The combined deduction limit for defined benefit (DB) and defined contribution (DC) plans has always been a source of confusion for me. Sure, I understand the basics: when the DB plan is PBGC-covered, a deductible contribution of up to 25% of compensation may be made to the DC plan, while up to the 404(o) limit may be contributed and deducted for the DB. If the DB is not PBGC-covered, up to 6% of DC plan compensation may be contributed to the DC plus up to the 404(o) maximum to the DB, or 31% of compensation between the DB and DC plans. (To be more precise, the 31% limit means 25% of the compensation paid to anyone who participates in either plan, plus an additional 6% contribution to the DC plan, which is based on compensation paid to DC plan participants and which does not count toward the 25% limit.)
But what happens when a plan sponsor contributes over these limits? Or what if the plan sponsor needs to contribute more than 6% of compensation to the DC plan to pass non-discrimination testing and the minimum required DB contribution is more than 25% of compensation? And how does one make a 4972(c)(7) election, anyway?
I decided to dig into the Internal Revenue Code and regulations to finally get a handle on this tricky subject.
For help, I contacted the deduction limit guru, Kevin Donovan, who was gracious enough to offer his expertise. This article will focus on combined deduction limits for non-PBGC-covered plans.
Stay tuned for the second installment focusing on the 404(a)(8) earned income limit for self-employed individuals.
WHAT DOES 404(a)(7) SAY?
I started my search at IRC section 404(a)(7). When a DB and DC sponsored by the same employer have at least one employee who is a beneficiary in both plans, the total combined deductible limit is greater of:
(i) 25% of compensation (of participants benefitting in either the DB or DC plan)
(ii) The greater of (a) the minimum required contribution and (b) the excess of the funding target over the actuarial value of assets (where presumably both are based on 430 segment rates)
IRC 404(a)(7)(C)(iv) provides that the above-combined limit does not apply to PBGC-covered plans.
They are only subject to the respective individual plan limits. Thus, the deductions can be up to the 404(o) maximum for the DB and up to 25% of compensation for the DC plan.
For non-PBGC-covered plans, IRC 404(a)(7)(C)(iii) provides that DC contributions of 6% or less (of DC plan compensation) can essentially be disregarded when calculating the combined plan limits, which is why a non-PBGC plan can deduct up to the 404(o) maximum plus 6% of DC compensation. But if the employer contributes more than 6% of compensation to the DC plan, the 404(a)(7) limit above is applied to the DB contributions plus the DC contributions in excess of 6% of compensation. The 404(o) maximum is no longer available.
WHAT OPTIONS ARE AVAILABLE WHEN THERE IS A LIMIT VIOLATION?
In cases where the DB plan is not PBGC-covered, if the DC contribution is greater than 6% of DC compensation, the portion deposited prior to year-end was no more than 6% of compensation, and the employer has not yet filed its business tax return and taken the deduction for the prior year, the limit violation can often be avoided by pushing the deduction of the excess contribution to the year of deposit while keeping the allocation for the prior plan year.
IRC 404(a)(6) provides that a contribution made after the plan year-end may be deducted in the prior year if the contribution is made no later than the employer’s tax filing deadline.
In Revenue Ruling 76-28, the IRS elaborated that for a contribution made after year-end to be deducted in the prior year, the employer needs to, no later than the due date of the business tax return, designate in writing that the contribution is on account of (that is, it is to be deducted in) the prior year, or claim it as a deduction on the return for the preceding tax year. There is also the option of allocating the contribution as a prior plan year contribution but deducting it in the year of deposit.
Note that this may be done with all or part of the DB or DC contribution (or both), assuming the deduction has not yet been claimed for the prior year. If using this option, the amount the employer deducts in the year of the deposit will count against the deposit year deduction limit. For example, if the entire contribution is made in 2023 and allocated to the 2022 plan year, the portion deducted in 2023 would count against the 2023 deductible limits, along with any 2023 plan year allocations being deducted in 2023.
Note that the employer has until the due date of the tax return (including extensions) to amend the return to deduct a contribution made after year-end, but once the deduction has been claimed for the prior year, the return may not be amended to push the deduction into the following year (the year of deposit).
If DB or DC contributions intended for a given year are deposited prior to the end of that year, the contribution generally must be allocated in that plan year (to the extent possible within the IRC 415(c) annual addition limits) and deducted in the associated tax year. If the 404(a)(7) limit is violated, the entire contribution would still be allocated in that plan year and reported on the current year’s Form 5500. If the entire DC contribution cannot be allocated within 415(c) limits, the excess would need to stay in the plan, would not be currently deductible per IRC 404(j)(1)(B), and would be held in suspense to be allocated (and deducted) as limits allow in future years. For the DB contribution, the entire contribution would be included in the following year’s 430 assets. Still, presumably, only the deductible portion would be included in the assets for purposes of calculating the following year’s 404(o) limit.
