What’s the Impact of 2017 IRS Retirement Plan Limits?

The IRS just announced the 2017 retirement plan benefit limits, and there are some notable changes from 2016. What does it all mean for employer-sponsored retirement plans? Here is a table summarizing the primary benefit limits, followed by our analysis of the practical effects for both defined contribution (DC) and defined benefit (DB) plans.

Qualified Plan Limit 2015 2016 2017
415 maximum DC plan annual addition $53,000 $53,000 $54,000
Maximum 401(k) annual deferral $18,000 $18,000 $18,000
Maximum 50+ catch-up contribution $6,000 $6,000 $6,000
415 maximum DB “dollar” limit $210,000 $210,000 $215,000
Highly compensated employee (HCE) threshold $120,000 $120,000 $120,000
401(a)(17) compensation limit $265,000 $265,000 $270,000
Social Security Taxable Wage Base $118,500 $118,500 $127,200

 

Changes affecting both DB and DC plans

  • Qualified compensation limit increases to $270,000. High-paid participants will now have more of their compensation “counted” towards qualified plan benefits and less towards non-qualified plans. This could also help plans’ nondiscrimination testing if the ratio of benefits to compensation decreases.
  • HCE compensation threshold remains at $120,000. For calendar year plans, this will first affect 2018 HCE designations because $120,000 will be the threshold for the 2017 “lookback” year. When the HCE compensation threshold doesn’t increase to keep pace with employee salary increases, employers may find that more of their employees become classified as HCEs. This could have two direct outcomes:
    • Plans may see marginally worse nondiscrimination testing results (including ADP results) if more employees with large deferrals or benefits become HCEs. It could make a big difference for plans that were previously close to failing the tests.
    • More HCEs means that there are more participants who must receive 401(k) deferral refunds if the plan fails the ADP test.

DC-specific increases and their significance

  • The annual DC 415 limit increases from $53,000 to $54,000 and the 401(k) deferral limit remains at $18,000. A $1,000 increase in the overall DC 415 limit may not seem like much, but it will allow participants to get a little more “bang” out of their DC plan. Since the deferral limit didn’t increase, this means that any additional DC benefits will have to come from higher employer contributions. Individuals can now receive up to $36,000 from match and profit sharing contributions ($54K – $18K).
  • 401(k) “catch-up” limit remains at $6,000. Participants age 50 or older still get a $6,000 catch-up opportunity in the 401(k) plan, which means they can effectively get a maximum DC deduction of $60,000 ($54K + $6K).

DB-specific increases and their significance

  • DB 415 maximum benefit limit (the “dollar” limit) increases to $215,000. This limit finally increased after being static for three straight years. The primary impact is that individuals who have very large DB benefits (say, shareholders in a professional firm cash balance plan) could see a deduction increase if their benefits were previously constrained by the 415 dollar limit.
  • Social Security Taxable Wage Base increases to $127,200. This is a big jump from the prior $118K limit and effectively reflects two years of indexing (the limit couldn’t increase last year because the Social Security COLA was 0% and caps the wage base increase rate). With regards to qualified retirement benefits, a higher wage base can slightly reduce the rate of pension accruals for highly-paid participants in integrated pension plans that provide higher accrual rates above the wage base.

What’s the Impact of 2016 IRS Retirement Plan Limits?

The IRS just announced the 2016 retirement plan benefit limits, and there are virtually no changes from 2015. What does it all mean for employer-sponsored retirement plans? Below is a table summarizing the primary benefit limits, followed by our analysis of the practical effects for both defined contribution (DC) and defined benefit (DB) plans.

Qualified Plan Limit 2015 2016
415 maximum DC plan annual addition $53,000 $53,000
Maximum 401(k) annual deferral $18,000 $18,000
Maximum 50+ catch-up contribution $6,000 $6,000
415 maximum DB “dollar” limit $210,000 $210,000
Highly compensated employee (HCE) threshold $120,000 $120,000
401(a)(17) compensation limit $265,000 $265,000
Social Security Taxable Wage Base $118,500 $118,500

 

