Maximizing Retirement Plan Benefits

The impact of the $150,000 limit on recognized compensation.

    • THE $150,000 LIMIT ON RECOGNIZED compensation—imposed by Congress in 1994—restricts the amount of benefits available to higher paid employees under tax-favored retirement plans. Indexing for inflation increased this limit to $160,000 in 1997.
    • USING "PERMITTED DISPARITY," PLANS are allowed to have limited discrimination in favor of higher paid employees. However, even this technique does not have a substantial impact on the contribution rate for such employees when contributions are expressed as a percentage of pay.
    • COMPANIES MUST USE PLAN DESIGN TO achieve their goal of providing greater benefits to higher paid employees within the limits imposed by the Internal Revenue Code. Among the designs that will do this is for employer contributions to be allocated using weighting factors—assigned either to job classifications or to individuals. Another way is to design a plan that emphasizes bonuses in the contribution allocation formula.
    • COMPANIES THAT IGNORE THE compensation cap are vulnerable to Internal Revenue Service audit. Violations can result in the loss of a plans tax-qualified status, with substantial penalties.
    • SEVERAL IRS PROGRAMS HAVE BEEN designed to help companies correct retirement plan defects before an audit. The voluntary compliance resolution (VCR) program is for employers that know they have a disqualifying defect in their plan and want to correct it voluntarily. A January 1997 policy statement—the administrative policy regarding self-corrections—permits certain plan operating mistakes to be corrected without sanctions before an audit begins.
ROBERT B. EASTWOOD, JR., is vice-president-technical of Actuarial Consultants, Inc. in Torrance, California.
G. PATRICK BYRNES is president of Actuarial Consultants, Inc. Both are members of the American Society of Pension Actuaries and the American Academy of Actuaries.

E ver since Congress imposed the $150,000 limit on recognized compensation for tax-favored retirement plans in 1994, companies have found there to be severe restrictions on the amount of benefits available to higher paid employees. Whats more, the limit generally forces plans to practice "reverse discrimination" by providing highly paid participants with benefits that are a much smaller percentage of their pay than those provided to lower paid participants. Some plan sponsors have misinterpreted the new rule; others have devised unusual plan designs to indirectly overcome the limitation. This article describes how a company can use plan design to accomplish the retirement funding objectives of its highly paid executives.


The idea of limiting how much compensation can be recognized by a qualified retirement plan has been around for about 15 years. In 1982, plans that awarded 60% or more of total benefits to "key employees" (as defined in Internal Revenue Code section 416) were forced to limit recognized compensation to $200,000 per year. The Tax Reform Act of 1986 extended this limit to all retirement plans effective in 1989. Because the cap was tied to a cost of living index, it steadily increased to $235,840 by 1993.

Is Reform Needed?
In a survey of small and medium-size businesses, only 9% listed pension simplification and reform as one of the three most important issues facing them today.
Source: Arthur Andersen, 1996 Survey of Small and Mid-Sized Businesses.

Congress, seeking ways to increase tax revenues, lowered the limit to $150,000 in the Omnibus Budget Reconciliation Act of 1993. The $150,000 cap also was tied to a cost of living index; however, Congress passed the Uruguay Round Agreements Act in 1994, which rounded the cap down to a multiple of $5,000. This rule kept the $150,000 limitation unchanged until 1997, when it increased to $160,000.

The original $200,000 limit generally had an impact only on small retirement plans. But the 1989 expansion to all plans created problems for both large and small plans alike. Dropping the limit from what by now would have been—due to cost of living increases—more than $250,000 to $160,000 has had a substantial impact on every plan covering individuals who earn more than $160,000.


Most plan sponsors are not pleased with the idea of a retirement plan that gives a greater percentage-of-pay benefit to lower paid employees than it does to the higher paid. Plans designed before any compensation limits were imposed frequently gave everyone an employer contribution equal to the same percentage of pay. For example, if the contribution was 10% of pay, the president and the janitor—and everyone in between—received an allocation equal to 10% of pay. Exhibit 1 illustrates the effect on a group of employees whose earnings total $1 million when the employer decides to contribute $100,000. Because of compensation limits, those earning $160,000 or less receive an allocated contribution of 13.51% of pay while the highest paid executive receives only 6.18% of pay—even though she earned $350,000. This percentage would be even lower had she earned $700,000 or $1 million.

