Compensation and Benefit Limits Affected by Short Plan Year

If a short plan year is created when a plan is amended, terminates or is newly adopted, proration of the Internal Revenue Code annual compensation dollar limit and limit on DC plan additions will be needed.

Retirement plans may experience a short plan year upon termination, upon a new plan’s adoption or if the plan year is amended, for example.

The Internal Revenue Service (IRS) reminds plan fiduciaries that certain compensation and benefit limits must be prorated when a short plan year occurs.

According to an IRS Issue Snapshot, a plan may not base allocations for a plan year on compensation exceeding the dollar limit imposed under Internal Revenue Code (IRC) Section 401(a)(17) or use more than this amount in applying certain nondiscrimination rules. This year, the annual compensation dollar limit is $275,000. This limit is subject to annual cost-of-living adjustments. The dollar limit applies for a 12-month period. If the plan uses a compensation measurement period of less than 12 months in calculating employee allocations, the limit must be prorated, the snapshot says.

For example, Plan A is a profit-sharing plan with a calendar plan year. This June 30, the plan will be amended to change the plan year to a fiscal year ending June 30. The amendment creates a short plan year from January 1 through June 30, 2018. The plan document provides that allocations for the plan year ending June 30 will be based on compensation for the six-month period. Because the short plan year begins in 2018, the prorated short-year limit is calculated based on the 2018 limit of $275,000 under IRC Section 401(a)(17). The prorated short-year limit is $137,500—i.e., $275,000 x (6/12) = $137,500.

The IRS also provides examples for initial short plan years and plan termination. The agency notes that the compensation limit is not prorated for employees who enter or leave the plan mid-year, provided the plan continues to use a measurement period of 12 months for the other employees.

Calculating 415 annual additions for a short plan year

In another Issue Snapshot, the IRS discusses how to adjust the IRC Section 415(c) defined contribution (DC) dollar limitation for a short limitation year, resulting from, for example, an initial, amended or terminating plan year.

Total annual additions to a participant’s DC plan account are limited to the dollar amount imposed by IRC Section 415(c). Annual cost-of-living adjustments apply to this dollar limit. If the participant’s compensation is less than the dollar limit, annual additions during a limitation year must not exceed 100% of compensation.

The limit applies to the total of:

  • elective deferrals, excluding catch-up contributions within the meaning of IRC Section 414(v);
  • employee contributions;
  • employer matching and nonelective contributions, but not restorative payments under Section 1.415(c)-1(b)(2)(ii)(C); and
  • allocations of forfeitures.

For 2018, the dollar limit on annual additions to a participant’s accounts for all DC plans maintained by an employer is $55,000.

The contribution limit for a short limitation year is determined by multiplying, by a fraction, the applicable dollar limit for the calendar year in which the short limitation year ends. The numerator of the fraction is the number of months—including any fractional parts of a month—in the short limitation year, and the denominator is 12.

Limits on annual additions and compensation are not prorated for employees who are eligible to participate in the plan for only part of the limitation year—for example, participants entering the plan in July of a calendar limitation year. Proration of these limits applies only when the limitation year is less than 12 months. However, plan provisions can limit compensation taken into account to the period of participation. For instance, a plan’s administrable definition of compensation can be defined to provide that compensation for purposes of applying the allocable share of profit-sharing contributions applies only to that portion of a plan year during which an employee is an eligible participant.