2007, could be included in taxable income in four
yearly installments. Conversions after January 1, 2007, would be taxed in the year of the
conversion. Under current law, individuals and couples with incomes in excess of
$100,000 may not convert a traditional IRA to a Roth IRA. There would be no income
limit on conversions of traditional IRAs to RSAs. Traditional IRAs could not accept new
contributions after 2006, but “rollover IRAs” could be created to receive amounts
transferred from employer-sponsored retirement plans. Distributions from employer plans
could be rolled over to an RSA by including the rollover amount (excluding the account
basis) in gross income in the year of the conversion.
Employer Retirement Savings Accounts. Beginning in 2006, §401(k),
§403(b), and governmental §457 plans would be consolidated into Employer Retirement
Savings Accounts (ERSAs), which would be available to all employers.1 Qualification
rules under the Internal Revenue Code would be simplified. Other rules governing
ERSAs would conform substantially to those that apply to §401(k) plans. Employees
could defer wages up to $15,000 in 2006. Employees age 50 or older could defer an
additional $5,000 in 2006. Both amounts would be indexed to the Consumer Price Index
(CPI) in later years. The limit on “annual additions” (employee salary deferrals plus
employer contributions) would be the lesser of 100% of compensation or $42,000.
Employee contributions to an ERSA could be made either on a pre-tax or after-tax basis.
Distributions of after-tax employee contributions and qualified distributions of investment
earnings would be tax-free. All other distributions would subject to the income tax. The
requirement for distributions to begin at age 70½ (or retirement, if later) would apply to
ERSAs. Current §401(k) plans would be renamed ERSAs and could continue to operate
as before. Section 403(b) plans and governmental §457 plans could be operated as
ERSAs, or operated separately. If not converted to ERSAs, these plans could not accept
new contributions after 2006.
The consolidation would also include Savings Incentive Match Plans for Employees (SIMPLE
plans) and Simplified Employee Pension (SEP) plans.
Special Rule for Small Employers. Employers with 10 or fewer employees who
earned $5,000 or more during the prior year would be allowed to fund an ERSA by
contributing to a custodial account, similar to a current-law IRA, provided that the
employer’s contributions satisfy a design-based “safe harbor.” This would relieve firms
with 10 or fewer employees from most of the fiduciary obligations, reporting rules, and
disclosure requirements that apply to larger employers under the Employee Retirement
Income Security Act (ERISA), as is the case under current law for the SIMPLE IRA.
Current-law Requirements for Employer-sponsored Retirement Savings
Plans. Tax-qualified retirement plans cannot discriminate in favor of highlycompensated employees (HCEs) with regard to coverage, amount of benefits, or
availability of benefits. A “highly compensated employee” is defined in law as any
employee who owns 5% or more of the company or whose compensation exceeds
$90,000 (indexed to inflation). An employer can elect to count as HCEs only employees
who rank in the top 20% of compensation in the firm, but it must include all 5% owners.
Coverage and Nondiscrimination. To be tax-qualified, a §401(k) plan must
satisfy one of two tests: either the proportion of non-highly compensated employees
(NHCEs) covered by the plan must be at least 70% of the proportion of highly
compensated employees (HCEs) covered by the plan, or the average contribution
percentage for NHCEs must be at least 70% of the average contribution percentage for
HCEs.2 Contributions to a plan cannot discriminate in favor of HCEs. Plans that have
after-tax contributions or matching contributions are subject to the “actual contribution
percentage” (ACP) test, which measures the contribution rate to HCEs’ accounts relative
to the contribution rate to NHCEs’ accounts. Some §403(b) plans are subject to
nondiscrimination rules; §457 plans generally are not. The actual contribution percentage
of HCEs in a §401(k) plan generally cannot exceed the limits shown in Table 1.
Table 1. Maximum Average 401(k) Contributions for Highly
Nonhighly compensated employees (NHCEs)
Highly compensated employees (HCEs)
Maximum average deferral and match:
Maximum average deferral and match:
2% of pay or less
NHCE percentage X 2
2% to 8% of pay
NHCE percentage + 2%
8% of pay or more
NHCE percentage X 1.25
Note: “Deferral and match” is the sum of employer and employee contributions.
