Application of Annual Compensation Limits on Partial Year

[Guest a1newman]

The plan document reads as follows:

"Highest Average Monthly Compensation: The highest average monthly compensation paid to you during a 60-consecutive-month period during your entire employment history. 'Compensation,' for purposes of this Plan, includes regular base salary, overtime, incentive and performance bonuses, paid sales incentives and tax-deferred contributions, up to the amount eligible under current IRS guidelines."

The amount eligible is limited by the annual compensation limit established by the IRS. Does the IRS spell out what to do for partial years and how the limits apply or is this up to each plan as to what to do? How does the limit apply for an individual who leaves the company September 30th who every single year prior to that point always reached the limit? If we take calendar years 2005 forward with the last date of employment being September 30th 2010, does the fact that the 2010 annual limit is $35K larger than the 2005 limit impact the calculation of the highest average monthly compensation? The highest average monthly compensation has a maximum of $18,833.33 for calendar years 2005-2009 and $19,416.67 for CYs 2006-2010. Is there a pro-ration done so that the average used in the example would be $19,270.83?

Thank you for any assistance you can provide on this.

[Andy the Actuary]

The 401(a)(17) regs. cover your questions. In short, the limit is generally pro-rated only if a short compensation period. For example, if the compensation measurement period is 7/1-6/30 and is changed effective 7/1/2012 so that we have 7/1/2012-12/31/2012 and thereafter the calendar year, the limit for the six months 7/1/2012-12/31/2012 is $125,000. So, suppose there is no short compensation period and a participant has pensionable compensation of $500,000 paid through the employee's termination date of January 20, 2012. If the Plan does not limit compensation to completed months, then count $250,000 for January 2012.

[Guest a1newman]

The 401(a)(17) regs. cover your questions. In short, the limit is generally pro-rated only if a short compensation period. For example, if the compensation measurement period is 7/1-6/30 and is changed effective 7/1/2012 so that we have 7/1/2012-12/31/2012 and thereafter the calendar year, the limit for the six months 7/1/2012-12/31/2012 is $125,000. So, suppose there is no short compensation period and a participant has pensionable compensation of $500,000 paid through the employee's termination date of January 20, 2012. If the Plan does not limit compensation to completed months, then count $250,000 for January 2012.

Let's be more specific as to what we have. The plan uses Highest Average Monthly Compensation during a 60-consecutive-month period during your entire employment history. The employee is a 20 yer employee with highest compensation from 10/1/2007 to 9/30/2012 where 9/30/2012 is the last day of employment. Does the annual limit for calendar year 2012 of $250K apply in any way? In any case, what are the limits for those 60 months?

[Andy the Actuary]

Let's assume a calendar year Plan Year and there are no short Plan Years or short computation periods. 401(a)(17) applies to the Plan Year compensation.

I would set the calculation up as follows:

Compensation 401(a)(17) Lesser

10-1-2007 - 12-31-2007 $225,000

1-1-2008 - 12-31-2008 $230,000

1-1-2009 - 12-31-2009 $245,000

1-1-2010 - 12-31-2010 $245,000

1-1-2011 - 12-31-2011 $245,000

1-1-2012 - 9-30-2012 $250,000 _________

/ 60

Others should weigh in if they believe this is inappropriate.

[Guest a1newman]

Let's assume a calendar year Plan Year and there are no short Plan Years or short computation periods. 401(a)(17) applies to the Plan Year compensation.

I would set the calculation up as follows:

Compensation 401(a)(17) Lesser

10-1-2007 - 12-31-2007 $225,000

1-1-2008 - 12-31-2008 $230,000

1-1-2009 - 12-31-2009 $245,000

1-1-2010 - 12-31-2010 $245,000

1-1-2011 - 12-31-2011 $245,000

1-1-2012 - 9-30-2012 $250,000 _________

/ 60

Others should weigh in if they believe this is inappropriate.

This seems high as someone who made $50K a month would end up with $150k/60 more in this scenario than if their last day of employment was 12-31-2012.

I have several scenarios in mind but didn't want to assume that they were right or wrong or the only possibilities.

