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George F. Bearup, J.D. Senior Legal Trust Advisor

6-Oct-20

Compensation Limits for Qualified Plans

Take-Away: As we approach the last calendar quarter of 2020 and individuals begin to think about their final 2020 income tax liability, adjustments may be made to their elective contributions to their employer’s 401(k) plan to reduce their reportable taxable income for the year. However, they often forget that there are compensation limits imposed by the Tax Code on their elective deferrals. These limits can also affect the 401(k) plan’s qualified status if highly compensated individuals defer too much of their compensation to their qualified plan account.

Background: Highly paid qualified plan participants can have their retirement contributions limited by the annual compensation limit imposed under the Tax Code. Each year that limited compensation amount is adjusted by the cost-of-living.

  • 2020 Compensation Limit: In 2020 a participant’s compensation limit is $285,000. For comparison purposes, that compensation limit in 2019 was $280,000 and for 2018 that limit was $275,000.
  • Excess Compensation: Any participant compensation above the compensation limit cannot be used to determine employer contributions to 401(k) accounts, Simplified Employer Plans (SEP IRAs) and SIMPLE IRAs. Nor can any excess compensation be used to determine earned or accrued benefits in a defined benefit pension plan.
  • Example #1: Chris, a dermatologist, is an eligible employee in a SEP IRA plan sponsored by his medical practice. Chris’s compensation for the year is $400,000. Chris’s employer makes a 10% SEP contribution for all eligible employees of the medical practice. The eligible contribution to Chris’ SEP IRA is limited to $28,500, or 10% of $285,000.
  • Example #2: Rosie, a plaintiff’s attorney, has compensation of $350,000 for the year. She makes a $19,500 elective deferral in her law firm’s 401(k) plan. Rosie’s employer matches 50% of all elective deferrals, taking into account elective deferrals up to 6% of compensation. The 401(k) plan may only recognize $285,000 of Rosie’s compensation for purposes of calculating the employer-match. Although Rosie makes $19,500 of elective deferrals, only $17,100, or 6% of $285,000, can be matched by the employer. As a result, Rosie’s matching contribution from her employer is limited to $8,550 (50% of $17,100.)

Nondiscrimination ‘Testing:’ Additionally, the annual compensation limit restricts pay that can be taken into account for some of the IRS’ nondiscrimination tests that a qualified plan is required to pass. A qualified plan must annually perform what is called the average deferral percentage (ADP) ‘test’, if the employer does not qualify for ‘safe harbor’ contributions to the plan. The ADP ‘test’ limits the deferrals made by highly compensated employees based on the level of compensation deferrals made by non-highly compensated employees. Under this complicated ‘testing’ process, initially a deferral percentage is calculated for each participant (the participant’s deferral amount is divided by their compensation.) However, only compensation up to the compensation limit can be used for that initial calculation. Next, an average deferral percentage of all non-highly compensated employees and an average deferral percentage for all highly compensated employees are calculated and compared. Under the IRS’s rules, the highly compensated employee’s deferral percentage cannot be more than 6.0%. If that deferral percentage is higher, the qualified plan fails the ADP ‘test.’

  • Example #3: In 2019, an employer sponsors a 401(k) plan. The employer has three non-highly compensated employees: Harpo, Chico, and Gummo. There is only one highly compensated employee of the employer, Groucho. Groucho’s actual pay in 2019 was $380,000. Due to the IRS’s compensation limit though, only $280,000 of Groucho’s compensation can be recognized. Step #1: Harpo’s compensation was $40,000, yet he made no elective deferrals, so that Harpo’s deferral percentage is 0%. Chico’s compensation in 2019 was $60,000; Chico made elective deferrals of $3,600, so Chico’s non-highly compensated employee elective deferral percentage is 6.0%. Gummo’s compensation was $80,000 for 2019, and Gummo made elective deferrals of $4,800. Thus, Gummo’s elective deferral percentage is 6.0%. Groucho’s elective deferral amount for 2019 was $19,000. Therefore, Groucho’s highly compensated employee elective deferral was 6.8%, i.e. $19,000 of $280,000. Step #2: The non-highly compensated employee average deferral percentage is 4% [0% + 6.0% +0% divided by 3= 4.0%.] Groucho’s highly compensated employee elective deferral percentage is 6.8%. Since the highly compensated employee elective deferral percentage cannot be more than 6.0%, this qualified plan fails the ADP ‘test.’ If Groucho’s 2019 compensation of $380,000 could have been used, his elective deferral percentage would be 5.0% and the plan would have passed the ADP ‘test.’

Conclusion: Qualified plan participants tend to forget the IRS imposed compensation limits when making elective deferrals to a 401(k) plan. While plan participants usually ignore these limits, the plan sponsor is highly aware of them and their impact on the ADP ‘test.’