Qualified retirement
plans are funded by contributions from employers and/or employees.
These contributions are subject to a number of annual limitations.
In defined benefit plans, some of the limits are based on the
maximum benefit that can be provided at retirement. Adherence to
these limitations is important since the qualification of the plan
is at stake.
Recently released regulations to Internal Revenue Code (IRC)
section 415 have made changes that impact plan limits effective for
plan years beginning after June 30, 2007. Let’s take a close-up look
at plan limitations and the manner in which they are calculated.
Compensation
Contribution and benefit limits are based in part upon
participants’ compensation. The maximum compensation that can be
considered for plan purposes for plan years beginning in 2007 is
$225,000. Generally, compensation for limitation purposes must
include all forms of remuneration paid to an employee. Salary
deferrals to qualified plans under any of the following IRC sections
must also be included: 401(k), 403(b), 457, 125 (cafeteria plans)
and 132(f)(4) (transportation fringe benefit plans). Compensation
also includes deemed payments to disabled participants.
Under the new regulations, compensation paid after an employee’s
termination date ("post-severance compensation") will not be
included unless (1) it is paid within 2½ months of employment
termination or by the end of the limitation year, if later, and (2)
it would have been paid had the employee remained employed.
For partners and self-employed owners of unincorporated
businesses, compensation means net earnings with certain
adjustments. Net earnings are reduced by 50% of self-employment tax
as well as employer contributions to retirement plans made on behalf
of the partner or self-employed individual. Salary deferrals are not
deducted from net earnings for limitation purposes.
In S corporations, only income that is distributed to the owner
as wages, subject to social security taxes, can be used for
retirement plan purposes. Pass-through income is not included.
Limitation Year
The measuring period for contribution and benefit limitations is
called the "limitation year" and is usually the plan year. However,
a different 12-month period may be elected by the employer. Where a
change in the limitation year results in a short plan year of less
than 12 months, the annual additions, annual benefit and
compensation limits are pro-rated accordingly. Under the new
regulations, this now applies to plans that terminate prior to the
last day of the limitation year.
Annual Additions Limit
IRC section 415(c) provides the maximum "annual additions" that
can be allocated to an individual’s account in a defined
contribution plan (profit sharing, 401(k), etc.). Annual additions
include:
- Employer contributions;
- Employee contributions (deductible or after-tax); and
- Forfeitures allocated to the participant’s account.
The annual additions limit is the lesser of:
- 100% of a participant’s compensation, or
- A specified dollar amount--for limitation years ending in
2007, the dollar limit is $45,000.
Defined Benefit Limit
Contributions to a defined benefit plan are actuarially
calculated to fund the retirement benefits provided under the plan.
Under IRC section 415(b), the annual benefit limit at normal
retirement ages between 62 and 65 is the lesser of:
- 100% of a participant’s high consecutive three-year average
compensation, or
- A specified dollar amount--for limitation years ending in
2007, the dollar limit is $180,000.
The limit is actuarially adjusted for retirement ages above 65
and below 62.
Plan Aggregation
For limitation purposes, all defined contribution plans of an
employer are treated as one plan, and all defined benefit plans of
an employer are treated as one plan.
Plans sponsored by related employers must also be aggregated for
limitation purposes, including the compensation from such related
employers. A related employer can be a controlled group of
businesses (parent-subsidiary or brother-sister groups) or an
affiliated service group. Controlled groups are connected by stock
ownership rules, while affiliated service groups are connected
through business operations, including the management of the
businesses and/or the services provided.
A section 403(b) plan will not be combined with other plans of
the same employer because a 403(b) plan is considered to be
maintained by each individual employee for section 415 purposes.
However, if a 403(b) plan participant owns more than 50% of a
business, then that business is considered to be the sponsor of the
owner’s 403(b) plan for section 415 purposes. As a result, any other
plan sponsored by such business must be combined with the owner’s
403(b) plan for limitation purposes.
Under the new regulations, plans of a predecessor employer and
plans of a formerly related employer must also be aggregated for
section 415 purposes.
Salary Deferrals
Employees are allowed to make salary deferrals to section 401(k),
403(b) and 457 plans. The annual deferral limit into these plans is
the lesser of:
- 100% of compensation, or
- $15,500 for the 2007 calendar year ($10,500 for SIMPLE plans).