Under IRC 404(a)(7)(B), contributions exceeding the 404(a)(7) limit are carried forward to be deducted in future years as limits allow (and they take priority for being deducted). Contributions in excess of 404(a)(7) are subject to a 10% excise tax reportable on IRS Form 5330, but there are exceptions to when an excise tax is due.
WHAT ELECTIONS ARE AVAILABLE WHEN THERE IS A LIMIT VIOLATION?
IRC 4972(c)(7) provides that, at the election of the employer, DB contributions may be disregarded when determining the amount of non-deductible contributions subject to the excise tax. Using this exception requires DC contributions to be deducted first, and then DB contributions. Thus, the 404(a)(7) limit essentially becomes the 31% limit when using this exception for a 404(a)(7) combined limit violation.
You would not have a combined limit violation unless you had contributed more than 6% of DC compensation to the DC plan, and you are required to deduct the DC contribution first under this exception.
The excess DB contributions are carried forward to be deducted in the following year as limits allow (which often is not an issue since 404(o) limits tend to be high for many established plans).
IRC 4972(c)(6) provides that if the excess DC contribution does not exceed the amount of the matching contribution, no excise tax is due on the DC portion.
However, the DB portion would still be subject to the excise tax. (Recall that as soon as more than 6% is contributed to the DC, the employer no longer has the option of deducting a DB contribution up to the 404(o) maximum; the 404(a)(7) limit listed above applies). When using a 4972(c)(6) election, the employer is required to deduct the DB contributions first. Thus, you could not use 4972(c)(7) and 4972(c)(6) exceptions together. It seems a 4972(c)(6) election makes sense only if the DB contribution were no more than the greater of the minimum required contribution and the excess of the IRC 430 funding target over the actuarial value of assets—a fairly narrow application. Moreover, the requirement to deduct the DB contribution first could potentially make it difficult to deduct both the DC carryforward and the following year’s DC contribution in the same year within the following year’s deductible limits (unless there is some plan design change or demographic shift in the following year).
For example, if the profit-sharing contribution was 5% of compensation and the match was 3%. The DB contribution was 40%; the employer could use this exception to avoid the excise tax on the 2% overage to the DC plan. However, if the DB minimum required contribution was less than 25% of compensation (and the excess of the 430 funding target over the actuarial value of assets was no greater), the employer would still have a 15% of compensation overage to the DB plan that they would not be able to use the 4972(c)(7) exception for (due to the requirement to deduct the DB portion first). If, on the other hand, the 40% of the compensation contribution to the DB was equal to the minimum required contribution, the entire DB contribution could be deducted and the 4972(c)(6) exception could be used to avoid the 2% overage to the DC plan. The 2% DC overage would then be carried forward to be deducted in the following year and would apply against the following year’s limits.
The Form 5330 instructions require only employers liable for a tax under IRC 4972 to file a Form 5330.
Thus, if all excess contributions qualify for exceptions under IRC 4972, Form 5330 does not need to be filed. However, if that exception is being used, there would need to be at least some documentation of the 4972(c)(7) election. The United States Tax Court in Pizza Pro Equipment Leasing v. Commissioner) rejected the assertion that simply not filing a Form 5330 and not paying the excise tax is tantamount to making the election. The court noted that the election could have been evidenced by filing Form 5330 and completing the appropriate line items. Form 5330 contains a line on Schedule A for excess contributions for which the 4972(c)(6) and 4972(c)(7) exceptions are being used, which is a convenient place to document the 4972(c)(7) election. Some have also suggested including the election with Form 5500 (and the court in the Pizza Pro case alluded to that possibility).
Presumably, Form 5330 should continue to be filed each year where there are non-deductible contributions from prior years that have not been deducted yet.
CONCLUSION
Combined DB/DC, deduction limit violations can get very messy. Still, there are strategies that can help, such as limiting contribution deposits during the year (especially DC plan contributions) and utilizing and properly documenting the exceptions under IRC 4972. Also, many combined deduction limit issues where non-discrimination testing is a factor can be avoided when DC plans are designed to minimize required contributions.
For example, amending a safe harbor 401(k) to provide a 3% nonelective contribution allocated to NHCEs only and using class-based profit-sharing allocations with separate classes for each participant can help keep DC contributions within the 6% of compensation limit. Or, if all else fails, consult a deduction limit guru.
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