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Treatment of the Annual Compensation in Defined Contribution Plans in a Short Plan Year

This article discusses how defined contribution retirement plan plans sponsors should adjust the annual compensation limit under Internal Revenue Code (“IRC”) Section 401(a)(17) in a plan year of less than 12 months (“short plan year”), such as a first plan year, an amended plan year, or a year of plan termination.

Overview

A plan may not allocate contributions for a plan year on compensation exceeding the dollar limit imposed under IRC Section 401(a)(17) or use more than this amount in applying certain nondiscrimination rules. For 2018, the annual compensation dollar limit is $275,000 and is subject to annual cost-of-living adjustments in future years. The annual dollar limit applies for a 12-month period. If the plan uses a compensation measurement period of less than 12 months in calculating employee contribution allocations, the limit must be prorated.

Proration of limit

The compensation limit for a short year is determined by multiplying the applicable annual compensation dollar limit for the calendar year in which the short year begins by a fraction, the numerator of which is the number of months in the short plan year, and the denominator of which is 12 months.

Example 1 – Plan amendment creating a short plan year

Plan A is a profit sharing plan with a calendar plan year. On June 30, 2018, the plan is amended to change the plan year to a fiscal year ending June 30. The amendment creates a short plan year from January 1 to June 30, 2018 (six months). The plan document provides that allocations for the plan year ending June 30 are based on compensation for the six-month period. Because the short plan year begins in 2018, the prorated short year limit is calculated based on the 2018 limit of $275,000. The prorated short year limit is $137,500 ($275,000 x (6/12) = $137,500).

Example 2 – Initial short plan year

ABC Company establishes a new 401(k) profit sharing plan effective October 1, 2018. The plan is a calendar year plan and the first plan year ends December 31, 2018 (3 months). For the first plan year, compensation taken into account under the plan is compensation earned after the effective date of the plan. Thus, for the first plan year, the prorated short year limit for the initial plan year is $68,750 ($275,000 x (3/12) = $68,750).

Example 3 – Initial short plan year – 12-month measurement period

The same facts as in Example 2 except ABC Company establishes a new section 401(k) profit sharing plan in July 2018, but the plan is effective January 1, 2018, and the plan document states that compensation taken into account under the plan is compensation earned for the calendar year. The compensation limit is not prorated for the first plan year because the compensation measurement period under the plan is 12 months.

Note: ABC Company must have been in existence for all of calendar year 2018 in order for the above example to apply. If ABC Company first came into existence on April 1, 2018, the plan could not be effective prior to this date and the compensation limit would be prorated based on a short plan year of a maximum of nine months (April 1 to December 31).

Example 4 – Plan termination

Plan C is a profit sharing plan with a calendar plan year. The plan sponsor adopts a resolution to terminate the plan effective September 30, 2018. Final allocations under the plan are based on compensation earned from January 1 to September 30, 2018 (nine months). Because the compensation measurement period is less than 12 months in 2018, the compensation limit must be prorated. The prorated short year limit is calculated based on the 2018 limit of $275,000. Therefore, the prorated short year limit is $206,250. ($275,000 x (9/12) = $206,250).

Participants who join or leave the plan mid-year

A plan may (but is not required to) allocate contributions to participants based on compensation earned by an employee only while he or she is a participant in the plan. If that is the case, the compensation limit is not prorated for employees who participate for only a portion of the plan year (for example, who enter the plan in July of a calendar plan year) provided the plan continues to use a measurement period of 12 months for the other employees who participate in the plan.

Example 1 – New participant

Plan D is a calendar year 401(k) profit sharing plan. The plan allocates employer non-elective contributions to participants based on compensation earned during each employee’s period of participation under the plan. Participant Smith begins employment on January 1, 2018, and becomes a participant in the plan on August 1, 2018. Smith’s elective deferrals and allocated employer non-elective contribution for 2018 are based on compensation earned during the period August 1 to December 31, 2018. However, the compensation limit applicable to Smith is not prorated because the compensation measurement period applicable to all plan participants is 12 months.

Conclusion

Plan sponsors should be aware of the circumstances that require the proration of the annual compensation limit 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.

Peter Alwardt is a Tax Partner specializing in employee benefits, tax and ERISA issues for domestic and international clients. He is a member of the American Institute of Certified Public Accountants and NY State Society of CPAs.

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