My administrator just informed me that we have exceeded 415 limits, but I know for a fact our contribution for the year is under the maximum 404 limit. What gives? Let’s look at the difference between Internal Revenue Code (IRC) 404 - Deduction of Employer Contributions and IRC – 415 Maximum Annual Additions.
IRC SECTION 404 - MAXIMUM CONTRIBUTION LIMIT:
The deduction limit for the total cash and stock contributions to all qualified profit sharing and stock bonus plans of the employer is limited to 25% of covered compensation. Deduction limits for ESOPs sponsored by C corporations are a little more generous in that the IRC allows a deduction of 25% of covered compensation for principal payments on an exempt loan plus a separate deduction limit of 25% of covered compensation for the sum of contributions to the ESOP not used for loan payments plus employer contributions to all other defined contribution plans. For C Corp ESOPs, contributions paid for interest payments on the ESOP loan are deductible without any limit. Also note that elective deferrals contributed by a Participant to a 401(k) Plan are not included in the 25% deduction limit. These are deducted separately (usually as wages).
IRC SECTION 415(c) - MAXIMUM ANNUAL ADDITIONS
IRC Section 415 limits the annual additions allocated to a participant’s account in all defined contribution plans to the lesser of 100% of the participant’s compensation or the statutory limit in effect for the calendar year in which the Plan year ends. For Plan years ending in 2022, the statutory limit is $61,000.00 [Statutory Limit for 2022 Plan Year End https://www.irs.gov/retirement-plans/cola-increases-for-dollar-limitations-on-benefits-and-contributions]. Annual additions consist of all employer contributions, forfeitures allocated to a Participant’s account and any elective deferrals the Participant elected to contribute. For employer contributions used to repay an exempt loan, if the Plan terms permit, the annual addition can be determined based on the lesser of the contribution made for the loan payment or the fair market value of shares released by the loan payments . The actual 415 amount cannot exceed the statutory limit.
So, circling back to the opening question I know my deductible contributions are under the (IRC 404) 25% limit, but I have individuals which have exceed their (IRC 415) annual addition limit. It may be helpful to think of 404 as a plan level limit and 415 as an individual limit. One of the common reasons a Participant exceeds the individual 415 limit is the result of the number and composition of plan participants and the amount of the employer contribution and/or forfeitures to be allocated. For example, you have a population of 50 participants but a few of those participants are highly compensated employees (HCEs) and the rest of the participants have lower compensation. The HCEs contribute the maximum elective deferrals to the 401(k) and receive the maximum match along with the highest allocations to the ESOP. It’s not uncommon for the HCEs to go over the 415 limit even though all contributions are fully deductible under the 404 limits. The situation isn’t necessarily a bad thing but nonetheless will need to be corrected.
The respective plans should have provisions on how to correct 415 failures. Most commonly the correction methods described in the IRS Employee Plans Compliance Resolution System (EPCRS) are used. In most cases a Plan Administrator can use the Self-Correction Program (SCP)(see https://www.irs.gov/retirement-plans/fixing-common-plan-mistakes-failure-to-limit-contributions-for-a-participant). What we see most of the time is unmatched 401k deferrals being returned to the participant(s) exceeding the limit. If the return of unmatched deferrals is not enough to correct, the process continues by refunding matched deferrals along with forfeiting the associated match (the forfeited match is placed in a suspense account and can be used for current year matching contribution). If that’s not sufficient the process continues by reducing other contributions. Again the Plan Documents should have specific language instructed you what action to take.
What if I failed 404 and not 415? This can happen as well. Although, I typically see if you have 404 issues, you will have 415 issues too. So, how do we correct?
1) You could reclassify some of the cash contribution amount as dividends (in the case of a C Corporation) or S Corp income distributions. Dividends and S Corp income distributions are considered earnings. You would want to consult with ERISA and tax counsel to make sure this is viable.
2) For contributions that exceed the 404 deduction limit, the Employer will have to pay an excise tax equal to 10% of the nondeductible amount and file Form 5330. Also note that the amount of the excess, except in very limited circumstances, cannot be returned to the Employer as a way to correct the excess.
In conclusion it’s not “game over” if you fail one of these compliance tests. Yes, it will create a bit of administration headache and could cause some penalties, but in the end, they will not disqualify your plan as long as they are taken care of in a timely manner. Again, the plan documents should have specific instructions on corrective actions needed.