To help employers properly administer their 401(k) plans, in 2022, Foley & Lardner LLP is authoring a series of monthly “401(k) Compliance Check” newsletters. This article discusses the IRS limits on 401(k) plan contributions and how plan sponsors can address situations where a participant’s contributions exceed those limits.
In last month’s 401(k) Compliance Check, we discussed timing rules for properly amending 401(k) plans. This month we focus on the IRS limits on the maximum amount that may be contributed to a 401(k) plan during the year and what plan sponsors can do if a participant’s contributions exceed those limits.
Why is This Topic Important?
Deferring money into an account-based retirement plan on an annual basis is one of the best things an employee can do for their financial well-being. In the world of 401(k) plans, however, you can have too much of this good thing.
While the Internal Revenue Service (IRS) has taken steps to support employers that adopt plan designs that encourage participant participation (as an example, see 401(k) Compliance Check #3, which discusses more flexible correction rules available to plans with automatic enrollment features), the Internal Revenue Code (Code) still puts strict limits on how much an individual is permitted to contribute to tax-favored arrangements during the year. The failure to adhere to these limits results in double taxation to the affected individual and may put a 401(k) plan’s tax qualification in jeopardy. This Compliance Check explains those limits, how they apply, and the consequences for failing to satisfy them.
What is the annual elective deferral limit?
Code Section 402(g) limits the amount of annual elective deferrals that an individual may make to various retirement plans, including employer-sponsored 401(k) and 403(b) plans, SAR-SEPs and SIMPLE-IRAs. For 2022, this limit for 401(k) and 403(b) plans is $20,500. For 2022, this limit for SIMPLE-IRAs is $14,000.
If a 401(k) plan permits catch-up contributions for participants age 50 and over under Code Section 414(v), then those participants are also permitted to contribute an additional $6,500 as catch-up contributions in 2022 (for a total contribution of $27,000).
What contributions count toward this limit?
For this purpose, elective deferrals include pre-tax deferrals and Roth contributions. Traditional after-tax contributions do not count toward the annual elective deferral limits, but must be taken into consideration for purposes of calculating the total contribution limit under Code Section 415.
When does this most often become an issue?
In our experience, individuals most often exceed the Code Section 402(g) limit in the following circumstances:
The 401(k) plan recordkeeping service is not set up to automatically stop contributions in a single plan or across plans sponsored by related employers. For example, a participant under age 50 who has eligible compensation of $200,000 and elects to make a 15% deferral, but his contributions are not stopped automatically when the participant has contributed $20,500 (in 2022).
Individuals make deferrals to multiple arrangements during the same year. For example, an individual under age 50 who works for Employer A for the first three months of the year and contributes $6,000 to Employer A’s plan and $18,000 to Employer B’s plan. In that case, even if Employer B’s plans automatically stop contributions to Employer B’s plan at the 402(g) limit, Employer B would not know that the individual already contributed $6,000 to Employer A’s plan that year and, as a result, would allow the individual to make the full $18,000 contribution.
How is this fixed?
A participant who makes excess deferrals will be subject to double-taxation on the amount of the excess (in the year the contributions are made and the year they are ultimately distributed), unless the excess contributions, plus amounts earned on the excess deferrals during the calendar year are distributed to the participant by April 15 following the year in which the excess deferrals were made. Note that, under current IRS rules, amounts earned on the excess deferrals during the “gap period” between the end of the calendar year and April 15 do not need to be distributed.
In most cases, if this error occurs in a single plan (like in the first circumstance described above) or multiple plans sponsored by related employers, then the plan takes responsibility for processing and distributing the excess deferrals by the deadline. On the other hand, if the excess relates to more than one plan or arrangement maintained by unrelated employers (like in the second circumstance described above), then 401(k) plans generally make the participant responsible for affirmatively reporting the excess to the plan from which the participant would like to take the corrective distribution.
What is a practical takeaway?
If your company sponsors a 401(k) plan, then be sure to (i) double-check that your systems are effectively tracking deferral limits during the year, across all related plans and (ii) confirm that plan communications clearly explain the process for participants to report excess deferrals and include a deadline that allows the plan enough time to satisfy the April 15 distribution deadline.