If an individual has a defined benefit plan and the minimum funding re

[Guest mbb]

If an individual has a defined benefit plan and the minimum funding requirement for the DB is $100,000 can this person fund $14,000 of elective deferrals into a 401(k) plan? There are no other employees other than the owner who is 55 years old and draws $100,000 of W-2 wages from the business.

[AndyH]

yes, because the deferral no longer counts towards the deduction limit.

[dmb]

I have a similar situation. I have a one life sole prop that has a DB and a 401k deferral only. For 2002 would the $12,000 deferral reduce the benefit comp used to calculate the DB benefit/contribution. Thanks.

[Mike Preston]

It depends on the definition of compensation in the document. However, there is no statutory requirement to have the deferrals reduce compensation taken into account for benefit purposes in 2002.

[AndyH]

Mike, could you elaborate on that comment please. Now I'm a little confused.

Say you have one sole propietor with no employees and his net income after 1/2 of FICA is $100,000.

His maximum deduction to a MP plan would be $20,000, correct?

Would it differ if he instead deferred $10,000 into a k plan and contributed $10,000 to a MP plan? Would he then be able to put more into a PS plan? Is that what you are saying?

Or as another example, if he defers $10,000 into a k plan, is his DB 415 limit $100,000 or $90,000?

[Mike Preston]

20k is correct into the MP.

Yes, he would still be able to put 20k into a PS (or MP) plan, with a 10000 deferral. So, his DC limit with 100k net income is really 31k for 2002, 32k for 2003 each 1000 higher if age 50 or older.

I'll change your last sentence to something like if he defers 10000 or not, the compensation that goes into the high 3 year average for 415 limit purposes is 100k in the absence of any other PS or MP contribution.

[David MacLennan]

Isn't the provision in 415c3D, that you count 401k deferrals as comp for the DC 100% limit, absent in 415b3 for the DB Hi-3 Avg limit? If so, it seems Mike's last statement would be incorrect, unless I misunderstood. Am I missing something?

AndyH, did your question address the 404a8C limit? I know you said 415, but based on my reading of 404n the 404a8C limit would be reduced by the 401k deferral, resulting in 90k deduction limit for the DB. This is for a sole proprietor case, so is not applicable to mbb initial question.

[Mike Preston]

David, this is pretty interesting. I agree with you that the Code was only changed in the "DC" section (415©). However, the definition of compensation under 415©(3) is defined in regulation section 1.415-2(d). Further, when you look at 1.415-3(a)(3), the high 3 year average for defined benefit plans, it specifically references 1.415-2(d).

So, the question is whether the latest change to the Code renders the regulation's cross reference no longer applicable.

I don't think so, or else the IRS would have identified it to us by now. Do you have anything that indicates what the IRS position is on this issue?

I find it hard to believe that they would take the approach of modifying the cross-reference. Take a participant in both a k and a DB that makes $10,000, but defers the entire amount. That person's high 3 year average will be pretty close to zero (payroll taxes only) and their DB 415 limit will be inconsequential as well. I just don't think the IRS will institute a regulation that disenfranchises this person.

We weren't talking about 404a8c (at least, I wasn't), but this is as good a time as any to do so. When you track that backwards to the definition of "earned income", I'm not seeing the corresponding change as I would have expected with respect to 404n. Hmmmmmm. That cascades back to the regulation under 415 (1.415-2(d)) so it may very well be that I will need to modify my prior answer to AndyH. But it is getting late, so I'll take up the search tomorrow.

[AndyH]

Yes, I'm questioning the definition of earned income. This is specific to a self employed person (or partner in some cases).

Does a deferral reduce earned income (thereby impacting 415 and 404) in the same manner as an employer contribution does?

[David MacLennan]

Mike, I haven't heard anything about what the IRS position may be on the validity of the cross reference in the regs. I actually had only reviewed the code section changes and hadn't given it too much thought. You would think that somebody in pension-land must have given this issue some consideration by now and come to a conclusion. I'll need to know for sure since I'm setting up quite a few 401k + DB plans for sole proprietors.

[Mike Preston]

All the ones that I'm setting up have income well in excess of 200k, so the issue has not presented itself. I'm not sure it rises to the level of a technical correction, if your interpretation is correct, but it sure would put the sole prop/partner. at a disadvantage to the S-corp/C-corp owner.

[Mike Preston]

I think I'm going to hold to my original position. I know this is tenuous and a more direct citation would be desirable, but try this one on for size. 404(n) is quite broad. It says that for 401(k) deferrals, "such elective deferrals shall not be taken into account in applying ANY such limitation to ANY other contributions". The beginning of 404(n) indicates that it will apply to "paragraph (3) ....of subsection (a)".

If we look at 404a8c, it starts by saying that it applies to plans described in paragraphs "(1), (2) or ***(3)***".

Does the reference in 404a8c to "(3)" coupled with the reference in 404(n) to "(3)" mean that 401©(2)(A)(5), which reads: "with regard to the deductions allowed by section 404 to the taxpayer" is applied without reducing earned income by elective deferrals?

I think a strong argument can be made that this was the intent of 404(n).

Will we know for sure until some clearer guidance is issued? I don't think so.

As mentioned in my last message, most of the time it doesn't make much difference, as a sole prop that has a DB along with a 401(k) is likely to have average compensation in excess of the 415 dollar limit even without resolving this issue favorably.

A freind of mine sent me the following quote from RIA, which supports this conclusion:

illustration: An owner-employee with $100,000 of earnings for 2003 (before compensation to, and contributions and deferrals for, the owner, and disregarding social security taxes) seeks to maximize deductible contributions through a 401(k). If incorporated, this would be a total of $32,000-that is, $12,000 elective deferral and $20,000 corporate profit-sharing contribution (25% of $80,000 salary). The owner pays income tax on $68,000 (salary less elective deferral).

*** If unincorporated, contributions also total $32,000-that is, $12,000 elective deferral and $20,000 of profit-sharing contribution (25% of $100,000 minus $20,000). The unincorporated owner-employee is taxed on $68,000-that is, $100,000 less deduction of $32,000.***

[AndyH]

Mike, FWIW, I think that your "ANY" references are on point and make the case for me that the deferrals are ignored for purposes beyond profit sharing limits, i.e. including DB limits.