It is generally the case that the more compensation one earns, the bigger the contributions and benefits he may receive from a qualified retirement plan. The limits on salary deferrals in 401(k) plans, annual additions in defined contribution plans, and annual benefits paid from defined benefit plans are capped at 100% of compensation. Deductible contributions to a defined contribution plan are also limited to a percentage of total payroll.
Occasionally, we will have a business owner client who does not wish to pay himself a large salary. While most ordinary American workers would be happy to have the biggest salary they can possibly get, some business owners who are later in their careers want as small a salary as possible. They have enough savings to meet their lifestyle needs. Taking a big salary just means paying high taxes.
These individuals would rather steer most of their business income into a retirement plan and be able to shelter that money from current taxation. But how would they be able to do this if high compensation is needed for big plan benefits? Are they trying to have their cake and eat it, too? It turns out the idea is not as half-baked as you might think. Under the right circumstances, a maximum defined benefit plan can be established even if current compensation is next to nothing.
Section 415 Limits for DC and DB Plans
Let’s look at defined contribution (DC) plans first. It is absolutely true that current-year compensation needs to be at a certain level in order to receive maximum DC plan allocations. The salary deferral limit in a 401(k) plan in 2019 is the lesser of $19,000 and 100% of pay. If your W-2 income is only $15,000 for the year, then $15,000 is all you can defer into the 401(k) plan, since you cannot defer more than what’s in your paycheck. (To get nit-picky, your maximum deferral would have to be slightly less than $15,000 because of FICA withholding.)
Likewise, the annual addition limit in 2019 is the lesser of $56,000 and 100% of pay. Annual additions are the sum of deferrals, matching contributions, profit sharing contributions, safe harbor nonelective contributions, and other items. If your compensation is $200,000, for instance, you may be able to get the full $56,000 annual addition. If your salary is only $30,000, then $30,000 is all the annual addition you can get.
Defined benefit (DB) plans work differently. DB plans are designed to pay an annual benefit at retirement that may not exceed the lesser of
- $225,000 (in 2019), or
- 100 percent of the participant's average compensation for his high 3 years.
The $225,000 limit is called the “415(b) dollar limit.” It does not mean that the annual DB contribution on behalf of an individual may not exceed $225,000. The $225,000 is a retirement benefit limit, not a current contribution limit. The $225,000 limit is adjusted if the employee participated in the plan for fewer than 10 years or if the benefits commence earlier than age 62 or later than age 65.
Once a benefit is set forth in the plan document, the annual contribution to be made by the employer is developed by the plan’s Enrolled Actuary based on that benefit and a host of other factors, including the participant’s age, the age at which benefits are assumed to commence, years of service or plan participation, and value of plan assets. The law does not specify a particular contribution limit. The contribution attributable to one individual’s benefit may well come to more than $225,000, which is A-OK.
The second limit is known as the “415(b) compensation limit” or just the “100%-of-pay limit.” It says that the annual benefit payable from a DB plan may not exceed 100% of the average compensation from the three consecutive calendar years that the employee’s compensation was the highest. Congress does not feel it is appropriate to give favorable tax treatment for pensions that exceed what you earned while working. If the employee earned $150,000 every year of his career, then he would not be able to receive an annual benefit of $225,000. Rather, the annual benefit would be limited to $150,000. This limit is reduced if the employee has less than 10 years of service with the employer.
Just as the 415(b) dollar limit doesn’t mean your contribution is limited to $225,000, the 100%-of-pay limit does not limit your DB contribution to 100% of your current pay. A client of ours once received an inquiry from a governmental agency because he made a contribution of $220,000 to his one-participant plan in a year when the maximum compensation that could be taken into account was only $210,000. Obviously, the client did nothing wrong, but it is nevertheless disconcerting to receive a piece of mail from the government poking into your affairs. To make the problem go away, we had to educate the government employee on the difference between DC plan annual addition limits and DB plan benefit limits. (I will not name the government agency here, but it has three letters that can be rearranged to spell “SIR.”)
415(b) Comp Limit May Use Pay Before Plan Inception
To get the maximum DB benefits available under the law, an employee or owner will need to have had a three-year stretch of compensation during which the annual average was at least $225,000. This could be exactly $225,000 for three years in a row. It could be $215,000, followed by $225,000 and $235,000. It could be any combination of pay amounts that average out to $225,000 or more. Note the following, however:
- The compensation from any given year included in the average may not be greater than the maximum compensation amount that may be considered for a plan under Code Section 401(a)(17). Even if the individual earns $1 million per year, the three-year average from 2016 through 2018 could not exceed ($265,000 + $270,000 + $275,000) = $270,000, reflecting the 401(a)(17) limits for those years.
- The compensation used in determining the 100%-of-pay limit may be from any three consecutive years of service with the employer. It does not need to be from the final three years of employment, nor does it even need to be from years during which the plan was in effect. There may be a business owner who averaged $245,000 from 2009 through 2011 and then took a reduced salary thereafter. The owner could establish a DB plan in 2018 and base benefits on the 2009-2011 compensation.
In conclusion, if a high three-year compensation average has been established in past years, it may be possible for an owner to take no salary or minimal salary now and instead channel into a DB plan most of the dollars that would otherwise have been paid as salary. This would not be possible with a DC plan.
This article does not constitute tax or compensation payment advice. An employer will wish to review its compensation payment practices with a CPA or other qualified advisor.