Common Retirement Plan Deduction Pitfalls

Most large retirement plans don’t worry about the maximum pension deduction limit because the plan benefits (and related contributions) are often well below the IRS limits. However, small- and medium-sized retirement plans can unknowingly run into the limits. This post summarizes important deduction pitfalls to be aware of.

  • Self-employment “earned income” limit [§404(a)(8)]. For self-employed individuals, a year of low earnings can hinder pension plan deductions. This is because annual retirement plan deductions cannot exceed your “earned income” for the year (net self-employment income with a Social Security tax adjustment).
  • Combined DC and DB plan deduction limit of 25% of payroll [§404(a)(7)]. This annual contribution limit has a couple of important adjustments.
    • Contributions to a defined benefit plan insured by the PBGC are excluded from the 25% calculations. So, most PBGC-covered pension plans won’t have to worry about the combined limit.
    • For defined benefit plans that are not covered by the PBGC, the limit applies only to the extent that employer DC contributions (other than 401(k) deferrals) exceed 6% of payroll. This means that:

1.  The total DB/DC deduction can exceed 25% of payroll if employer DC contributions are 6% or less; and

2. When DC employer contributions exceed 6%, the combined deduction limit is essentially 31% of payroll.

  • 401(k) deferral refunds reclassified as catch-up contributions. If your 401(k) plan fails the ADP test, the most common remedy is to refund deferrals to HCEs. Don’t forget, though, that if an eligible HCE has not yet reached the catch-up contribution limit then their refund should be reclassified as a catch-up contribution to the extent possible.

There can be a lot of confusion among sponsors of small- and medium-sized pension plans regarding the different deduction limits. This post aims to clarify some of these issues, but you should consult with a tax professional regarding the details and your specific situation.

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