Debt Commission DC Limits-Policy Change, Not Deficit Reduction

Last week, a USA Today reporter asked me about the impact of the Presidential Debt Commission recommendation to reduce the current $49,000 combined contribution limit for employer-sponsored defined contribution plans to the lower of 20 percent of pay or $20,000. My comment was that such a change would be devastating. I believe it would significantly reduce the incentive for small employers to offer plans and would virtually eliminate profit sharing and other non-elective employer contributions.

It is no surprise that many small companies do not have plans. Companies with fewer than 100 employees are owner managed. Because most of these plans will eventually be top-heavy, this means a mandatory employer contribution of 3 percent for every eligible employee comes directly from the owner-manager's pocket. Plus, owner-managers usually serve as the fiduciary and administrator on their plans. These responsibilities may take their attention away from other business activities, which may ultimately reduce the owner-manager’s income.

Plans are designed so legal limits are not violated, especially by highly compensated employees. Currently, subtracting the maximum 401(k) contribution of $16,500 from the $49,000 limit leaves $32,500 for matching contributions, profit sharing, and forfeitures. This is 13.3 percent of pay for someone making $245,000, the maximum compensation that can be considered for plan purposes. Because most profit sharing plans still have vesting, and thus forfeitures, this means profit sharing contributions are limited to between 12 percent and 13 percent of pay, if there are no matching contributions.

If there are matching contributions, the potential for profit sharing is reduced further. To illustrate why, I will use the safe harbor matching approach, which requires a match of 4 percent of pay if the employee contributes 5 percent of pay or more. (22 percent of plans had this feature in 2009, according to PSCA’s 53rd Annual Survey of Profit Sharing and 401(k) Plans.).

For someone making $245,000 and using the current $49,000 combined limit:

In a plan with employer matching contributions, someone making $245,000 can only receive a profit sharing contribution of 9.3 percent of pay, or in practice, one between 8 percent and 9 percent, if there are forfeitures.

The result of reducing the combined limit from $49,000 to $20,000 is to virtually eliminate employer contributions for those responsible for implementing and maintaining plans. In this world of “unintended consequences” there will be no room for profit sharing or other non-elective employer contributions. And, if all employees are to be treated equally, the employer match would be significantly reduced as well.

If you think that small company owner-managers would maintain plans requiring a 3 percent of pay contribution for all the eligibles – without being able to participate themselves – then you probably also believe in the Easter Bunny. The Debt Commissions recommendation is not about deficit reduction; it's a stake into the heart of the employer-sponsored defined contribution system.