IRS on How 401(k) Administration Is Affected by Excess Compensation

When an employee’s compensation exceeds the annual limit, how does that affect 401(k) salary deferrals and what employers and plan administrators have to do? In the March 20, 2012 edition of Employee Plans News, the IRS provides an answer.

The IRS says that unless plan terms provide otherwise, the 401(k) 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 (Code Sections 402(g) and 414(v));
• annual compensation: $250,000 (Code Section 401(a)(17)); and
• total employee and employer contributions plus forfeitures: the lesser of 100 percent of an employee’s compensation or $50,000, plus $5,500 catch-up contributions if age 50 or older (Code Section 415(c)).

Here’s an example.

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.

If a plan provides for matching contributions, the employer or plan administrator must follow the plan’s match formula.

Example. The plan requires a match of 50 percent on salary deferrals that do not exceed 5 percent 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 percent x (5 percent x $250,000)). Although Mary makes salary deferrals of $17,000, only $12,500 (5 percent of $250,000) will be matched. She must receive a matching contribution of $6,250 (50 percent x $12,500).

Although not common, a plan can specifically require that salary deferrals cease once a participant’s compensation reaches the annual limit.

If a plan specifies that salary deferrals be based on a participant’s first $250,000 compensation, then an employer or plan administrator must stop allowing the participant to make salary deferrals when his or her year-to-date compensation reaches $250,000, even though the employee hasn’t reached the annual $17,000 limit on salary deferrals, and must base the employer match on actual deferrals.