Prorating Retirement Plan Limits for a Short Plan Year

An employer-sponsored retirement plan operates on a 12-month cycle known as a plan year. A short plan year occurs when this operational period is less than 12 months, which happens when a business establishes a new plan, terminates an existing one, or changes its designated plan year. The primary implication involves the proration of certain annual contribution and testing limits, so these caps are adjusted proportionately for the shorter operational period.

Events Creating a Short Plan Year

A short plan year is created under a few distinct circumstances. The most common event is the establishment of a new plan. If a plan’s effective date is not the first day of its designated 12-month plan year, the initial year of operation will be short. For instance, a calendar-year plan established on May 1 will have an initial eight-month short plan year.

Another cause is the formal termination of an existing retirement plan, which creates a final, short plan year running from the beginning of the regular cycle to the termination date. A company may also amend its plan to change the annual cycle, such as shifting from a calendar to a fiscal year. This change requires a transitional short plan year and a formal plan amendment for a valid business purpose.

Plan Limits Requiring Proration

When a short plan year occurs, several Internal Revenue Code (IRC) limits must be adjusted downward. This proration ensures that caps are applied fairly relative to the shortened period of plan operation. The limits that require this adjustment include:

• The annual compensation limit under IRC Section 401(a)(17). This rule caps the total amount of an employee’s pay that can be considered when calculating employer contributions and for certain nondiscrimination tests.
• The annual additions limit under IRC Section 415(c). This restricts the total contributions—including employee deferrals, employer matches, and profit-sharing—that can be allocated to a participant’s account in a single year.
• The compensation level used to identify Highly Compensated Employees (HCEs). This classification is fundamental to tests that ensure a plan does not unfairly favor high earners.
• The compensation threshold for identifying Key Employees for top-heavy testing purposes. A plan is considered “top-heavy” if more than 60% of its assets are held by Key Employees.

Calculating the Prorated Limits

The method for calculating prorated limits is to multiply the full annual limit by a fraction. The numerator is the number of months in the short plan year, and the denominator is 12. This calculation adjusts the limit to be proportional to the plan’s operational period.

For example, consider a plan with a six-month short plan year in 2025. The full annual compensation limit of $350,000 would be multiplied by (6 / 12). This calculation results in a prorated limit of $175,000 for that plan year.

Using the same six-month scenario, the full 2025 annual additions limit of $70,000 would be prorated to $35,000. This means total contributions to a participant’s account cannot exceed $35,000 during that period.

The compensation thresholds for identifying HCEs and Key Employees are adjusted using the same monthly proration formula. Plan administrators must use the correct year’s full limit as the basis for the calculation to determine the adjusted threshold.

Limits Not Subject to Proration

Not all retirement plan limits are affected by a short plan year. Certain contribution limits do not require proration because they are tied to the individual taxpayer’s calendar year, not the plan’s fiscal year.

The elective deferral limit under IRC Section 402(g) is the maximum amount an employee can contribute from their salary. For 2025, this limit is $23,500. This limit applies to the employee’s personal tax year (January 1 to December 31), so their ability to contribute the full amount is not reduced by a short plan year.

Similarly, catch-up contribution limits for older employees are not prorated because they are also tied to the employee’s calendar tax year. For 2025, employees aged 50 and over can contribute an additional $7,500. A higher limit also allows those aged 60, 61, and 62 to contribute up to $11,250, and an eligible employee can contribute the full amount for their age group during the calendar year.