Any of three “safe-harbor” designs are deemed to satisfy the ACP test automatically
for employer matching contributions (up to 6% of compensation):
The employer matches 100% of employee elective deferrals up to 3% of
compensation, and 50% of elective deferrals between 3% and 5% of
compensation, and all employer matching contributions are fully vested.
For the purposes of the latter test, the average contribution percentage is defined as all employer
contributions divided by total compensation. A third test — that at least 70% of NHCEs must
be covered by the plan — will automatically satisfy the first test listed above.
Employer matching contributions can follow any other matching formula
that results in total matching contributions that are no less than under the
first design. All employer matching contributions vest immediately.
The employer automatically contributes an amount equal to at least 3%
of pay for all eligible NHCEs. Employer contributions vest immediately.
All §401(k) plans must satisfy an “actual deferral percentage” (ADP) test, which
measures employees’ elective-deferral rates. The same numerical limits are used as under
the ACP test. Three “safe-harbor” designs, similar to the safe-harbor designs for the ACP
test, are deemed to satisfy the ADP test automatically. In addition, “cross-testing” allows
defined-contribution plans to satisfy the nondiscrimination tests based on projected
account balances at retirement age, rather than current contribution rates. This permits
bigger contributions for older workers. Because higher-paid employees receive
proportionally smaller Social Security benefits relative to earnings than lower-paid
workers, employers are permitted to make larger contributions on earnings in excess of
the Social Security wage base ($90,000 for 2005). Regulations limit the size of the
permitted disparity in favor of workers whose earnings are above the wage base.
Vesting; “Top-heavy” Plans. Employee contributions to an employer-sponsored
plan are immediately and fully vested. Employer contributions must vest at least as
quickly as mandated under law. Under cliff vesting, employees must be fully vested in
matching contributions after three years of service and fully vested in all other employer
contributions after five years of service. Under graded vesting, employees must be 20%
vested in matching contributions after two years of service and fully vested after six years
of service. With respect to all other employer contributions, employees must be 20%
vested after three years of service and fully vested after seven years of service. Additional
requirements apply to plans in which more than 60% of the benefits accrue to “key”
employees, defined as (1) company officers whose compensation exceeds $130,000, (2)
those who own more than 5% of the company, and (3) those who own more than 1% and
have compensation that exceeds $150,000. Top heavy plans are subject to an accelerated
vesting schedule and stricter requirements for minimum benefits and contributions for
Administration’s Proposal. The President’s proposed budget for FY2006 would
substantially change several aspects of employment-based retirement savings plans.
ERSA Nondiscrimination Testing. There would be a single test for
nondiscrimination with respect to contributions. If the non-highly compensated
employees’ average contribution is 6% of pay or less, the average contribution of highlycompensated employees could be no more than twice the NHCE percentage. If the
average contribution of the non-highly compensated employees exceeds 6%, there would
be no nondiscrimination test.3 Plans sponsored by state and local governments would be
exempted. Plans sponsored by charitable organizations would be exempted unless they
permit after-tax employee contributions or make matching contributions, but all
employees would have to be allowed to participate. The ACP and ADP tests would be
repealed. A “safe harbor” plan design would satisfy the nondiscrimination test for
The contribution percentage would be calculated for each employee as the sum of all employee
and employer contributions divided by the employee’s compensation.
ERSAs. A plan would qualify under the safe harbor if all NHCEs eligible to participate
in the plan are eligible to receive fully vested employer contributions equal to at least 3%
of pay. Both matching and non-elective (i.e., automatic) employer contributions would
count toward satisfying the nondiscrimination test. However, if the employer
contributions of 3% of compensation for NHCEs are matching contributions rather than
non-elective contributions, the match formula must be one of two qualifying formulas:
An employer match of 50% of employee deferrals up to 6% of pay, or
Any alternative formula in which (a) the rate of the matching contribution
does not increase as the employee’s elective contributions increase, and
(b) the aggregate amount of matching contributions at a given rate of
elective deferrals is at least equal to the aggregate amount of matching
contributions that would be made if the match were made on the basis of
the percentages described in the first formula. Also, the rate of matching
contribution with respect to an HCE at any rate of elective contribution
could be greater than the matching rate for an NHCE.
The date for after-tax “Roth” contributions to ERSAs would be January 1, 2006.
Under current law participants in §401(k) and §403(b) plans can elect “Roth” treatment
for their contributions on January 1, 2006. “Roth” contributions would not be excluded
from income, but qualified distributions would be tax-free.
