Prorating the Defined Contribution Dollar Limit for a Short Limitation Year

This article discusses how to adjust the Internal Revenue Code (“IRC”) Sec. 415(c) defined contribution dollar limitation for a short limitation year (a period of less than 12 months), resulting from, for example, an initial, amended, or terminating plan year.

Background

Total credits to a participant’s defined contribution plan account are limited to the maximum dollar amount under IRC Sec. 415(c). This limit, known as the annual additions limit, is $56,000 for 2019 and is subject to annual cost-of-living adjustments. If the participant’s compensation is less than the annual additions dollar limit, then total annual additions to his plan account during a limitation year cannot exceed 100% of his compensation.

Annual additions to a participant’s account are comprised of the following:

• the participant’s elective deferrals (including designated Roth contributions, but excluding annual catch-up contributions for participants age 50 or older under IRC Sec. 414(v) – currently a maximum of $6,000 annually),
• voluntary or mandatory employee after-tax contributions,
• employer matching and nonelective contributions (typically profit sharing), excluding restorative payments under IRC Sec. 1.415(c)-1(b)(2)(ii)(C)), and
• allocations of forfeitures.

The dollar limit on annual additions is a single limit that applies to a participant’s accounts for all defined contribution plans maintained by an employer. Employers that are part of a controlled or affiliated service group under IRC Secs. 414(b), (c), and (m) are considered a single employer for purposes of the limitation.

Short Limitation Years

Although most plans maintain limitation years concurrent with the plan year, a plan may be established with or, amended to change, the limitation year to a different 12-month period beginning with any day within the current limitation year. This creates a short limitation year that begins on the first day of the current limitation year and ends on the day before the first day of the new limitation year.

A terminating defined contribution plan is treated as having amended its limitation year if the effective date of the termination is any date other than the last day of the plan’s limitation year. The short limitation year ends on the effective date of the plan termination.

Depending on how the plan document is drafted, it is possible for a new plan to have an initial limitation year of less than 12 months. However, a new plan adopted after the beginning of the new limitation year will not have a short limitation year if the effective date of the plan is retroactive to the first day of the 12-month limitation year (note: participant elective deferrals cannot begin before the adoption date of the plan). For example, a new plan with a calendar year limitation year is adopted on June 30 with an effective date of January 1 of the same year.

Proration of the IRC Section 415(c) Limit

The maximum annual additions limit for a short limitation year is determined by multiplying the applicable dollar limit for the calendar year in which the short limitation year ends by a fraction, the numerator of which is the number of months (including any fractional parts of a month) in the short limitation year and the denominator of which is 12.

Example 1 – Plan Amendment

Plan A is a profit-sharing plan with a calendar year limitation year. On June 30, 2019, the plan is amended to change the limitation year to a fiscal year ending June 30. The amendment creates a short limitation year from January 1 to June 30, 2019 (six months). Since the short limitation year ends in 2019, the prorated short limitation year is calculated based on the 2019 limit of $56,000.

The prorated maximum annual additions limit for the short limitation year: $56,000 x (6/12) = $28,000.

Plan Termination

One of the most common situations in which the maximum annual additions limit is required to be prorated is when a plan terminates. As noted above, most plans are administered with concurrent plan and limitation years. Termination of such a plan before the last day of its limitation year will lower the maximum annual additions dollar limit that may be credited to a participant’s account in its final year. The regulations under IRC Sec. 415 require that when a defined contribution plan is terminated effective as of any date other than the last day of its limitation year, the plan is treated as if it has been amended to change the limitation year to a period ending on the date of termination. This requires proration of the IRC Sec. 415(c) dollar limitation for the termination year and may restrict the maximum amount otherwise allocable to a participant.

Example 2

Plan B is a profit-sharing plan with a calendar-year limitation year. The plan is terminated effective September 15, 2019. The plan termination is treated as if an amendment has been adopted to change the limitation year to a year beginning September 16, 2019. A short limitation year is created from January 1 to September 15, 2019 (8.5 months). Because the plan terminated in 2019, the prorated short year maximum annual additions limit is calculated based on the 2019 limit of $56,000.

The prorated short year IRC Sec. 415(c) limit is: $56,000 x (8.5/12) = $39,667.

Participants Eligible for Part of the Limitation Year

The limit on annual additions is not prorated for employees who are eligible to participate in a plan for only part of the limitation year (for example, participants entering the plan in July of a calendar-year limitation year). The limit is only prorated when the limitation year is less than 12 months.

Example 3

Plan C is a profit-sharing plan with a calendar-year limitation year. Susan becomes a participant in the plan on July 1, 2019. The IRC Sec. 415(c) dollar limit is not reduced for Susan even though she is a participant in the plan for only six months of the year.

Conclusion

Plan sponsors should be aware of the circumstances that require the proration of the annual additions limitation in order to avoid making impermissible contributions to their plan that will have to be removed from the plan and the necessity of explaining the removal to plan participants.