The IRC permits two types of tax qualified plans: defined contribution plans, and defined benefit plans.

A defined contribution plan is characterized by two elements: 1) each participant has an individual account, and 2) all benefits are provided solely from the accumulated value of those accounts based on amounts contributed by employee and employer, forfeiture reallocation and accruals, plus income, expenses, gains and losses (e.g., 401(k) plan).¹ Defined contribution plans contain a formula for determining the amount of the contribution or how a discretionary contribution to the plan is allocated to each participant’s account.

A defined contribution plan can be either a pension (Q 3733) or a profit sharing plan (Q 3749). Profit sharing, age weighted and cross-tested profit sharing plans include 401(k) plans (Q 3752), stock bonus plans (Q 3816), and employee stock ownership plans (Q 3817). Pension plans include money purchase and target benefit plans (Q 3734).

See Q 3728 for the application of the Section 415 limits to defined contribution plans and Q 3726 for special qualification requirements.

A defined contribution plan must contain a limitation on the amount of “annual additions” that may be credited to a participant’s account each year, or, if an employer has more than one plan, to all accounts of all defined contribution plans of the employer (Q 3728, Q 3868). The plan must require a separate accounting for each employee’s benefit under the plan.¹

A defined contribution plan may not exclude from participation in the plan employees who are beyond a specified age.²

Hybrid plans, which combine the features of defined contribution plans and defined benefit plans, are treated as defined contribution plans to the extent that benefits are based on the individual account. One type of hybrid plan is the target benefit plan (Q 3734). The participant’s target benefit is calculated according to a formula, and an actuary determines the contribution necessary to reach this target by retirement age. This amount is allocated to the participant’s account.

A defined contribution plan must provide for (1) allocation of contributions and trust earnings to participants in accordance with a definite formula, (2) distributions in accordance with an amount stated or otherwise ascertainable and credited to participants, and (3) a valuation of investments held by the trust, at least once a year, on a specified inventory date, in accordance with a method consistently followed and uniformly applied.³ The third requirement may be satisfied in a plan where contributions are invested solely in insurance contracts or in mutual fund shares even if there is no provision in the plan for periodic valuation of assets.⁴

A defined contribution plan will not fail to satisfy the participation, coverage, and vesting requirements merely because it does not unconditionally provide for an allocation to a participant with respect to a computation period in which he or she completes 1,000 hours of service (Q 3841, Q 3869). Thus, for example, a plan may require that a participant be employed as of the last day of a computation period to receive an allocation.⁵ This provision will not violate nondiscrimination requirements (Q 3848).

A money purchase pension plan or a profit sharing plan will not be qualified unless the plan designates the type of plan it is.⁶ The IRS has ruled that amounts transferred or directly rolled over from a money purchase pension plan to an otherwise qualified profit sharing plan must continue to be subject to the restrictions on money purchase pension plans. In the absence of such restrictions, the profit sharing plan would fail to qualify under IRC Section 401(a).⁷

For plan years beginning after December 31, 2006, a diversification requirement applies to certain defined contribution plans that hold publicly-traded employer securities (Q 3732).¹

A qualified defined contribution plan, other than a profit sharing plan, that is established by an employer whose stock is not readily tradable on an established market and that holds more than 10 percent of its assets in employer securities must provide that plan participants are entitled to exercise voting rights with respect to employer stock held by the plan with respect to approval of corporate mergers, consolidations, recapitalizations, reclassifications, liquidation, dissolution, sales of substantially all of the business’s assets, and similar transactions as provided in future regulations. Each participant must be given one vote with respect to an issue, and the trustee must vote the shares held by the plan in a proportion that takes into account the one participant/one vote requirement.²

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Planning Point: There has been significant litigation in recent years, with a resurgence in 2016-2017 against employers who allow or continue to allow investment in company stock, especially companies experiencing financial difficulties. Sears became the subject of such a class action lawsuit on August 1, 2017.³ Companies that have defeated such litigation include Eaton Corp., IBM, JP Morgan Chase, Lehman Brothers, RadioShack Corp., and Whole Foods Corp., to name some of the more prominent companies sued by employees. Even good performance of company stock has not prevented employee lawsuits against companies like Chesapeake Energy Corp., General Cable and Seventy Seven Energy Inc., based upon complaints involving company stock accounts in their plans. For this reason, an employer should have significant business reasons for including company stock in the plan’s portfolio in the present litigious environment. In addition, the Plan Committee should monitor company financial affairs closely for changes in investment policy when company stock is included.

