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Deferral election timing for the self employed

“Several of my clients are self-employed and have 401(k) plans. What is the date by which a self-employed individual must make his or her salary deferral election?”

ERISA consultants at the Retirement Learning Center 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 a financial advisor from Nevada is representative of a common inquiry related to 401(k) plan salary deferral elections.

Highlights of the Discussion

Special rules regarding salary deferral elections apply to self-employed individuals (e.g., sole proprietors or partners). They must make their cash or deferred elections no later than the last day of their tax year (e.g., by December 31, 2018, for a 2018 calendar tax year). The timing is connected to when the individual’s compensation is “deemed currently available” [see Treasury Regulation Section (Treas. Reg. §) 1.401(k)-1(a)(6)(iii)].

Often a self-employed individual’s actual compensation for the year is not determined until he or she completes his or her tax return, which, in most cases, is after the end of the partnership or individual’s taxable year. However, the IRS deems a partner’s compensation to be currently available on the last day of the partnership taxable year and a sole proprietor’s compensation to be currently available on the last day of the individual’s taxable year. Therefore, a self-employed individual must make a written election to defer compensation by the last day of the taxable year associated with the partnership or sole proprietorship.

EXAMPLE

A partner can make a cash or deferred election for a year’s compensation any time before (but not after) the last day of the year, even though the partner takes draws against his/her expected share of partnership income throughout the year.

There are also special rules that address when salary deferrals for self-employed individuals are treated as made to the plan (versus when they may actually be made). Treas. Reg. §1.401(k)-2(a)(4)(ii) states that an elective contribution made on behalf of a partner or sole proprietor is treated as allocated to the individual’s plan account as of the last day of the partnership or sole proprietorship’s taxable year.

With respect to the DOL’s deferral deposit deadline, deferrals for self-employed individuals must be deposited as soon as they can be reasonably segregated from the business’s general assets. The DOL’s safe harbor for plans with fewer than 100 employees also applies. Therefore, as long as the deferrals are transmitted within seven business days after the amounts are separated from the business’s assets, the contributions are deemed timely made.

From the IRS’ tax perspective, in no event can the deferrals be deposited after the deadline for filing the business’s tax return, plus extensions.

Conclusion

With respect to making a salary deferral election, a self-employed individual must do so no later than the last day of his or her tax year. The election should be documented in writing for proof in the event the plan later undergoes an audit. Therefore, those self-employed individuals following a calendar tax year must be sure to execute their written deferral elections by December 31, 2018!

© Copyright 2018 Retirement Learning Center, all rights reserved
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What is a Long-Term Incentive Plan?

“My client says she has a Long-Term Incentive Plan (LTIP). What is an LTIP, and is it a type of qualified retirement plan?”

ERISA consultants at the Retirement Learning Center 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 a financial advisor from New York is representative of a common inquiry related to compensation programs.

Highlights of the Discussion

A Long-Term Incentive Plan or LTIP is a type of compensation incentive program designed to reward executives for achieving the sponsoring company’s strategic objectives while maximizing shareholder value. It in not an IRC Sec. 401(a) qualified retirement plan [e.g., profit sharing or 401(k)], but rather, a way of compensating executives for reaching specified company performance goals.

An LTIP may be one components of a senior executive’s pay package, which may include:

  • Base salary;
  • Performance based annual incentive (e.g. annual bonus);
  • Performance based long-term incentive;
  • Benefits (e.g., Social Security, Medicare, Workers Compensation, and Unemployment Insurance, life and health insurance, 401(k), defined benefit, nonqualified deferred compensation plans, etc.);
  • Executive perquisites or “perks” (e.g., drivers to and from work, convenient parking, installation of home communications systems, financial planning, use of company airplanes for personal travel, etc.) and/or
  • Contingent Payments (e.g., payments to executives in the case of involuntary termination resulting from a merger or acquisition).