Changes affecting both DB and DC plans

  • Qualified compensation limit remains at $265,000. A flat qualified compensation limit could have several consequences. These include:
    • More compensation counted towards SERP excess benefits if a participant’s total compensation (above the threshold) increases in 2016.
    • Lower-than-expected qualified pension plan accruals for participants whose pay is capped at the 401(a)(17) limit and were hoping for an increase.
  • HCE compensation threshold remains at $120,000. For calendar year plans, this will first affect 2017 HCE designations because $120,000 will be the threshold for the 2016 “lookback” year. When the HCE compensation threshold doesn’t increase to keep pace with employee salary increases, employers may find that more of their employees become classified as HCEs. This could have two direct outcomes:
    • Plans may see marginally worse nondiscrimination testing results (including ADP results) if more employees with large deferrals or benefits become HCEs. It could make a big difference for plans that were previously close to failing the tests.
    • More HCEs means that there are more participants who must receive 401(k) deferral refunds if the plan fails the ADP test.

DC-specific increases and their significance

  • The annual DC 415 limit remains at $53,000 and the 401(k) deferral limit remains at $18,000. Although neither of these limits has increased to allow higher contributions, it should make administering the plan a little easier in 2016 since there are no adjustments to communicate or deal with. Since the 401(k) deferral limit counts towards the total DC limit, this means that an individual could potentially get up to $35,000 from profit sharing ($53K – $18K) if they maximize their DC plan deductions.
  • 401(k) “catch-up” limit remains at $6,000. Participants age 50 or older still get a $6,000 catch-up opportunity in the 401(k) plan, which means they can effectively get a maximum DC deduction of $59,000 ($53K + $6K).

DB-specific increases and their significance

  • DB 415 maximum benefit limit (the “dollar” limit) remains at $210,000. This limit remained unchanged for a third straight year, which may constrain individuals with very large DB benefits (e.g., shareholders in a professional firm cash balance plan) who were looking forward to increasing their DB plan contributions/deductions.
  • Social Security Taxable Wage Base remains at $118,500. When this limit increases, it can have the effect of reducing benefit accruals for highly-paid participants in integrated pension plans that provide higher accrual rates above the wage base. When the wage based remains unchanged (like this year), it means that these individuals’ accruals may be higher-than-expected if their total compensation (above the wage base) continues to increase.

 

What’s the Impact of 2015 IRS Retirement Plan Limits?

The IRS just announced the 2015 retirement plan benefit limits and we’re seeing some modest increases from 2014. What does it all mean for employer-sponsored retirement plans? This post analyzes the practical effects for both defined contribution (DC) and defined benefit (DB) plans, followed by a table summarizing the limit changes.

Changes affecting both DB and DC plans

  • Qualified compensation limit increases from $260,000 to $265,000. Highly-paid participants will now have more of their compensation “counted” towards qualified plan benefits and less towards non-qualified plans. This helps for both nondiscrimination testing as well as for benefits.
  • HCE compensation threshold increases from $115,000 to $120,000. For calendar year plans, this will first affect 2016 HCE designations because $120,000 will be the threshold for the 2015 “lookback” year. Slightly fewer participants will meet the new HCE compensation criteria, which will have two direct outcomes:
  • Plans may see better nondiscrimination testing results (including ADP results) if there are fewer participants at the low end of the HCE range, especially those with big deferrals. It could make a big difference for plans that were close to failing the tests.
  • Fewer HCEs means that there are fewer participants who must receive 401(k) deferral refunds if the plan fails the ADP test.

DC-specific increases and their significance

  • The annual DC 415 limit increases from $52,000 to $53,000 and the 401(k) deferral limit increases from $17,500 to $18,000. A $1,000 increase to the overall DC limit and $500 increase to the deferral limit may not seem like much, but it will allow participants to get a little more “bang” out of their DC plan. This means that individuals can get up to $35,000 from employer match and profit sharing ($53K – $18K) if they maximize their 401(k) deferrals. Previously, their profit sharing limit would have been $34,500 ($52K – $17.5K).

What’s the Impact of 2014 IRS Retirement Plan Limits?

The IRS just announced the 2014 retirement plan benefit limits and we’re seeing some modest increases from 2013. What does it all mean for employer-sponsored retirement plans? This post analyzes the practical effects for both defined contribution (DC) and defined benefit (DB) plans, followed by a table summarizing the limit changes.

