David J. Kupstas, FSA, EA, MSEA Chief Actuary
Back in 2001, a law called the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) was passed. Some referred to it as the Bush Tax Cuts, Round One. The law had a number of provisions related to qualified retirement plans. Among these, in a section of the law called “Enhancing Fairness for Women,” was the catch-up contribution.
There had long been a cap on how much a worker could contribute from his paycheck into a 401(k) retirement plan; in calendar 2021, that limit is $19,500. The catch-up contribution allowed workers age 50 and older to contribute an additional amount. In 2021, the catch-up limit is $6,500. So a worker age 49 may defer $19,500 into a 401(k), but a worker age 50 may defer $26,000. The part about fairness for women had to do with the fact that many women spend time out of the workforce to raise children or for other reasons. The catch-up contribution was a way for these women to catch up on the retirement savings they missed while out of the workforce.
Of course, catch-up contributions aren’t restricted to women. Men may make them, too. And there is no requirement that an employee actually be behind on retirement savings to take advantage of the catch-up rules. In the end, it’s just a higher limit for employees age 50 and over.
The Wonder Potion We’ve Always Dreamed About
When you were a kid, did you ever dream of inventing a wonder potion that did everything – help plants grow big, heal bodily wounds, kill roaches? A catch-up contribution is kind of like that. As regular readers of this blog know, retirement plans have all sorts of contribution limits. What makes catch-up contributions so beautiful is that they are subject to almost none of these limits. Here is a list of limits and tests that don’t apply to catch-up contributions:
- The annual salary deferral limit of $19,500.
- Any plan-imposed limit on deferrals. For example, if a plan allows an employee to contribute only 15% of his pay into the 401(k) plan, a catch-up contribution may be contributed on top of that.
- The Section 415(c) limit on annual additions. In 2021, that limit is $58,000, but the limit rises to $64,500 if there is a $6,500 catch-up contribution.
- Catch-up contributions are not counted in an employee’s Actual Deferral Ratio for the ADP test. And if an ADP test fails, a deferral contribution might be able to be reclassified as a catch-up contribution.
- Catch-up contributions are not counted in coverage and nondiscrimination testing, including cross-testing.
- Unlike non-catch-up deferrals, a catch-up contribution is not counted as a contribution to a key employee for top-heavy purposes. Prior year catch-up contributions are included when determining the top-heavy ratio, though.
- Your deferrals are capped at 100% of your compensation. Catch-up contributions do not allow you to exceed that limit. This rule applies mainly to self-employed individuals who do not receive a paycheck. For those who do receive a paycheck, it would be hard to defer more salary than you are paid.
Since catch-up contributions are salary deferrals, they cannot be part of profit sharing plans that do not have a 401(k) feature. The annual addition limit in a profit sharing plan is the same for employees age 50 and over as it is for employees younger than 50. The catch-up limits also don’t apply to SEPs. SARSEPs and SIMPLEs have their own catch-up limits which won’t be discussed here.
As wonderful as they are, plans are not required to allow catch-up contributions. If an employer does allow catch-up contributions, then all catch-up eligible participants of the employer must be provided the opportunity to make catch-up contributions. This is known as the universal availability requirement. “Catch-up eligible” means you are eligible to make salary deferrals and will be at least 50 by the end of the calendar year.
One wonders if a plan could limit elective deferrals to $0 but then allow catch-up contributions on top of that. Zero dollars would be a plan limit on salary deferrals which presumably could be exceeded by a catch-up contribution. However, it seems that anyone allowed to defer $0 isn’t eligible to make salary deferrals, which is one of the requirements for making catch-up contributions. This is a controversial idea. A plan may wish to allow at least some level of deferrals greater than $0 if it wants to allow catch-up contributions.
If deferrals are made which exceed the annual limit even after catch-up contributions are taken into account, there is an excess deferral which must be refunded.
Reclassification to Catch-Up in Lieu of ADP Refund
The idea of catch-up contributions is fairly straightforward: they are extra salary deferrals that will not cause a limit to be violated or a test to fail. However, there are some practical applications of catch-up contributions that are rather complicated. One of these is the reclassification of a contribution from non-catch-up to catch-up in lieu of making a refund for a failed ADP test.
In this article, there were two examples illustrating refund amounts that would be owed to Highly Compensated Employees as a result of a failed ADP test. In one example, Adams and Baker were HCEs who had each deferred $18,000. The ADP failure would be corrected if both received a refund of $3,000. Could the catch-up rules make it so neither Adams nor Baker would need to receive a physical refund of salary deferrals?
Assume Adams is age 55, Baker is age 45, and it’s the year 2021. Since Adams is at least 50 years old, and his deferral for 2021 is less than the $19,500 maximum, $3,000 of his deferral may be reclassified as a catch-up contribution. He would no longer have an excess contribution and would not need to receive a refund. Baker would still have to receive a $3,000 refund since he has not attained age 50 and therefore cannot have his $3,000 reclassified as a catch-up contribution.
