What is the limit on a contribution to a 401(k) plan for 2005? I read someplace it is the lesser of 25% or $14,000. Then I saw another place say it is the lessser of 100% or $14,000. Which is correct?
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401(k) limits
There are three separate and distinct limitations:
1. For 2005, the employee can elect to defer up to 100% of wage or $14,000, whichever is less. If the employee is age 50 or older, the $14,000 limit is increased to $18,000.
2. The employer's deduction is limited to 25% of the combined wages of all employees. For purposes of calculating 25% of wages, any elective deferrals by the employees are not taken into account.
3. Combined employee elective deferrals and employer matching contributions is limited to 100% of wage or $42,000, whichever is less.
A simple example to illustrate the inter-relationship of these three rules is as follows.
Assume a company only has one employee who earns $10,000 per year in total wages. The employee elects to defer $6,000 into a 401(k) plan. So far OK because the $6,000 is less than 100% of wages or $14,000.
Next the employer decides to match 25% of wages. $10,000 X 25% = $2,500. So far OK because the employer’s deduction is limited to 25% of all employee wages not counting elective deferrals.
Next we see that combined employee elective deferrals and employer matching equals $8,500. These combined contributions equal 85% of the employee’s wage, which fall below the limits of 100% of wage or $42,000.
All three tests are satisfied and the $8,500 contributions to the employee’s 401(k) are fine.
I did not go into the top heavy rules, which would probably kill this above example. However, if this were a self-employed taxpayer, there are new 401(k) rules that allow single participant 401(k) plans to ignore the top heavy rules, thus allowing this above example to work.
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