According to the Center for Executive Compensation, an LTIP can take the form of stock-based compensation, such as stock options, restricted stock, performance shares, cash, or stock-settled performance units. Usually, LTIPs are a mix of types of equity and may include a cash component. The performance period for an LTIP typically runs between three and five years. The executive does not receive any pay from the incentive program until the end of the performance period and the performance measure is met. Long-term incentive goals vary by company but the most prevalent are focused on Total Shareholder Return (TSR), operational measures such as earnings per share and return measures, such as return on assets.

Conclusion

An LTIP is a general name for a type of compensation for executives, the form of which may vary, depending on the company’s specific pay program. An LTIP can have material impact on an investment client’s overall finances. Therefore, reviewing the documentation associated with such arrangements and understanding their impact can go a long way to achieving a client’s goal of financial wellness.

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Discretionary plan trustee vs. directed trustee

“What defines a discretionary plan trustee vs. a directed plan trustee?”

ERISA consultants at the Retirement Learning Center 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 a financial advisor from Kentucky is representative of a common inquiry related to retirement plan trustees.

Highlights of the Discussion

ERISA Section 403(a) (see page 207 of linked information) provides that the assets of a qualified retirement plan must be held in trust by one or more trustees. The trustee will be either named in the plan document or appointed by a person who is a named fiduciary. The appointment of a plan’s trustee(s) is an important fiduciary decision that must be undertaken in a prudent manner by the plan sponsor or retirement plan committee with the proper authority.

Not all trustees, however, have the same authority or discretion to manage or control the assets of a plan. A trustee that has exclusive authority and discretion to manage and control the assets of the plan is a discretionary trustee. A discretionary trustee may be an employee of the company, but, more than likely, this role is outsourced to a third party.

However, a plan can expressly provide that the trustee is subject to the direction of a named fiduciary who is not a trustee. This is a directed trustee. The scope of a directed trustee’s duties is “significantly narrower than the duties generally ascribed to a discretionary trustee …” (Field Assistance Bulletin 2004-03). While a directed trustee is still a plan fiduciary, his or her fiduciary liability is limited, because he or she is required to act upon the direction of another plan fiduciary. The use of a directed trustee is a common plan model in the retirement industry. Many organizations serve as directed trustees.

“Direction” of the trustee is proper only if it is “made in accordance with the terms of the plan” and “not contrary to the Act [ERISA].” Accordingly, when a directed trustee knows or should know that a direction from a named fiduciary of the plan is not made in accordance with the terms of the plan or is contrary to ERISA, the directed trustee should not, consistent with its fiduciary responsibilities, follow the direction.

Conclusion

There are two basic flavors of qualified retirement plan trustee: discretionary and directed. Check the terms of the governing plan document and trust agreement for a particular plan to determine which applies.

 

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Retirement Savings Tax Credit

“What contributions are eligible for the retirement savings tax credit?”

ERISA consultants at the Retirement Learning Center 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 Oklahoma is representative of a common inquiry regarding available tax credits for retirement contributions.

Highlights of Discussion

IRA owners and retirement plan participants (including self-employed individuals) may qualify for a retirement savings contribution tax credit. Details of the credit appear in IRS Publication 590-A and here Saver’s Credit.

The credit

  • Equals an amount up to 50%, 20% or 10% of the taxpayer’s retirement plan or IRA contributions up to $2,000 ($4,000 if married filing jointly), depending on adjusted gross income (as reported on Form 1040, 1040A or 1040NR);
  • Relates to contributions taxpayers make to their traditional and/or Roth IRAs, or elective deferrals to a 401(k) or similar workplace retirement plan; and
  • Is claimed by a taxpayer on Form 8880, Credit for Qualified Retirement Savings Contributions.

Contributors can claim the Saver’s Credit for personal contributions (including voluntary after-tax contributions) made to

  • A traditional or Roth IRA;
  • 401(k),
  • Savings Incentive Match Plan for Employees (SIMPLE) IRA,
  • Salary Reduction Simplified Employee Pension (SARSEP) IRA,
  • 403(b) or
  • Governmental 457(b) plan.

In general, the contribution tax credit is available to individuals who

1) Are age 18 or older;

2) Not a full-time student;

3) Not claimed as a dependent on another person’s return; and

4) Have income below a certain level.

