When are deferrals excluded from ADP test due to 414v?

[Jed Macy]

Subject: Catch-up contributions permitted by §414(v)

Assume that a single employer with only one 401(k) plan allows each participant to defer up to the lesser of 25% of pay or the §402(g) limit of $13,000 during 2004; or to $16,000 if age 50 or more. [Note that the 25% limit is not in the plan document, but rather an Administrative Committee decision.]

Assume a 50 year old HCE-owner whose 2004 gross pay is $40,000 who defers $10,000 which is 25% of her pay.

When doing the 401(k) test, how much of her deferrals are included? Is it all $10,000 or just $7,000?

If, based on the above facts, the answer is that $10,000 needs to be included in the test, would it change the result if the Administrative Committee imposed a limit on HCEs only of 17.5%? The authority to impose such a limit is in the plan document, but the actual amount (i.e., 17.5%) is not.

[FundeK]

See Treas. Reg 1.414(v)-1(b)(1)(ii) which states

Employer-provided limit. An employer-provided limit is any limit on the elective deferrals an employee is permitted to make (without regard to section 414(v) and this section) that is contained in the terms of the plan, but which is not required under the Internal Revenue Code. Thus, for example, if, in accordance with the terms of the plan, highly compensated employees are limited to a deferral percentage of 10% of compensation, this limit is an employer-provided limit that is an applicable limit with respect to the highly compensated employees.

In order to be taken into account for catch-up contributions, a plan-imposed limit must be prescribed by the plan document, which in your case I don't believe it is. (without reading the exact wording in the document)

Either way, your question asks if $7,000 would be included in the test, or $10,000. This has me a little confused as $10,000 is 25% of the participant's salary. Even if the plan was expressly written to limit a participant's deferrals to 25% of pay, the entire $10,000 would be included in the test. Anything above $10,000, up to the catch-up limit, would be classified as catch-up contributions and excluded from the test.

If, based on the above facts, the answer is that $10,000 needs to be included in the test, would it change the result if the Administrative Committee imposed a limit on HCEs only of 17.5%? The authority to impose such a limit is in the plan document, but the actual amount (i.e., 17.5%) is not.

I would say no. Administrative limits on deferrals are not plan imposed limits. In this case, no deferrals would be classified as catch-up contributions until a statutory limit has been met.

Is the plan failing the test? If so, do they allow the corrective distribution to be classified as catch-up?

[QDROphile]

What limit is exceeded by the amount over $7000 and under $10,001? None that I can see if the 25% limit is in effect.

I am of the school that respects administrative limits if properly provided for in the plan document and properly effected administratively. The IRS has hedged. In the last round of determination letters, some reviewers took issue with these provisons, most did not. The IRS had to take the position that adminstrative limits are OK because it approved the methodology set forth in the plans that had them (look at the waffle language in the preamble to the catch up regulations). It may be reconsidering its position about the methodology, but the plan is good for now if it has a determination letter.

You know and I know that the plan provision was designed to help the plan administrator with compliance with the ADP test and avoidance of distributions of excesses. The catch up rules take quite a bit of pressure off the ADP test. So what if you set the HCE percentage to 17.5%? The entire $10,000 is OK because $7000 is the "regular" deferral and $3000 is the catch up for 2004.

I suspect what you are after is a higher ADP limit because of other HCEs. You want only $7000 in the ADP test for the low paid HCE in order to keep the average down and create more room for dollars of the higher paid HCEs. Your low paid HCE doesn't care because she really wants only $10,000. I think the ploy works because I think the administrative limit is just as good as an amount stated in the plan document. But it gets a bit uncomfortable explaining how the limit is set at 17.5%, especially when that number doesn't make so much sense compared to the way we used to set the number for the ADP test, which was the basis for the plan provision with the administrative authority to set the limit. It probably helps a bit if the limit is established as early in the year as possible, or better yet, before the year starts.