Changes affecting both DB and DC plans

  • Qualified compensation limit increases from $255,000 to $260,000. Highly-paid participants will now have more of their compensation “counted” towards qualified plan benefits and less towards non-qualified plans. This helps for both nondiscrimination testing as well as for benefits.
  • HCE compensation threshold remains at $115,000. For calendar year plans, this will first affect 2015 HCE designations because $115,000 will be the threshold for the 2014 “lookback” year. When the HCE compensation threshold doesn’t increase to keep pace with employee salary increases, employers may find that more of their well-paid employees become classified as HCEs. Eventually, this could have two direct outcomes:
  • Plans may see marginally worse nondiscrimination testing results (including ADP results) if more employees with large deferrals or benefits become HCEs. It could make a big difference for plans that were close to failing the tests.
  • More HCEs means that there are more participants who must receive 401(k) deferral refunds if the plan fails the ADP test.

DC-specific increases and their significance

  • The annual DC 415 limit increases from $51,000 to $52,000 but the individual 401(k) deferral limit remains unchanged at $17,500. A $1,000 increase to the overall DC limit will allow participants to potentially get a little more “bang” out of their DC plan – at least if their employer wants to give them more money.

Since the 401(k) deferral limit counts towards the total DC limit, this means that an individual could potentially get up to $34,500 from employer profit sharing ($52K – $17.5K). Previously, their profit sharing limit would have been $33,500 ($51K – $17.5K).

What’s the Impact of 2013 IRS Retirement Plan Limits?

The IRS just announced the 2013 retirement plan benefit limits and we’re seeing some modest increases from 2012. What does it all mean for employer-sponsored retirement plans? This post analyzes the practical effects for both defined contribution (DC) and defined benefit (DB) plans, followed by a table summarizing the limit changes.

Changes affecting both DB and DC plans

  • Qualified compensation limit increases from $250,000 to $255,000. Highly-paid participants will now have more of their compensation “counted” towards qualified plan benefits and less towards non-qualified plans. This helps for both nondiscrimination testing as well as for benefits.
  • HCE compensation threshold remains at $115,000. For calendar year plans, this will first affect 2014 HCE designations because $115,000 will be the threshold for the 2013 “lookback” year. When the HCE compensation threshold doesn’t increase and keep pace with employee salary increases, employers may find that more of their well-paid employees become classified as HCEs. Eventually, this could have two direct outcomes:
  • Plans may see marginally worse nondiscrimination testing results (including ADP results) if there are more HCEs. It could potentially make a big difference for smaller plans that were very close to failing the tests.
  • More HCEs means that there are more participants who must receive 401(k) deferral refunds if the plan fails the ADP test.

DC-specific increases and their significance

  • Increase in annual DC 415 limit from $50,000 to $51,000 and 401(k) deferral limit from $17,000 to $17,500. A $1,000 increase to the overall DC limit and $500 increase to the deferral limit isn’t much, but it will allow participants to get a little more “bang” out of their DC plan. Since the 401(k) deferral limit counts towards the total DC limit, this means that an individual could potentially get up to $33,500 from profit sharing ($51K – $17.5K) if they maximize their DC plan deductions. Previously, their profit sharing limit would have been $33,000 ($50K – $17K)

Employers Need to Understand Minimum Profit Sharing Benefits for Frozen/Terminated DB plans

Freezing or terminating a defined benefit (DB) pension plan can have unforeseen implications for a company’s profit sharing plan. This is especially true if the plans are top-heavy or rely on IRS cross-testing methods (e.g., professional firm cash balance plans). This post explores changes to minimum profit sharing benefits that occur when plan sponsors freeze or terminate their top-heavy/cross-tested DB plan.

Background

When retirement plans are top-heavy and/or rely on cross-testing procedures to pass IRS nondiscrimination testing, there are several minimum benefits that must be provided to non-Key employees and non-highly compensated employees (NHCEs). For sponsors of both a DB and a DC plan, these minimum benefits often include:

  • 5% DB/DC top-heavy minimum for all participants employed at year-end or who work at least 1,000 hours during the year (note: separate DB and DC options are available instead of the single 5% minimum)
  • 7.5% DB/DC minimum “gateway” allocation for cross-testing

What happens when the DB plan is frozen or terminated?

When accruals in the DB plan cease, there are a couple of immediate consequences for the minimum profit sharing allocations. Read more…

What’s the Impact of 2012 IRS Retirement Plan Limits?

The IRS just announced the 2012 retirement plan benefit limits and we’re finally going to see some (very) modest increases after 3 years of flat rates. What does it all mean for employer-sponsored retirement plans? This post analyzes the practical effects for both defined contribution (DC) and defined benefit (DB) plans, followed by a table summarizing the limit changes.

