Impact of $150,000 compensation limit for benefit plans.

The Revenue Reconciliation Act of 1993 reduced the limit on the amount of compensation that may be taken into account under qualified pension and profit-sharing plans to $150,000. This limit also applies for deduction limit purposes and for testing plan benefits for nondiscrimination. Indexed for inflation, the 1993 limit was $235,840.

The reduction is effective for 1994 plan years. Existing accrued benefits at the end of 1993 based on compensation of more than $150,000 are protected. After 1994, the $150,000 limit will be indexed for inflation in $10,000 increments.

Plan amendments incorporating the $150,000 limit are not required to be in place before the end of the 1994 plan year. As long as it is adopted in a timely manner, the amendment may apply retroactively even though it results in a reduction of some accrued benefits. The IRS has provided model plan amendment language that satisfies the new requirements.

Because the reduced compensation limit has to be taken into account in calculating maximum deduction limits, it will result in delayed funding for some defined benefit pension plans. Moreover, because it must be reflected in applying the plan's benefit formula, future benefit accruals for employees earning more than $150,000 will be reduced. In recently proposed rules the Service has clarified how future defined benefit accruals will be affected by the "grandfathered" accrued benefit at the end of 1993 that may be based on compensation of more than $150,000. The IRS has provided three alternative methods for coordinating the 1993 grandfathered accrued benefit with future benefit accruals subject to the $150,000 limit. These are the same transition alternatives provided when the $200,000 limit took effect in 1989. In selecting the appropriate alternative, plan sponsors must weigh competing objectives, such as maximizing qualified plan benefits and administrative simplicity.

Additionally, future allocations under defined contribution plans for employees earning more than $150,000 will be reduced because the limit will have to be taken into account in applying the plan contribution formula. In the past, simple profit-sharing plans could generate the maximum $30,000 annual allocation for employees earning more than $200,000. Because the maximum deductible contribution to a profit-sharing plan is limited to 15% of compensation up to $150,000, these arrangements will have to be modified to preserve maximum $30,000 allocations.

In determining deferral amounts under Sec. 401(k) plans, employees will need to base deferral elections on no more than $150,000 of compensation. For example, in 1993, employees earning $235,840 or more could defer approximately 4% of compensation to reach the $8,994 limit. For 1994, those employees will have to defer approximately 6% of compensation to reach the same level. Because the reduced compensation limit has to be taken into account in applying the annual nondiscrimination tests, it will tend to further reduce deferral opportunities for highly compensated employees under Sec. 401(kl plans.

Many companies will continue to rely on unfunded, nonqualified deferred compensation arrangements to restore benefits that can no longer be provided under qualified plans due to the reduced compensation limit.

From Jeff Davis, J.D., Washington, D.C.