Scenario 1 - use 25% of $225K limit for 2007 and 75% of $250K limit for 2012.

Scenario 2 - recognize that 100% of $225K limit in 2007 was used in the first 5 months of 2007 and that 100% of $250K limit in 2012 can be used for the 9 months pf 2012.

Scenario 3 - Use in the formula process

10-1-2007 - 9-30-2008 with $225K limit

10-1-2008 - 9-30-2009 with $230K limit

10-1-2009 - 9-30-2010 with $245K limit

10-1-2010 - 9-30-2011 with $245K limit

10-1-2011 - 9-30-2012 with $245K limit

They all appear possible although the last one implies that the 2012 limit does not apply until you have a full calendar year which appears odd on the face of things but that does not mean it is impossible.

Further scenarios might apply if the employees made $15K a month in 2007 with a bonus in March of $60K with those amounts increasing annually above the max until 2012 when $20K a month was the compensation with a $60K bonus in March. I can identify those scenarios if needed.

[Andy the Actuary]

perhaps my formatting wasn't clear -- there were supposed to be four columns

Time Period

Compensation

401(a)(17) dollar

Lesser of Compensation and 401(a)(17) dollar.

When I typed, it was in columns but blog destroyed my spacing.

[Guest a1newman]

perhaps my formatting wasn't clear -- there were supposed to be four columns

Time Period

Compensation

401(a)(17) dollar

Lesser of Compensation and 401(a)(17) dollar.

When I typed, it was in columns but blog destroyed my spacing.

I think I understand what you show. Let me take the $50K a month employee and apply what you show.

Time period 60 Mos Avg Period Comp 401(a)(17) Amount used

10-01-2007 - 12-31-2007 $150,000 $225,000 $150,000

01-01-2008 - 12-31-2008 $600,000 $230,000 $230,000

01-01-2009 - 12-31-2009 $600,000 $245,000 $245,000

01-01-2010 - 12-31-2010 $600,000 $245,000 $245,000

01-01-2011 - 12-31-2011 $600,000 $245,000 $245,000

01-01-2012 - 09-30-2012 $450,000 $250,000 $250,000

Total $1,365,000 with a 60 month average of $22,750.

If the employee worked to 12-31-2012, then the amounts used would be

Time period 60 Months Per. Comp 401(a)(17) Amount used

1-1-2008 - 12-31-2008 $600,000 $230,000 $230,000

1-1-2009 - 12-31-2009 $600,000 $245,000 $245,000

1-1-2010 - 12-31-2010 $600,000 $245,000 $245,000

1-1-2011 - 12-31-2011 $600,000 $245,000 $245,000

1-1-2012 - 12-31-2012 $450,000 $250,000 $250,000

Total $1,215,000 with a 60 month average of $20,250.

Thus my prior conclusion that the suggested scenario seems improper.

Any reactions to my suggested scenarios?

[Andy the Actuary]

perhaps my formatting wasn't clear -- there were supposed to be four columns

Time Period

Compensation

401(a)(17) dollar

Lesser of Compensation and 401(a)(17) dollar.

When I typed, it was in columns but blog destroyed my spacing.

I think I understand what you show. Let me take the $50K a month employee and apply what you show.

Time period 60 Mos Avg Period Comp 401(a)(17) Amount used

10-01-2007 - 12-31-2007 $150,000 $225,000 $150,000

01-01-2008 - 12-31-2008 $600,000 $230,000 $230,000

01-01-2009 - 12-31-2009 $600,000 $245,000 $245,000

01-01-2010 - 12-31-2010 $600,000 $245,000 $245,000

01-01-2011 - 12-31-2011 $600,000 $245,000 $245,000

01-01-2012 - 09-30-2012 $450,000 $250,000 $250,000

Total $1,365,000 with a 60 month average of $22,750.

If the employee worked to 12-31-2012, then the amounts used would be

Time period 60 Months Per. Comp 401(a)(17) Amount used

1-1-2008 - 12-31-2008 $600,000 $230,000 $230,000

1-1-2009 - 12-31-2009 $600,000 $245,000 $245,000

1-1-2010 - 12-31-2010 $600,000 $245,000 $245,000

1-1-2011 - 12-31-2011 $600,000 $245,000 $245,000

1-1-2012 - 12-31-2012 $450,000 $250,000 $250,000

Total $1,215,000 with a 60 month average of $20,250.

