Limits on Deductibility of 401(k) Plans?

When it comes to defined contribution plans such as 401(k) plans, an employer’s deductions for their contribution to their plan is limited to 25% of the participant’s compensation.

Internal Revenue Code Section 404(a)(3)(A)(i) limits employer tax deductions for profit sharing plans such as 401(k) plans to “25 percent of the compensation otherwise paid or accrued during the taxable year to the beneficiaries under the stock bonus or profit-sharing plan”.

A recent private letter ruling puts a spin on that limit. Suppose you have a 401(k) plans where a participant defers, but is not eligible for matching and profits sharing contributions, do you include that participant’s compensation for that 25% limit on deductions for employer contributions?

Private Letter Ruling 201229012 says no.  In Private Letter Ruling 201229012, the IRS ruled that a plan does not include the compensation of a participant who is only eligible for the elective deferral portion of the plan. The reason is because of a change in Section 404(a)(4) caused by EGTRRA in 2002, which disregarded salary deferrals when applying the 25% limit. (in the old days, 401(k) plans only had a 15% deductibility limit and salary deferrals counted towards that limit).

The Private Letter Ruling has only precedential value, except to the taxpayer who received it. It just goes to the IRS’ thinking. Is that thinking inconsistent with the Code? Well until further guidance, that’s up for debate.

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