Qualified defined contribution retirement plans that include 401(k), money purchase pension, profit sharing and IRA-based Simplified Employee Pension (SEP) plans must provide limits for contributions and forfeitures allocated to a participant’s account. The total of employer contributions, employee contributions and forfeitures allocated to a participant’s account cannot exceed the limits under Internal Revenue Code Section (IRC) 415(c).
IRC Section 415(c) generally provides that during a limitation year (the calendar year, unless another 12-month period is specified in the plan), the total of employer contributions, employee contributions and forfeitures made for a participant cannot exceed the lesser of:
1) $40,000 or
2) 100% of the participant’s compensation.
IRC Section 415(d) provides for a cost of living adjustment to the $40,000 dollar limit ($53,000 in 2015 and 2016; $54,000 in 2017; $55,000 in 2018; and $56,000 in 2019).
The types of contributions subject to the limit include:
- elective contributions (pre-tax or Roth) made to 401(k), and salary reduction SEP plans;
- after-tax employee contributions;
- employer matching contributions;
- employer profit-sharing contributions; and
- any employer contributions.
In 2015, John earned $100,000 in compensation as an employee of the QP Corporation and was a participant in QP Corporation’s 401(k) Plan. At the end of 2015, John is Age 48. The plan permits elective contributions and provides 100% matching employer contributions up to $11,000, as well as discretionary profit-sharing contributions. The plan does not allow an employee to designate any portion of his or her elective contribution as a Roth contribution. QP did not allocate any forfeitures to participants in 2015. During 2015, QP made contributions totaling $64,000 for John consisting of:
- elective contributions: $18,000
- employer matching contributions: $11,000
- employer profit-sharing contributions: $35,000
The 415(c) contribution limit for John is $53,000 (the lesser of $53,000 or 100% of John’s $100,000 compensation). Accordingly, the $64,000 contributions made for John in 2015 exceeded the limitation under IRC Section 415(c) by $11,000.
QP discovered the failure to limit the contributions for John in 2016.
Finding the Mistake:
In order to find the mistake, the plan administrator should timely prepare allocation schedules showing amounts contributed and allocated for plan participants. The allocated amounts should include all employer contributions, employee contributions (including elective contributions) and forfeiture allocations. Review the allocation schedules by comparing total allocations to the IRC Section 415(c) limitations.
Fixing the Mistake:
If contributions for a participant include both employer and employee elective contributions, exceed IRC Section 415(c), correct in the following manner:
Step 1: Distribute unmatched elective contributions (adjusted for earnings) to the affected participant. If any excess remains, then proceed to Step 2.
Step 2: Distribute elective contributions (adjusted for earnings) that are matched, and forfeit related matching contributions (adjusted for earnings). If any excess remains, then proceed to Step 3.
Step 3: Forfeit other profit-sharing contributions.
The employer should report the corrective distribution made to the participant on Form 1099-R. The participant should include the distribution as income but does not have to pay the 10% additional tax on early distributions under §72(t) of the Code. In addition, the participant may not rollover the corrective distribution to another qualified plan or to an IRA.
The plan sponsor should transfer the forfeited employer contributions (profit-sharing or matching) to an unallocated account. These amounts are used to reduce employer contributions in the current year and, if applicable, subsequent year(s).
Applying these steps, the correction of the excess contribution of $11,000 for John would be as follows:
Step 1: John made $7,000 in unmatched elective contributions (elective contributions of $18,000 less $11,000 that QP matched). The plan must distribute the $7,000 (adjusted for earnings) to John. After the distribution, the remaining excess contribution of $4,000 the plan must correct, to the extent possible, under Step 2.
Step 2: John made $11,000 in matched elective contributions. The plan must distribute $2,000 in matched elective contributions (adjusted for earnings) and forfeit the corresponding matching contribution of $2,000 (adjusted for earnings). This step fully corrects John’s remaining $4,000 excess.
As a result, John will receive a total distribution of $9,000 (adjusted for earnings). John must include the entire corrective distribution in his income. However, John will not have to pay the additional 10% tax on early distributions under IRC Section 72(t). The distribution is not eligible for rollover to another qualified plan or an IRA. In addition, the plan will forfeit $2,000 (adjusted for earnings) from John’s matching contribution account. This amount will be transferred to an unallocated account and used to reduce employer contributions required for the current year and if applicable, subsequent year(s).
Correction Program(s) Available:
QP Corporation may use the correction programs described in the Employee Plans Compliance Resolution System.to correct the mistake.
Avoiding the Mistake:
The employer should monitor employees’ elective contributions made during the limitation year. After determining the corresponding matching contribution under the terms of the plan, the employer should consider the IRC Section 415 limitations while determining (a) the amount of discretionary profit-sharing contribution and (b) where appropriate, the manner in which the profit-sharing contribution could be allocated among plan years.