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Is Congress Closing the Backdoor to Roth IRAs?

An advisor asked: “Is Congress Closing the Backdoor to Roth IRAs?”

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 a financial advisor from California is representative of a common inquiry related to Roth conversions.

Highlights of the Discussion
Potentially, yes, as well as restricting other Roth conversion strategies. As part of the tentative measures to help fund the proposed $3.5 trillion budget reconciliation package (a.k.a., Build Back Better Act ), the House Ways and Means Committee has suggested, among other tactics, restricting “back-door Roth IRAs,” a popular tax-reduction strategy where individuals convert traditional IRA and/or retirement plan assets to Roth IRAs. If enacted as proposed, after-tax IRA and after-tax 401(k) plan conversions would be eliminated after 12/31/2021. For amounts other-than after-tax (i.e., pretax assets), traditional IRA and plan conversions for taxpayers who earn over the following taxable income thresholds would cease after 12/31/2031:

• Single taxpayers (or taxpayers married filing separately) with AGI over $400,000,
• Married taxpayers filing jointly with AGI over $450,000, and
• Heads of households with AGI over $425,000 (all indexed for inflation).

The buildup of Roth assets can be a source of tax-free income later if certain conditions are met. Ending Roth conversions using after-tax contributions in a defined contribution plan or IRA, and restricting Roth conversions of pre-tax plan or IRA assets would materially limit many taxpayers’ ability to accumulate Roth assets in a tax-free or tax-reduced manner.
You won’t find the phrase backdoor Roth IRA in the Internal Revenue Code or Treasury regulations. Nor is it a specific product, but the industry has known about the phenomena for years. A backdoor Roth IRA is merely a series of transactions or steps an individual can take to have a Roth IRA—regardless of income level. While initially poorly understood and lacking clear IRS guidance, so called “back-door Roth IRAs” have been legitimized over the years by the IRS.

The ability to make a 2021 Roth IRA contribution is phased out and eliminated for single tax filers with income between $125,000-$140,000; and for joint tax filers with income between $198,000-$208,000. Consequently, if a person earns too much, he or she cannot make a Roth IRA contribution directly (i.e., through the front door). But many can still take another route—by converting traditional IRA or qualified retirement plan assets, a transaction that has become known as the backdoor Roth IRA.

Congress repealed any income limitations for Roth IRA conversions in 2010. Consequently, regardless of income level, anyone could fund a Roth IRA through a conversion. For example, if a person exceeds the income limitation for contributions to a Roth IRA, he or she could contribute amounts (deductible or nondeductible) to a traditional IRA based on earned income and, shortly thereafter, convert the contribution from the traditional IRA to a Roth IRA. Similarly, a person with a 401(k)-plan account balance could convert eligible plan assets either in-plan to a designated Roth account (if one exists) or out-of-plan to a Roth IRA through a plan distribution. Assets that are taxable at the point of conversion would be included in the individual’s taxable income for the year. Going forward, earnings would accumulate tax-deferred and, potentially, would be tax-free upon distribution from the Roth IRA. Under the authority of IRS Notice 2014-54, a qualified plan participant can rollover pre-tax assets to a traditional IRA for a tax-free rollover and direct any after-tax assets to a Roth IRA for a tax-free Roth conversion.

Conclusion
Plan participants and IRA owners need to be aware that as part of the 2021 budget reconciliation process, the ability to convert assets to Roth assets may be sunsetting. If revenue-generating provisions of the Build Back Better Act are enacted as currently proposed, Roth conversions of after-tax IRA and after-tax 401(k) plan assets would be eliminated after 12/31/2021; and Roth conversions of pre-tax IRA and plan assets would cease after 12/31/2031.

Click here for an RLC webinar on the proposed changes.

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Are Plan Committee Members Fiduciaries?

An advisor asked: “Can an individual member of a 401(k) plan committee have personal fiduciary liability?”

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 Indiana is representative of a common question on plan committee members.

