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Issue Snapshot - Treatment of 401(a)(17) Limitation in Defined Contribution Plan in a Short Plan Year

This Snapshot discusses how to adjust the IRC Section 401(a)(17) limit in a short plan year, such as an initial, amended or terminating plan year.

IRC Sections and Treasury Regulations

  • IRC Section 401(a)(17)
  • Treas. Reg. Section 1.401(a)(17)-1

Resources

Analysis

A plan may not base allocations for a plan year on compensation exceeding the dollar limit imposed under IRC Section 401(a)(17) or use more than this amount in applying certain nondiscrimination rules. Treas. Reg. Section 1.401(a)(17)-1(a)(1).

In 2018, the annual compensation dollar limit is $275,000. This limit is subject to annual cost-of-living adjustments.

The dollar limit applies for a 12-month period. If the plan uses a compensation measurement period of less than 12 months in calculating employee allocations, the limit must be prorated. Treas. Reg. Section 1.401(a)(17)-1(b)(3)(iii)(A). Proration of the annual limit is generally not necessary when employees join or leave the plan mid-year, since the 12-month compensation measuring period (i.e., the plan year) remains the same. Treas. Reg. Section 1.401(a)(17)-1(b)(3)(iii)(B).

Proration of limit

The compensation limit for a short year is determined by multiplying the applicable annual compensation dollar limit for the calendar year in which the short year begins by a fraction, the numerator of which is the number of months in the short plan year, and the denominator of which is 12. See Treas. Reg. Section 1.401(a)(17)-1(b)(3)(iii)(A).

Example 1 – Amendment creating a short plan year

Plan A is a profit sharing plan with a calendar plan year. On June 30, 2018, the plan is amended to change the plan year to a fiscal year ending June 30. The amendment creates a short plan year from January 1 to June 30, 2018 (6 months). The plan document provides that allocations for the plan year ending June 30 are based on compensation for the 6-month period. Because the short plan year begins in 2018, the prorated short year limit is calculated based on the 2018 limit of $275,000 under IRC Section 401(a)(17). The prorated short year limit is $137,500 ($275,000 x (6/12) = $137,500).

Example 2 – Initial short plan year

Company C establishes a new § 401(k) profit sharing plan effective October 1, 2018. The plan is a calendar year plan and the first plan year ends December 31, 2018 (3 months). The plan has matching contributions equal to 100% of the first 4% of compensation deferred by a participant for the plan year. For the first plan year, compensation taken into account under the plan is compensation earned after the effective date of the plan. Thus, for the first plan year, the prorated short year limit for the initial plan year under IRC Section 401(a)(17) is $68,750 ($275,000 x (3/12) = $68,750).

Example 3 – Initial short plan year – 12-month measurement period

The same facts as Example 2 except Company C establishes a new Section 401(k) profit sharing plan in July 2018, but the plan is effective January 1, 2018, and the plan document states that compensation taken into account under the plan is compensation earned for the calendar year. The limit under IRC Section 401(a)(17) is not prorated for the first plan year because the compensation measurement period under the plan is 12 months.

Example 4 – Plan termination

Plan B is a profit sharing plan with a calendar plan year. The plan sponsor adopts a resolution to terminate the plan effective September 30, 2018. Final allocations under the plan are based on compensation earned from January 1 to September 30, 2018 (9 months). Because the compensation measurement period is less than 12 months in 2018, the compensation limit must be prorated. The prorated short year limit is calculated based on the 2018 limit of $275,000 under IRC Section 401(a)(17). The prorated short year limit is $206,250. ($275,000 x (9/12) = $206,250).

Participants who join or leave the plan mid-year

A plan may allocate contributions to participants based on compensation earned by an employee only while he or she is a participant in the plan. If that is the case, the IRC Section 401(a)(17) compensation limit is not prorated for employees who participate for only a portion of the plan year (for example, who enter the plan in July of a calendar plan year) provided the plan continues to use a measurement period of 12 months for the other employees. See Treas. Reg. Section 1.401(a)(17)-1(b)(3)(iii)(B).

Example 5 – New participant

Plan P is a calendar year Section 401(k) plan. The plan allocates nonelective contributions to participants based on compensation earned during each employee’s period of participation under the plan. Participant B begins employment on January 1, 2018, and becomes a participant in the plan on August 1, 2018. B’s elective deferrals and allocated nonelective contribution for 2018 is based on compensation earned during the period August 1 – December 31, 2018. However, the IRC Section 401(a)(17) limit is not prorated because the compensation measurement period applicable to all employees is 12 months.

Audit tips

  1. Identify the plan year. Is there a short plan year?
  2. If there is a short plan year, what is the period for measuring compensation?
    • If compensation is measured on the basis of the short plan year, the IRC Section 401(a)(17) limit must be prorated.
    • If compensation is measured on the basis of a full 12-month period during which the short plan year occurs, in the case of an ongoing plan, the IRC Section 401(a)(17) limit is not prorated.
  3. How does the plan measure compensation for participants who enter the plan during the plan year? Was this formula followed in operation?
  4. In the case of a terminating plan that results in a short plan year, is the IRC Section 401(a)(17) limit prorated for the short plan year?