By Ian Berger, JD
IRA Analyst
Many retirement plans base employer contributions on employee compensation. For many years, Congress has limited the compensation that can be taken into account for those contributions. Fortunately, this dollar limit only applies to very highly paid employees.
The compensation limit increases most years based on inflation. For 2024, it was $345,000, and it went up to $350,000 for 2025. If you’re fortunate enough to be affected by the limit, it doesn’t mean you can’t receive an employer contribution. It just means that the contribution can only be made on your pay up to the dollar limit for the year.
One type of employer contribution often affected by the compensation limit is 401(k) matching contributions.
Example 1: Mark, age 52, is CEO of FB Company and earns $1.0 million dollars in 2025. The company’s 401(k) matches 50% of each employee’s elective deferrals, up to 6% of pay (a typical formula). For 2025, Mark defers the maximum $31,000 ($23,500 + $7,500 catch-up). The plan can only recognize $350,000 of Mark’s compensation in making the match. So, Mark’s matching compensation is limited to $10,500 [50% x (6% x $350,000)]. If all of his pay could be recognized, his match would be $30,000.
(Don’t feel too sorry for Mark. Many companies have non-qualified deferred compensation plans that allow higher paid employees to defer on their pay without being capped by the annual elective deferral limit.)
The compensation limit also comes into play when a 401(k) employer makes an across-the-board contribution (sometimes called a “profit sharing contribution”) to all employees, whether they defer or not.
Example 2: FB decides to make a flat 4% contribution to the 401(k) plan — instead of a match — for 2025. Mark’s contribution will be limited to $14,000 (4% x $350,000).
SEP IRAs are also subject to the compensation limit. The 2025 maximum SEP contribution is capped at 25% of up to $350,000 of pay, but in no event more than $70,000. SIMPLE IRAs may also be affected. A SIMPLE IRA sponsor can make either a matching contribution or an across-the-board contribution. Oddly, the compensation limit must be applied if an across-the-board contribution is made but not if a match is made.
Most defined benefit pension plans calculate benefits based on a formula that takes into account pay. For example, the plan might pay an annual benefit at retirement equal to 2% of average annual pay times years of service with the employer. In that case, pay cannot include amounts above the compensation limit for the year.
If you have technical questions you would like to have answered, be sure to submit them to [email protected], to be answered on an upcoming Slott Report Mailbag, published every Thursday.
https://irahelp.com/slottreport/how-the-compensation-limit-affects-retirement-plan-benefits/