Fundamentals I of Retirement Plan Issues Chapter Seven/Week Eight Limitations on Qualified Defined Benefit and Defined Contribution Plans Fundamentals I of Retirement Plan Issues Chapter Seven/Week Eight

Limitations for Defined Benefit Plans Code § 415 Dollar Limit Compensation Limit IRC §401(a)(15) sets forth the qualification requirement that there are maximum dollar and percent of compensation limits for defined contribution and defined benefit plans. So as to prevent employers from circumventing these rules, all qualified defined contribution plans must be aggregated and then subjected to the maximum limits; similarly all qualified defined benefit plans must be aggregated and then subjected to the maximum limits. Hence, qualified plans must set forth which plans will be the “cut back” plans so that the maximum limits are not exceeded. There use to be another limitation that prevented the same employer from using up to 100% of the maximum defined contribution limits and 100% of the maximum defined benefit limits. That has sent been repealed. Both the defined contribution and defined benefit maximum limits use two limitations – a maximum dollar cap and a maximum percentage of compensation cap. A participant’s benefit is subject to the lesser of the two caps. As the maximum limits use a percentage of compensation, what constitutes “compensation” for purposes of the limits is defined by the Code, not the plan’s definition of compensation used for allocation or accrual purposes. §7.09 of Chapter 7 depicts how often the dollar limits and compensation limits have changed over time. As the tax expenditures extended to qualified plans are so large, lowering the amount that can be deferred under a qualified DB or DC plan reduces the size of the deduction for the employer, and therefore reduces the tax expenditure afforded to these qualified vehicles.

Limitations for Defined Benefit Plans Adjustments to Dollar Limit Commencement of Benefits Forms of Payment Other The maximum limits applicable to qualified defined benefit plans reflect the fact that the normal retirement benefit formula has three parts: a formula used to determine the dollar value of the benefit; a normal retirement age, say 65; and a normal form of payment, which must be at least J&50%S for married participants and usually life only for single participants. Thus, the maximum limits of IRC §415 specify the following: the lesser of a dollar limit or 100% of FAE, depending on the year in which the individual retires; the presumed normal retirement age of 65 (reinstated by EGTRRA ‘01), but no adjustment required to be made to the lesser of the dollar limit or 100% of FAE is the benefit is distributed between age 62 and 65; and the presumed normal form of life only for unmarried participants and J&50%S for married participants. Thus, if the actual distribution of benefits is according to another form permitted under the plan (e.g., 15 certain and life), the lesser of the dollar limit or 100% of FAE must be adjusted. Let’s do an example: A plan’s NRB = [100% × FAE]/65/life only or J&50%S, subject to IRC §§401(a)(17) and 415. A participant has FAE of $100,000 at age 65 and elects a 15 certain & life form of payment. There is a 10% charge under the plan for this form of payment. For the 2009 plan year, the IRC §401(a)(17) limit of $245,000 applies and the IRC §415 limits of the lesser of $195,000 or 100% of FAE apply. Hence, the participant would like a NRB = 90% × [100% × $100,000]/65/15 C&L = $90,000/65/15 C&L. The IRC §415 limit = [lesser of $195,000 or 100% × FAE]/65/life only or J&50% S= [100%×FAE]/65/life only or J&50%. Since the participant wants a 15 certain & life form of payment, the maximum limit of 100% × FAE must be adjusted by the actuarial amount of 24.3%, resulting in a IRC §415 limit of $75,700/65/15 C&L.. Hence under this form of payment, the plan may not distribute an annual 15 C&L benefit to this participant in excess of $75,700.

Limitations for Defined Contribution Plans Input limitations on annual additions Dollar limit Compensation limit Since there are a variety of annual inputs (e.g., allocation, investment earnings, employee contributions) and annual outputs (e.g., investment fees, administrative fees) that affect an employee’s accrued benefit, Congress decided not to subject all of the annual inputs to the maximum limits of IRC §415. Hence, there is a new term of art referred to as the “annual addition” to describe which of the annual inputs items will be aggregated and then subject to the maximum limitation. Hence, annual addition includes any employer contribution allocated to the participant’s account; any forfeitures allocated to his/her account; and all employee contributions (including 401(k) deferrals) contributed to his/her account. As noted in the textbook, to the extent the employee has been making 401(k) deferrals throughout the plan year through payroll deferrals, he/she risks using up part of the IRC §415 maximum limit. For example, for the 2009 plan year, the maximum IRC §415 for defined contribution plans was the lesser of $49,000 or 100% of compensation. If a participant making $200,000 deferred $16,500 of 401(k) contributions and was otherwise entitled to a 100% matching employer contribution and a nonelective employer contribution of 10% of $200,000, the participant’s annual addition could not be $16,500 + $16,500 + $20,000 = $52,000, as that would exceed the maximum of $49,000. Since the 401(k) deferrals have already been made to the plan, the nonelective contribution of $20,000 would have to be cutback to $17,000, so that the annual addition would equal $49,000.

Pre-Termination Restrictions 25 highest paid HCEs Limitations on distributions Escrow These pre-termination restrictions were created by the IRS through the nondiscrimination regulations to restrict the ability of the highly paid participants taking a lump sum distribution from the plan and then terminating the plan, resulting in the remaining participants bearing the brunt of the underfunding of their benefits. For example, if plan liabilities total $100,000 and plan assets total $90,000, and a highly compensated participant receives 100% of his/her benefit in a lump sum of $50,000, the plan liabilities are now $50,000 but the plan assets are now $40,000, leaving the remaining participants with the underfunding and not the highly compensated participant with an underfunded benefit.

Compensation Uses of Compensation Includes all wages, salary, commission, bonuses, tips, some expenses, certain stock options and excluding deferred compensation Alternative definitions: Reduction Safe Harbor Supplemental Safe Harbor HCE Exclusions Safe Harbor Uses of Compensation

Compensation Limitations