Highlights of the Discussion

  • A plan committee member may be a plan fiduciary and, consequently, held personally liable to the plan if he or she is granted or exercises discretion in the operation or administration of a retirement plan that is subject to the Employee Retirement Income Security Act of 1974 (ERISA).
  • According to the Department of Labor (DOL) Interpretive Bulletin 75-5, if the governing plan documents state the plan committee controls and manages the operation and administration of the plan and specifies who shall constitute the plan committee (either by position or by naming individuals to the committee), then such individuals are named fiduciaries of the plan pursuant to ERISA §402(a) (see page 212 of linked document).
  • A number of court cases have found that a plan committee member may be a functional fiduciary of the plan because of his or her actions and subject to personal liability if he or she exercises discretion in the administration of the plan Gaunt v. CSX Transp., Inc., 759 F. Supp. 1313 (N.D. Ind. 1991).
  • Pursuant to ERISA §409 (see page 250 of linked document):

Any person who is a fiduciary with respect to a plan who breaches any of the responsibilities, obligations, or duties imposed upon fiduciaries … shall be personally liable to make good to such plan any losses to the plan resulting from each such breach, and to restore to such plan any profits of such fiduciary which have been made through use of assets of the plan by the fiduciary, and shall be subject to such other equitable or remedial relief as the court may deem appropriate, including removal of such fiduciary.

  • Having a committee charter may help mitigate fiduciary liability for the committee members by carefully outline the members roles and responsibilities. Please see our Case of the Week 401(k) Plan Committee Charter for best practices.

Conclusion

A plan committee member may be a plan fiduciary and, consequently held personally liable to the plan for losses resulting from fiduciary breaches.  Having a committee charter may help mitigate fiduciary liability for the committee members.

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Real Estate Agents and Retirement Plans

“A client of mine is a real estate agent who receives income that is reported on Form 1099-MISC, Miscellaneous Income. Can this individual contribute to a retirement plan?”

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 North Dakota is representative of a common question related plan eligibility.

Highlights of Discussion

• Some unique rules for retirement plan eligibility apply for real estate agents, based on their worker status as a “statutory nonemployee.” (Since each employment scenario is based on unique facts and circumstances; it is recommended that workers seek professional tax advice for a definitive determination in their particular situations.)
• Individuals who perform services for businesses may be classified as an independent contractor, a common law-employee, a statutory employee, or a statutory nonemployee. The IRS explains each classification in more detail in Publication 15-A, Employer’s Supplemental Tax Guide.
• There are three categories of statutory nonemployees: direct sellers, licensed real estate agents, and certain companion sitters. Licensed real estate agents include individuals engaged in appraisal activities for real estate sales if they earn income based on sales or other output.  Direct sellers and real estate agents are treated as self-employed for all Federal tax purposes, including income and employment taxes, if the following are true.

1. Substantially all payments for their services as direct sellers or real estate agents are directly related to sales or other output, rather than to the number of hours worked; and
2. Their services are performed under a written contract that provides they will not be treated as employees for Federal tax purposes.
Because real estate agents are considered self-employed, they are eligible to establish a retirement plan based on their earnings from self-employment. Please see IRS Publication 560, Retirement Plans for Small Businesses.

Conclusion
If a licensed real estate agent meets the above criteria, he or she could establish a retirement plan using his or her Form 1099-MISC income. Since each employment scenario is based on unique facts and circumstances, it is recommended that workers seek professional tax advice for a definitive determination.

 

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401(k) Plans for Owner-Only Businesses

“Can an unincorporated, owner-only business have a 401(k) plan and, if so, are there any special considerations of which we need to be aware?”

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 North Carolina is representative of a common question related to owner-only businesses and retirement plans.