Note that the deferral limit is not based on the plan year but on
the calendar year. Where an employee participates in two or more
salary deferral plans of different employers in a calendar year, it
is the employee’s responsibility to make sure he does not exceed the
annual limit. If so, he must take steps to initiate the necessary
refunds by April 15th of the following year.
Participants who are considered "highly compensated employees"
(generally 5% owners and those earning over $100,000) may be subject
to an additional deferral limit based on the plan’s average deferral
percentage (ADP) test.
Catch-Up Contributions
Individuals age 50 and over as of the last day of the calendar
year may be eligible to make additional deferrals into their salary
reduction plans, if permitted under the terms of the plan. These
"catch-up" contributions are limited to $5,000 for 2007 ($2,500 for
SIMPLE plans). Catch-up contributions are defined as deferrals in
excess of any one of the following:
- The annual dollar deferral limit ($15,500 for 2007);
- The annual additions limit ($45,000 for 2007);
- The ADP test limit; or
- Any plan imposed deferral limit.
Catch-up contributions are not counted when determining if other
limitations have been met but actually serve to extend these
limitations. Consequently, in salary deferral plans, the annual
additions limit is extended from $45,000 to $50,000 and the deferral
limit is extended from $15,500 to $20,500 for participants age 50
and over.
Contribution Deductions
One advantage of a qualified plan is that the employer
contributions to the plan are tax deductible. Separate deduction
limits apply to defined benefit plans, defined contribution plans
and a combination of the two. Contributions that are not deductible
are subject to a 10% excise tax.
The Pension Protection Act of 2006 (PPA) made a number of changes
to the contribution deduction rules.
Defined Contribution Plans
For defined contribution plans, the deduction limit is 25% of the
total plan compensation of all eligible participants. Salary
deferrals are not counted towards the 25% limit.
Defined Benefit Plans
For defined benefit plans, the contributions that are necessary
to satisfy the plan’s actuarial funding requirements can be
deducted, even if they exceed 25% of eligible compensation. PPA
liberalized the funding rules for defined benefit plans which
significantly increased deductible contribution opportunities in an
attempt to improve the funding status of such plans.
Combination of Plans
PPA changed the deduction rules for employers who maintain a
combination of defined benefit and defined contribution plans. The
previous deduction limit for combined plans was the greater of 25%
of compensation or the amount necessary to fund the defined benefit
plan. Where the defined benefit plan funding exceeded the 25% limit,
only elective deferrals could be contributed to a defined
contribution plan.
As of 2006, employers who sponsor a defined benefit plan can also
contribute and deduct up to 6% of compensation for the same
employees in a defined contribution plan even if the total
contributions exceed 25% of compensation. The new rule allows a
defined benefit plan sponsor to establish a safe harbor 401(k) plan,
if desired. This would allow all participants to defer up to the
maximum dollar amount because ADP nondiscrimination testing would
not be required.
Example: Company X sponsors
both a defined benefit and a 401(k) plan for its employees. The
required annual contribution for the defined benefit plan is
$100,000, which is approximately 30% of eligible compensation.
Prior to PPA, contributions to the 401(k) plan would be limited to
salary deferrals since they are not part of the deduction limit
calculation, and no other employer contributions to the plan could
be deducted. But as of 2006, the employer can make and deduct a
match and/or nonelective contribution of up to 6% of eligible
compensation into the 401(k) plan.
If a safe harbor notice was distributed to participants by
December 1, 2006, the plan could become a safe harbor 401(k) plan
for 2007, since 6% is more than enough to satisfy either the 3%
nonelective or the maximum 4% match safe harbor contribution
requirements.
As of 2008, defined benefit plans that are subject to the federal
Pension Benefit Guaranty Corporation (PBGC) insurance program can be
completely ignored in determining deduction limits for combinations
of plans. That means an employer will be able to deduct up to 25% of
eligible compensation in a defined contribution plan in addition to
the contribution that is necessary to fund a defined benefit plan,
regardless of the amount.
Conclusion
It is important to make certain each year that your plan’s
contributions and/or benefits are within the allowable limits.
Dollar limits are adjusted periodically for cost-of-living and
should be reviewed on an annual basis. New regulations have made
changes in the way certain limitations are calculated. Recent
increases in contribution deduction limits have provided new
opportunities for retirement planning.
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