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The Interrelationship between the Individual Contribution/Benefit and Employer Deduction Limits - January 1, 2002 (updated January 1, 2004 to reflect 2004 limits)

Starting in 2002, increases in the maximum individual contribution/benefit limits, and in employer deduction limits, provide new planning opportunities.   The increase in the individual 401(k) deferral limit, the availability of the new 401(k) "catch-up" contributions, the increase in the limit on maximum individual compensation used in determining contributions/benefits, and the repeal (in 2001) of the combined plan limitations under Internal Revenue Code §415(e) also have significant impact these opportunities. 

This article focuses on how the interrelationship of these increased limits impacts the planning opportunities available for single owner or partner only business entities (e.g., self-employed individuals, independent contractors, and companies with no employees other than the owner, partners or spouses of the owners or partners).  While not discussed specifically in this article, the increased limits also provide planning opportunities for employers of all sizes and individuals ages 21 and older who earn any appreciable level of earned income (typically $25,000 or more).

Click here to review the individual and employer limits that are outlined at the end of this article or you may refer to the complete descriptions of the limits by clicking on the hyperlinks within each of the interrelationship situations discussed below.

Interrelationship 1:  Maximum Annual Addition to a Defined Contribution Plan Limit / Maximum Individual Compensation Limit / Maximum 401(k) Limit / Maximum Employer Deduction Limit

Click here to view complete case study referenced in this interrelationship situation

A 45 year old physician earns in excess of $250,000 annually.  The physician's 45 year old spouse is the office manager and bookkeeper earning $41,000.  There are no other employees.  The physician and spouse desire a plan that provides the maximum deductible contribution. 

As the case study illustrates, the maximum contribution to the practice sponsored Profit Sharing Plan with a 401(k) feature is $82,000, $41,000 for the physician and $41,000 for the spouse.  Here's how the math works to provide the $82,000 total deductible contribution.

The maximum annual addition limit is the lesser of 100% of compensation or $41,000, the maximum individual compensation limit is $205,000, the maximum individual 401(k) limit is the lesser of 100% of compensation or $13,000 and the maximum employer deduction limit for a defined contribution plan is 25%.

Therefore, the physician's compensation is limited to $205,000 and the maximum deductible contribution is determined as follows:

  • Each individual elects to make a 401(k) deferral of $13,000 (the lesser of 100% of compensation or $13,000 in 2003)

  • The employer contribution to the Profit Sharing portion of the plan is $28,000 for each individual ($56,000 total contribution) 

  • The $56,000 employer profit sharing contribution is deductible since it is less than or equal to the aggregate of the eligible compensation times 25% ($205,000 plus $41,000 times 25% equals $61,500)

  • The 401(k) contributions do not offset the 25% employer deduction limit and are separately deductible

The $82,000 deduction is permitted through the interrelationship of the maximum annual addition to a defined contribution plan limit, the maximum individual compensation limit, the individual 401(k) limit and the maximum employer deduction limit.

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Interrelationship 2:  Maximum Individual Contribution/Benefit Limits / Maximum Individual Compensation Limit / Maximum 401(k) Limit / Maximum Combined Defined Contribution and Defined Benefit Plan Employer Deduction Limit

Click here to view complete case study referenced in this interrelationship situation

A 35 year old physician earns in excess of $250,000 annually.  The physician has no employees and desires a plan that provides the maximum deductible contribution. 

As the case study illustrates, the maximum contribution to the practice sponsored combination Profit Sharing Plan with a 401(k) feature and Defined Benefit Pension Plan is $63,700.  Here's how the math works to provide the $63,700 total deductible contribution.

The maximum annual addition limit to a defined contribution plan is the lesser of 100% of compensation or $40,000, the maximum annual benefit payable from a defined benefit pension plan is $165,000 beginning at age 62, the maximum individual compensation limit is $205,000, the maximum individual 401(k) limit is the lesser of 100% of compensation or $13,000, the maximum combined plan employer deduction limit is the greater of the defined benefit normal cost or 25%, and 401(k) contributions are not considered in determining the employer deduction limit.