2018 Saver’s Credit Income Levels

Credit Rate Married Filing Jointly Head of Household All Other Filers*
50% of your contribution AGI not more than $38,000 AGI not more than $28,500 AGI not more than $19,000
20% of your contribution $38,001 – $41,000 $28,501 – $30,750 $19,001 – $20,500
10% of your contribution $41,001 – $63,000 $30,751 – $47,250 $20,501 – $31,500

*Single, married filing separately, or qualifying widow(er)

The IRS has a handy on-line “interview” that taxpayers may use to determine whether they are eligible for the credit.

Conclusion

Every deduction and tax credit counts these days. Many IRA owners and plan participants may be unaware of the retirement plan related tax credits for which they may qualify.

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Defined contribution plans and QJSA/QOSA/QPSA requirements

“Are defined contribution plans subject to the survivor annuity requirements for distributions?”

ERISA consultants at the Retirement Learning Center 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 a financial advisor from Massachusetts is representative of a common inquiry related to the survivor annuity rules for qualified plans.

Highlights of the Discussion

As you may know, all defined benefit (DB) plans are subject to the survivor annuity requirements. There are also some defined contribution (DC) plans that must satisfy these rules as well, although they are few and far between (IRC Secs. 401(a)(11) and 417).

As background, for plans that must satisfy the survivor annuity rules, if a participant dies before plan distributions are required to begin (i.e., the annuity starting date), benefits must be paid to the surviving spouse in the form of a qualified pre-retirement survivor annuity (QPSA). If a participant dies after the annuity starting date, the participant’s account balance must be used to purchase a qualified joint and survivor annuity (QJSA) Treas. Reg. § 1.401(a)-20, Q&A 8(a)]. 1.401(a)-20.

Under the Pension Protection Act of 2006 (PPA), starting with plan years beginning on or after January 1, 2008, a plan is required to offer a qualified optional survivor annuity (QOSA) in the event a participant waives the QJSA. A QOSA is an annuity that is

  • For the life of the participant;
  • Has a survivor annuity for the life of the spouse equal to 75 percent if the QJSA was less than 75 percent, or 50 percent if the QJSA was greater than or equal to 75 percent;
  • Payable during the joint lives of the participant and the spouse; and
  • The actuarial equivalent of a single annuity for the life of the participant.

First, any DC plan to which the minimum funding standard of IRC Sec. 412 applies (such as a money purchase pension plan) must follow the QJSA/QOSA/QPSA rules. However, even if a DC plan is not subject to the minimum funding standard, it may still have to meet the QJSA/QOSA/QPSA requirements. In order to avoid the survivor annuity mandate the plan must meet all of the following stipulations:

  1. The plan must provide that the participant’s spouse is entitled to the full, nonforfeitable account balance upon the participant’s death. (If there is no surviving spouse or the surviving spouse properly waives the benefit, the designated beneficiary must be entitled to the account balance.)
  2. The participant does not elect a life annuity.
  3. The account balance is not from a “transferee plan” that is subject to the survivor annuity requirements, or separate accounting between transferred benefits and any other benefits under the plan has been established. (Separate accounting means the plan must allocate all gains, losses, withdrawals, contributions, forfeitures and other charges and credits on a reasonable and consistent basis between the accrued benefits subject to the survivor annuity rules and other benefits that are not. If such accounting does not exist, then the plan must make all benefits subject to the survivor annuity requirements.)

A DC plan is a transferee plan for any participant if it

  • Holds a participant’s benefit that had been transferred to it by a DB plan after January 1, 1985;
  • Is a DC plan subject to the minimum funding standard under IRC 412; or
  • Is a DC plan that is otherwise subject to the survivor annuity rules.

Note that a rollover contribution (including a direct rollover) is not a direct or indirect transfer that would cause the survivor annuity requirements to apply.

Conclusion

The following schematic illustrates when a DC plan may be subject to the QJSA/QOSA/QPSA requirements.

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403(b) 15 years-of-service catch-up contribution election

“How does the special 15-year catch-up contribution rule works for 403(b) plans?”