[Jed Macy]

FundeK, Thank you for your thorough and thoughtful response, especially the citations. Yours is the interpretation that I expected. But my goal is merely to be sure that she gets $3,000 into the plan that is not at risk of being correctively distributed. The obvious solution is to (1) have the Administrative Committee increase the maximum deferral from 25% to at least 40%, (2) have her defer $16,000 [40% x $40,000], (3) run the ADP test including her at 32.5% [$13,000 ÷ $40,000]; and (4) make the necessary corrective distributions.

Or is there a way to accomplish the goal of her getting to make the full catch-up contribution without any risk of corrective distribution and yet have her defer only $10,000?

QDROphile, yours is also a very much appreciated and thought provoking response. When the regulation says: "that is contained in the terms of the plan", I assumed that it really means that the deferral percentage limit must be "in the document". However, your interpretation that it is "contained in the terms of the plan" when the document authorizes the Administrative Committee to set limits, should be the IRS's position and would probably be the Tax Court's position. But my client does not want to sponsor the litigation on this issue especially if there is a simpler solution. Any additional thoughts would be appreciated.

[FundeK]

See the ERISA Outline book, Chapter 11, Section XI, B which states

3.b.2)e) Administrative limits on deferrals are not plan-imposed limits. Some plans do not specify an elective deferral limit, but rather authorize the implementation of administrative limits on what an employee can defer. A plan may not treat this as a plan-imposed limit for catch-up purposes. See Prop. Treas. Reg. §1.414(v)-1(b)(2)(ii). In fact, the preamble to the regulations (see part A. of the ihExplanation of Provisionslo in 66 F.R. 53555, October 23, 2001) implies that imposing a limit that is not in the plan document might cause the plan to fail to be a definite written program and to provide for a definite predetermined formula for allocating contributions. The definite written program and predetermined allocation formula requirements might not be violated, however, if there are written criteria in the document regarding administrative limits (e.g., the administrator might cap the deferral rates of HCEs in an attempt to prevent a violation of the ADP test). Nonetheless, under an administrative limit, no portion of the participant™s elective deferrals will be treated as catch-up contributions unless one of the statutory limits (i.e., IRC §401(a)(30) or IRC §415©) is exceeded or, in the case of an HCE, the ADP limit (see 4.a. below) is exceeded.

Just throwing Sal's perspective in the mix.

Or is there a way to accomplish the goal of her getting to make the full catch-up contribution without any risk of corrective distribution and yet have her defer only $10,000?

Good question! Does the company not want to have a deferral limit in the plan document?

[Jed Macy]

FundeK, thanks for the quote from Sal. He has a very experienced eye. Neither I nor the company want to amend the plan as we prefer the flexibility of having such limits be set as needed by the Administrative Committee. But if that is the only way to do it, then we would.

[FundeK]

The obvious solution is to (1) have the Administrative Committee increase the maximum deferral from 25% to at least 40%

Why would you increase from 25% to 40%?

[WDIK]

If I'm following the logic of this thread, the proposed increase to 40% would be to ensure that a statutory limit was reached, thus allowing the catch-up contributions. Then excess deferrals based on the ADP test would be returned.

[FundeK]

If the plan amended their document to state that HCEs are able to defer up to 17.5% of their compensation, the deferrals above 17.5% would be treated as catch up contributions. Deferrals are treated as catch up contributions when they have either exceeded a plan imposed limit or a statutory limit. The document must allow a way for the catch-up eligible participant to make the contribution. I would the plan imposed limit up to the catch-up limit in any given year would be sufficient.

_________Compensation_______Deferrals__________________Catch-Up

HCE1____$200,000____________$13,000 (Hits 402(g) first)___$3,000

HCE2____$100,000____________$13,000 (Hits 402(g) first)___$3,000

HCE3____$40,000_____________$7,000 (Plan imposed)_____$3,000

HCE4 ____$10,000_____________$1,750 (Plan imposed)_____$3,000

Does this make sense?

[WDIK]

It does to me. I don't want to put words in anyone else's mouth, but I think that the 40% option was brought up since Jed Macy was exploring options that would allow the limits to be established by the Administrative Committe rather than requiring a percentage limit in the plan document itself.