Changes affecting both DB and DC plans

  • HCE compensation threshold increases from $110,000 to $115,000. For calendar year plans, this will first affect 2013 HCE designations because $115,000 will be the threshold for the 2012 “lookback” year.  Slightly fewer participants will meet the HCE compensation criteria, which will have two direct outcomes:
  • Plans may see marginally better nondiscrimination testing results (including ADP results) if there are fewer HCEs. It could potentially make a big difference for smaller plans that were very close to failing the tests.
  • Fewer HCEs means that there are fewer participants who must receive 401(k) deferral refunds if the plan fails the ADP test.
  • Qualified compensation limit increases from $245,000 to $250,000. Highly-paid participants will now have more of their compensation “counted” towards qualified plan benefits and less towards non-qualified plans. This helps for both nondiscrimination testing as well as for benefits.

DC-specific increases and their significance

  • Increase in annual DC 415 limit from $49,000 to $50,000 and 401(k) deferral limit from $16,500 to $17,000. A $1,000 increase to the overall DC limit and $500 increase to the deferral limit isn’t much, but it will allow participants to get a little more “bang” out of their DC plan. Since the 401(k) deferral limit counts towards the total DC limit, this means that an individual could potentially get up to $33,000 from profit sharing ($50K – $17K) if they maximize their DC plan deductions. Previously, their profit sharing limit would have been $32,500 ($49K – $16.5K)

The Value of Tax Deferral

Happy couple

We often hear the question “why should I contribute to a qualified retirement plan if tax rates might go up”?  Good question; here’s why:  you’ll probably end up with more money after tax.  That’s true even if tax rates go up in the future.

How much more you’ll end up with depends on your investment return, the deferral period, and your marginal tax rates at three different times:

  • when you contribute the money,
  • while it’s invested, and
  • when you withdraw it.

The key is that in a taxable account, you lose some of the power of compound interest every time you’re taxed on your contributions and investment earnings.

Let’s start with a simple example, using a 33-1/3% marginal tax rate all the way through.  That’s a bit lower than the 35% top Federal rate, but it makes the math easy.  Suppose you have $3,000 to contribute, and investment earnings average 6%.

Tax deferred account / qualified plan

Contributing your $3,000 to a 401(k) or other qualified plan, you have the whole amount to invest and investment earnings are tax free – but you have to pay tax when you withdraw it.  Leaving it in for, say, 20 years you would have $6,414 after paying your tax:  $3,000 x (1.06 ^ 20) x (1-.3333).

Taxable account

Contributing to a taxable account, you have $2,000 to invest after tax ($3,000 x (1-.3333)) and investment earnings are taxable so your effective investment return is 4% (6% x (1-.3333)).  But then you’re done paying taxes.  After 20 years you would have $4,382:  $2,000 x (1.04 ^ 20).

What if’s:  rising tax rates, capital gains, return, deferral period, Roth

In this simple example, the qualified plan clearly beats the taxable account.  But what if tax rates are higher at withdrawal?  For the $4,382 in the taxable account to beat the qualified plan, the tax rate would have to suddenly jump to 54.5% at withdrawal:  $3,000 x (1.06 ^ 20) x (1-.545) = $4,378.   Any tax increase that happens more gradually would be worse for the taxable account, with no effect on the qualified plan.

What about capital gains?  If the current 15% long term capital gains rate is sustainable and all your investments qualify, your effective return is 5.1% (6% x (1-.15)).  You still start with $2,000 to invest after tax, so after 20 years you would have $5,408:  $2,000 x (1.051 ^ 20).  That’s not bad, but it’s still less than the $6,414 you would have had from a qualified plan.

What about different investment returns and deferral periods?  We’ve used 6% return for 20 years in this simple example, but how does it change for other returns and time periods?  The short answer is that higher investment returns and longer deferral periods favor the qualified plan.  Lower returns and shorter time favor the taxable account.

What about a Roth IRA or 401(k)?  As it turns out, Roth and regular 401(k) results are identical if your marginal tax rates are equal at contribution and withdrawal.  Roth is better if your marginal rate at withdrawal is higher than at contribution time; otherwise a regular 401(k) is better.  And they both blow the taxable account out of the water.

Deferred comp plans: when they’re a great choice, and when they’re not

Nonqualified deferred compensation plans are a common feature of executive pay packages.  They’re a great choice in the right conditions, i.e. when:Which door to choose?