Highlights of Discussion

  • Yes, an unincorporated, owner-only business may have a 401(k) plan—commonly referred to as a(n) “individual (k)” or “solo (k)” plan.
  • Special considerations with respect to the solo (k) plan include, but would not be limited to, the
    • Deadline for establishing a 401(k) plan,
    • Deadline for making a salary deferral election, and
    • Owner’s compensation for contribution purposes.
  • The deadline for establishing a 401(k) plan for any eligible business changed beginning in 2021 to the business’s tax filing deadline plus applicable extensions.[1] The prior deadline was the last day of the business’s tax year (e.g., December 31 for a calendar year tax year). However, keep in mind the timing of when a salary deferral election must be made has not changed.
  • Salary deferrals can only be made on a prospective basis [Treasury Regulation (Treas. Reg.) 1.401(k)-1(a)(3)]. Therefore, the salary deferral election must be made prior to the receipt of compensation. For self-employed individuals (i.e., sole proprietors and partners), compensation is considered paid on the last day of the business owner’s taxable year. The timing is connected to when the individual’s compensation is “deemed currently available” [see Treas. Reg. § 401(k)-1(a)(6)(iii)]. Therefore, a self-employed person has until the end of his or her taxable year to execute a salary deferral election for the plan (e.g., December 31, 2020, for the 2020 tax year).
  • The definition of compensation for contribution purposes for an unincorporated business owner is unique [IRC 401(c)(2)(A)(I)]. It takes into consideration earned income or net profits from the business which then must be adjusted for self-employment taxes. Please refer to the worksheet for calculating compensation for and contributions to a solo (k) plan for a self-employed individual in Publication 560, Retirement Plans for Small Businesses. A business owner who wants to have a 401(k) plan should work with his or her CPA or tax advisor to determine his or her earned income and maximum contribution for plan purposes.
  • The 2020 contribution for an unincorporated business owner to a solo (k) plan with enough earned income could be as high as $57,000 (or $63,500 if he or she turned age 50 or older before the end of the year). For 2021, those limits are $58,000 and $64,500, respectively.

Example:

Ryan is a sole proprietor who would like to set up a solo k plan effective for 2020.  The IRS extended his tax filing deadline for 2020 to May 17, 2021, and if Ryan files for an extension, his extended tax deadline would be October 15, 2021. Therefore, the latest Ryan could potentially set up a solo k plan for 2020 would be October 15, 2021. Since Ryan is past the deadline for making a salary deferral election for 2020, however, his contribution would be limited to an employer profit sharing contribution based on his adjusted net business income for 2020. The sooner Ryan sets up the solo k for his business, the sooner he will be able to make employee salary deferrals for 2021.

Conclusion

For self-employed individuals and their tax advisors, there are several special considerations with respect to setting up and contributing to solo (k) plans, including, but not limited to, the deadline for establishing a 401(k) plan, the deadline for making a salary deferral election, and the owner’s compensation for contribution purposes.

[1] Section 201 of the Setting Every Community Up for Retirement Enhancement Act of 2020

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Still Time for a 2020 Nonelective Safe Harbor Plan?

“Although it is already November, can my client amend her traditional 401(k) plan to be a safe harbor plan for 2020?”

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 a financial advisor from Illinois is representative of a common inquiry related to safe harbor plans.

Highlights of the Discussion

Yes, but she must hurry. The Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019 relaxed the deadline for amending a 401(k) plan to add a safe harbor nonelective contribution for the current year.

Under Section 103 of the SECURE Act, plan sponsors may amend their plans to add a three percent safe harbor nonelective contribution at any time before the 30th day before the close of the plan year. The SECURE Act also did away with the mandatory participant notice requirement for this type of amendment.

Furthermore, amendments after that time would be allowed if the amendment provides

1) a nonelective contribution of at least four percent of compensation for all eligible employees for that plan year,

and

2) the plan is amended no later than the close of the following plan year.

EXAMPLE:

Safety First, Inc., maintains a calendar-year 401(k) plan. Based on the plan’s preliminary actual deferral percentage (ADP) test (which the plan is failing), Safety First decides a safe harbor plan is a good idea for 2020. It’s too late to add a safe harbor matching contribution for 2020. However, the business could add a three percent safe harbor nonelective contribution for the 2020 plan year (without prior participant notice) as long as Safety First amends its plan document prior to December 1, 2020. While Safety First still could add a nonelective safe harbor contribution to the plan for 2020 after that date, the minimum contribution would have to be at least four percent of compensation, and the company would have to amend its plan document no later than December 31, 2021.

Conclusion

Thanks to the SECURE Act, 401(k) plan sponsors have more flexibility to amend their plans for “safe harbor” status. Plan sponsors who are failing their ADP tests for the year may find this type of plan amendment attractive as a correction measure.

 

 

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Two Plans–Two Limits?

“My client is a fireman who participates in the department’s 457(b) plan. He also runs his own electrical business. Can he set up a 401(k) plan and contribute to both plans?”

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 Massachusetts is representative of a common inquiry related to multiple retirement plans.

