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.

False alarm! IRS withdraws controversial proposed cross-testing regulation provisions

A couple of months ago, the IRS proposed some changes to the §1.401(a)(4) nondiscrimination testing regulations.  On Thursday, they withdrew the part of those proposed regulations that was bad news for plan sponsors, as noted in our prior post.

We are pleased the IRS has reconsidered the unintended consequences benefit formula restrictions and “facts and circumstances” based determinations could have on employers’ willingness to sponsor qualified retirement plans.

Surprises in the proposed cross-testing regulations

surprised face

On January 29th, the IRS proposed revisions to the nondiscrimination testing regulations of §1.401(a)(4).  The title of proposed regulations (and most of the attention generated by them) is focused on the relief for closed defined benefit (DB) plans.  This post summarizes the proposed changes that would affect more than just closed DB plans.  Most of them are beneficial to plan sponsors, but one is not.

 

The bad news – benefit formula restrictions

The biggest surprise is a proposed restriction in setting different benefit levels for different participant groups.

Currently, plans can generally separate the participant population into groups with different benefit levels/formulas as desired, so long the plan is doesn’t disproportionately favor Highly Compensation Employees (HCEs) relative to non-HCES.  Plans can even go so far as to separate each plan participant into his or her own “group”.

The proposed regulations would require HCEs’ benefit formulas to apply to a “Reasonable Classification” of employees*.  This is a “facts and circumstances” determination.  §1.410(b)-4(b) states that “reasonable classifications generally include specified job categories, nature of compensation (i.e. salaried or hourly), geographic location, and similar business criteria”.  Picking participants by name (or in a way that effectively does that) is not considered a reasonable classification.

This is an important issue for plans that allow each participant to have a separate benefit level and rely of the Average Benefit Test to satisfy §1.401(a)(4).  Other plans may need to consider if their benefit groups are a reasonable classification.

*Unless the rate group satisfies the Ratio Percentage Test.

 

The good news – cross-testing gateways for aggregated DB/DC plans

The favorable part of the proposed regulations is more flexibility in combining DB and DC plans for nondiscrimination testing.  These proposed changes were suggested by the IRS in Notice 2014-5, so they aren’t a surprise to those that have kept up with the IRS’s previous relief efforts for closed DB plans.  However, those suggestions haven’t got much attention so they are good news for many.

Plans must pass through a “gateway” before aggregating DC and DB plans in a cross-test.  A cross-test is generally much more favorable than testing each plan separately.  The currently available gateways are:

  1. The DB/DC plan is “primarily defined benefit in character”
  2. The DB/DC plans consist of broadly available separate plans
  3. The DB/DC plan provides a minimum allocation to all benefitting non-HCEs

 

The proposed regulations would expand the DB/DC gateway options in three ways:

1.  New gateway: The proposed regulations would add another gateway – passing the cross-test test with a 6% interest rate (rather than the standard 7½% to 8½%). While the DB/DC would technically still need to pass the cross-test with a standard interest rate, this option could practically eliminate the gateway requirement for DB/DC plans that can pass with 6% interest.

2.  Matching contributions use: The proposed regulations would allow the average matching contribution for non-HCEs (up to 3% of pay) to count toward the DB/DC minimum allocation gateway. Matching contributions would still not be included in the cross-test.

3.  Option to average DC allocation rates: Current rules allow DB allocation rates for non-HCEs to be averaged for satisfying the minimum allocation gateway. The proposed regulations would allow the same treatment for DC allocation rates.  The purpose of this change is to allow plans to provide lower allocation rates for those with less service by providing higher rates to those with more service.

The IRS notes that they’re considering if restrictions on this option are needed to ensure it is used as intended, and not as another technique for minimizing non-HCE benefits.  The proposed regulations would also limit averaging of DB and DC rates to reduce the impact of outliers.

 

Many plans that satisfy the §1.401(a)(4) requirements with a general test will need or want to revisit their benefit formula design if these proposed regulations become final.  There is sure to be a lot of resistance to the benefit formula restrictions, so the regulations may not be finalized as proposed.  If you would like to send comments on the proposed regulations you can do so until April 28, 2016.

Plan sponsors may apply the proposed regulations specific to closed DB plans right away, but may not use the flexibility of the other proposed cross-testing rules until they are finalized.  We encourage you to contact your actuary if you have questions about how these proposed rules would affect your plan.

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.