ERISA consultants at the Retirement Learning Center 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 a financial advisor from Massachusetts is representative of a common inquiry related to 403(b) salary deferrals.

Highlights of the Discussion

The IRS allows certain long-term employees to catch-up on the funding of their 403(b) plans by electing to increase their elective deferrals over the standard dollar limit. The election is available only to employees who have completed at least 15 years of service with one of the following types of employers:

With the exception of church-related organizations or organizations controlled by a church-related organization, years with different employers cannot be added together for purposes of satisfying the 15-year requirement.

Example 1

Anna is a teacher with the West County School System. She has been employed by West County for six years, but worked for the East County School System for 10 years prior to coming to West County. There is a State Teachers Retirement System that covers all of Anna’s years with both West and East Counties. However, only the years that Anna worked while a teacher for West County may be counted for purposes of eligibility for the 15-year catch-up contribution election [see Treas. Regs. 1.403(b)-4(c)(3)(ii)(B) and 1.403(b)-4(e)(3)].

Under the special 15-year catch-up election, the standard annual deferral limit (i.e., $18,500 for 2018) is increased by the lesser of the following three numbers:

  1. $3,000 or
  2. $15,000 minus any elective deferrals previously excluded under this catch-up election, plus any amount of designated Roth contributions in prior years under this catch-up, or
  3. $5,000 multiplied by the employee’s years of service minus the elective deferrals made to plans of the organization in prior taxable years.

There is a lifetime limit of $15,000 for this catch-up election. And, to complicate matters further, an individual age 50 or older may make an additional standard catch-up of $6,000. For an employee eligible to use both the 15-year catch-up and the age 50 catch-up, he or she must apply the 15-year catch-up first. Then an amount may be contributed as an age 50 catch-up to the extent the age 50 catch-up limit exceeds the 15-year catch-up limit.

Example 2

Let’s apply all this in an example.

For 2018, Dion, age 50, has taxable compensation of $70,000. He has worked for the local hospital for 15 years. Dion has made no other elective deferrals during the year, and this will be the first year he contributes to the hospital’s 403(b) plan.

The general 402(g) limit is $18,500. Dion can use up to $3,000 of the 15-year catch-up, and he qualifies for the age 50 catch up of $6,000. Therefore, the maximum amount Dion can elect to defer is $27,500 ($18,500 + $3,000 + $6,000). If Dion defers only $24,500, then $3,000 will count as his 15-year catch-up contribution (reducing future 15-year catch-up contributions because of the $15,000 lifetime limit) and $3,000 will count as his age 50 catch-up.

Example 3

Similarly, Fiona, age 50, has taxable compensation of $70,000 for 2018. She has worked for the local hospital for 20 years. Fiona has made no other elective deferrals during the year, but she has made elective deferrals in prior years to the 403(b) plan of $175,000.

The general 402(g) limit is $18,500. The 15-year catch-up is only available if prior deferrals do not exceed $5,000 x her years of service (i.e., $5,000 x 20 = $100,000). Fiona had prior deferrals of $175,000. Therefore, she has used up her 15-year catch-up. However, because she has attained age 50, she is eligible for the age 50 catch-up limit of $6,000. Consequently, the maximum Fiona can elect to defer is $24,500 ($18,500 plus $6,000 under the age 50 catch-up).

Be sure to check the terms of the 403(b) document for any additional limitations that may apply on salary deferrals.

Conclusion

Certain long-tenured 403(b) plan participants who work for eligible employers such as a public school system, hospital or church have special considerations when it comes to the maximum amount they can defer into their 403(b) plans. Plan language can also affect how much participants are eligible to contribute. The rules are complicated; therefore, 403(b) plan participants should be encouraged to discuss their contributions with a tax advisor.

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Rollovers to SIMPLE IRAs

“Can my client roll over money to her SIMPLE IRA.”

ERISA consultants at the Retirement Learning Center 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 a financial advisor from California is representative of a common inquiry related to savings incentive match plans for employees (SIMPLE) IRA rollovers.