Highlights of Discussion

This is an important tax question that your client should discuss with his tax professional to make sure all the facts and circumstances of his financial situation are considered. Generally speaking, however, the IRS rules would allow your client to contribute to both his 457(b) plan and 401(k) plan up to the limits in both.

For 2020, 457(b) contributions (consisting of employee salary deferrals and/or employer contributions combined) cannot exceed $19,500, plus catch-up contribution amounts if eligible [Treasury Regulation Section (Treas. Reg. §1.457-5)]  and 457(b) contribution limit].  The same maximum deferral limit applies for 401(k) plans in 2020 (i.e., $19,500, plus catch-up contributions). The catch-up contribution rules differ slightly between the two plan types.

401(k) and 457(b) Catch-Up Contribution Rules

401(k) 457(b)
Age 50 or Over Option

 

Employees age 50 or over can make catch-up contributions of $6,500 beyond the basic 402(g) limit of $19,500 for 2020.

 

Age 50 or Over Option

 

Employees age 50 or over can make catch-up contributions of $6,500 beyond the basic 457 deferral limit of $19,500 for 2020.

 

Special “Last 3-Year” Option

 

In the three years before reaching the plan’s normal retirement age employees can contribute either:

 

•Twice the annual 457(b) limit (in 2020, $19,500 x 2 = $39,000),

 

Or

 

•The annual 457(b) limit, plus amounts allowed in prior years not contributed.

 

Note:  If a governmental 457(b) allows both the age-50 catch-up and the 3-year catch-up, one or the other—but not both—can be used.

Since 2002, contributions to 457(b) plans no longer reduce the amount of deferrals to other salary deferral plans, such as 401(k) plans. A participant’s 457(b) contributions need only be combined with contributions to other 457(b) plans when applying the annual contribution limit. Therefore, contributions to a 457(b) plan are not aggregated with deferrals an individual makes to other types of deferral plans. Consequently, an individual who participates in both a 457(b) plan and one or more other deferral-type plans, such as a 403(b), 401(k), salary reduction simplified employee pension plan (SAR-SEP), or savings incentive match plan for employees (SIMPLE) has two separate annual deferral limits.

Another consideration when an individual participates in more than one plan is the annual additions limit under IRC Sec. 415(c),[1] which typically limits plan contributions (employer plus employee contributions for the person) for a limitation year [2] made on behalf of an individual to all plans maintained by the same employer. It this situation, the annual additions limit is of no concern for two reasons:  1) there are two separate, unrelated employers; and 2) contributions to 457(b) plans are not included in a person’s annual additions [see 1.415(c)-1(a)(2)].

Conclusion

IRS rules would allow a person who participates in a 457(b) plan and a 401(k) plan to contribute the maximum amount in both plans. However, it is important to work with a financial and/or tax professional to help determine the optimal amount based on the participant’s unique situation.

[1] For 2020, the limit is 100% of compensation up to $57,000 (or $63,500 for those > age 50).

[2] Generally, the calendar year, unless the plan specifies otherwise.

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American Depositary Receipts and Shares

“My client is asking me about ADRs and whether he can invest in them through his 401(k) plan. Can you explain, please?”

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 a financial advisor from Indiana is representative of a common inquiry related to 401(k) plan investments.

Highlights of the Discussion

Think of an ADR as similar to a stock certificate that represents ownership of a share in a company. An ADR, which stands for American Depositary Receipt, is a negotiable certificate that represents an ownership interest in American Depositary Shares (ADSs). ADSs are shares of a non-U.S. company that are held by a U.S. depository bank or custodian outside the US, and made available for sale on a US stock exchange or over-the-counter market.

ADRs are registered in the US with the Securities and Exchange Commission (SEC), trade in US dollars and clear through US settlement systems, allowing ADR holders to avoid transacting in a foreign currency. Transactions are generally performed by brokers and other types of investors who are active in foreign securities markets. According to the SEC, the stocks of most foreign companies that trade in the US markets are traded as ADRs.

It is possible that a 401(k) plan could offer the ability to invest in ADRs, however, a plan sponsor must first decide whether such an investment option would be prudent from a fiduciary stand point to offer in the plan and, if so, make sure there is accommodating plan language.

Investors who may be interested in ADRs should learn all they can and consult with a financial advisor regarding specific questions. The SEC has introductory information on ADRs in its Investor Bulletin: American Depositary Receipts.