Coverage, Top-heavy Plans, Permitted Disparity, Cross-testing, and
Highly-compensated Employees. Plans would continue to be required to cover a
percentage of non-highly compensated employees that is at least 70% of the percentage
of highly compensated employees that are covered. This test would be applied in the
same manner as under current law. The average deferral percentage (ADP) test and the
average contribution percentage (ACP) test would be repealed. The current-law
top-heavy rules would be retained. The permitted disparity rules and cross-testing rules
would continue as under current law. Both the definition of compensation and the
definition of a highly-compensated employee would remain as in current law.
The Treasury Department has offered several reasons for the proposed changes to
individual retirement accounts and employer-sponsored retirement plans. They state that:
The many rules regarding eligibility, contributions, withdrawals, and tax
treatment to which savings accounts are subject create complexity and
redundancy in the tax code;
Taxpayers must periodically re-evaluate their eligibility for each type of
account as their financial circumstances change;
Non-retirement withdrawals from IRAs weaken the focus on retirement
saving. Restrictions on withdrawals and additional taxes on early
distributions discourage many taxpayers from making contributions;
Consolidating the three types of IRAs into one account, and creating a
new account that could be used for any reason would simplify the
taxpayer’s decision-making process while further encouraging savings;
Simplifying the rules, making savings opportunities universally available,
and making it easier for people to set money aside through direct deposit
would encourage financial education and retirement planning.
Policy Issues. One reason that small employers sponsor retirement plans is that
the business owners can participate in the plans, which allow them to save more for
retirement on a tax-deferred basis than they could save in an IRA. The maximum annual
salary deferral under a 401(k) plan is $14,000 in 2005, Which is $6,000 more than a
married couple can contribute to an IRA. In its budget for FY2004, the Administration
proposed maximum annual contributions to RSAs and LSAs of $7,500 per account for
each individual. Some pension specialists were concerned that small business owners
would be less likely to sponsor retirement plans for their workers if married couples could
together contribute as much as $30,000 per year to RSAs and LSAs. In response to these
concerns, the Administration reduced the proposed maximum annual contributions to
both RSAs and LSAs from $7,500 to $5,000 each. The proposal for FY2006 also would
allow firms with 10 or fewer employees to establish “custodial account” ERSA plans,
similar to SIMPLE IRAs. This would relieve very small firms of many of the
administrative tasks required of larger firms that sponsor retirement plans. As a result of
theses changes, the American Society of Pension Actuaries (ASPA) believes the proposals
“will not negatively affect small business retirement plan coverage.”4
Other analysts are concerned that the proposals would benefit mainly higher-income
individuals who do not need additional tax incentives to save for retirement, and that the
plans will substantially reduce future federal tax revenue without any net increase in total
national saving. In analyzing a similar proposal in the President’s budget for FY2004, the
Congressional Budget Office concluded that “most taxpayers would simply save the same
amount in one of the new accounts as they would have saved in one of their current tax
free accounts,” and that “people who currently have assets in taxable accounts could
reduce their tax liability by selling those assets and putting the cash from the sale into the
tax preferred accounts — an action that would have no effect on private saving.”5
Another concern is that Lifetime Savings Account would promote consumption over
savings because account balances could be withdrawn at any time for any purpose. The
American Council of Life Insurers has said that “LSAs will harm the retirement security
of American families by siphoning long-term savings into a short-term vehicle where it
would be accessed early and often for non-retirement purposes.”6 Another financial
institution has said that “LSAs target the wrong kind of savings. Because individual
savers can withdraw money for any reason at any time with no penalty, investors will have
little incentive to save long-term for financial security at retirement.”7
Bills in the 109th Congress. H.R. 1162 and S. 546 would establish retirement
savings accounts. H.R. 1163 and S. 545 and would establish lifetime savings accounts.
Congress took no action on these bills in 2005.
Administration Announces Revised Savings Proposals, ASPA, Feb. 2, 2004.
U.S. Congressional Budget Office, An Analysis of the President’s Budgetary Proposals for
Fiscal Year 2004, Mar. 2003, p. 25.
“Bush to Tinker with Proposals to Revamp Savings Plans,” Congress Daily, Jan. 30, 2004.
J. Barry Griswell, chairman, Principal Financial Group, press release, Jan. 28, 2004.