Highlights of the Discussion

As of 2016, (or December 18, 2015, to be more precise), SIMPLE IRAs can receive rollovers from traditional IRAs and simplified employee pension (SEP) IRAs, as well as from eligible employer-sponsored retirement plans, such as 401(k), 403(b), or governmental 457(b) plans, as long as it has been two years since the individual first participated in the SIMPLE IRA plan. So, if your client has owned her SIMPLE IRA for two years, then she can roll over money into it from another eligible plan. SIMPLE IRAs still may not accept rollovers from Roth IRAs or designated Roth accounts within 401(k) plans.

Prior to 2016, a SIMPLE IRA plan could only accept rollover contributions from another SIMPLE IRA plan. The Consolidated Appropriations Act, effective December 18, 2015, allowed greater portability between SIMPLE IRAs and other plan types by broadening the retirement plans that are eligible for rollover to a SIMPLE IRA.

The restrictions on rollovers from a SIMPLE IRA during the first two-years of participation have remained constant. Under both prior and current law, during the initial two-year period, a SIMPLE IRA owner may only move assets between SIMPLE IRAs via a trustee-to-trustee transfer.  If, during the initial two-year period, a SIMPLE IRA owner transfers or rolls over assets to an IRA or plan that is not a SIMPLE IRA, then the IRS treats the payment as a distribution from the SIMPLE IRA. The SIMPLE IRA owner must include the amount in his or her taxable income. On top of that, a 25 percent additional early distribution penalty tax applies to the amount, unless the taxpayer qualifies for an exception under IRC 72(t).

SIMPLE IRA assets may never be rolled over to a designated Roth account in a 401(k) plan and vice versa.

For a handy reminder of what retirement assets can roll where and when, please link to the IRS’s Rollover Chart.

Conclusion

The rules regarding rollovers to SIMPLE IRAs changed after December 18, 2015, allowing more freedom to move eligible retirement assets into a SIMPLE IRA. The restrictions on rollovers from a SIMPLE IRA during the first two-years of participation have remained constant.

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Like plans for lump sums

My client has a 401(k)/profit sharing plan and a defined benefit plan at work. He wants to take advantage of the special tax treatment for net unrealized appreciation (NUA) in employer stock that is part of a lump sum distribution. For this purpose, does he have to withdrawal the balances from both plans in order to have a true lump sum distribution?”

ERISA consultants at the Retirement Learning Center 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 a financial advisor from New Jersey is representative of a common inquiry related to the definition of lump sum distribution for special tax purposes.

Highlights of the Discussion

No; in order to meet the definition of lump sum, the IRS requires that only “like plans” of the same employer be combined when determining whether the participant’s entire balance has been paid out within one taxable year. A pension plan and 401(k)/profit sharing plan are not considered like plans in this case.

The term ‘‘lump-sum distribution’’ means payment within one taxable year of the balance to the credit of an employee that becomes payable as a result of an employee’s death, attainment of age 59 ½, separation from service, or disability. The IRS clarifies in IRC Sec. 402(d)(4)(D)(ii)(I) that “balance to the credit” means all pension plans maintained by the same employer are grouped together and treated as a single plan; all profit-sharing plans maintained by the same employer are grouped together and treated as a single plan; and all stock bonus plans maintained by the same employer are grouped together and treated as a single plan.

Conclusion

Although defined benefit pension plans and profit sharing plans are both types of qualified retirement plans under IRC. Sec. 401(a), they are not considered like plans for the purpose of taking a lump sum distribution.

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Comparing profit sharing allocation formulas

“What are the most common contribution formulas for profit sharing plans and how do they compare?”

ERISA consultants at the Retirement Learning Center 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 a financial advisor from Virginia is representative of a common inquiry related to profit sharing plan contributions.

Highlights of the Discussion

Profit-sharing plan contributions are discretionary in most cases, and they must be made according to a nondiscriminatory allocation formula. The most common formula used is a formula that allocates contributions based on a percentage of each participant’s compensation, but there are several others, including flat dollar, integrated and cross-tested as described in the following paragraphs. The actual formula that a sponsor must apply will be detailed in the plan document that governs the plan.