The Internal Revenue Code allows plans to practice limited discrimination in favor of higher paid employees on the theory that the Social Security system discriminates against those individuals by providing lower paid employees with greater benefits as a percentage of pay. This discrimination is referred to as "permitted disparity" in the code and regulations.

Does permitted disparity solve the problem? No. Consider exhibit 2 which uses the same fact pattern as exhibit 1 except permitted disparity has been built into the plans allocation formula. Essentially, contributions are allocated using a formula equal to 11.026% of all recognized compensation plus 5.7% of recognized compensation in excess of the FICA wage base ($65,400 in 1997). The highest paid employees contribution rate increases a meager 0.40% when the allocated contribution is expressed as a percentage of pay.


If the usual designs dont work, what does? The answer involves creating some uncommon plan designs, described below; but first lets examine the popularity of pro rata and permitted disparity plans.

IRC section 401(a)(4) says a plan sponsor must not unduly discriminate in favor of highly compensated employees. The companion regulation, 1.401(a)(4), consisting of scores of pages, details the various mathematical tests to be performed to demonstrate whether prohibited discrimination exists. This regulation also provides two safe-harbor profit-sharing plan design formulas that automatically satisfy section 401(a)(4), thus avoiding any mathematical tests. These safe-harbor designs—pro rata and permitted disparity—are also the most common.

In other words, profit-sharing plan designs that circumvent the compensation limit require mathematical demonstrations of nondiscrimination. Although the regulation may seem daunting, a surprisingly large number of alternative plan designs satisfy the requirements—as long as the sponsor is willing to go through the effort and expense of performing the nondiscrimination calculations. Passing or failing these tests depends on the demographics of the employee group covered by the plan and the creativity and persistency of the individual performing the calculations.

Suppose a hypothetical plan sponsor decides to move away from the safe-harbor formulas to legally circumvent the compensation cap. The plan is amended so the employer profit-sharing contribution is allocated using weighting factors. (These factors are multiplied by compensation, and the weighted compensation amounts are used in allocating contributions. See exhibit 3) Various job classifications have been identified, and each is given corresponding salary weighting factors. Contributions are allocated based on individual ratios of weighted compensation to total weighted compensation. Note that the three executives receive higher contributions, while all other employees receive less. However, employee A still receives only 7.88% of pay while other executives, notably employee D, receive much greater contributions as a percentage of pay. Employee D could be excluded from plan participation with no adverse consequences, because he is a "highly compensated employee" (as defined in IRC section 414[q]). Similarly, employee Cs allocation could be lowered by simply reducing the weighting factor for the marketing job classification. Alternatively, employee C could be excluded from the plan with no adverse consequences because she is also a "highly compensated employee."

Companies can use the technique illustrated in exhibit 3 to reward various classes of employees, particularly those earning above the compensation limit. But what about the company that simply wants to contribute 10% of (unlimited) compensation and wants each participant to get just that: 10% of compensation? Exhibit 4 shows how this can be accomplished. This plan assigns weighting factors to individuals, not job classifications. The factors are designed to reproduce each employees unlimited compensation. When the contribution—10% of compensation—is allocated on the basis of weighted salaries according to the plans weighting factors, the sponsors objective is achieved. Unfortunately, this design requires an annual plan amendment if the relationship between any participants actual compensation and his or her limited compensation changes. For example, if employee Cs compensation is increased to $200,000 and the limit stays at $160,000, the factor for her must increase to 1.25.

Companies that are not satisfied with allocations that result in a uniform percentage of unlimited pay may vary the weighting factors in exhibit 4 to achieve higher allocations to those earning more than $160,000.

Another alternative plan design involves the use of discretionary bonuses, with a corresponding plan design that emphasizes bonuses in the contribution allocation formula. (See exhibit 5.) This plan weights discretionary bonuses five times more than regular salary. Since the employer has complete discretion over salary and bonus levels, this design is an extremely attractive way to skew contributions in favor of selected employees.

Under a weighted plan such as this one, for example, an employee earning a $150,000 salary with no bonus has a weighted compensation of $150,000 for profit-sharing-plan allocation purposes. On the other hand, an employee earning a $50,000 salary with a $100,000 bonus has a weighted salary of $550,000—resulting in an allocation that is 367% of the individual earning $150,000 without a bonus. This design not only results in substantially greater allocations as a percentage of pay for higher paid employees but it also permits the employer to engineer greater or lesser retirement plan allocations by modifying the mix of bonus vs. base pay. Note that in exhibit 5 allocations as a percentage of pay increase as pay rises, even for individuals earning more than the $160,000 cap.


