IRS COMPENSATION LIMITS IN COMPANY RETIREMENT PLANS

Wednesday, July 15, 2020

By Ian Berger, JD
IRA Analyst
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Admittedly, it’s not such a bad problem to have. Nonetheless, it’s true that high-paid company plan participants can have their benefits limited by the IRS compensation limit.

The compensation limit is $285,000 for 2020 and goes up most years based on cost-of-living increases. It was $280,000 for 2019 and $275,000 for 2018.

Pay above the limit can’t be used in determining employer contributions made to 401(k) plans and SEP and SIMPLE IRAs. Excess pay also can’t count towards benefits earned in defined benefit pension plans.

Example 1: Khalil is an eligible employee in a SEP IRA plan with pay of $300,000 in 2020. For 2020, Khalil’s employer makes a 10% SEP contribution for all eligible employees. Khalil’s contribution is limited to $28,500 (10% x $285,000).

Example 2: Brandi has pay of $350,000 and makes $19,500 of 2020 elective deferrals in her company’s 401(k) plan. The company matches 50% of elective deferrals, taking into account elective deferrals up to 6% of pay. The plan may only recognize $285,000 of Brandi’s pay. Although she makes $19,500 of elective deferrals, only $17,100 (6% x $285,000) can be matched. Therefore, Brandi’s matching contribution is limited to $8,550 (50% x $17,100).

The compensation limit also restricts pay that can be taken into account in certain IRS nondiscrimation testing that company plans are required to pass. The effect of that restriction is to make it harder for plans to pass those tests.

For example, many 401(k) plans must annually perform the ADP test. (The test is not required if the employer makes “safe harbor” contributions.) This test limits deferrals by highly-compensated employees (HCEs) based on the level made by non-highly compensated employees (NHCEs). First, a deferral percentage (deferrals divided by pay) for each employee is calculated. But only pay up to the compensation limit can be used in that calculation. Second, an average deferral percentage for all NHCE’s and an average for all HCE’s are calculated and compared.

Example 3: Company A, with three NHCEs and one HCE (Jeremy), performs the ADP test for 2019. Assume Jeremy’s actual 2019 pay is $380,000. Because of the compensation limit, however, only $280,000 (the 2019 limit) can be recognized.

Employee                          Elective deferrals                    Pay              Deferral Percentage

NHCE1                                     $      0                              $40,000                        0%

NHCE2                                      3,600                                60,000                      6.0

NHCE3                                      4,800                                80,000                      6.0

 

HCE                                         19,000                              280,000                      6.8

The NHCE average deferral percentage is 4.0% [(0% +6.0%+ 6.0%)/3], and the HCE percentage is 6.8%. Under IRS rules, the HCE percentage can’t be more than 6.0%, so the plan fails the ADP test. If all of Jeremy’s 2019 pay ($380,000) could be used, his deferral percentage would be 5.0%, and the plan would pass.

 

 

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