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Closer scrutiny of state and local plans by Sec. 415.

The effects of Sec. 415 on potential state retirees requires prompt attention.

Tax-exempt pension funds

A state retirement system that satisfies aH of the requirements of Sec. 401(a) will be exempt from Federal taxation. Additionally, a qualified retirement fund has the following advantages.

* Participants are not taxed on the earnings generated by fund assets while they remain in the fund.

* Participants are not taxed on contributions made by the employer on behalf of the participants.

* In accordance with Sec. 414(h), employee contributions may be "picked up" by the employer and will not be taxed before being contributed to the fund.

Ignoring Sec. 415

A nonqualified fund loses all of these advantages. Under Sec. 401(a), a fund will be nonqualified if the Sec. 415 limitations are exceeded. One limit is on the amount of the retirement benefit to be paid to retirement plan participants.

Sec. 415 benefit limits

Under Sec. 415(b)(2)(F), special rules apply to exempt state and local government defined benefit retirement plans. The actuarial reduction of the limit on annual benefits for early retirement may not be reduced below (1) $90,000 (indexed amount for 1992 is $112,221) for benefits beginning on or after the date the participant reaches age 69., (2) $75,000 for benefits beginning on or after age 55, or (3) the actuarial equivalent of $75,000 at age 55 for benefits beginning before age 55.

Likewise, if benefits begin after age 65, the limit will be increased by actuarial adjustment. Between the ages of 62 through 65, the benefit limit remains constant except for cost-of-living adjustments.

The limit on annual benefits will also be exceeded if the annual benefit is greater than 100% of the participant's average taxable compensation for three consecutive years.

It is not easy to comply with this limit, as the example at right illustrates.

The point made by these scenarios is that a violation of a Sec. 415 limitation can occur at a relatively modest level of salary, and not (as one might assume) only at high levels.

The penalty is extreme. It takes only one participant violating the "limitation" to disqualify the entire fund.


Regs. Sec. 1.415-1(d)requires that a plan's provisions must preclude the possibility that the limitation imposed by Sec. 415 will be exceeded or the fund will lose its qualification for tax exemption.

The easiest and most practical way to accomplish this is to inelude a provision in the plan providing for an automatic freeze or reduction in the rate of benefit accrual for a defined benefit plan (which will insure that Sec. 415 limits will not be exceeded). For the short run, this will work. For the long run, it will not. As a practical matter, early retirement incentive plans will be affected first. Reduction or elimination of these plans may not be politically possible. The deadline for facing the problem may only be delayed. Many state and local government funds have been prohibited by court rulings from reducing benefits. If the plan attempts to abide by the Sec. 415 limitations by reducing benefits, it is not unreasonable to expect that such action will be challenged by members adversely affected and that they might prevail.

The unanswered questions and the possible adverse scenarios make it imperative that those to be affected seek a permanent solution. A partial solution might be to index the $75,000 limit to a cost-of-living adjustment. The reason the $75,000 limit was not indexed is because it was more generous than the limits provided by private plans.

By complete indexing, the Government's goal presumably was to allow the less generous limits in the private sector to catch up over time with the public sector limits. Therefore, concerned public employees and their organizations will have to be very effective lobbyists to obtain a permanent solution.

Interested groups are pursuing two remedies: revision of the rules by the IRS or legislation. The Service has not appeared anxious to fix the problem; therefore, a legislative remedy may be the better alternative.

There are several areas that need to be addressed legislatively so funds will not be subject to disqualification, and pension benefits will not be unfairly restricted.

The best solution would be to exempt all public pension funds from the Sec. 415 limits. However, this may not be possible given the current political and budgetary environments. Therefore, a five-pofnt proposal has been developed, which has been included in HR 11 for Congress's and the President's consideration.

1. Exempt service-connected disability pension from the Sec. 415 limits: This would resolve many problems in which service-connected disability pensions exceed the Sec. 415 limits.

2. Redefine "uniform compensation" in order to calculate the percentage of benefits on taxable W2 earnings plus employer pickup contributions (Sec. 414(h)) and Sec. 457 deferred compensation: This would cause the 100% limitation to be based on real wages and not penalize those retirees who have employer pickups or have decided to enhance retirement. benefits through a Sec. 457 deferred compensation plan.

3. Do not penalize an entire fund if one person exceeds the Sec. 415 limits: It is unfair to disqualify the entire fund if just one individual exceeds the Sec. 415 limits. There should be another way to ensure that pensions comply with the Sec. 415 limits.

4. Exempt state and local government from the 100% compensation rule.

5. Allow state and local government retirement participants to use excess benefit plans currently provided only to private sector employees: Allowing the use of excess plans would protect qualified retirement plans from noncompliance with Sec. 415 limitations both for 100% compensation and the dollar limitation rule.


Currently, retirees' benefits do not exceed the Sec. 415 benefit limits. The solution to "freeze benefits" at these limits while offering a temporary reprieve may be impractical in the long run. The best course of action would be to seek a permanent solution by changing the law. The problem for the private sector may be greater than for the public sector because of lower thresholds. Defined contribution plans have these problems also. This is but one small surprise in Sec. 415. From Terry L. Lantry, LD., CPA, Professor of Accounting and Taxation, College of Business, Colorado State University (not affiliated with DFK), Fort Collins, Colo.
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Author:Lantry, Terry L.
Publication:The Tax Adviser
Date:Oct 1, 1992
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