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401(k) Catch-Up Contributions

When does a 401(k) deferral become a catch-up contribution?”

ERISA consultants at the Retirement Learning Center (RLC) Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, and Social Security and Medicare.  We bring Case of the Week to you to highlight the most relevant topics affecting your business.

A recent call with an advisor in Virginia involved a question on 401(k) catch-up contributions.

Highlights of Discussion

An employee salary deferral becomes a catch-up contribution when it exceeds the lowest of the following three limits (See Treasury Regulation § 1.414(v)-1 ):

  • A statutory or legal limit (as explained below),
  • A plan-imposed limit stated in the plan document and
  • The plan’s actual deferral percentage (ADP) limit on salary deferrals.

Salary deferrals above the lowest of these three limits will be considered catch-up contributions up to the annual catch-up maximum amount for a 401(k) plan (i.e., $7,500 for 2023).

Examples of a statutory or legal limit include the IRC § 402(g) limit (i.e., 22,500 for 2023) or the IRC § 415(c) annual additions limit (i.e., 100 percent of a participant’s compensation up to $66,000 for 2023)]. An example of a plan limit would be if the plan document were to specify that employee salary deferrals are limited to 10 percent of a participant’s annual compensation. Finally, a plan’s ADP limit on employee salary deferrals is determined by comparing the salary deferrals of the highly compensated employees (HCEs) to those of the nonhighly compensated employees (NHCEs) and limiting deferrals for HCEs to a level that allows the plan to satisfy the ADP nondiscrimination test.

Example:  Rowan is a 55-year-old HCE who participates in a 401(k) plan he established for his firm. His compensation for the year is $100,000. The maximum IRC Sec. 402(g) limit for the year is $22,500. The terms of the 401(k) plan limit employee salary deferrals to 10% of compensation or, in Rowan’s case, $10,000. The plan administrator determines the salary deferral ADP limit for the year is $8,000.  The lessor of $22,500, $10,000 or $8,000 is $8,000. Therefore, any salary deferral Rowan would make above $8,000 (up to a maximum catch-up limit of $7,500) would be considered a catch-up contribution.

Conclusion

There may be more to catch-up contributions than the average person realizes. An employee salary deferral becomes a catch-up contribution when it exceeds the lowest of a legal limit, a plan-imposed limit or the ADP limit.

 

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Retirement Proposals in the 2024 U.S. Budget

“I heard the 2024 Budget for the U.S. contains some restrictions on retirement savings and Roth conversions. Can you explain the provisions and when they take effect?”

ERISA consultants at the Retirement Learning Center (RLC) Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, and Social Security and Medicare.  We bring Case of the Week to you to highlight the most relevant topics affecting your business. A recent call with an advisor in California involved a question on President Biden’s 2024 Budget.

Highlights of Discussion

Let’s start with the second half of your question first—when do the provisions take effect? The federal budget contains estimates of federal government income and spending for the upcoming fiscal year (October 1 through September 30) and includes suggestions or proposals—not laws—on how to achieve income and spending goals. Consequently, while there are recommended effective dates tied to the provisions of the budget, nothing has been enacted. The provisions are merely suggestions. The president’s release of the budget to Congress is an early step in the entire budget process.

That said, the budget does reflect what is on the Administration’s mind, and the retirement proposals are ones that are recurring themes (e.g., included in the 2021 “Build Back Better” bill). The related General Explanations of the Administration’s Fiscal Year 2024 Revenue Proposals includes a description of “modifications to rules relating to retirement plans.”

Among other items, the budget suggests imposing $10 million and $20 million caps on savings in tax-favored retirement accounts for “high income taxpayers,” and requiring distributions of a portion of the excess based on the applicable cap.

A high-income taxpayer would be someone with gross income over

  • $450,000, if the taxpayer is married and filing jointly (or is filing as a surviving spouse); or
  • $425,000, if the taxpayer is a head-of-household; or
  • $400,000, in other cases.

High-income taxpayers with accumulations of more than $10 million would be required to distribute 50 percent of the excess amount, and if accumulations exceeded $20 million, then the required distribution would be the lessor of the excess or all Roth accumulations.

Second, plan administrators of a tax-favored retirement arrangements would be required to report to the Treasury Secretary any vested account balance of a plan participant or beneficiary that exceeds $2.5 million.

Third, certain Roth conversions would be eliminated for high-income taxpayers (as described above).

While action on these initiatives is not expected this year, targeting large retirement account balances has some populist appeal, and has had the support of Democrat policymakers for some time. The idea of capping retirement accumulations is likely to persist beyond the next election.

Conclusion

The president’s budget proposal, containing suggestions on how to achieve income and spending goals, is an early step in the budget process. None of the budget’s provisions are law at this point. But several themes targeting excessive retirement savings in the budget reflect the current focus of the Administration and are likely to be points of discussion and debate in Congress.

