170 K compensation limit

[Guest jin.limledoux]

Can someone clarify this rule. Do you use the $170K compensation limit to determine maximum employee contribution allowed or the employer matching contribution. We track the $10,500 employee contribution limit and the employer contribution limit at $5,100. (3% match on a compensation limit of $170K). We have some employees, who may reach the 170K in June, thus they may not shelter the 10,500 max allowable contribution or the company match.

[RCK]

The employee cannot defer any earnings after they reach the $170,000 level, and employer contributions cannot be made on earnings in excess of the $170,000 level.

So if you allow employee contributions of at least 6.2%, the employee can reach the $10,500 limit before they reach the $170,000 limit. If the employer contribution is a true match, then it has to be defined as a percentage of the employee deferrals. And if you defined the match as 50% of the first 6% of ee deferrals, then the employer match would be 50% of 6% of $170,000, which equals $5,100.

It gets really interesting if you have a non-calendar year 401(k) plan. Then, the $170,000 is a plan year limit and the $10,500 is a calendar year limit, and trying to maximize the employee contributions and the employer match can become pretty challenging.

RCK

[QDROphile]

The first half of the first sentence from RCK is absolutely wrong as a statement of what the law requires.

If the last sentence of the original post is correct, the plan was designed by an idiot. More likely the plan was interpreted by someone who was misinformed.

Sorry about the strong language, but this misinterpretation of the 401(a) (17) limit has been kicking around way too long after it has been refuted.

[Medusa]

In RCK's defense, there has been more than one person confused about this issue. However, on numerous occasions the IRS has been asked this question and has responded that the limit does not apply to deferrals in this way. Most notably in the Summer 1997 issue of the IRS Western District Key Office's EP/EO Bulletin and also at 1999 ASPA Conference Q & A session.

[Guest bobclp1]

QDROphile - please explain why the employer contribution portion of the first sentence is incorrect.

[QDROphile]

The 401(a) (17) limit is not sensitive to timing. It is an annual limit. It says that for purposes of determining benefits, amounts in excess of the limit cannot be the basis of the benefit. In the most simple terms, if a money purchase pension plan says benefits shall be 15% of compensation, then 15% of the limit is the maximum benefit. 401(a) (17) says nothing about when the compensation is earned during the year. For 2001, the maximum would be $25,500. So apply that to a 401(k) deferral. Assume the plan limits deferrals to 15 percent of compensation. The 402(g) limit of $10,500 is well below $25,500. 401(a) (17 applies, but it applies by looking at the entire year, and is not a block to maximum deferrals.

And think about it from a policy point of view. What purpose would such an interpretation of 401(a)(17) serve? We joke about the law, but it does have some rationality. We all see that it is simply a math trap. By a simple reconfiguration of deferral arrangements, nobody would be limited by the wrong interpretation. So why cause gyrations of administration or screw unsuspecting particpants who are no different from their neighbors but who simply time deferrals differently during the year?

You could have a plan drafted by an idiot that provides that deferrals turn off when the 170,000th dollar of compensation is earned, but I bet you don't ever see a plan that says exactly that. What you see is plan that has a general statement about the 401(a) (17) limit and some poor plan administrator who does not understand the law possibly committing a breach of fiduciary duty by an incorrect interpretation of plan terms that unfairly limits deferrals. Or you could defend the poor soul by saying that the paln administrator has great discretion to interpret the plan and an interpretation that discriminates against the highly compensated is OK.

[Medusa]

You do have to be careful with employer contributions, though. For example, I had a plan that made a quarterly allocation rather than an annual one. For the quarter, I could only use 1/4 of the annual limit. So in effect, an individual whose compensation is not paid evenly throughout the year (as in the case of a bonus) is SOL. With the $170,000 limit and a 5% employer contribution rate, my person made $25,000 in Q1, $25,000 in Q2, $25,000 in Q3 and $80,000 in Q4 because of the bonus. Even though the individual did not reach the $170,000 cap for the year, he did reach the quarterly cap in Q4 and we could only use $42,500 of the $80,000.