  • The executive’s share of company profits is very small, and
  • The executive is willing to shoulder the employer’s credit risk, and
  • Providing the benefits through a qualified plan would be too expensive.

But they’re not so great when any of these conditions are missing.  Let’s examine each in turn.

Small share of company profits:  Nonqualified deferred compensation isn’t deductible for the company until it becomes taxable for the executive.  If the executive is a substantial owner in a profitable enterprise, e.g. a law firm or medical group partner, any deferred income boomerangs right back as taxable profit.  In contrast, qualified retirement plan contributions are deductible for the company when they’re made, and not taxable to the employee until they’re received in cash.

Willing to shoulder the employer’s credit risk:  Funding vehicles like rabbi trusts can protect the executive from the employer’s unwillingness to pay, but not against its inability to pay.  In today’s economic environment where even large companies are struggling, this risk may be unacceptable.  Protection from both of these risks – and even from the executive’s personal creditors – is provided by a qualified plan.

Qualified plan too expensive:  This is usually the main reason for setting up a deferred compensation plan.  Qualified plans have many requirements that don’t apply to most nonqualified plans:  coverage, nondiscrimination, government filings etc.  But they’re more flexible than most people realize.  In a cross-tested profit sharing/401(k) plan, top executives can often reach the annual $49,000 defined contribution limit with a 5% staff contribution.  And if that’s not enough, a cash balance or other defined benefit plan can allow much higher deductions:  up to an additional $100k-200k per year.

So, are we biased toward qualified plans?   Oh, absolutely.  Nonqualified plans can be a great choice, but make sure you’ve maximized your qualified plans first.

Strategic 401(k) Design: Preventing ADP Failures

If your 401(k) plan is failing the Actual Deferral Percentage (ADP) test, then it’s time to consider some plan design changes. You need to figure out a way to encourage non-highly compensated employees (NHCEs) to save more retirement money in their 401(k) accounts while keeping benefit costs under control. This post will guide plan sponsors through some strategic (yet straightforward) benefit changes that can improve your plan’s chances of passing the ADP test next year.

1. Add a 401(k) match. If your plan doesn’t already have a 401(k) match, adding one will encourage employees to at least defer a minimal amount into their 401(k) accounts. More NHCE deferrals = better ADP test results.

2. Enhance the current 401(k) match. If your plan already has a match but it isn’t getting NHCEs to defer, then there are a couple of options:

Increase the match: Maybe that 1% match just isn’t worth it for some folks. A 3% match is about average, and any increase can be factored-in when considering an employee’s total compensation package.

“Extend” the match: The goal here is to increase the amount of compensation eligible for a match while not increasing employer costs. For example, if you currently match 50% of the first 6% deferred then consider amending the plan to match 40% on the first 7½% deferred. Both formulas have a potential match of 3% of compensation, but the latter encourages employees to save at a higher rate in order to earn the full match.

3. Add an automatic enrollment feature. An Eligible Automatic Contribution Arrangement (EACA) is a feature where new participants are automatically enrolled in the 401(k) plan at a uniform deferral rate, unless they elect to opt out. If your 401(k) plan is suffering the ADP failure blues because few new hires are deferring, then this is a great way to increase your ADP rate and encourage employees to save for retirement. There’s also the Qualified Automatic Contribution Arrangement (QACA) option, which is a safe harbor plan combined with an automatic enrollment feature.

4. Add a “safe harbor” plan design. If you adopt one of these IRS-prescribed benefit formulas, then you get a “free pass” on ADP testing. Safe harbor benefits are 100% vested immediately and you must provide notice of the safe harbor status to participants at least 30 days prior to the start of the plan year. The minimum safe harbor benefit formulas are:

– At least a 3% automatic (i.e., non-matching) employer contribution to each participant’s 401(k) account; or

– An employer match of at least 100% on the first 3% deferral plus a match of at least 50% on the next 2% deferral (i.e., a potential match of 4% of pay).

If you have a cross-tested profit-sharing plan or cash balance plan, then the 3% non-elective option is often the best choice since those benefits count towards the non-discrimination tests whereas the matching formula does not.

Each of the options above has variations and can be combined with the others. Combined with a thorough campaign to educate participants about the changes, they’ll improve your chances of passing the ADP tests next year and avoid having to refund HCE deferrals as taxable income.