The treatment of purchased service credits under IRC Section 415(n).

Author:Zorn, Paul
Position:Internal Revenue Code

Many state and local government defined benefit plans allow members to purchase credits for service with other governmental employers. Some plans also allow members to purchase credits for periods when the member was on leave or worked for non-governmental employers. Usually the member purchases the service credits with after-tax dollars. Prior to passage of the Taxpayer Relief Act of 1997 (TRA 97), this purchase was treated as a contribution made to a defined contribution plan for the purpose of testing under IRC Section 415.

The following article addresses the treatment of purchased service credits under Internal Revenue Code (IRC) Section 415(n), which was added by TRA 97. Since regulations have not been written on the application of Section 415(n), what follows is based on a literal interpretation of the code. Implementation of these provisions will be controlled by the regulations. This article is not intended and should not be construed as offering legal advice. Readers should obtain the advice of qualified tax counsel before taking action that would affect plan participants.

IRC Section 415 limits the employer-provided benefits that can accrue to participants in defined benefit plans and the amounts that can be contributed to defined contribution plans. Under IRC Section 415(a), failure to meet the Section 415 limits will result in loss of the plan's tax-qualified status. For defined benefit plans, IRC Section 415(b) limits the annual employer-provided benefit of governmental workers retiring between ages 62 and 65 to a specific dollar amount ($130,000 in 1998, indexed for inflation). This dollar limit is actuarially reduced for general governmental employees who retire before age 62 using a specified mortality table (GAM 1983, 50/50) and an interest rate that is the greater of 5 percent or the interest rate specified by the plan. For general governmental workers retiring on or before age 55, the dollar limit cannot be less than the actuarial equivalent of $75,000 at age 55. Similar limitations apply to private plans as well. There is no actuarial reduction of the $130,000 dollar limit for qualified police or firefighters.

For defined contribution plans, IRC Section 415(c) limits the annual additions made to a participant's account to the lesser of $30,000 (indexed for inflation) or 25 percent of annual compensation. In cases where an employee is a participant in both a defined benefit and defined contribution plan maintained by the same employer, IRC Section 415(e) requires that the sum of the defined benefit plan fraction and defined contribution plan fraction not exceed 1.0. The details of the 415(e) test are beyond the scope of this article; however, the Small Business Jobs Protection Act of 1996 repeals Section 415(e) for limitation years beginning after December 31, 1999.

Testing Purchased Service Credits

As noted above, service credit purchases made with after,tax dollars prior to TRA 97 were treated as voluntary member contributions to a defined contribution plan and tested under IRC Sections 415(c) and...

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