Permissive Service Credits

[tja]

Can a governmental plan permit a participant to purchase an enhanced benefit without relying upon section 415(n) if it otherwise complies with section 415?

[Kelly]

Not sure what you mean.  Are you asking if they can buy the time if it is not listed in a CBA?

[Carol V. Calhoun]

We've actually thought about that one, and it's not at all clear.

Before the passage of section 415(n), it was unclear whether the contributions made by employees to purchase service credit should be treated as annual additions subject to the limits of 415(c), or part of the defined benefit subject to the limits on benefits of section 415(b). The reason was that the 415 regulations state that "If voluntary employee contributions are made to the plan, the portion of the plan to which voluntary employee contributions are made is treated as a defined contribution plan pursuant to section 414(k) and, accordingly, is a defined contribution plan pursuant to §1.415(c)-1(a)(2)(i). Accordingly, the portion of a plan to which voluntary employee contributions are made is not a defined benefit plan within the meaning of paragraph (a)(2) of this section and is not taken into account in determining the annual benefit under the portion of the plan that is a defined benefit plan."  While this makes sense for nongovernmental plans, it is not clear that it is true for a governmental plan.  A section 414(k) plan must be "A defined benefit plan which provides a benefit derived from employer contributions which is based partly on the balance of the separate account of a participant."  Amounts used to purchase permissive service credit are typically not put into any kind of separate account.  So the question is whether the language in the 415 regulations could actually apply to them, since the plans to which they are contributed are not in fact 414(k) plans.

Section 414(n) was intended to remedy this issue by providing that if certain requirements were met, the plan could treat the purchase of service credit as subject to either 415(b) or (c), at its option.  However, the down side is that purchases of more than five years of nonqualified service credit are automatically treated as violating section 415, even if they would otherwise comply with 415(b) or (c).

However, the question is whether you can avoid the 415(n) rules simply by allowing people to contribute to the defined benefit plan, and increasing the benefit under the plan, without measuring the increased benefit by years of service.  For example, suppose the benefit under the plan is 2 percent of compensation times years of service.  The employee has compensation of $50,000 and 20 years of service, meaning that without anything else happening, the benefit would be $20,000.  It is clear that you could not allow that employee to purchase 10 years of nonqualified service (which would result in a total benefit of $30,000) without running afoul of 415(n).  However, can you simply provide that if the employee makes a contribution of $X, they will get an extra $10,000 in benefits, without tying that $10,000 to years of service?

On the one hand, section 415(n) by its terms applies only to "service credit," which would suggest that the previous strategy would work (at least if you could figure out whether the 415(b) or (c) limit should apply, and limit the benefit or the employee's contribution accordingly).  On the other hand, that employee has achieved exactly what would have happened if the extra 10 years of service had been credited, so this seems an end run around 415(n).

To the best of my knowledge, the IRS has never considered this issue.  So you are kind of on your own in figuring out a) whether this works at all, and b) whether the contributions should be treated as subject to 415(b) or (c) limits.