Purchased Service Credit (Posted on January 16, 1998 by )


Carol V. Calhoun, Counsel
Venable LLP
600 Massachusetts Avenue, NW
Washington, DC 20001
Phone: (202) 344-4715
Fax: (202) 344-8300
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Carol V. Calhoun

  1. Budget Bill Changes to Section 415 Limits on Purchased Service Credit. The 1997 Budget Bill, Public Law 105-34, contained provisions regarding the section 415 implications of purchased service credit, as follows:

    1. Prior law. The Internal Revenue Code imposes two sets of limits on contributions to qualified plans:

      1. Benefits under a defined benefit plan, to the extent attributable to employer contributions or to pretax employee contributions, are subject to a maximum benefit limitation under Code section 415(b), currently $130,000.
      2. Contributions to a defined contribution plan are subject to an annual contribution limit under Code section 415(c) equal to the lesser of 25% of compensation or $30,000. IRS regulations have in the past treated all after-tax contributions to defined benefit plans as if they were contributions to defined contribution plans for this purpose.

    2. Changes:
      1. The bill eliminated annual limits on after-tax employee contributions imposed by Code section 415(c) (25% of compensation or $30,000) for purchased service credit contributions made before July 1, 1998. It also eliminated such limits for purchased service credit contributions made on or after July 1, 1998 by employees hired before that date, to the extent the plan language already in place on August 5, 1997 permitted contributions to purchase service credit.
      2. For employees hired on or after July 1, 1998, the bill eliminated the annual limits for after-tax employee contributions on purchases of not more than five years of “nonqualified” service credit after participating in the plan for at least five years, or to purchase “qualified” service credit. Qualified service is service not otherwise credited for benefit purposes (1) as a Federal, State, or local government employee, (2) as an employee of an association representing Federal, State or local government employees, (3) as an employee of an educational institution which provides elementary or secondary education, or (4) for military service. The bill treats parental, medical, sabbatical, and similar leave as qualified service.
      3. In all of the instances in which the statute eliminates the Code section 415(c) annual limit on contributions to purchase service credit, the benefit attributable to the purchase of service credit is subject to the normal 415(b) limits. This treatment is the same as has in the past applied when purchased service credit was purchased on a pretax basis.
      4. This means employees who have made or will make service credit purchases on an after-tax basis fall into five categories:


        CategoryCompliance Status
        Employees who make any type of purchase before 7/1/98 under current planIn compliance; no action necessary; subject only to 415(b) limits
        Employees hired before 7/1/98 who make a purchase any time thereafter in an amount which the plan document would have permitted as of August 5, 1997In compliance; no action necessary; subject only to 415(b) limits
        Employees hired after 7/1/98 who purchase credit for government, association, private elementary/secondary education, or military service at any time, if they received no credit under a retirement system for the prior serviceIn compliance, no action necessary; subject only to 415(b) limits
        Employees hired after 7/1/98 who purchase credit for more than five years of nonqualifying service, or those who purchase any credit for government, association, private elementary/secondary education, or military service for which they also receive credit under a prior employer’s planPurchase is at least subject to 415(c) limits and may be impermissible; benefits attributable to purchase exempted from section 415(b) limits.
        Employees hired after 7/1/98 who purchase credit for more than five years of nonqualifying service, or those who purchase any credit for nonqualifying service after fewer than five years of service.Purchase is at least subject to 415(c) limits and may be impermissible; benefits attributable to purchase exempted from section 415(b) limits.

        Note that the rule treating purchases of credit for prior governmental service as nonqualifying if the employee receives credit under the prior employer’s plan may pose a particular problem for employees who change employment within a particular state, if they are covered by both a statewide plan and a local supplemental plan with each employer. Technically, it would appear that such an employee could not purchase credit under the new employer’s supplemental plan if he or she will ultimately be entitled to a benefit under the statewide plan based in part on the service with the old employer. This problem can apparently be avoided if the statewide plan permits an employee to be cashed out upon termination of service with the first employer, and then to repurchase the service credit using the refund to pay for the repurchase. However, it is difficult to see why the law would require an essentially meaningless interim step.