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Annual additions include employee contributions, employer contributions, and forfeitures. The annual additions to a participant’s account (or all such accounts aggregated, if the employer has more than one defined contribution plan) must not exceed the lesser of 100 percent of the participant’s compensation or $69,000 (for 2024, $66,000 for 2023, up from $61,000 in 2022, $58,000 in 2021, $57,000 in 2020).¹ This limit is indexed for inflation in increments of $1,000.²

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Planning Point: When an HSA is available (see Q 393 for a discussion of the HSA eligibility rules), it can allow an individual to defer additional pre-tax amounts above the 401(k) contribution limits to the HSA, grow the HSA funds tax-free and, to the extent not used for valid healthcare expenses, eventually withdraw the amounts tax-free once the individual has reached age 65 (amounts used for valid healthcare expenses can always be withdrawn from the HSA tax-free). Moreover, Congress is discussing reducing the limits on the use of HSAs so that the option may become available to more individuals as a supplement to 401(k) deferrals for employees who are above the 401(k) limit.

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Limitations applicable when an individual is a participant in one or more elective deferral plans (including 401(k) plans, SIMPLE IRAs, SAR-SEPs, and tax sheltered annuities) are explained in Q 3760. For general rules affecting the application of the Section 415 limits, see Q 3868; for defined benefit plan limits, see Q 3719. The regulations referenced throughout this question were issued April 5, 2007 and are effective for limitation years beginning after June 30, 2007.³

The following amounts are not annual additions:

(1)    Catch-up contributions (Q 3761)

(2)    Payments made to restore losses resulting from a breach of fiduciary duty

(3)    Excess deferrals that are distributed as required in regulations (Q 3760)

(4)    Certain restorations of accrued benefits⁴

Earlier regulations provide for corrective measures when contributions in excess of the Section 415 limits (i.e., excess annual additions) are made due to the allocation of forfeitures, due to reasonable error in estimating a participant’s compensation, or under certain other limited circumstances.⁵ The preamble to the 2007 regulations states that guidance on this subject is in the Employee Plans Compliance Resolution System (EPCRS).⁶

Any amount allocated to a separate account that is required to be established in a welfare benefit fund (Q 4103) to provide postretirement medical or life insurance benefits to a key employee (Q 3931) must be treated as an annual addition to a separate defined contribution plan for purposes of calculating the annual additions to defined contribution plans of an employer.⁷ Such amounts are not subject to the 100 percent of compensation limit under IRC Section 415(c)(1)(B) discussed above.

While annual additions are the sum credited to a participant’s account for any limitation year, of (1) employer contributions, (2) employee contributions, and (3) forfeitures, “employee contributions” do not include rollovers from another qualified plan or from an IRA (Q 3996), contributions under IRC Section 457(e)(6), or employee contributions to a SAR-SEP (Q 3701) that are excludable from the employee’s gross income.⁸ A direct transfer of funds or employee contributions from one defined contribution plan to another will not be considered an annual addition for the limitation year in which the transfer occurs.⁹

A corrective allocation to a participant’s account because of an erroneous forfeiture or a failure to make a required allocation in a prior limitation year will not be considered an annual addition for the limitation year in which the allocation is made, but will be considered an annual addition for the limitation year to which the corrective allocation relates.¹⁰

Restorative payments made to a defined contribution plan, to the extent they restore plan losses that result from a fiduciary breach (or a reasonable risk of liability for a fiduciary breach), are not contributions for purposes of IRC Section 415(c). In contrast, payments made to a plan to make up for losses due to market fluctuations, but not due to a fiduciary breach, will be treated as contributions, not as restorative payments.¹¹

Earlier regulations stated that if an allocation of forfeitures or a reasonable error in estimating a participant’s annual compensation would cause additions to exceed the limit, they may, under certain circumstances, be held in suspense, be used to reduce employer contributions for that participant or be returned to the participant.¹² (A return of mandatory contributions could result in discrimination.) Certain other transactions between a plan and an employer, or certain allocations to participants’ accounts, could be treated as giving rise to annual additions.¹³

Generally, an employer may elect to continue contributions under a profit sharing or stock bonus plan on behalf of permanently and totally disabled participants.¹⁴ For the purpose of determining whether such contributions comply with the limitation on contributions, the disabled participant’s compensation is deemed to be the amount of compensation he would have received for the year if paid at the rate of compensation he received immediately before becoming permanently and totally disabled. Contributions made under this provision must be nonforfeitable when made.¹⁵ The IRS has privately ruled that a 401(k) plan that purchased a group long-term disability income policy to insure the continuation of benefit accumulation for disabled employees would not be required to include amounts paid under the policy as annual additions.¹⁶

