Pre-tax deferrals after 401(a)(17) limit

[Guest Tom Moses]

Is anyone aware of any circumstances when pre-tax elective deferrals under a 401(k) plan may continue after an employee's (otherwise) eligible compensation has exceeded the 401(a)(17) limit for that year? For instance, a highly-compensated individual who elected to defer 2%, would hit the 401(a)(17) limit prior to hitting the 402(g)

limit. Are you aware of any rulings (PLRs included) that speak to this issue?

[LCARUSI]

Let's assume an employee earns $320,000. If he/she is contributing at a rate of 2% of pay, I think he/she can contribute for the entire year. By the end of the year, the following will happen:

1) the participant will have contributed $320,000x2%=$6,400(less than $10,000).

2) the participant's contribution rate for the year is 4% ($6400/$160,000), which presumably will not violate the terms of the plan.

I see no problem with this as long as there is no specific unusual language in the Plan which might be in conflict.

[Guest Tom Moses]

My read of 401(a)(17) would prohibit the plan from attributing any elective deferrals to compensation in excess of $150,000 (as indexed).

[david shipp]

Although the statute would seem to limit compensation from which a salary deferal can be made to $160,000 (currently), the IRS is taking the position that the limit only applies to the determination of the ADP for 401(k) purposes. This was explained in the Summer 1997 issue of the Western Key District EP/EO Bulletin which set forth the following Q/A:

"Must an eligible employee cease making salary deferrals immediately once his compensation for the year reaches $160,000?

NO. . . . The employee's compensation in the above scenario has exceeded the $160,000 limit for the purposes of Reg. section 1.401(a)(17)-1©(1) and Code section 401(k)(3). However, keep in mind that the limit applies only in the denominator of the 401(k)(3) ADP fraction, NOT to the definition of compensation for deferral purposes. If the plan itself imposes a limitation on the amount of compensation taken, then the plan must follow its terms."

This same position has been stated at IRS-attended conferences.

[This message has been edited by david shipp (edited 10-07-98).]

[This message has been edited by david shipp (edited 10-07-98).]

[Wessex]

In my fairly recent experience, IRS National Office personnel have expressed a different view in informal telephone conferences. That is, that deferrals must stop once the 401(a)(17) limit is reached regardless of the percentage of compensation actually deferred. Of course, the IRS could have changed its position, and, as pointed out in the prior message, the plan document definition of compensation may require that result.

[Guest Mitch]

I participated in an ABA-CLE TeleConference "Curing What Ails You: Correcting a Retirement Plan's Problems" on 9/25/98. Joyce Kahn (Chief, Employee Plans Division VCR) stated that their are in fact "two schools of thought" on this issue. She said the IRS current position is that you DO NOT have to stop the deferral after reaching the 401(a)(17) limit as long as (1) the 402g limit is not exceeded, (2) the ADP test is passed, and (3) this practice does not violate plan terms. In this case, the IRS' position is that there has been no violation of the 401(a)(17) limit.

[Guest Tom Moses]

Was similar treatment given to the calculation of employer matching contributions?

[Guest Martin]

Just to add to the confusion, the current LRM states that the $150,000 limit applies "for determining all benefits provided under the plan."

[MWeddell]

There's a temptation in the messages posted above to say that you only need to worry about the $160,000 limit when performing the discrimination testing, but that's not quite true. Ignoring the limit entirely can lead to crediting too many contributions, most commonly a problem with too much match.

The most common example is a plan that matches 50% of the first 6% of pay deferred. A participant earns over $160,000, elects to contribute 6% or less of his or her total pay, makes $10,000 of elective deferrals, and is credited with a $5,000 match. If one looks at the situation at the end of the plan year, this participant received a 3.125% of pay match (5000/160,000) whereas all nonhighly compensated employees couldn't have received more than a 3% of pay match (50% times 6%). This results in a discriminatory benefit, right, or feature that violates Treas. Reg. 1.401(a)(4)-4. In this particular example, the employer should have limited the match to a maximum of $4,800 per plan year which would have indirectly enforced the $160,000 limit.

