Employee Benefits-IRS Provides Guidance On Salary Deferrals And The Annual Compensation Limit

In Employee Plans News, March 20, 2012, the Internal Revenue Service (“IRS”) dealt with the following issues: We have a 401(k) plan and some employees’ compensation will exceed the annual compensation limit this year. Should we stop their salary deferrals when their compensation reaches the annual compensation limit? How do we calculate the employee’s matching contribution?

The IRS responded as follows: Unless your plan terms provide otherwise, the salary (elective) deferral limit is applied uniformly to the compensation that the employee receives throughout the year. Compensation and contribution limits are subject to annual cost-of-living adjustments. The 2012 annual limits are:

• salary deferrals – $17,000, plus $5,500 catch-up contributions if the employee is age 50 or older (IRC sections 402(g) and 414(v))
• annual compensation – $250,000 (IRC section 401(a)(17))
• total employee and employer contributions plus forfeitures – the lesser of 100% of an employee’s compensation or $50,000, plus $5,500 catch-up contributions if age 50 or older (IRC section 415(c))

Example: Mary, age 49, whose annual compensation is $300,000 ($25,000 per month), elects to defer $1,417 per calendar month, up to $17,000 for the year. Mary may contribute to the plan until she reaches her annual deferral limit of $17,000 even though her compensation will exceed the annual limit of $250,000 in November.

Employer matching contributions
If your plan provides for matching contributions, you must follow the plan’s match formula.

Example: Your plan requires a match of 50% on salary deferrals that do not exceed 5% of compensation. Although Mary earned $300,000, your plan can only use up to $250,000 of her compensation when applying the matching formula. Mary’s matching contribution would be $6,250 (50% x (5% x $250,000)). Although Mary makes salary deferrals of $17,000, only $12,500 (5% of $250,000) will be matched. She must receive a matching contribution of $6,250 (50% x $12,500).

What does your plan say?

Although not common, a plan can specifically require that salary deferrals cease once a participant’s compensation reaches the annual limit. If your plan specifies that salary deferrals be based on a participant’s first $250,000 of compensation, then you must stop allowing Mary to make salary deferrals when her year-to-date compensation reaches $250,000, even though she hasn’t reached the annual $17,000 limit on salary deferrals, and you must base the employer match on her actual deferrals.