Because both the Internal Revenue Code (Code) and PEPRA sometimes “conspire” to limit the retirement benefits of public agency employees in ways that make it harder for affected agencies to hire and retain certain individuals, it may become necessary for those agencies to consider the use of a section 415(m) plan.
What is a section 415(m) plan? A section 415(m) plan is a special type of “excess benefit plan” available exclusively to governmental employers. It is not a tax-qualified plan under Code section 401(a), but it does receive special tax treatment. If the requirements for section 415(m) are met, the plan is treated as though it were a nonqualified deferred compensation plan of a taxable entity – that is, it is not taxed under the rules of Code section 457(f). This is important because section 457(f) generally taxes deferred compensation that has become “vested,” even if the deferred compensation has not been paid yet. 415(m) plans also are not subject to the various rules and requirements of Code section 409A, which generally apply to other forms of nonqualified deferred compensation.
As an “excess benefit plan,” a 415(m) plan must be maintained solely for the purpose of providing benefits that are in excess of the limits imposed by Code section 415. Code section 415 imposes two types of participant-level limits: a limit on the maximum annual benefit that can be paid from a tax-qualified defined benefit plan; and a limit on the maximum annual contribution that can be paid into a tax-qualified defined contribution plan.
As part of PEPRA, the use of excess benefit plans that provided benefits in excess of the applicable defined benefit limit (currently, $230,000 in 2021) was severely curtailed. However, PEPRA does not appear to prohibit the use of an excess benefit plan that provides a “contribution” that exceeds the annual contribution limit (currently, $58,000 for 2021). For simplicity, let’s refer to this type of plan as an “excess contribution plan.”
Three other requirements of section 415(m) are worth mentioning:
- The excess contribution must be entirely employer-funded;
- Because the constructive receipt rules still apply, care must be exercised when designing and administering distribution alternatives; and
- Plan benefits may not be paid from a regular, tax-qualified trust – however, they can be paid either from a “rabbi” trust or the employer’s general assets.
When might you need a 415(m) plan? An excess contribution plan might be considered in situations where a public agency has one or more employees who may be entitled to significant additional amounts of current (or deferred) compensation. For example, some special districts or municipalities find it necessary to establish and maintain a special 401(a) plan in order to recruit or retain certain employees. Although up to $58,000 (for 2021) can be contributed by the employer into such a plan on an annual basis, there are occasional situations where an employer contribution of that magnitude is not enough. If a public agency finds itself in this situation – of needing to pay or set aside larger amounts of money in order to recruit or retain certain experience or expertise – an excess contribution plan may be worth considering. Such a plan could provide the employer with flexibility to determine whether an excess contribution will be made in one year but not another. It may also be possible to use such a plan to provide some level of so-called PEPRA make-whole benefits – that is, additional amounts designed to compensate for the differing treatment afforded PEPRA hires.
These plans need to be carefully thought out and implemented. Because they are not subject to the same design processes as tax-qualified retirement plans, it may be desirable, in the case of more complex situations, to obtain a private letter ruling that the particular plan design will work as envisioned.
Jeff Chang is a partner at Best Best & Krieger LLP. He has four decades of experience skillfully evaluating benefit and retirement plan compliance to achieve maximum outcomes for public agency clients throughout California. He can be reached at email@example.com or (916) 329-3685.