Conclusion

ADRs represent shares of foreign companies traded in US dollars on US exchanges. It is a popular and streamlined way to invest in non-US companies. For additional background information, please see the following material:

SEC Regulation of American Depositary Receipts

 

 

 

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Oops … How to fix switched contributions

“My client initially elected to make designated Roth contributions to her 401(k) plan and a few years later switched her election to pre-tax elective deferrals. We just discovered the employer is still treating her deferrals as designated Roth contributions. Is there a way to retroactively treat these amounts as pre-tax salary deferrals?”

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 a financial advisor from Massachusetts is representative of a common inquiry related to designated Roth contributions in 401(k) plans.

Highlights of the Discussion

Yes, there is a way of correcting the situation where an employer has failed to make the correct type of salary deferral to a 401(k) plan (i.e., pre-tax/designated Roth, or vice versa) based on the participant’s deferral election. It will require some correcting of IRS tax forms and the employer’s participation in the IRS’s Employee Plans Compliance Resolution System (EPCRS) program. Please refer to Fixing Common Mistakes-Correcting a Roth Contribution Failure and Revenue Procedure 2019-19.  

Generally speaking, an employer in this situation can correct the error by executing three steps.

Step 1: Transfer deferrals

The employer transfers the erroneously deposited deferrals, adjusted for earnings, from the designated Roth account to the pre-tax salary deferral account. The employer must ensure the information on IRS Form W-2, Wage and Tax Statement, for the participant is correct (i.e., reflecting the correct contribution type). That may involve the employer filing a corrected Form W-2 with the IRS showing the previously misidentified designated Roth contributions as pre-tax salary deferrals.

Step 2: Follow EPCRS or Audit CAP

Since the error represents an operational failure on the plan sponsor’s part, the sponsor should follow plan correction procedures outlined in the IRS’s EPCRS program. Depending on the circumstances, it may be possible for the employer to self-correct the error, without penalty or a formal filing with the IRS. Otherwise, a sponsor can file with the IRS under the IRS’s Voluntary Correction Program (VCP). If the error was discovered during an IRS audit, the only corrective option is to follow the Audit Closing Agreement Program (Audit CAP).

Step 3: Establish avoidance procedures

Part of correcting a plan error is to ensure that the error will not happen again. Plan sponsors should create, document and follow new policies and procedures that will prevent future failures such as these.

Conclusion

The IRS has identified the misclassification of employee salary deferrals as designated Roth contributions and vice versa by plan sponsors as a common plan mistake. Fortunately, there is a relatively painless IRS process to remedy the situation.

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Deadlines to deposit elective deferrals

“I get confused by the various deposit deadlines for employee salary deferrals. Can you summarize them for me, please?” 

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 a financial advisor from North Carolina is representative of a common inquiry related to depositing employee salary deferrals.  

Highlights of the Discussion

The following table summarizes the Department of Labor’s (DOL’s) deferral deposit deadlines for various plan types.

Plan Type Deadline Citation
Small 401(k) Plan

A plan with fewer than 100 participants

 

Safe Harbor Rule: The plan sponsor has seven business days following the day on which such amounts were withheld to deposit them to the plan. DOL Reg. 2510-3-102(a)(2)

 

Large 401(k) Plan

A plan with 100 or more participants

The plan sponsor must deposit deferrals as soon as they can be reasonably segregated from the employer’s assets, but not later than 15 business days following the month the deferrals are withheld from the participants’ pay. DOL Reg. 2510-3-102(a)(1) and (b)(1)

 

Savings Incentive Match Plan for Employees of Small Employers (SIMPLE) IRA Deferrals must be deposited within 30 days after the end of the month in which the amounts would otherwise have been payable to the employee. DOL Reg. 2510.3-102(b)(2)

 

Salary Reduction Simplified Employee Pension (SAR-SEP)

An IRA-based plan with 25 or fewer employees.

Safe Harbor Rule: The plan sponsor has seven business days following the day on which such amounts were withheld to deposit them to the plan. DOL Reg. 2510-3-102(a)(2)

 

Conclusion

The DOL’s top compliance concern is the timely deposit of employee salary deferrals to their respective plans. Plan sponsors and service providers must ensure policies and procedures are in place to ensure deferral deposit deadlines are met.