Thus my prior conclusion that the suggested scenario seems improper.

Any reactions to my suggested scenarios?

Nah, the plan document reads as follows:

"Highest Average Monthly Compensation: The highest average monthly compensation paid to you during a 60-consecutive-month period during your entire employment history.

Thus, at 12/31/2012, the appropriate average compensation would be $22,750. You will need to discuss the result you believe to be improper with others.

[Guest a1newman]

perhaps my formatting wasn't clear -- there were supposed to be four columns

Time Period

Compensation

401(a)(17) dollar

Lesser of Compensation and 401(a)(17) dollar.

When I typed, it was in columns but blog destroyed my spacing.

I think I understand what you show. Let me take the $50K a month employee and apply what you show.

Time period 60 Mos Avg Period Comp 401(a)(17) Amount used

10-01-2007 - 12-31-2007 $150,000 $225,000 $150,000

01-01-2008 - 12-31-2008 $600,000 $230,000 $230,000

01-01-2009 - 12-31-2009 $600,000 $245,000 $245,000

01-01-2010 - 12-31-2010 $600,000 $245,000 $245,000

01-01-2011 - 12-31-2011 $600,000 $245,000 $245,000

01-01-2012 - 09-30-2012 $450,000 $250,000 $250,000

Total $1,365,000 with a 60 month average of $22,750.

If the employee worked to 12-31-2012, then the amounts used would be

Time period 60 Months Per. Comp 401(a)(17) Amount used

1-1-2008 - 12-31-2008 $600,000 $230,000 $230,000

1-1-2009 - 12-31-2009 $600,000 $245,000 $245,000

1-1-2010 - 12-31-2010 $600,000 $245,000 $245,000

1-1-2011 - 12-31-2011 $600,000 $245,000 $245,000

1-1-2012 - 12-31-2012 $450,000 $250,000 $250,000

Total $1,215,000 with a 60 month average of $20,250.

Thus my prior conclusion that the suggested scenario seems improper.

Any reactions to my suggested scenarios?

Nah, the plan document reads as follows:

"Highest Average Monthly Compensation: The highest average monthly compensation paid to you during a 60-consecutive-month period during your entire employment history.

Thus, at 12/31/2012, the appropriate average compensation would be $22,750. You will need to discuss the result you believe to be improper with others.

If that is the way it should be applied, then the highest 60 month would be from 7-1-2007 to 6-30-2012 with an average of $24,000 as both the 2007 year and the 2012 year would have compensation greater than the limit. That result would apply whether employment ended 9-30-2012 or 12-31-2012. That average being larger than any single year's 401(a)(17) limit monthly average seems to be a troubling result.

Does http://employerbook.hypermart.net/a17.htm have an example suggesting that my suggested scenario 3 is the correct one? Here is their example:

"Example 3. Plan Y is a defined benefit plan that bases benefits on an employee's high consecutive 36 months of compensation ending within the plan year. Employee B's high 36 months are the period September 1995 to August 1998, in which Employee B earned $50,000 in each month. Assume that the annual compensation limit is first adjusted to $160,000 for plan years beginning on or after January 1, 1997. The annual compensation limit is $150,000, $150,000, and $160,000 in 1995, 1996, and 1997, respectively. To satisfy this paragraph (b), Plan Y cannot base Employee B's plan benefits for the 1998 plan year on compensation in excess of $153,333. This amount is determined by applying the applicable annual compensation limit to compensation for each of the three 12-consecutive-month periods. The September 1995 to August 1996 period is capped by the annual compensation limit of $150,000 for 1995; the September 1996 to August 1997 period is capped by the annual compensation limit of $150,000 for 1996; and the September 1997 to August 1998 period is capped by the annual compensation limit of $160,000 for 1997. The average of these capped amounts is the annual compensation limit applicable in determining benefits for the 1998 year."

