Understanding the Annual Additions Limit for Defined Contribution Plans
By Gunnar Kuehl, QKA
How much can be contributed each year to a participant’s account under a defined contribution plan, such as a 401(k) plan?
Under Internal Revenue Code Section (IRC Sec.) 415, the “annual additions” to a defined contribution plan, including a 401(k) plan, for each participant may not exceed the lesser of
100 percent of the participant’s compensation or
$57,000 for 2020, and $58,000 for 2021.
A plan must comply with the IRC Sec. 415 annual additions limit. “Annual additions” is the annual total of
employer contributions (including employee elective deferrals under a 401(k) plan),
nondeductible employee contributions, and
forfeitures.
Not all credits to a participant’s account are considered annual additions. For example, the annual additions limit does not apply to rollover contributions, transfers from other retirement plans, or loan repayments. These amounts were subject to the applicable limits when originally contributed or allocated, so IRC Sec. 415 does not require that they be counted again. Catch-up deferral contributions and trust earnings (i.e., growth on plan investments) are likewise exempt from the annual additions limit.
Note that if an individual participates in more than one defined contribution plan of the same employer, the benefits received under all plans are aggregated for purposes of such individual’s annual additions limit.
What counts as “compensation” for purposes of the annual additions limit?
As a general rule, compensation incorporates all of a participant’s wages, salaries, fees, and other amounts received for personal services rendered that are actually paid during the limitation year. In other words, compensation includes all amounts paid by the employer during the limitation year.
For self-employed individuals, their compensation is their earned income. For compliance testing under IRC Sec. 415, compensation includes salary deferral amounts (unreduced compensation).
What is the “limitation year?”
The limitation year is the period over which compensation and benefits are measured. It is generally the calendar year, unless the employer’s plan document explicitly specifies another consecutive 12-month period. Many employers draft their plan documents to align the limitation year with the plan year for ease of administration.
If a plan document defines the limitation year with reference to the plan year and a short plan year occurs (e.g., due to a plan amendment or a mid-year liquidation date), then the annual additions limit is prorated based on the number of months in the short limitation year. Similarly, compensation will include only amounts paid during the short limitation year.
Example: An employer’s plan document defines the limitation year as the plan year, which is defined as the calendar year. The employer decides to terminate the plan and distributes the last remaining assets on March 31, 2021. The dollar limit on annual additions is determined as follows: $58,000 x (3 months / 12 months) = $14,500. Therefore, the annual additions limit is the lesser of 100 percent of compensation from January 1 to March 31, 2021, or $14,500.
What happens if a participant exceeds the annual additions limit?
If a participant receives an allocation in excess of the annual additions limit, the employer must deal with the excess—or risk potential plan disqualification. Excess annual additions can be corrected under the IRS’ Employee Plans Compliance Resolution System (EPCRS). While the appropriate corrective method will depend on the cause of the excess, some options generally available for correction under the EPCRS include the following.
If the IRC Sec. 415 excess is attributable to employee after-tax contributions, these contributions should be distributed to the extent such return would eliminate or reduce an excess annual addition. Any corresponding matching contributions are forfeited, further reducing the excess.
If the IRC Sec. 415 excess is attributable to elective deferrals, the elective deferrals should be distributed to the extent such distribution would eliminate or reduce an excess annual addition. Any corresponding matching contributions are forfeited, further reducing the excess.
If an excess is the result of an employer contribution that would otherwise have been allocated to other participants had the excess not occurred, the plan should reallocate the excess annual addition amounts, plus earnings, to the other plan participants’ accounts, according to the plan’s allocation formula.
If an excess resulting from an employer contribution would not otherwise have been allocated to other participants, the excess amount plus earnings should be placed in a “suspense account” to hold and use in a subsequent year. The plan must use this suspense account to reduce the next possible employer contribution (other than employee elective deferrals).
What can an employer do to help avoid exceeding the annual additions limit?
The best way for an employer to avoid the problem of excess annual additions is to test the plan periodically throughout the year to ensure that the allocation limit is not being exceeded. When testing, an employer must consider all annual additions that have been allocated to a participant during the given limitation year under all defined contribution plans maintained by the employer. Note that for annual additions purposes, the sponsoring employer and any related employers, including members of a controlled group or affiliated service group, are included. This means that an employee who works for and receives retirement benefits from two or more such related employers must have these benefits combined when applying the annual additions limit.
The IRC Sec. 415 annual additions limit is one of the more complex, multi-dimensional compliance concerns for those who participate in—or administer—defined contribution retirement plans.
