By now, you probably understand the basic differences between defined benefit plans and defined contribution plans. Defined contribution plans establish the limit up front, while defined benefit plans define a benefit at retirement.
Both types of plans are governed by Internal Revenue Code (IRC) section 415. In this post, we will take a look at how the benefit limitations under code section 415 work for defined benefit plans.
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What is the 415 Limit and how is it calculated?
I have discussed before that defined benefit plans are looking for a large benefit amount at retirement age. Let’s just assume that number is $3 million at age 62.
Why can’t a business owner just put all that money into the plan today?
That would be nice. But in reality, the IRS has established limitations. IRC 415 and related rulings limit benefits provided in a qualified defined benefit plan. According to IRC §415(b)(1), the maximum annual retirement benefit that a defined benefit plan may provide is limited to the lesser of:
- A dollar limit of $235,000 (as of 2020) that is indexed by cost-of-living in $5,000 increments; or
- 100% of the participant’s average compensation (often referred to as the percentage limit).
How is compensation determined? Compensation is averaged over the highest three consecutive calendar years. The IRC §401(a)(17) maximum compensation limit of $290,000 (as indexed for cost-of-living adjustments) through 2021 applies to a plan’s specified accrual formula, as well as to the 100% of average compensation percentage limit.
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If the company had never maintained a defined contribution plan in which the employee participated, a $10,000 de minimis annual benefit could be provided, regardless of compensation. But in most situations, the company has a 401(k) plan so this is typically not applicable.
Both the dollar and the percentage limit apply to the plan’s limitation year, which is the calendar year, unless the employer adopts a different twelve-month period. The plan year is determined in the adoption agreement.
All employer defined benefit plans are treated as a single plan for the IRC §415 limitations. This includes plans that were established in the past and have since terminated and distributed out the assets.
As discussed below, adjustments may need to be made to these limits depending on retirement age and length of service and/or participation. The limits do not apply to any benefits derived from mandatory employee contributions or to benefits derived from rollover contributions.
IRC 415 Exceptions
There are a few exceptions where portions of IRC §415 do not apply. The percentage limit will not apply to collectively bargained plans that meet certain conditions. The percentage limit also will not be applicable to governmental or multiemployer plans.
Do the 415 limits also include defined contribution plans?
Interestingly, defined contribution limitations are covered under IRC §415 as well. This is a little-known fact.
IRC §415 limits the benefits that can be paid to an individual participant from defined benefit plans sponsored by the same employer and limits the contributions made to defined contribution plans sponsored by the same employer.
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These limits (defined benefit and defined contribution) are independent of each other. There is no IRC §415 limit on the combined amounts that can be received from defined benefit plans together with defined contribution plans.
The allocation of employer contribution to the cash balance account can exceed the IRC §415 defined contribution maximum annual addition for cash balance plans. However, the actuarially equivalent accrued benefit must not exceed the IRC §415 defined benefit maximum benefit.
Both the dollar and the percentage limits can be increased after separation of service for cost of living if the plan so allows. Because the effective limit can be increased after separation of service, it is sometimes said that the IRC §415 limits do not apply to the accrued benefit, but only to the amount of the accrued benefit that can be distributed in a given limitation year.
The IRC §415 limits apply to each limitation year as a whole and not separately to the months within the year. When an actuary calculates contribution requirements for a defined benefit plan, the actuary may not assume future increases to the IRC §415 limits and also may not assume future increases to the IRC §401(a) (17) compensation limits even though the actuary illustration may have included an assumption for future inflation.
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By law these limits increase each year based on inflation. The IRS considers changes to these limits to be plan amendments. As such, future year plan amendments cannot be taken into account in a current year valuation. However, it allows language in plan documents permitting the increases annually as the IRS announces them.
How do limitation reductions work?
The IRC §415 dollar limit is reduced by 10% for each year of plan participation less than ten at the determination date, although it is never reduced below 10% of the full limit.
The percentage limit (100% of average compensation) and the $10,000 de minimis benefit are both reduced by 10% for each year of service less than ten at the determination date. However, they are never reduced below 10% of the full limit.
The dollar limit reduces based on participation while the percentage limit reduces based on service is important to remember (although it does not have an obvious rationale).
Let’s take a look at an example that illustrates the dollar limit:
The IRC §415 Dollar Limit is $235,000 and the IRC §401(a)(17) pay cap is $290,000 for 2021, $285,000 for 2020, and $280,000 for 2019. The employee has 8 years of participation and 9 years of service. The Dollar Limit is reduced to $235,000 × 8/10 = $188,000. The percentage limit is reduced to (($290,000+$285,000+$280,000)/3) × 9/10 = $256,500.
There are reductions to the dollar limit (but not the percentage limit) for payments before age 62. The dollar limit is increased when the payments start after age 65.
If benefits begin before age 62, the dollar limit is reduced to equal the lesser of:
- The actuarial equivalent benefit based on the plan’s interest rate and mortality table (or tabular factors) for early retirement reductions; or
- The actuarial equivalent benefit based on 5% interest and the applicable mortality table prescribed by the Treasury Secretary.
If benefits begin after age 65, the dollar limit is increased to equal the lesser of:
- The actuarial equivalent benefit based on the plan’s interest rate and mortality table (or tabular factors) used to determine late (postponed) retirement benefits; OR
- The actuarial equivalent benefit based on 5% interest and the applicable mortality table.
There are additional reductions in both the dollar and the percentage limits if the benefit is payable in a form other than a life annuity or qualified joint and survivor annuity (QJSA). In these situations, special interest rates and mortality tables must be used to determine actuarial equivalence of the life annuity benefit.
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A participant who is an active employee, beyond normal retirement age and whose accrued benefit is limited by the IRC §415 percentage limit, is unique. If the participant’s current pay is not impacting the high 3-year average used to determine the 100% of compensation limit, this participant is not receiving additional accruals. (It is assumed that they are beyond the 10-year service period for full IRC §415 limits).
In this particular case, the participant is effectively frozen at the 415 limit. There is no notification required to be given to the participant since plan provisions and the IRC limits determine accruals, and there are no choices for the employer or the participant to make.
Lump-Sum Calculation Subject to the IRC §415 Limit
A participant upon separation from service may be eligible to receive a lump-sum distribution. As mentioned earlier, some plans offer unlimited lump-sum amounts while others only pay lump sums up to the $1,000 or $5,000 minimum threshold level.
After the plan benefit is determined, the IRC §415 limits that apply to this participant are determined. A comparison is made between the plan benefit and the IRC §415 limit. The lesser benefit is used.
Remember that the IRC §415 limit is itself the lesser of the percentage and dollar limits. So in actuality, the accrued benefit is the smallest of three different numbers. The administrator provides election forms to the participant to decide which benefit options should be selected.
One of these options may be a lump sum, payable as of a certain date. Adjustments must be made to the IRC §415 limit due to a form of benefit payment other than a life annuity or a QJSA.
