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Applying Code § 401(a)(17) to Contribution Calculations
Internal Revenue Code (“Code”) § 401(a)(17) establishes a limit on the amount of annual compensation that can be recognized in qualified retirement plans. The Code § 401(a)(17) limit is subject to an annual cost of living adjustment, currently set at $270,000 for 2017, and has two applications. First, it caps the annual compensation upon which a qualified plan can base allocations (in the case of defined contribution plans) or benefit accruals (in the case of defined benefit plans). Second, the limit caps the annual compensation that can be taken into account when applying various nondiscrimination rules. This article focuses on the application of the Code § 401(a)(17) limit to the calculation of contributions; therefore, its application with respect to nondiscrimination testing will not be discussed.
General Application of the Code § 401(a)(17) Limit
In determining employer allocations to participants in a defined contribution plan, an employer is only permitted to take into account an employee’s compensation up to the Code § 401(a)(17) limit. For example, assume an employee makes $350,000 in 2017 and participates in a plan under which the employer match is 100% of deferrals up to 3% of compensation. If the participant deferred 5% of her compensation throughout the year, for a total of $17,500, her match would be $8,100 (3% x $270,000), not $10,500 (3% x $350,000).
Applying the Code § 401(a)(17) Limit on a Pay Period Basis
Plans that provide employer matching contributions on a pay-period basis must pay careful attention to the Code § 401(a)(17) limit. Although the employer matching contributions are calculated on a pay-period basis, cumulative compensation must be taken into account to determine if the participant has reached the Code § 401(a)(17) limit. When a participant reaches the Code § 401(a)(17) limit in the middle of a pay period, the employer matching contribution must be calculated on only the portion of that pay period’s compensation that, when added to all prior pay periods in the year, does not exceed the Code § 401(a)(17) limit.
For example, assume that a participant earns $20,000 on a biweekly basis in 2017. This participant will reach the Code § 401(a)(17) limit between the 13th and 14th biweekly pay cycles. Assuming this participant has been deferring consistently all year and has not yet reached the Code § 402(g) limit, she will have already been matched on $260,000 of compensation ($20,000 per week times 13 biweekly pay cycles). For her next pay cycle, only $10,000 of compensation (i.e., the amount remaining in the 2017 Code § 401(a)(17) limit) can be taken into account when calculating the employer matching contribution for that pay period.
Applying the Code § 401(a)(17) Limit to Non-Calendar Year Plans
The Code § 401(a)(17) limit is aligned with the calendar year. Therefore, when applying the limit to a non-calendar year plan, the dollar limit in effect at the beginning of that plan year must be used. For example, if a plan is applying the Code § 401(a)(17) limit to a plan year in effect from July 1, 2016 – June 30, 2017, the Code § 401(a)(17) limit in effect for 2016 must be utilized, and would apply to all compensation paid during that plan year.
Applying the Code § 401(a)(17) Limit for Compensation Measuring Periods of Less than 12 Months
The Code § 401(a)(17) limit must be prorated if compensation for a period of less than 12 months is used. This may arise in the context of a short plan year, such as when a plan changes plan years or when a new plan becomes effective on a date other than the first day of its plan year. In that case, the limit is reduced in the same proportion as the reduction in the 12-month period, by multiplying the annual compensation limit by a fraction equal to the number of months for which compensation is used over twelve. For example, assume a new plan is established effective as of March 1, 2017, and its plan year is the calendar year. The Code § 401(a)(17) limit applicable to the short first plan year will be a prorated amount of the full limit in effect for 2017, or $225,000 (10/12 of the full 2017 limit $270,000).
This situation also arises when a plan adds or eliminates an employer contribution feature during the course of a plan year, and bases contributions on compensation earned during the portion of the plan year that the feature was in place. For example, if a calendar year plan is amended as of July 1, 2017 to add a profit sharing feature, which will be calculated on compensation from July 1, 2017 through December 31, 2017, the maximum amount of compensation that may be recognized to calculate a participant’s allocation will be $135,000 (6/12 of $270,000). Alternatively, when a calendar year plan is amended, for example as of September 30, 2017, to prospectively eliminate an employer contribution feature, the maximum amount of compensation that may be recognized in calculating the employer contribution is $202,500 (9/12 of $265,000). Note that when a contribution is added or eliminated mid-year but allocations are still based on compensation for the full year, the full Code § 401(a)(17) limit would apply.