A defined contribution plan may provide for an automatic adjustment which reflects the cost-of-living increases in the limit on annual additions.¹⁷ Like defined benefit plans, the plan may provide for automatic freezing or reduction in the rate of annual additions to prevent exceeding the limitation.¹⁸

In the case of an ESOP, if no more than one-third of the deductible employer contributions applied by the plan to the repayment of principal and interest on loans incurred to acquire qualifying employer securities are allocated to highly compensated employees (Q 3930), forfeitures of employer securities acquired with such loans and deductible employer contributions applied by the plan to the payment of interest on such loans may be excluded for purposes of the limitations on contributions.¹⁹ Where an employer reversion is transferred to an ESOP, amounts in excess of the Section 415 limit which are held in a reversion suspense account are not deemed to be annual additions until the limitation year in which they are allocated to the participants’ accounts.²⁰

Compensation to which the limit is applied is the compensation for the limitation year from the employer maintaining the plan.¹ It includes wages, salaries, fees for professional services, and other amounts for services actually rendered (such as commissions, percentage of profits, tips, and bonuses).² Compensation also includes (i) elective deferrals to 401(k) plans, SAR-SEPs, SIMPLE IRAs, and Section 457(b) plans to the extent not includable in the employee’s income and (ii) any amounts contributed or deferred by the election of the employee and excluded from gross income of the employee under IRC Sections 125 (cafeteria plans), 132(f) (qualified transportation fringe benefit plans), or 457 (deferred compensation plan of a government or tax-exempt organization).³ The foregoing items may be used as a simplified safe harbor definition of compensation.⁴

The regulations also permit the following to be included as compensation to the extent they are includable in the gross income of the employee: certain payments received under an employer’s accident and health plan, certain moving expense reimbursements, the value of nonqualified options in the year granted, and certain property transferred in connection with the performance of services.⁵

In the case of a self-employed person, his earned income is compensation.⁶

The SECURE Act also modified the definition of compensation so that certain stipends provided to graduate students can be counted as compensation for IRA contribution purposes after December 31, 2019. Similarly, qualified foster care payments (excluded from income) can be treated as compensation for plan years effective after December 31, 2015 (retroactively) for defined contribution plans and after 2019 for IRAs.⁷

Except as noted above, compensation does not include nontaxable employer contributions toward deferred compensation plans, qualified or nonqualified, in the year in which they were contributed. Furthermore, deferred compensation distributions are not compensation when received whether or not excludable from gross income, except that distributions of unfunded nonqualified deferred compensation may be considered compensation in the year in which they are includable in gross income.⁸ Excludable premiums for group term life insurance are not compensation.⁹ Foreign source income generally will be treated as compensation even though excluded from gross income.¹⁰

The compensation must be actually paid or made available to be taken into account within the limitation year.¹¹ Compensation includes compensation from all employers that are members of a controlled group of corporations or a group of trades or businesses under common control.¹² Regulations also provide for safe harbors based on wages for income tax withholding or wages as reported in Box 1 on Form W-2.¹³

Post-severance compensation of the following amounts is included as compensation if paid within 2½ months following severance from employment: (1) payment for unused sick or vacation leave the employee could have used had employment continued or (b) amounts that would have been paid had employment continued, such as compensation and overtime, commissions, bonuses, or similar compensation. It should be noted that this treatment will not apply to other types of post-severance packages, such as parachute payments under IRC Section 280G and unfunded nonqualified deferred compensation.¹⁴

The IRC permits employers to make contributions to certain qualified plans in the form of employer stock, if the plan permits.¹ The restrictions on prohibited transactions normally limit these contributions to certain profit sharing plans and plans established as employee stock ownership plans (“ESOPs”).² ESOPs also are permitted to purchase stock from the employer under a complex set of ERISA and IRC provisions.

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Planning Point: No employer should consider such a transfer or sale unless the decision is coordinated with ERISA-qualified legal counsel.

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In plan years beginning after December 31, 2006, defined contribution plans (other than certain ESOPs) that hold publicly traded employer securities must satisfy a diversification requirement to be qualified.¹ In May 2010, the IRS issued final regulations on the diversification requirement.² The final regulations are effective for plan years beginning on or after January 1, 2011.³ Until that effective date, a plan was required to comply with the diversification requirement, but could rely on the proposed regulations, or the final regulations for purposes of satisfying the requirements of IRC Section 401(a)(35).