Therefore, the physician's compensation is limited to $205,000 and the maximum deductible contribution/benefit is determined as follows:

  • The physician elects to make a 401(k) deferral of $13,000 (the lesser of 100% of compensation or $13,000 in 2004)

  • The maximum deductible employer contribution to the Profit Sharing portion of the plan is $28,000 ($41,000 if no 401(k))

  • The normal cost to fund the Defined Benefit Pension Plan benefit is $22,700

  • The $50,700 combined plan contributions are deductible since the defined contribution plan ($28,000) contribution and defined benefit plan normal cost ($22,700) are less than or equal to the combined plan employer deduction limit (the greater of the defined benefit plan normal cost or 25% of $205,000)  

  • The 401(k) contribution does not offset the 25% employer combined plan deduction limit and is separately deductible

The $63,700 deduction is permitted through the interrelationship of the maximum annual addition to a defined contribution plan limit, the maximum benefit payable from a defined benefit plan, the maximum individual compensation limit, the individual 401(k) limit and the maximum combined plan employer deduction limit.

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Interrelationship 3:  Maximum Individual Contribution/Benefit Limits / Maximum 401(k) Limit / Maximum Combined Defined Contribution and Defined Benefit Plan Employer Deduction Limit

Click here to view complete case study referenced in this interrelationship situation

A 45 year old insurance broker earns a W-2 income of $164,000.  The insurance broker has no employees and desires a plan that provides the maximum deductible contribution. 

As the case study illustrates, the maximum contribution to the practice sponsored combination Profit Sharing Plan with a 401(k) feature and Defined Benefit Pension Plan is $92,400.  Here's how the math works to provide the $92,400 total deductible contribution.

The maximum annual addition limit to a defined contribution plan is the lesser of 100% of compensation or $41,000, the maximum annual benefit payable from a defined benefit pension plan is $165,000 beginning at age 62, the maximum individual 401(k) limit is the lesser of 100% of compensation or $13,000, the maximum combined plan employer deduction limit is the greater of the defined benefit normal cost or 25%, and 401(k) contributions are not considered in determining the employer deduction limit.

The insurance broker's compensation is $164,000 and the maximum deductible contribution/benefit is determined as follows:

  • The insurance broker elects to make a 401(k) deferral of $13,000 (the lesser of 100% of compensation or $13,000 in 2003)

  • The maximum deductible employer contribution to the Profit Sharing portion of the plan is $28,000 ($41,000 if no 401(k))

  • The normal cost to fund the Defined Benefit Pension Plan benefit is $79,400

  • The $92,400 combined plan contributions are deductible since the defined benefit plan normal cost ($79,400) is less than or equal to the combined plan employer deduction limit (the greater of the defined benefit plan normal cost or 25% of $160,000)  

  • The 401(k) contribution does not offset the employer combined plan deduction limit and is separately deductible

The $92,400 deduction is permitted through the interrelationship of the maximum annual addition to a defined contribution plan limit, the maximum benefit payable from a defined benefit plan, the individual 401(k) limit and the maximum combined plan employer deduction limit.

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Maximum Individual Contribution/Benefit and Employer Deduction Limits

Maximum Limit on Individual Compensation

$205,000 in 2005 (indexed annually based on cost-of-living adjustments subject to a $5,000 minimum increment).  Back to previous location

Maximum Annual Addition to a Defined Contribution Plan (Profit Sharing, Profit Sharing/401(k) and Money Purchase Pension Plans)

The lesser of 100% of compensation or $41,000 in 2004 (indexed based on cost-of-living adjustments subject to a $1,000 minimum increment).  This is an annual addition limit that considers all employer contributions and forfeitures, and employee contributions that are allocated to an individual's account in all defined contribution plans sponsored by the employer (or a group of employers considered under common control or affiliated).  This limit applies separately to individuals who participate in multiple plans of employers that are not considered under common control or affiliated.  Back to previous location

