Deduction Limits for “Combination” Retirement Plans: What Employers Need to Know

Key Points

• When DC and DB retirement plans are combined, new deduction limits apply that often creates confusion.
• If an employer has a combination plan, Section 404(a)(7) of the tax code limits that employer’s contribution deductions.
• Separate deduction limits for the DB and DC plans should be calculated before applying the Sec. 404(a)(7) limits.

Generally speaking, an employer’s contributions to a qualified retirement plan are deductible if they’re ordinary and necessary expenses of carrying on a trade or business and are compensation for services rendered. However, an employer’s qualified plan contributions are limited. For example, an employer sponsoring a defined contribution (DC) plan, such as a 401(k), is allowed a deduction for contributions of up to 25% of the compensation paid or accrued to plan beneficiaries during the employer’s tax year.

If the employer contributes to two or more DC plans, those plans are considered a single plan for purposes of applying the 25% limit. Meanwhile, the tax code provides a separate maximum deduction for contributions to a defined benefit (DB) plan (often called a “pension plan”). When DC and DB retirement plans are combined, new limits apply. It’s a variance that can get convoluted and confusing.

“The combined plan deduction limits come up often when we are preparing 401(k) and Cash Balance Plan designs for our business owner clients,” said EisnerAmper Partner Jeremy Palm. “It’s valuable for business owners to be aware of the specific deduction limits and when they apply.”

A little clarity can go a long way. In that spirit, the following is a snapshot, courtesy of the Internal Revenue Service, of what you need to know about combination retirement plans and their associated deduction limits.

Combination retirement plans: what are the rules?

If an employer has a combination plan, Section 404(a)(7) of the tax code limits that employer’s contribution deductions. These limits apply only in a tax year when:

• At least one participant benefits under both plans and receives allocations other than elective deferrals in the DC plan (called “overlapping coverage”),
• The DB plan is exempt from Pension Benefit Guaranty Corporation coverage, and
• Both the DB and DC plans are single-employer plans

If a DB and DC plan have overlapping coverage and employer contributions to the DC plan (other than elective deferrals) don’t exceed 6% of the aggregate compensation of DC plan beneficiaries, the limit on combination plans doesn’t apply.

However, if there’s overlapping coverage and the employer contributions to the DC plan (other than elective deferrals) do exceed 6% of aggregate compensation of the DC beneficiaries, then the combination plan limits are applied by considering only those DCs that exceed 6%.

Calculating the deduction limit

According to the Issue Snapshot, the separate deduction limits for the DB and DC plans should be calculated before applying the Sec. 404(a)(7) limits. Thus, the combined deduction limit on contributions to a single-employer DB plan and a single-employer DC plan that have overlapping coverage is the greater of:

• 25% of the compensation otherwise paid or accrued during the tax year to beneficiaries, or
• The greater of the minimum required contribution to the DB plan for the plan year or the excess of the funding target over the plan’s assets for that plan year.