In the qualified retirement plan world, there are limits on how much money may be contributed to a plan by an individual or a company.  There is also a cap on the wages that may be taken into account for an employee in determining contributions and benefits.  These limits are adjusted annually based on a cost-of-living index.

Back in October, the IRS announced that most of these limits would remain unchanged from 2015 to 2016 because the cost-of-living index did not rise enough to trigger an increase.  The same thing happened with Social Security benefits; those will remain unchanged in 2016.  Since there are no cost-of-living adjustments (COLAs) for us to report on, let’s instead take a moment to delve more deeply into what some of these terms mean.  When we talk about qualified plan limits, what exactly is it that is being limited?

First, the limit on salary deferrals under Code Section 401(k) will stay at $18,000 for 2016.  The salary deferral limit also applies to 403(b), most 457 plans, and the federal government’s Thrift Savings Plan, but for brevity we will refer solely to 401(k) plans in this article.  A salary deferral is the amount an employee agrees to have deducted from his paycheck and contributed to the 401(k) plan instead.  The deferral is not subject to current income taxation, but it is counted as wages for Social Security and Medicare purposes.  Deferrals are made according to a written election by the employee.  Usually, an employee will contribute a level dollar amount or level percent of pay from each paycheck, but it is permissible to frontload the deferrals from early-year paychecks or contribute the whole $18,000 from a single paycheck (like a year-end bonus).  You cannot defer more from a paycheck than the amount of that paycheck (less FICA withholding).  You cannot write a personal check to the plan and call it a deferral.  Contributions must be done through the payroll system.  (The rules are different for self-employed individuals.)

The $18,000 is an individual limit for the taxable year – usually the calendar year.  An employee working more than one job may participate in the 401(k) plans at each of those companies.  However, his deferrals in all of the plans combined may not exceed $18,000.  Workers who are age 50 or older may contribute an additional $6,000 “catchup contribution.”  The rules governing catchup contributions are complex and beyond the scope of this article.

There are some who think $18,000 is the limit on all types of contributions to a 401(k) plan.  Not true.  The $18,000 is the limit on what the employee may have withheld from his paycheck and contributed.  The employer may contribute over and above the $18,000 deferral limit.  This brings us to our second limit:  a participant’s “annual additions” to a 401(k) account are limited to $53,000 per year.  Annual additions are governed by Code Section 415(c).  In addition to salary deferrals, annual additions consist of matching contributions, profit sharing contributions, money purchase contributions, safe harbor nonelective contributions, reallocated forfeitures, and more.  Annual additions do not include rollovers from another account or investment earnings.

An employee’s annual additions may not exceed 100% of his pay if it is less than $53,000.  The dollar limit is based on the limitation year which is usually the plan’s fiscal year.  Unlike deferrals, an employee has a separate annual addition limit for each employer he works for, so an employee could work several jobs and get $53,000 in annual additions in the plans at each of those jobs, assuming he had sufficient pay at each job (and generous employers).

Finally, the limit on compensation that may be considered in a qualified plan is $265,000, according to Code Section 401(a)(17).  If an employee makes $1 million, for plan purposes you ignore all of the pay except for $265,000.  A company that makes a profit sharing contribution of, say, 10% of pay for each eligible employee would base the contribution for this employee on $265,000 rather than $1 million, so the contribution for that individual would be $26,500 even though 10% of what he really earned is a lot higher than that.

A number of our clients who own businesses will pay themselves exactly $265,000.  These owners often have the ability to take more salary but prefer to minimize their W-2 compensation and instead take S-Corp dividends or do something else with their business revenue.  Taking exactly $265,000 enables them to take full advantage of plan contribution opportunities without paying themselves more than the amount contributions may be based on.

You now have additional insight on a few of the qualified plan limits we see in our business.  Stay tuned next year to see whether there will be an increase for 2017 or not