[david shipp]

*REVISED*

I would respectfully disagree that the benefits, rights and features determination with respect to matching contributions under 401(a)(4) is based on 401(a)(17)compensation. In defining other rights and features under 1.401(a)(4)-4 (e)(3), example (G) indicates that different rates of match will exist "if they are based on definitions of compensation or other requirements or formulas that are not substantially the same."

Under the 401(a)(4) regulations, the term "compensation" is not defined, however, the term "plan year compensation" is defined as 414(s) compensation. (Under the -2 regs dealing with DC plans, safe harbor treatment and general testing is based on "plan year compensation.")

I would submit that a single “rate of allocation of matching contributions” exists (and satifies -4) where deferrals are permitted on unlimited compensation and the matching formula is a percentage of deferrals. In this case, the matching rate would be the same for all participants since all compensation is taken into account. Of course, the ACP test will have to be run using (a)(17)-limited compensation.

(This can be distinguished from the 401(a)(4) problem where a matching contribution on a returned deferral is not forfeited. In that case, the plan's matching formula does not call for the amount of match remaining in the plan, resulting in a different matching rate for the affected HCE.)

Other opinions are solicited.

[This message has been edited by david shipp (edited 10-23-98).]

[Guest ESOPwizard]

Take an example in which an HCE earns $40,000 per month and elects to defer 6% of his compensation.

Compensation is limited to $160,000. Therefore, his deferrals for the year must equal exactly

$9600 (6% X $160,000), prior to the application of the ADP test.

IMHO it doesn't matter whether the $9600 is withheld over 4 months, 12 months, or anywhere in between

as long as not more than the 401(a)(17) limit is taken into account whne the amount of the deferral for the

plan year is calculated/. [Note: depending on how the plan document is written, it may make a difference

in his match whether the 401(k) contributions are withheld over 4 months or 12 months.]

[Guest Tom Moses]

This is the crux of the issue. Opinions vary as to whether the 401(a)(17) limit applies "before" the ADP/ACP tests, or only in the application "of" the ADP/ACP tests ... for example, see David Shipp's 10/7/98 message.

[MWeddell]

Responding to DShipp's messages, I'd agree that others' opinions would be of interest, but I'll chime in again.

DShipp's second message asserts that benefits, rights, and features (BRF) determination with respect to matching contributions under 401(a)(4) is not based on the 401(a)(17) limit on compensation. However, the first sentence of Treas. Reg. 1.401(a)(17)-1©(1) states otherwise, that the 401(a)(17) limit on compensation applies to 401(a)(4)'s nondiscrimination rules.

The 1997 EP/EO Bulletin cited in DShipp's first message, which is reprinted at paragraph 26,644 in CCH's Pension Plan Guide, doesn't address the example mentioned in my first message regarding the possibility of a discriminatory BRF if matching contributions are limited to reflect the $160,000 limit. The author of that unofficial guidance stated that the $160,000 only applies to the ADP test because he/she wasn't thinking at all about BRF testing. The author was addressing elective deferral calculations where there's scant chance of a BRF violation, which the author never discussed. I don't believe the EP/EO Bulletin squarely enough addressed the possibility of the match being a discriminatory BRF to override what seems to me to be a clear statement in the 401(a)(17) regulations.

Although I'd prefer DShipp's result, I'm inclined to stick with my claim that the example in my first message produces a discriminatory BRF.

[Guest Tom Moses]

In re: Fred Farkash

Thank you for the refocused attention on my initial request, which was for written guidance: "Are you aware of any rulings (PLRs included) that speak to this issue?"