Maximum Annual Benefit for Individuals in a Defined Benefit Pension Plan

The lesser of 100% of average compensation (highest 3 consecutive years) or a $165,000 annual benefit in 2004 (indexed based on cost-of-living adjustments subject to a $5,000 minimum increment) payable at age 62 for an individual in all defined benefit plans sponsored by the employer (or a group of employers considered under common control or affiliated).  This limit applies separately to individuals who participate in multiple plans of employers that are not considered under common control or affiliated.  Back to previous location

Maximum Individual 401(k) Limit

The lesser of 100% of compensation or $13,000 in 2004 (indexed based on $1,000 annual preset limits through 2006).  This limit is an individual calendar year limit that considers all plans in which an individual is eligible to make salary deferrals.  This individual limit applies even if the employers who sponsor the plans are not considered under common control or affiliated.  Back to previous location

Individual 401(k) "Catch-up" Limit

The lesser of 100% of compensation or $3,000 in 2004 (indexed based on $1,000 annual preset limits through 2006).  The "catch-up" contribution is available to individuals who are currently age 50 or who will become age 50 within the applicable calendar year.  Individuals are not eligible to make catch-up contributions for a plan year unless no further elective deferrals can be made to the plan for that year due to any limitation or other restriction contained in the terms of the plan.  This limit is an individual calendar year limit that considers all plans in which an individual is eligible to make salary deferrals.  This individual limit applies even if the employers who sponsor the plans are not considered under common control or affiliated.  Back to previous location

Maximum Employer Deduction Limit - Defined Contribution Plan

The deduction limit is 25% of the aggregate compensation (subject to the individual compensation limit) of the eligible plan participants.  This employer deduction limit does not consider elective 401(k) deferrals which are deducted separately.  Employee 401(k) contributions do not offset any part of the 25% employer deduction limit available for other employer contributions to the plan.  This is an overall employer deduction limit that applies to the aggregate of all employer contributions to all defined contribution plans sponsored by the employer (or an employer who is under common control or affiliated).  Back to previous location

Maximum Employer Deduction Limit - Defined Benefit Pension Plan

In general, the deduction limit for defined benefit plans is the greater of the minimum funding amount, the level funding amount or the amortization amount. 

The minimum funding amount is determined in accordance with the funding method chosen by the plan actuary and other actuarial assumptions (e.g., pre and post retirement interest rates and mortality table).  In general, the level funding amount is the normal cost that would be necessary to fund the total unfunded benefits over the remaining service of the participants.  The amortization amount is the normal cost of the plan plus the amount necessary to amortize the unfunded costs attributable to past service or other supplementary credits over a 10-year period.  

The employer typically has a range of contributions that can be made to the plan for the plan year.  The minimum funding amount is the smallest amount that should be contributed and the amortization amount is the largest amount.

Lastly, the deduction limit for a defined benefit pension plan cannot exceed the "full funding limit" even if the aforementioned requirements otherwise produce a greater deduction limit.  The “full funding limit” is calculated separately based on government mandated parameters subject to interest rates published monthly.  Back to previous location

Combined Plan Deduction Limit - Defined Contribution and Defined Benefit Pension Plans

The combined plan deduction limit only applies if there are common participants in both the Defined Contribution and the Defined Benefit Plans of a common or affiliated employer/plan sponsor.  When applicable, the combined limit is the greater of 25% of the aggregate compensation (subject to the individual compensation limit) of all participants or the minimum funding amount.  This employer deduction limit does not consider elective 401(k) deferrals which are deducted separately.  Employee 401(k) contributions do not offset any part of either the 25% or the minimum funding amount deduction limit available for employer contributions to the plan.  This is an overall employer deduction limit that applies to the aggregate of all employer contributions to all defined contribution and defined benefit plans sponsored by the employer (or an employer who is under common control or affiliated).   Back to previous location

© 2002-2004 Milberg Consulting LLC  All Rights Reserved

We intend the information in this publication as a general resource, not as legal or plan compliance advice or counsel. If you consider any actions discussed in this update, we suggest that you consult a tax or ERISA professional. Milberg Consulting LLC and Barry R. Milberg do not warrant and are not responsible for any errors and omissions from this update.