Flat Dollar

A plan sponsor who uses a flat dollar contribution formula in its profit sharing plan must contribute the same dollar amount to each eligible employee, regardless of the participants’ level of pay.

Pro Rata

An allocation formula that provides eligible participants with a contribution based on the same percentage of compensation is known as a pro rata formula.

Integrated

An integrated allocation formula allows a plan sponsor to provide higher contributions for eligible participants who earn amounts over a set threshold, as long as the “permitted disparity rules” of IRC Sec. 401(l) are satisfied. Integrated plans are also known as “Social Security-based” or “permitted disparity” plans. The permitted disparity rules allow plan sponsors to give eligible participants who earn compensation above the “integration level,” which is typically the Social Security Taxable Wage Base (TWB), an additional contribution. This additional contribution is equal to the lesser of

  • Two times the base contribution percentage, or
  • The base contribution percentage plus the “permitted disparity factor.”

If the plan sponsor sets the integration level at the TWB, then the permitted disparity factor equals 5.7 percent. Note that the plan sponsor may set the integration level at an amount lower than the TWB. If this is done, however, the plan sponsor must then reduce the permitted disparity factor according to the following table.

 

Integration Level Applicable Permitted Disparity Factor
The Taxable Wage Base (TWB) 5.7%
81-99% of the TWB 5.4%
21-80% of the TWB 4.3%
0-20% of the TWB 5.7%

 

Cross-Tested

Profit sharing plans typically satisfy general nondiscrimination rules by comparing the amount of contributions given to participants. The IRS allows plan sponsors to prove their plans are nondiscriminatory under a testing alternative known as the “cross-testing method.” Under the cross-testing method, contributions are converted to equivalent benefits payable at normal retirement age, and then compared to determine whether or not the benefits unduly favor highly compensated employees over nonhighly compensated employees. This is similar to defined benefit plan testing. The most common types of cross-tested plans are age-weighted and new comparability plans.

  1. Age-weighted

In an age-weighted profit sharing plan, the employer’s contribution to the plan is allocated among employees based on factors that combine compensation with deferred annuity factors based on age. The higher the age, the larger the factor, and the larger the allocation to the participant will be.

2.  New comparability plans permit plan sponsors to favor select groups of participants. Under the new comparability rules, plan sponsors are allowed to define and assign employees to different contribution “rate groups” within the plan. The contribution level for each rate group may vary, as long as the plan proves nondiscriminatory under the cross-testing method.

  Comparing Profit Sharing Plan Contribution Allocation Formulas for 2018
Employee Age Compensation Flat Dollar Pro Rata Integrated Age Weighted New Comparability
Owner A 48 $275,000.00 $7,500 $55,000.00 $55,000.00 $55,000.00 $55,000.00
Owner B 60 $275,000.00 $7,500 $55,000.00 $55,000.00 $55,000.00 $55,000.00
Participant C 43 $60,000.00 $7,500 $12,000.00 $10,180.56 $8,389.03 $3,987.12
Participant D 50 $60,000.00 $7,500 $12,000.00 $10,180.56 $13,917.81 $3,987.12
Participant E 32 $30,000.00 $7,500 $6,000.00 $5,090.28 $1,893.16 $1,993.56
    $700,000.00 $37,500 $140,000.00 $135,451.40 $134,200.00 $119,967.80
               
 Assumptions       % of Compensation Integration Level (TWB) Factor Rate Groups
         20% $128,700  7.50% 1. owners
              2. non-owners

The above represents a hypothetical scenario for illustrative purposes only to maximize contributions for the business owners. It cannot be used for tax or legal advice.

Conclusion

When made, profit-sharing plan contributions must be allocated according to a nondiscriminatory formula as specified in the plan document. But as the table above illustrates, some formulas (depending on the make up of employees) can allow a greater share of the overall contribution to be given to owners or other more highly paid participants.

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Definitions of compensation for plan purposes

What definition of compensation does a 401(k) plan use in plan administration?”

