Internal Revenue Code (IRC) section 404 places maximum deductible limits on the amount of contributions to retirement plans that are tax-deductible by the sponsor of such Qualified retirement plans.
Defined Benefit Plans
For Defined Benefit Plans, the deductible contribution is determined by Actuarial methodology specified in this section. The maximum deductible contribution is not defined directly (such as a percentage of pay or payroll), but is determined indirectly by the benefits promised by the plan. In turn, the benefits defined by the plan are subject to other limitations (such as section 415), which ultimately are integral in determining the maximum deductible limit. In addition, the deductible contribution is always at least as much as the minimum required contribution under section 412. In many cases, the amount determined under the basic provisions of 404 is smaller and must be adjusted upwards to the minimum required contribution (under 412), so that the maximum deductible amount and minimum required amount are the same. See the DBMinMax table for the resulting application of these various limits to a new plan sponsor depending on their current age and past service. This table shows the resulting maximum contribution and the minimum compensation needed to support that contribution.
Defined Contribution Plans
For Defined Contribution Plans, the deductible limit is 25% of covered payroll. Note, however, that 401(k) deferrals (as elected by the employees) are tax deductible to the employer in addition to the 25% deductible Defined Contribution contributions (see further discussion below).
If an employer sponsors both a Defined Benefit Plan (DB plan) and a Defined Contribution Plan (DC plan) and at least 1 employee is benefiting under both of these plans, then the maximum aggregate deductible contribution made to both plans is the greater of:
25% of covered payroll, or
the section 412required contribution for the DB plan plus 6% of covered payroll.
That is, if the required DB plan contribution (412) exceeds 19% of payroll, there is only room for a small 6% contribution to a DC plan.
Additional relief to this combined plan limit can be obtained for overlapping plans during the first year of the DB plan by use of a Staggered Accounting Schedule in which some contributions are counted for different years for the requirement of section 412 vs. the deduction taken under section 404.
This turns out to be a frequent question as employers are transitioning from a SEP or other DC plan to a DB plan: suppose they have already made a SEP (or other) contribution for a year and then decide they want to adopt a DB plan for the year. It is possible to go ahead and establish the DB plan for the year and to make the full contribution to both plans through the Staggered Accounting Schedule strategy . This does introduce added complexity in the timing of contributions, but the benefit of contributing to both plans for one year may be worth the trouble. For more information see Staggered Accounting Schedule.
401(k) deferrals (as elected by the employees) are always tax deductible to the employer. These deferrals are not subject to the 25% of payroll Defined Contribution plan limit (discussed above).
Similarly, 401(k) deferrals fall outside of the combined plan limits imposed on Defined Benefit plus Defined Contribution plans. So a 401(k) Deferral Only plan can be adopted alongside of a Defined Benefit plan without being subject to any combined plan limit (such as 25% of payroll).
Example: In 2006, an age 60 entrepreneur without any employees could take W-2 wages of $87,500 and be able to contribute $213,747 to a Defined Benefit plan plus elect to make a $15,000 401(k) deferral plus a $5,000 401(k) catch-up deferral, for a total contribution for $233,747.
Note that other limitations and tests apply to the 401(k) deferrals and must be observed:
If there are rank-and-file employees, the nondiscrimination ADP test may drastically limit the availability of meaningful deferrals for Highly Compensated Employees in a 401(k) Deferral Only plan.
Regular 401(k) deferrals (but not catch-up deferrals) are included among the Defined Contribution allocations for an individual for their 415 Maximum Benefit limits. Example: In a Profit Sharing/401(k) plan in 2006, an age 60 individual who defers $20,000 could receive at most a total of $49,000 (= $29,000 Profit Sharing allocation + $15,000 401(k) deferral + $5,000 catch-up deferral).