How Does the IRS Compensation Limit Work?
By Ian Berger, JD
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Towards the end of each year, the IRS announces cost-of-living increases for several retirement-related dollar limits that will become effective for the next year. For example, last November, the IRS said that the limit on employee pre-tax deferrals and Roth contributions in company plans would increase to $20,500 for 2022. You may have also seen that the IRS compensation limit also increased for 2022 to $305,000. What is this limit all about?
The compensation limit is a cap on the amount of pay that can be considered when determining the amount of employer contributions that highly-paid participants receive in a company plan, including SEP and SIMPLE IRAs. It’s also used in performing nondiscrimination testing for 401(k) and 403(b) plans.
With a compensation limit of $305,000 for 2022, most employees will never be affected. And if your pay does exceed the cap, it doesn’t mean you can’t receive a contribution. It just means your pay in excess of $305,000 can’t be used in calculating the company contribution made on your behalf.
Company contributions are made in most 401(k) plans and in some 403(b) plans. Those contributions are of two types: either a matching contribution (only for employees making deferrals), or a flat contribution for all eligible employees (regardless of whether they make deferrals). In both cases, the compensation limit applies.
Example 1: Catherine, age 55, is CEO of Acme Industries and participates in its 401(k). Acme matches 50% of each employee’s elective deferrals up to 5% of compensation. Catherine defers $27,000 in 2022 and earns $400,000 this year. The plan can only recognize $305,000 of Catherine’s compensation. This limits her match to $7,625 [50% x (5% x $305,000)]. Without the $305,000 maximum, her match would have been $10,000 [50% x (5% x $400,000)].
Example 2: Andre is CFO of General Hospital and will make $350,000 in 2022. He chooses not to make elective deferrals to the hospital’s 403(b) plan, which provides a flat 3%-of-pay employer contribution. Even though Andre does not make elective deferrals, he can still receive a contribution from the hospital. But that contribution will be limited to $9,150 (3% x $305,000).
The compensation limit also applies to SEP IRA contributions. However, it does not always apply to SIMPLE IRAs. SIMPLE IRAs can have either a matching employer contribution or a flat contribution. If a flat contribution is made, the pay cap does apply. But if a matching contribution is made, the cap does not apply and all compensation can be taken into account.
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