Some companies have ignored the compensation cap. This practice is particularly common in 401(k) plans, and the Internal Revenue Service has acknowledged that such plans are particularly high on their audit list. Typically, payroll services or third-party administrators make errors when a 401(k) plan has a matching contribution subject to a percentage-of-pay ceiling. For example, the employer may match 50% of 401(k) salary deferrals up to the first 2% of compensation. Suppose an individual earning $300,000 per year defers $9,000. Were it not for the compensation limit, the match would be $9,000 3 50% = $4,500. However, the maximum match is $3,200 ($160,000 3 2%) because of the legally mandated limit on recognized compensation. All too often, those who administer the plan calculate the match as the lesser of the $4,500 figure or 2% 3 $300,000 = $6,000, thus permitting a full $4,500 match in our example. Treasury regulations section 1.401(a)(17)-(a)(1) clearly says compensation above the annual dollar limit annually may not be (directly) recognized.

Presumably, the above error is widespread because more than one payroll service has made this incorrect interpretation of section 401(a)(17). Upon IRS audit, the consequences of this misinterpretation can be severe. Violations can result in the loss of a plans tax-qualified status. This, in turn, results in the loss of the trusts tax-exempt status with respect to earnings, loss of the employers deduction for contributions allocated to nonvested employees and taxable income on allocated contributions to all vested employees.

As a practical matter, the IRS does not actually revoke a plans tax-favored status. Instead, it figures out the taxes associated with the plans loss of protected status and negotiates a settlement with the sponsor. The size of the settlement depends on the facts and the skills of the negotiating parties. Negotiated settlements can reach 70% of the applicable sanction if the plan is actually disqualified. This IRS program is referred to as the closing agreement program (CAP) because this written agreement closes the audit.

Suppose a CPA is involved with a plan that made the mistake of overlooking the section 401(a)(17) compensation limit. Further suppose that the violation was entirely innocent; nobody deliberately violated the law. Unfortunately, ignorance of the law is no excuse (although it might be a mitigating factor in negotiating an eventual CAP settlement). Should a CPA simply watch the calendar, waiting for an audit or the expiration of the statute of limitations?

Fortunately for those who find little excitement in playing "audit roulette," the IRS has developed a program so a plan sponsor can avoid nail biting for several years in fear of an audit. The voluntary compliance resolution (VCR) program is designed for employers that know they have a defect that can disqualify their plan and that want to do something about it. The VCR program allows a taxpayer to

  • Come forward and voluntarily disclose the problem to the IRS.

  • Offer to fix the problem retroactively.

  • Pay a relatively modest predetermined processing fee.

In return, the IRS issues a compliance statement to the plan sponsor in which the IRS agrees not to pursue plan disqualification.

Fees under VCR range from $350 to $10,000, depending on the type of defect, the size of the trust fund and the number of plan participants affected. The VCR program is available for plans that have received favorable determination letters from the IRS concerning the plans proper design under current tax laws but have been found to have operational defects.

The VCR program is not available if a plan has no letter of determination concerning its tax-qualified status or if the plan document does not comply with all legal requirements. Instead, the IRS offers a voluntary version of the CAP program (sometimes referred to as "walk-in CAP"). Under voluntary CAP, sanctions equal a fraction of those likely to be imposed when the CAP program is used to cure defects discovered while the plan is under audit.

The IRS issued an internal policy statement in January 1997 called the administrative policy regarding self-corrections (APRSC), which permits plan operating mistakes—discovered and corrected within a year or so—to avoid the sanctions discussed above as long as the plan has a letter of determination. The APRSC also allows "minor" mistakes (depending on facts and circumstances) to go unpunished if they are corrected after the IRS discovers them.

If a plan mistakenly recognized compensation above $160,000 or committed one of literally dozens of other errors that could result in potential plan disqualification, neither VCR nor walk-in CAP is available after the company has been notified that an IRS audit is to take place.


Companies can circumvent the limit on recognized compensation through plan design as long as participant demographics permit mathematical demonstrations that the plan does not violate section 401(a)(4) nondiscrimination requirements. Absent such a design, ignoring the compensation limit may result in severe consequences from the IRS. Therefore, CPAs involved in plan administration should take prompt corrective action, including any appropriate interface with the IRS, to fix retirement plan problems—before the IRS finds them and fixes them itself.


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