Defined contribution plans subject to this requirement must permit participants to direct the plan to divest the portion of their account attributable to employee contributions and elective deferrals invested in employer securities, and reinvest an equivalent amount in other investment options.⁴ With respect to employer contributions only, the diversification feature may be restricted to participants with at least three years of service, their beneficiaries, and the beneficiaries of deceased participants.⁵The plan must offer at least three investment options (other than employer securities) to which an employee affected by this provision may direct the proceeds from the divestment of the employer securities. Each investment option must be diversified and have materially different risk and return characteristics.⁶ A plan may limit the time for divestment and reinvestment to periodic, reasonable opportunities, provided they occur at least quarterly. If the plan places restrictions or conditions (other than the application of securities laws) with respect to the investment of employer securities that are not imposed on the investment of other assets in the plan, it will not satisfy the provisions of the diversification requirement.⁷

A transition rule, applicable only to securities acquired before January 1, 2007,⁸ allowed the plan to phase in the diversification requirement ratably over three years. The phase-in did not apply to participants who reached age 55 and completed three years of service before the first plan year beginning after December 31, 2005. Under the phase-in, an “applicable percentage” of the portion of an account attributable to employer contributions (other than elective deferrals) invested in employer securities is subject to the requirement as follows: 33 percent after the first plan year, 66 percent after the second plan year, and 100 percent after the third and subsequent plan years.

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Planning Point: A significant amount of litigation has been directed at plan sponsors’ failure to satisfy their fiduciary obligations based on poor investment decisions. In the closely-watched Intel case, participants alleged that the plan over-invested in hedge funds and private equity investments. Intel countered by alleging that the participants had received “actual knowledge” of the potential violation, thereby triggering the running of a three-year limitations period for filing suit. The case made it all the way to the Supreme Court, which ruled in favor of the plaintiffs that the generally applicable six-year limitations period for fiduciary breach applied. This was the case even though the plan sponsor mailed information about the investments that may have been sufficient to inform them of the violation—because the plaintiffs did not recall ever reading the information.⁹ While the decision leaves much unanswered, plan sponsors should exercise extreme caution in providing notice of investments to participants.

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The diversification requirement does not apply to certain ESOPs. If an ESOP does not hold any 401(k) contributions, Section 401(m) match amounts, or earnings attributable to them and the plan is a separate plan for purposes of the merger and consolidation requirements of IRC Section 414(l) with respect to any other defined benefit or defined contribution plan of the same employer or employers, then the diversification requirement does not apply.¹⁰

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Planning Point: The IRS has issued relief from the anti-cutback rules of Section 411(d)((6) for a plan sponsor who amends a non-exempt ESOP to eliminate a distribution option that had previously satisfied the diversification requirements of Section 401(a)(28)(B) if the amendment occurs no later than the last day of the first plan year beginning on or after January 1, 2013 or by the deadline for the plan to satisfy Section 401(a)(35), if later.¹¹

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Publicly traded employer securities for purposes of this requirement means employer securities that are readily tradable on an established securities market.¹²

Employer security means a security issued by an employer of employees covered by the plan or by an affiliate of such an employer. Life insurance, health insurance, and annuity contracts are not securities for this purpose.¹³

If an employer corporation, or any member of a controlled group that includes the employer corporation, has issued a class of stock that is publicly traded, the employer may be treated as holding publicly traded employer securities even if its securities are not otherwise publicly traded. Controlled group status is determined using a 50 percent test instead of an 80 percent test for this purpose.¹⁴

The diversification requirement does not apply to plans that meet the definition of a one-participant plan.¹⁵ This definition has the following five criteria:

(1)    On the first day of the plan year, the plan covered only one individual or that individual and his or her spouse, and the individual owns 100 percent of the plan sponsor (whether incorporated or not), or it covered only one or more partners and their spouses in the plan sponsor.

(2)    It meets the minimum coverage requirements of IRC Section 410(b) (Q 3842) without being combined with any other plan of the business that covers its employees.

(3)    It does not provide benefits to anyone except the individual or the partners and their spouses.

(4)    It does not cover a business that is a member of an affiliated service group, a controlled group or a group of businesses under common control (Q 3933, Q 3935).

(5)    It does not cover a business that uses the services of leased employees as defined in IRC Section 414(n) (Q 3929).

A partner, for purposes of this definition, also includes a 2 percent shareholder of an S corporation.¹⁶

ERISA applies this requirement to applicable individual account plans. An applicable individual account plan is “a pension plan which provides for an individual account for each participant and for benefits based solely upon the amount contributed to the participant’s account, and any income, expenses, gains and losses, and any forfeitures of accounts of other participants which may be allocated to such participant’s account.”¹⁷