Clearly that is a very different result as that $50K a month employee would have a 60 month average of $19,833.33 or more than 17% less than the suggested scenario producing $24,000.

Are there any experts who can confirm what is right?

[Hojo]

The regs say that for non-calendar years, the compensation limit is the limit in effect on the first day of the year. This also applies to calendar year plans that use a definition of compensation over a different 12-month period from the plan year (ie highest 60 month avg). Thus:

10-01-2007 - 09-30-2008 $225,000

10-01-2008 - 09-30-2009 $230,000

10-01-2009 - 09-30-2010 $245,000

10-01-2010 - 09-30-2011 $245,000

10-01-2011 - 09-30-2012 $245,000

Total $1,190,000 with a 60 month average of $19,833.

You can't double count limited plan years.

[Guest KennyH]

I agree with Hojo's interpretation and that is how we handle a similar situation. The issue is determining the appropriate "compensation" year when the participant has less than 60 months.

I was going to piggy bakc on this thread with my own comp limit question, but decided to start my own thread. Please take a looke here http://benefitslink.com/boards/index.php?showtopic=51109 and let me know what you think.

[Hojo]

Don't mean to rehash this, but this question was asked on the EA-2A exam a few times.... Fall 2010 #17, and Fall 2009 #22. The answers are consistent with my previous response in that you annual limit is based on the limit at the beginning of the 12 month period.

[Guest a1newman]

Don't mean to rehash this, but this question was asked on the EA-2A exam a few times.... Fall 2010 #17, and Fall 2009 #22. The answers are consistent with my previous response in that you annual limit is based on the limit at the beginning of the 12 month period.

I fully understand what is being stated. I do think that the approach established by I think by the IRS could lead to discrimination charges as the benefit of having an individual above the limit laid off in the second half of the year rather than after the end of the year is not tiny. The potential for discrimination charges would increase if a company routinely targets layoffs in the 2nd half of the year. No doubt some of the cost savings that one could calculate in determining cost benefit analysis of laying people off might be from this area. If it is, that might make the company more of a discrimination target.

Does anyone know why a pro rata process was not chosen?

[Hojo]

Does anyone know why a pro rata process was not chosen?

To protect against seasonal income being limited on a prorata basis, i.e. if you make $5,000 a month January - November and $200,000 in December, a pro rata limit of $240,000 would mean that there is no limit January - November and a limit of $20,000 for December so your limited 12 month salary would be $75,000 instead of $240,000.

It simply makes the regs easier. Limit is based on the limit in effect at the beginning of the 12 month period.

[Guest a1newman]

Does anyone know why a pro rata process was not chosen?

To protect against seasonal income being limited on a prorata basis, i.e. if you make $5,000 a month January - November and $200,000 in December, a pro rata limit of $240,000 would mean that there is no limit January - November and a limit of $20,000 for December so your limited 12 month salary would be $75,000 instead of $240,000.

It simply makes the regs easier. Limit is based on the limit in effect at the beginning of the 12 month period.

Sorry I didn't elaborate that I meant prorata on a 12 months rolling basis so that each period is part of a year but the limit for each 12 months would be x% of the second year and 100%-x% for the first year where x is proportion of year 2 worked. The key difference is that where a plan uses 60 consecutive months of income to determine the average wage, the difference between the limit of the first year included and the last year which is effectively eliminated in this process can be pf consequence in determining the average. For someone whose last work day is September 30,2010, the impact of proration is about a 2% increase in the 60 month average compared to the method used.

[Hojo]

Sorry I didn't elaborate that I meant prorata on a 12 months rolling basis so that each period is part of a year but the limit for each 12 months would be x% of the second year and 100%-x% for the first year where x is proportion of year 2 worked. The key difference is that where a plan uses 60 consecutive months of income to determine the average wage, the difference between the limit of the first year included and the last year which is effectively eliminated in this process can be pf consequence in determining the average. For someone whose last work day is September 30,2010, the impact of proration is about a 2% increase in the 60 month average compared to the method used.

The reason they didn't do that is for logistical purposes. Writing proration into law to help high paid individuals is counterintuitive and complex. They'd rather make the law simple and save employers 2%.