[Guest Jennifer Reid]

In simpler terms, 401(a)(17) does not say that deferrals must be made from the first $170,000 of compensation. It merely applies an upper limit upon which percentage calculations must be made. For example, a person who makes $20,000 per month in compensation can defer 0% for the first 10 months of the year and then defer $5,250 for the last two months of the year to reach is 402(g) limit (if the plan so allows), and the fact that he is deferring from compensation over $170,000 does not violate 401(a)(17) because when his deferral percentage (and match percentage and/or profit sharing percentage) is calculated, the $170,000 upper limit is used. Remember, unless the plan document states otherwise, limits and calculations must be computed based on annualized numbers, even though deferrals and matching contributions may be made more frequently for administrative convenience.

[QDROphile]

Medusa:

You did not apply 1/4 of the annual limit each quarter because the law required it. You may have used 1/4 of the limit because the plan was designed that way.

The 401(a) (17) limit is apportioned when you have a short plan year, but it still applies to the entire short year, not an internal segment of the year.

[Medusa]

QDROPhle:

I believe 1.401(a)(17)-1(B)(3)(iii)(A) requires it. It's worded kind of strangely and it would appear that it might just be talking about short plan years until you look at the example. (iii)(B) contains the exception for deferrals and matches. This was run by several competent ERISA attorneys and all agreed it was an issue.

If compensation for a period of less than 12 months is used for a plan year, then the otherwise applicable annual compensation limit is reduced in the same proportion as the reduction in the 12-month period. For example, if a defined benefit plan provides that the accrual for each month in a plan year is separately determined based on the compensation for that month and the plan year accrual is the sum of the accruals for all months, then the annual compensation limit for each month is 1/12th of the annual compensation limit for the plan year. In addition, if the period for determining compensation used in calculating an employee's allocation or accrual for a plan year is a short plan year (i.e., shorter than 12 months), the annual compensation limit is an amount equal to the otherwise applicable annual compensation limit multiplied by a fraction, the numerator of which is the number of months in the short plan year, and the denominator of which is 12.

[Guest Jennifer Reid]

The example still indicates that the apportionment would be plan driven based on benefit accrual requirements in the plan. Any apportionment that is not made pursuant to specific plan provisions and based merely on the administrative choice of the employer to, say, fund the match on a quarterly or some other periodic basis, would not be consistent with the overall regs (and probably also not consistent with the plan document).

[Medusa]

I don't agree AT ALL. By the way, take a look at the defined contribution LRM's RE 401(a)(17):

If a determination period consists of fewer than 12 months the annual compensation limit is an amount equal to the

otherwise applicable annual compensation limit multiplied by

a fraction, the numerator of which is the number of months

in the short determination period, and the denominator of

which is 12.

[Guest Jennifer Reid]

And what dictates what the "determination period" is? The plan document, of course.

[Medusa]

Have fun in jail.

[Medusa]

That was rude, sorry. In retrospect, I think you may have lost sight of my example. My document DOES define the determination period as a calendar quarter, because they are making allocations on a quarterly basis. You have in fact affirmed my point. Once a "determination period" other than annual has been specified in the plan document, it is not optional as to whether I limit 401(a)(17) to 1/4 of the annual amount. That part is governed by law, not by the plan document.

[QDROphile]

Then have we come full circle for 401(k) plans that define limits (and matching contributions) on a payroll by payroll basis (which I think is a bad design for many reasons)?

Not quite the same circumstances as the original post, but food for thought. In the original post, the deferral clock simply runs out at $170,000. No one has argued in favor of that interpretation.

Thanks, Medusa, for drilling down to an interesting layer within the issues.

For clarification, note that the discussion of proration of the 401(a) (17) limit does not apply to a 401(k) plan that bases elective deferrrals and matches on payroll periods within a year. Treas. Reg. section 1.401(a)(17)-1(B)(3)(iii)(B) expressly exempts those contributions, and employee contributions, from proration. Other types of employer contributions are not mentioned in the exemption.