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How the Retirement Plan Compensation Limit Works Thumbnail

How the Retirement Plan Compensation Limit Works

It’s certainly not a bad problem to have. But employees with very high compensation cannot have their retirement plan benefits based on all of their pay. Instead, the tax code allows only compensation up to a certain dollar amount to be taken into account.

Retirement plan benefits can't be based on an employee's entire pay, and instead have a compensation limit.

This dollar limit goes up most years based on the cost of living. For 2023, it’s $330,000. It was $305,000 for 2022 and $290,000 for 2021. The dollar limit is high enough that it’s not going to affect most employees. And, anyone earning more than the limit isn’t barred from receiving any benefit. Instead, compensation above the limit must be excluded when the amount of their benefit is calculated.

This restriction applies to company contributions in 401(k) and 403(b) plans. Those contributions are either matching contributions for employees making elective deferrals or across-the-board contributions for all plan participants. The compensation limit applies in both cases.

Example A: 50% Elective Employee Deferrals

Siobhan, age 55, is CEO of Waystar RoyCo and participates in its 401(k). Waystar matches 50% of each employee’s elective deferrals up to 6% of pay. In 2023, Siobhan will earn $500,000 and defer the maximum $30,000 ($22,500 + $7,500 catch-up). The plan can only recognize $330,000 of Siobhan’s pay. This limits her match to $9,900 [50% x (6% x $330,000)]. If the compensation limit didn’t apply, her match would have been $15,000 [50% x (6% x $500,000)].

Example B: 2% Employer Contributions to 401(k)s

Waystar decides to make a flat 2% employer contribution to the 401(k) – instead of a match – for 2023. In that case, the contribution for Siobhan (with $500,000 in pay) will be limited to $6,600 (2% x $330,000). Without the limit, she could have received a $10,000 contribution.

The compensation limit also applies to SEP IRA contributions and sometimes applies to SIMPLE IRAs. If a SIMPLE IRA has an across-the-board contribution, the limit will apply. But if a matching contribution is made, the limit won’t apply. Even pay in excess of the dollar limit can be taken into account.

Compensation over the dollar limit is also disregarded in calculating benefits earned in defined benefit pension plans.

Finally, pay above the limit can’t be taken into account in IRS nondiscrimination testing. That testing is required to make sure that plans don’t provide disproportionately greater benefits for high-paid participants. Restricting pay in nondiscrimination testing makes it harder for plans to pass those tests. (Certain testing is not required if the employer makes “safe harbor” contributions.)

By Ian Berger, JD
IRA Analyst
Ed Slott and Company, LLC

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Christian Cordoba, founder of California Retirement Advisors, has been a member of Ed Slott's Master Elite IRA Advisor Group since 2007.

Copyright © 2023, Ed Slott and Company, LLC Reprinted from The Slott Report, 05/01/23, with permission. https://www.irahelp.com/slottreport/how-retirement-plan-compensation-limit-works, Ed Slott and Company, LLC takes no responsibility for the current accuracy of this article.
Investment advisory services offered through Mutual Advisors, LLC DBA California Retirement Advisors, a SEC registered investment adviser. Securities offered through Mutual Securities, Inc., member FINRA/SIPC. Mutual Securities, Inc. and Mutual Advisors, LLC are affiliated companies. CA Insurance license #0B09076. This content is developed from sources believed to be providing accurate information and provided by California Retirement Advisors. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information and should not be considered a solicitation for the purchase or sale of any security. California Retirement Advisors, nor any of its members, are tax accountants or legal attorneys and do not provide tax or legal advice. For tax or legal advice, you should consult your tax or legal professional.