Employees with very high compensation cannot have their retirement plan benefits based on all of their pay. Instead, the tax code only allows compensation up to a certain dollar amount. A compensation limit is certainly not a bad problem to have.
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 who earns 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 1
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 2
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
Copyright © 2023, Ed Slott and Company, LLC Reprinted from The Slott Report, 2022, with permission. Ed Slott and Company, LLC takes no responsibility for the current accuracy of this article. Content posted in Ed Slott’s IRA Corner was developed and produced by Ed Slott & Co. to provide information on a topic that may be of interest. Ed Slott and Ed Slott & Co. are not affiliated with Ethos Capital Management, Inc. 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. The tax information provided is general in nature and should not be construed as legal or tax advice. Information is derived from sources deemed to be reliable. Always consult an attorney or tax professional regarding your specific legal, or tax situation. Tax rules and regulations are subject to change at any time. Ethos Capital Management, Inc. is a registered investment adviser. The firm only conducts business in states where it is properly registered or is excluded from registration requirements. Registration is not an endorsement of the firm by securities regulators and does not mean the adviser has achieved a specific level of skill or ability.
Ethos Capital Management, Inc (“ECM”) is an investment adviser registered with the SEC. Registration is not an endorsement of the firm by securities regulators and does not mean the adviser has achieved a specific level of skill or ability.
This content is provided for educational purposes only. Commentary should not be regarded as a complete analysis of the subjects discussed and should not be relied upon for entering into any transaction, advisory relationship, or making any investment decision. The information presented does not involve the rendering of personalized investment advice and should not be viewed as an offer to buy or sell any securities.
The article was prepared by a third party, Financial Media Exchange, which is not affiliated with ECA. Other organizations or persons may analyze investments and the approach to investing from a different perspective than that reflected in this article. All expressions of opinion reflect the judgment of the author on the date of publication and are subject to change.
Any tax information provided is general in should not be construed as legal or tax advice. Information is derived from sources deemed to be reliable. Always consult an attorney or tax professional regarding your specific legal or tax situation. Tax rules and regulations are subject to change at any time.