Note that it would not be permissible, knowing what results the ADP test will give, to simply apply the full $6,500 catch-up limit to Adams and therefore eliminate or reduce the refunds that would potentially need to be given to both HCEs. That’s not how the rule works. Rather, you don’t reclassify any deferrals as catch-ups in conjunction with a failed ADP test until after you’ve run the test and just before you’re ready to give refunds.
Now assume that both Adams and Baker would have to receive $7,000 refunds to correct the ADP test instead of $3,000. For Adams, the maximum $6,500 for 2021 could be reclassified as a catch-up contribution, meaning his refund would need to be only $500. Baker would need to be refunded his entire $7,000.
Finally, change the facts to assume Adams deferred $26,000 and Baker deferred $19,500. Adams is treated for the ADP test as having deferred $19,500, the remaining $6,500 counting as a catch-up contribution. The ADP test fails, with Adams and Baker both needing $3,000 refunds to correct it. This time, Adams must receive the $3,000 refund. It cannot be reclassified as a catch-up contribution since he has already used up his maximum catch-up contribution by deferring the full $6,500 in excess of the regular limit.
Off-Calendar Year Plans
The analysis gets a lot more complicated when a plan does not operate on a calendar-year basis. There are a couple of examples in the regulations on catch-up contributions which we will adapt below to reflect the current limits. (Yes, there is an entire regulation devoted to catch-up contributions.)
A 401(k) plan has a plan year ending October 31. Bill, age 55, is an HCE who defers $3,200 from 11/1/2020 through 12/31/2020 and $20,500 from 1/1/2021 through 10/31/2021. His deferrals did not exceed the dollar limit in 2020, nor did the ADP test fail at 10/31/2020. For the first 10 months of 2021, he has exceeded the deferral limit of $19,500 by $1,000. The $1,000 is treated as a catch-up contribution since Bill is at least 50. For the 10/31/2021 ADP test, Bill’s deferrals are $3,200 plus $19,500, which equals $22,700.
Let’s assume the ADP test at 10/31/2021 fails and no HCE could have deferred more than $19,300 in 2020-2021. Bill’s excess contribution is $22,700 minus $19,300, which equals $3,400. The catch-up contribution limit is $6,500. He used up $1,000 of that by exceeding the $19,500 deferral limit, so he still has $5,500 in available catch-ups for the 2020-2021 plan year. Since $3,400 is less than $5,500, $3,400 will be reclassified as catch-up, and Bill will not receive a refund due to the failed ADP test.
As for the remainder of the 2021 calendar year, Bill is treated as having deferred only $16,100 so far ($20,500 actually deferred, minus $1,000 catch-up for exceeding $19,500, minus the $3,400 catch-up for failing the ADP test), which leaves him another $3,400 he can defer in calendar 2021 without triggering any further catch-up contribution. On top of that, he still has $2,100 available catch-up left under the $6,500 limit. Should he choose to contribute that $2,100 in the last two months of 2021, it would be a catch-up contribution that would be subtracted from his 2021-2022 deferrals when the 10/31/2022 ADP test was performed.
In our final example, let’s look at Erin (age 52), who makes $200,000 a year, participates in a 401(k) plan that has a plan year running from July 1 through June 30, and likes living on the edge. Erin decides to defer $26,000 between 7/1/2020 and 12/31/2020 and another $26,000 from 1/1/2021 through 6/30/2021.
What limit has Erin violated? Well, none so far that we know of. She has deferred $52,000 in a single plan year. Normally, that’s unheard of and would exceed the individual deferral limit, but in this case it doesn’t because the plan is not a calendar year plan. She deferred $26,000 in 2020 and $26,000 in 2021. These are the maximum deferral amounts (including catch-up contributions) for those respective years. If she deferred nothing in the first half of 2020 and nothing in the second half of 2021, she’s golden as far as the individual deferral limit.
Issues Erin could run into are as follows:
- Erin’s un-catch-upped deferral amount ($19,500 times two) would be a lot to count for the ADP test if she is an HCE.
- Should Erin’s deferral limit be cut back because of an ADP test failure, there would be no opportunity to convert any more of her deferrals into catch-up contributions since she’s already used up her limit for the plan year. She would have to receive a refund of an excess contribution.
- If the limitation year is the plan year, Erin would not have room under the annual addition limit to receive much employer contribution. If she had deferred $26,000 in the plan year, she could receive an employer contribution of $38,500 in a 2021 limitation year. As it is, she may receive only $19,000 in employer contribution. The un-catch-upped deferral amount of $39,000 is applied toward the $58,000 maximum annual addition, leaving $19,000 she can receive in employer contribution. Still, she would be receiving $71,000 in the 2020-2021 plan year through a combination of deferrals and employer contributions, which is quite a lot for that short a time period.
These are some highlights of the catch-up contribution rules. Believe it or not, there are a number of things about catch-up contributions we have not covered in this article, including multiple plans and what to do when the deferral limit is exceeded even after catch-ups are taken into account. (Hint: it matters whether you’ve exceeded a statutory deferral limit or plan-imposed limit or annual addition limit.) If you run into a sticky issue with catch-up contributions, you will wish to review the regulations or talk to your third party administrator.