This is the second in a two-part series about deductible contribution limits to qualified retirement plans. The first part last week covered the limits to defined contribution plans.
The tax-deductibility of qualified retirement plan contributions is a huge incentive for employers to sponsor these arrangements. As we noted last week, there are limits to how much retirement plan contribution an employer may deduct in a given tax year. The limit depends on whether the plan(s) involved are defined contribution (DC), defined benefit (DB), or a combination of DB and DC plans. Today, we will look at DB plans and DB/DC combos.
No Specified Limit or Formula for DB Plan Deductions
The DB deduction limit is pretty simple and can be covered in one sentence. The deductible contribution limit for DB plans is whatever the plan’s Enrolled Actuary says it is. Done. Good night.
Maybe it’s unfair to summarize it that bluntly. Certainly, there are rules and standards of practice that govern the actuary’s calculations. For the most part, though, it is an accurate statement. Each year, the actuary performs a valuation which develops a minimum required contribution and a maximum deductible contribution. The details of the valuation process are way beyond the scope of the article, but how much an employer is required to (or allowed to) contribute to a DB plan depends on the benefits being funded and the level of assets in the plan as of the valuation date. There is no fixed percentage or formula for either the minimum required or maximum deductible contributions.
Once the minimum and maximum contribution amounts are developed, the employer chooses an amount within the range to contribute. How much is contributed will depend on the employer’s cash flow, profitability, and desire to fund the plan aggressively or not. The employer may want to contribute the maximum amount one year and the minimum amount the next, or vice versa. Contributing the maximum amount one year will lower the minimum amount in future years. Conversely, the maximum deductible contribution in a given year will be high if the employer has normally contributed near the minimum in previous years.
Combined Plan Limits Come Into Play for DB/DC Combos
Many companies sponsor both a DC plan and a DB plan, or more than one of both. If there is at least one employee that participates in both types of plan, the deduction limits get a bit interesting.
- If the DB plan is subject to Pension Benefit Guaranty Corporation (PBGC) coverage, then there are no special combined plan deduction limits. The DC plans are subject to the DC limits, and the DB plans are subject to the DB limits. An employer desiring high deductible contributions is able to fully max out both a DC and a PBGC-covered DB plan.
- If the DB plan is not subject to PBGC coverage, as is often the case with small plans maintained by doctors, lawyers, accountants, and other professionals, the limits go like this:
- If there is no employer contribution to the DC, then the maximum deductible DB amount may be contributed and deducted as if there were no DC plan.
- If there is an employer contribution to the DC, then the maximum deductible contribution to both types of plan combined is 25% of the compensation paid to anyone who participates in either plan. However, in no event will the maximum deductible contribution be less than the minimum required DB contribution.
- A 6%-of-pay deductible contribution may be made to the DC plan and ignored for the above limits.
- Salary deferrals to the 401(k) plan are not counted toward the deduction limit.
That’s a lot to wrap our heads around. Let’s start with why the wording about the 6% DC contribution is so strange. If the DB/DC limit is 25% of pay, but you ignore a contribution of up to 6% of pay in the DC plan, doesn’t that just mean the DB/DC limit is 31% of pay? Sometimes. Go back to the example of Thompson and Davis from last week. There are two employees at this company:
- Both Thompson and Davis are covered under the company DB.
- Only Thompson is covered under the company 401(k). We will use the terms “DC” and “401(k)” interchangeably, since the 401(k) is a type of DC plan.
- The minimum required and maximum deductible DB contributions are both less than $30,000.
Here come some more numbers. We will warn you, this gets gritty and grimy. Just hang in there. Twenty-five percent of the combined pay of Thompson and Davis is $30,000. Under the basic rule, this is the most that may be contributed between the DB and the DC and taken as a deduction. This could be $20,000 to the DB and $10,000 to the DC, or $5,000 to the DB and $25,000 to the DC, whatever, so long as the total deduction is $30,000 or less and neither of the individual plan limits is violated.
In addition, the rules allow a 6%-of-pay deductible contribution to be made by the employer to the 401(k) plan. This $6,000 would go entirely to Thompson since he’s the only one covered in the DC. Thus, total deductible contributions to the two plans are $36,000. But this is only 30% of their combined pay of $120,000, not 31%.
For purposes of the 6% DC contribution that is disregarded, Davis’ pay is not counted because he is not receiving an employer contribution in the DC. If Davis were benefitting in the DC plan, the 6% maximum DC contribution would be $7,200. The total limit for both plans in that case would indeed be 31% of pay. But because of situations where some employees in the DB are not benefitting in the DC, it cannot be said simply that the limit is 31% of pay.
As is the case when there is a DC plan alone, the DB/DC deduction limit is unaffected by any salary deferrals made by Thompson in the 401(k) plan. For that matter, any deferrals made by Davis would not count against the deductible contribution limit, either. However, as indicated in Part 1 of this series, it is not clear whether Davis’ pay may be counted when determining the 6%-of-pay DC contribution that is disregarded. His pay is counted for purposes of determining the 25%-of-pay DB/DC deduction limit since he is in at least one of the plans.
Stepping Over the 6% Cushion Could Cost You Some Deduction Space
We mentioned earlier that a DB plan has a minimum required contribution and a maximum deductible contribution. Let’s say the minimum contribution for a plan is $100,000 and the maximum deductible is $300,000. As soon as the employer makes a contribution to the DC plan that is greater than the 6% that is disregarded, it loses the ability to deduct the $300,000. The $100,000 minimum contribution effectively becomes the maximum deductible contribution.
The moral of that story is, if your DB plans are not PBGC-covered, be very careful how much you contribute to the DC plan, lest you wind up with a much lower deductible DB contribution than you might have thought.
This article does not constitute tax advice. An employer will wish to verify deductibility of any retirement plan contributions with its CPA or other tax return preparer.