      5. This change has both positive and negative aspects for plans. IRS regulations in the past have stated that all after-tax contributions, even those to purchase service credit, are subject to the section 415(c) limits. The statutory change avoids the potential for the IRS to require plans to include all amounts used to purchase service credit in calculating the 415(c) limits.
      6. At the same time, before the change, some plans took the position that no purchases were subject to the section 415(c) limits, and that they only gave rise to benefits subject to the section 415(b) limits. The statute has now changed in a way to make clear that a noneligible participant will not be able to purchase more than five years of nonqualified service credit on an after-tax basis, and will not be able to purchase any service credit before participating in a plan for at least five years, without becoming subject to the section 415(c) limits. And the statute is a bit muddy concerning whether allowing an employee to purchase nonqualified service before having five years of service, or allowing purchase of more than five years of service, will automatically violate the section 415 rules, or will merely have to be tested under section 415(c).
      7. The remaining issues under section 415 may cause plans to want to continue the existing trend of allowing the purchase of service credit via rollovers. It may be easier to get plans to do direct rollovers for the purpose of purchasing service credit in light of the statute. The statute clarifies that an administrator can reasonably conclude that another plan is qualified even if it does not have a determination letter. This can be helpful because many public plans do not routinely obtain determination
        letters.

  2. Elective Pick-Ups of Purchased Service Credit. Revenue Ruling 81-35, 1981-1 C.B. 255 and Revenue Ruling 81-36, 1981-1 C.B. 255 set forth the standards for a contribution to be picked up within the meaning of Internal Revenue Code (“Code”) section 414(h). These revenue rulings establish that the following criteria must be met: (1) the employer must specify that the contributions, although designated as employee contributions, are being paid by the employer in lieu of contributions by the employee, and (2) the employee must not be given the option of choosing to receive amounts directly instead of having them paid by the employer to the pension plan. These rulings specifically permit an employer to pick up contributions through a reduction in salary. Issues:
    1. Single Pick-Up Elections.

      1. Numerous IRS private letter rulings have treated purchases of service credit–even those pursuant to an employee’s election made after the employee began participating in the relevant plan–as picked up. Nevertheless, the statutory basis for the rulings appears weak. The Code and regulations raise a question about whether a participant can make an election to have picked up contributions made to a plan after an employee has begun participation in the System, or in any other plan to which the same employer contributes.
      2. Treas. Regs. ยงยง 1.401(k)-1(a)(3)(iv) normally treat an employee’s election to take a salary reduction, in exchange for the employer’s agreement to contribute to a qualified plan, as creating a cash or deferred arrangement.
      3. The one exception set forth in the regulation applies only to a one-time election made before the time the employee first commences participation in any plan of an employer. Thus, a court might see a System participant’s election to take a salary reduction in exchange for contributions to purchase service credit as creating a cash or deferred arrangement, if the participant could make the election after he or she commenced participation in the System.
      4. Code section 402(e)(3) excludes contributions to a cash or deferred arrangement from an employee’s income only if the cash or deferred arrangement is a qualified cash or deferred arrangement under Code
        section 401(k). For a variety of reasons, the contributions to the System would not be a qualified cash or deferred arrangement.
      5. Taken together, the above authorities arguably suggest that a pickup pursuant to an employee’s election will be pretax only if the election is a one-time election made before the date the employee first commences participation in any plan of the employer. Obviously, such an interpretation would cause most of the purportedly picked up contributions to be after-tax contributions.

    2. Multiple Pickup Elections. One IRS private letter ruling–Private Letter Ruling 9750053 (September 15, 1997) has explicitly permitted an employee to make more than one election to have purchases of service credit picked up. This, of course, goes even farther in ignoring the statute than the rulings which permit a single pick-up election.