Focus on short plan years

Short plan years arise for a variety of reasons. An employer may, for example, choose a mid-year effective date when establishing a plan. Short plan years also occur when an employer changes its tax year (if the plan year is defined as the employer’s tax year), changes the plan year, or terminates the plan.

Some of the most significant retirement plan provisions impacted by short plan years include compensation, contributions, nondiscrimination testing, and reporting. What follows is a high-level overview of how these areas are affected.

Compensation and contributions

The only time compensation is affected by a short plan year is when the compensation measuring period is defined as the plan year (rather than a different 12-month period, such as the calendar year). When this occurs, the impact is twofold:

1. Only compensation during the short plan year can be considered when determining contributions. The annual limit on employee elective deferral contributions, however, is not affected by the short plan year because it is based on the participant’s tax year, not the plan year.
2. The compensation cap is prorated for the short plan year, reducing the overall amount of compensation that may be considered for that period.

The annual additions limit (the annual per participant limit of employer and employee contributions to a plan) is prorated if the limitation year is defined as the plan year and a short plan year occurs.

Nondiscrimination testing

The impact of a short plan year on nondiscrimination testing varies from test to test.

The top heavy test continues to be performed using the determination date, which is the last day of the preceding plan year. For the initial plan year, the determination date is the last day of the plan year. The compensation used to determine key employees is prorated to reflect the short plan year.

Compensation, deferrals, and contributions that are used in actual deferral percentage (ADP) and actual contribution percentage (ACP) tests are limited to the short plan year. The definition of a highly compensated employee (HCE) remains the same because compensation of the prior year (look-back year) is used to determine who is considered an HCE.

Additionally, the plan still must pass minimum coverage and nondiscrimination tests for the short plan year.

Form 5500 deadlines

The deadline for the Form 5500 is the last day of the seventh month following the close of the short plan year.

Once again, this article offers general information regarding the effects of short plan years on retirement plan provisions. If you’d like more detailed information, talk to your trusted financial professional or a member of your Vanguard Retirement Plan Access Client Service Team.