[Guest Fred Farkash]

401(a)(17) says that annual compensation "taken into account" under the plan during the year will be limited to the 150,000 indexed, (currently 160,000). I agree with ESOPWizard that for both deferrals and match, it doesn't matter when the compensation is earned during the year so long as it doesn't exceed 160000 for the year. David Shipp and Mitch stated that a plan must follow its own limitation on compensation. ALL QUALIFIED PLANS MUST ABIDE BY THE 401(a)(17)LIMIT THEREFORE ALL QUALIFIED PLANS MUST SO LIMIT THE COMPENSATION TAKEN INTO ACCOUNT TO 160000 SO THIS IS A MOOT POINT UNLESS WE ARE TALKING ABOUT A NONQUALIFIED PLAN. All plans with qualified CODA/matches must meet both the qualification requirement of 401(a) and the specific nondiscrimintation requirements of 401k/401m to maintain qualified status. Quoting the IRS out of context on meeting a particular aspect of the regulations must not be interpreted to in any way nullify the effect of the other regulations on the code for another rule. Absent clear regulatory direction (which I believe is lacking here), it is better to err on the side of caution in these matters and observe the 401(a)(17) limit in determining both 401k and 401m contributions.

[Wessex]

Has anyone heard anything further regarding the 401(a)(17) limit and matching contributions?

[This message has been edited by Wessex (edited 04-02-99).]

[This message has been edited by Wessex (edited 04-02-99).]

[david shipp]

Despite my previous passionate responses arguing that the (a)(17) limit didn't necessarily apply with respect to determining deferrals (and matching contributions), I was apparently only half right based on the most recent pronouncement on the subject as contained in the 99 EA Gray Book.

"QUESTION #30

Other DC Issues: Application of Maximum Compensation Limit

In a 401(k) plan, does IRC Section 401(a) (17) preclude the following?

A. Employee A earns $300,000 annually. He enrolls in 401(k) calendar year plan in August, after earning $175,000. He defers $10,000 for the balance of the year.

B. Employee A earns $300,000 annually. He participates in a calendar year 401(k) plan making monthly deferrals of a flat dollar amount of 1/12 of $10,000 in 1998, even though his pay exceeded $160,000 before he was done making elective deferrals.

C. Same as B, but deferrals are a percentage of pay (3.33333%).

RESPONSE

All of the above are acceptable, assuming the plan is not drafted in such a way as to prevent it.

In situation C, for example, a plan provision permitting deferrals expressed as a percentage of compensation but not permitting deferrals expressed as a dollar amount could not accommodate deferrals on pay in excess of $160,000. Where the plan permits deferrals expressed as a dollar amount specified in the employee's salary reduction agreement, the reference to a percentage in the individual agreement is irrelevant."

I think the comments regarding option C begin to make it clear that any *percentage* election can only apply to $160,000-worth of compensation. That circumstance can be avoided, however, by electing either a flat-dollar amount of deferral which is not tied to compensation level, or electing the appropriate % that gets one to the 402(g) limit based on the (a)(17) limit. A flat dollar election would allow a participant to spread the deferral over the full plan year. The percentage approach would obviously accelerate deferrals if comp exceeded the (a)(17) limit.

If this is the case with deferrals, it should follow that the match is also affected where the overall match is a function of a % of compensation (e.g., 50% of first 6% of compensation). MWeddell's example above points out that the match in this type of formula will vary depending on whether the comp. limit is monitored. If not monitored, the match could exceed the level determined by limiting compensation to the (a)(17) limit. [i'm not sure it is a BRF issue as much as a failure to follow plan terms. In either case, however, the result is not good!]

So, this is a long response to a short question, and I now think the answer is to impose the (a)(17) limit where participant elections or plan provisions deal in percentages of compensation.

A favorite saying attributed to Yogi Berra:

It isn't what we don't know that get us in trouble. It's what we know for sure that just ain't so.

[Larry M]

[it's been a long harrowing week, so please forgive the confusion...]

Doesn't the IRS answer mean that as long as the plan allows the participant to choose a deferral which is either (1) a percentage of compensation or (2) a flat dollar amount, then, EVEN IF the particpant chooses a percentage which takes into account compensation in excess of 401(a)(17) the deferral is okay as long as the total dollar deferral is less than the 402(g) limit?