In general, the allowable deduction for employer contributions to a 401(k) plan in a single taxable year is limited to 25% of total compensation for all employees eligible to participate, also known as the Employer Contribution Deduction Limit. Any contributions that exceed this limit are not currently deductible for tax purposes but may be carried forward to a future year. This limit is applied on an employer-wide basis, meaning it applies to all contributions made in a single taxable year by the employer, and all of the employer’s affiliates, to all qualified plans maintained during that year. To ensure that a plan stays within this limit, we recommend not offering a cap on company matching or profit sharing contributions in excess of 25% of compensation. You can view the current status of your plan’s Deduction Limit test by visiting the Guideline Compliance Dashboard.
The 25% deduction limit for a single taxable year under IRC Sec. 404(c) is based on the total of all eligible employees' compensation for the year. Participant deferrals are not taken into consideration when determining the total eligible employees’ compensation. This means that an employer may currently deduct their contributions up to the 25% limit and, in addition, separately deduct the total participant deferrals.
Plan Sponsors are responsible for working with their business tax advisor to report employer contributions and handle any excise tax filing for excess amounts. Sponsors who wish to offer nonelective contributions or a cap on matching contributions that would exceed the 25% limit should reconsider the risk of making nondeductible contributions for this reason.
What if the employer makes nondeductible contributions in a year?
There is no correction needed; however, there is a penalty. Form 5330 must be completed and filed reporting the amount of the nondeductible contributions and the employer must pay a 10% excise tax on that amount. The nondeductible employer funds must remain in the plan.
Additionally, the sponsor should be advised to consult their tax advisor to accurately report the tax deduction and determine the appropriate treatment of the nondeductible contributions. Generally, they may be carried forward and deducted in the next taxable year, as long as it is within the deduction limit for that year.
Can the plan refund non-deductible employer contributions?
No, it is not permissible to refund or reverse the nondeductible employer contributions. Contributions must remain in the plan and allocated to participants (to the extent they do not exceed the limits under IRC 415 Annual Additions Limit).