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Deferral limit, multiple plans and excess deferrals

“What is a plan participant’s deferral limit if he or she participates in more than one 401(k) 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 Connecticut is representative of a common inquiry related to contribution limits.

Highlights of the Discussion

The IRC § 402(g) annual limit on employee salary deferrals is an individual taxpayer limit—not a per plan limit. Consequently, an individual under age 50 for 2018 was limited to deferring 100 percent of compensation up to a maximum of $18,500 (or $24,500 if age 50 or more)—regardless of the number of plans in which he or she participated during the year. For 2019, the respective limits are $19,000 and $25,000.

This annual limit is inclusive of employee salary deferrals (pre-tax and designated Roth) an individual makes to all of the following plan types:

  • 401(k),
  • 403(b),
  • Savings incentive match plans for employees (SIMPLE) plans [both SIMPLE IRAs and SIMPLE 401(k) plans[1]] and
  • Salary reduction simplified employee pension (SARSEP) plans.[2]

(Note: A person who participates in a 457(b) plan has a separate deferral limit that includes both employee and employer contributions.)

If a taxpayer exceeds the annual limit—the result is an excess deferral that must be timely corrected. The IRS could disqualify a plan for violating the elective deferral limitation, resulting in adverse tax consequences to the employer and employees under the plan. But there are ways to correct the error. It is important to follow the correction procedures contained in the governing plan document.

Generally, if a participant has excess deferrals based on the elective deferrals made to a single 401(k) plan or plans maintained by the same employer, then the plan must return the excess deferrals and their earnings to the participant no later than April 15th of the year following the year the excess was created [Treas. Reg. § 1.402(g)-1(e)(1)].

In the case of an employee who participates in more than one salary deferral-type plan of unrelated employers, it may be difficult for the plan sponsor to recognize there is an excess deferral. Therefore, the onus is on the participant to notify the plan administrator of the amount of excess deferrals allocated to the plan prior to the April 15th correction deadline (usually a notification date is specified in the plan).

[1] The 2018 limit for deferrals to a SIMPLE IRA or 401(k) plan is $12,500 ($15,500 if age 50 or more).

[2] The 2018 limit for deferrals to a SARSEP plan is 25% of compensation up to $18,500 ($24,500 if age 50 or more).

document). The plan is then required to distribute the excess and earnings to the participant no later than the April 15th correction deadline [Treas. Reg. § 1.402(g)-1(e)(2)].

If the excess deferrals are timely withdrawn by the April 15th correction deadline, then

  • The excess deferrals are taxed in the calendar year deferred;
  • The associated earnings are taxed in the year distributed;
  • There is no 10% early distribution penalty tax; and
  • There is no 20% withholding (since the amounts are ineligible for rollover).

If the excess deferrals are withdrawn after the April 15th correction deadline, then

  • Each affected plan of the employer is subject to disqualification and would need to go through the IRS’s Employee Plans Compliance Resolution System (EPCRS) to properly correct the error;
  • The excess deferrals are subject to double taxation—taxed in the year contributed and in the year distributed;
  • The associated earnings are taxed in the year distributed; and
  • The excess deferrals could also be subject to the 10% early distribution penalty tax if no exception applies.

EXAMPLE 1

Joe, a 45-year old worker, made his full salary deferral contribution of $18,500 to Company A’s 401(k) plan by October 2018. He then left Company A to go to work for Company B, an unaffiliated company, on November 1, 2018, and was immediately allowed to participate in the 401(k) plan. Not understanding how the 402(g) limit works, he begins making salary deferral contributions to Company B’s 401(k) plan. In December his financial advisor informed him that may have over contributed for 2018.

The onus is on Joe to report the excess salary deferrals to Company B. Company B is then required to distribute the excess deferrals and earnings by April 15, 2019.  The plan document also requires forfeiture of any matching contributions associated with the excess deferral.

Conclusion

Although the annual IRC §402(g) employee salary deferral limit is an individual employee limit, exceeding it can have consequences for both the employee and the plan sponsor. Timely correction of the excess is key to minimizing possible negative effects.  Plan sponsors should review the correction procedures outlined in their plan documents, and follow them carefully should they detect or be informed of an excess deferral. Also rely on the IRS’s EPCRS corrections program.

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