ERISA consultants at the Retirement Learning Center 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, 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 a financial advisor from Washington D.C. is representative of a common inquiry related to the definition of compensation for plan purposes.

Highlights of the Discussion
The term “compensation” has several different applications in qualified retirement plan operations, depending on the particular compliance goal. For example, a plan may use one definition of compensation to allocate employer contributions and a separate, distinct one for testing whether employee salary deferrals are nondiscriminatory. One of the top plan compliance concerns identified by the IRS is a plan sponsor’s failure to identify and apply the correct definition of compensation in a particular scenario. What follows is a general description of the various definitions of compensation that plan sponsors are required or permitted to use for various plan purposes.

The definitions of compensation used for the plan must be specified in the governing plan documents. Plan documents that are preapproved by the IRS simplify the process of selecting the various definitions of compensation. Plan sponsors are, ultimately, responsible for making sure the party administering the plan (e.g., CPA, record keeper, or third-party administrator) is using the appropriate definition of compensation.

At a high level, there are two primary definitions of plan compensation from the Internal Revenue Code (IRC) that apply in plan operations, one is found in IRC Sec. 415(c)(3) and the other is in IRC Sec. 414(s). Other IRC sections and regulations refer to one or the other of these definitions, and specify which of the compensation definitions a plan can or must use for a particular purpose.

IRC Sec. 415(c)(3) compensation

There are four different definitions of compensation in the regulations under IRC Sec. 415(c)(3) from which a plan sponsor may choose: 1) statutory; 2) simplified; 3) W-2; or 4) 3401 withholding wages. Please refer to the chart on pages 47-48 of the IRS’s material on Compensation for a comparison of the definitions.

A plan must use an IRC Sec. 415(c) definition of compensation when determining the following:

  • Annual limits on contributions and benefits;
  • Which employees are highly compensated employees and key employees;
  • A top-heavy minimum contribution, when needed;
  • The minimum “gateway” contribution for plans using a cross-tested contribution allocation method; and
  • A sponsor’s maximum tax deductible contribution for a year.

IRC Sec. 414(s) compensation

With respect to IRC. Sec. 414(s) compensation, any definition of compensation that satisfies IRC Sec. 415(c)(3) will automatically satisfy IRC Sec. 414(s). In addition, the regulations under IRC Sec. 414(s) also provide for a safe harbor alternative definition. Under the alternative safe harbor, a plan starts with a definition of compensation that satisfies IRC Sec. 415(c)(3), and reduces it by all of the following categories of compensation:

  1. Reimbursements or other expense allowances;
  2. Cash and noncash fringe benefits;
  3. Moving expenses;
  4. Deferred compensation; and
  5. Welfare benefits.

A plan must use a definition of compensation that meets the requirements of IRC Sec. 414(s) when determining the following:

  • Contributions for a design-based safe harbor plan[1] or a safe harbor 401(k) plan;
  • A participant’s actual deferral ratio and actual contribution ratio used in performing the actual deferral percentage (ADP) and actual contribution percentage (ACP) nondiscrimination tests in a 401(k) plan;
  • Whether contributions and benefits are nondiscriminatory under Sec. 401(a)(4) (other than the minimum contribution component of the gateway test mentioned previously);
  • Contributions under a design-based safe harbor plan with permitted disparity provisions[2].

Finally, a sponsor has some leeway in choosing a definition of compensation, provided it is reasonable and does not unduly favor highly compensated employees, when determining the following:

  • Contributions (if the plan is not a design-based safe harbor);
  • The maximum permitted deferrals within a 401(k) plan; and
  • The plan sponsor’s matching contributions for participants.

Conclusion

Applying the proper definition of plan compensation for a particular compliance purpose is one of the trickiest parts of administering a plan correctly. Sponsors and their CPAs, record keepers, and/or TPAs must always refer to the plan document for the correct definition of compensation to apply based on the function being performed.

[1] A design-based safe harbor plan is designed to demonstrate nondiscrimination with a uniform method of allocating contributions.

[2] Allocation formula integrated with Social Security

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