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What Are PS 58 Costs?

“My client has life insurance in her 401(k) plan. Her accountant told her that the “PS 58 costs” are taxable to her.  Can you explain?”

ERISA consultants at the Retirement Learning Center (RLC) Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, and Social Security and Medicare.  We bring Case of the Week to you to highlight the most relevant topics affecting your business. A recent call with an advisor in Illinois involved a case related to life insurance.

Highlights of Discussion

Your client’s accountant is correct. If the plan uses deductible employer contributions to purchase life insurance for her, then the cost of the protection (the premium paid) is included in her gross income [Treas. Reg. § 1.72-16(b)(2)].  The cost of this coverage is called the “PS 58 cost,” and is includible in income for the taxable year during which the plan pays the premium.

The plan administrator reports the taxable cost of life insurance (the PS 58 cost) annually on Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., even when there has been no physical distribution from the plan. Since these amounts have already been taxed, they create a basis in the plan. That means your client will not be taxed again on the cumulative PS 58 costs when the insurance contract is distributed to her or when the life insurance proceeds are distributed to her beneficiaries.

Conclusion

If the plan uses deductible employer contributions to purchase life insurance for a participant, then the cost of the protection (PS 58 cost) is reported on Form 1099-R. The participant must include the amount in taxable income for the year the premium is paid.

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Partial Plan Termination and the Applicable Period

“My client suffered an accident and cannot keep employees on at his business. He was wondering if he could lay off employees over time to avoid triggering full vesting for a partial plan termination?”

ERISA consultants at the Retirement Learning Center (RLC) Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, and Social Security and Medicare.  We bring Case of the Week to you to highlight the most relevant topics affecting your business. A recent call with an advisor in Ohio involved a case related to a partial plan termination.

Highlights of Discussion

  • The IRS will determine whether a partial plan termination has occurred based on the facts and circumstances of a particular scenario [Treasury Regulation § 1.411(d)-2(b)]. According to Revenue Ruling 2007-43, one of the circumstances considered is the employee turnover rate during “the applicable period.”
  • The applicable period is a plan year (or, in the case of a plan year that is less than 12 months, the plan year plus the immediately preceding plan year) or a longer period if there are a series of related severances from employment. Consequently, in your client’s situation, because the layoffs would all occur as a result of a single event—the IRS would consider them related severances.
  • There are other guidelines in Revenue Ruling 2007-43 that are helpful in determining if a partial plan termination has occurred.
  • A partial termination may be deemed to occur when an employer reduces its workforce (and plan participation) by 20 percent.
  • The turnover rate is calculated by dividing employees terminated from employment (vested or unvested) by all participating employees during the applicable period.
  • The applicable period is generally the plan year but can be deemed longer based on facts and circumstances. An example would be if there are a series of related severances of employment the applicable period could be longer than the plan year.
  • The only severances from employment that plan sponsors DO NOT factor in when determining the 20 percent ratio are those that are out of the employer’s control (e.g., an employee death, disability, retirement or depressed economic conditions).
  • Partial plan terminations can also occur when a plan is amended to exclude a group of employees that were previously covered by the plan or vesting is adversely affected.
  • In a defined benefit plan partial plan termination can occur when future benefits are reduced or ceased.
  • The IRS adopted the 20 percent guideline in Rev. Rul. 2007-43 from a 2004 court case Matz v. Household International Tax Reduction Investment Plan, 388 F. 3d 577 (7th Cir. 2004), which, ironically, was dismissed in 2014 after its fifth appeal [Matz v. Household Int’l Tax Reduction Inv. Plan, No. 14-2507 (7th Cir. 2014)]. The 20 percent threshold still stands under the IRS’s revenue ruling.
  • Keep in mind that employee turnover is not the only reason for a partial termination. A partial termination can also happen if a sponsor adopts amendments that adversely affect the rights of employees to vest in benefits under the plan, excludes a group of employees that previously had been included, or reduces or ceases future benefit accruals that can result in a reversion to the employer (in the case of a defined benefit plan), the IRS may find that a partial termination occurred, even if the turnover rate is under 20 percent (Issue Snapshot-Partial Plan Termination).
  • If a partial termination may be an issue, a plan sponsor may seek an opinion from the IRS as to whether the facts and circumstances amount to a partial termination. The plan sponsor can file, IRS Instructions for Form 5300, Application for Determination for Employee Benefit Plan with the IRS to request a determination of partial plan termination.

Conclusion

Based on facts and circumstances over the applicable period, a company could be deemed to have a partial plan termination. The participants affected by the partial plan termination must become 100 percent vested in their account balances upon termination. Plan sponsors should monitor their companies’ turnover rates and amendment activities to be aware of potential partial plan terminations.

 

 

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