Key Points
Overview
The tax code places limits on contributions to and benefits from qualified plans. For defined contribution plans, the limitation applies to contributions. For defined benefit plans, the limitation applies to the maximum annual benefit the plan may provide. Employers and employees who exceed these limits face penalty taxes.
The contribution and benefit limits apply to all plans maintained by the employer under the “aggregation-of-plans” rule:
- all defined contribution plans maintained by the employer are treated as one plan, and
- all defined benefit plans maintained by the employer are treated as one plan.
The purpose of this rule is to prevent employers from exceeding the limits by simply establishing additional plans. All plans under the common control of an employer must also be aggregated — this applies when a sole proprietor owns more than one business, a parent company and subsidiary, etc.
Defined Contribution Plans
The contribution limits for defined contribution plans relate to the “total annual additions” to a participant’s account. The total annual amount that may be contributed or “added” to an employee’s retirement account is the lesser of:
- 100% of the participant’s compensation, or
- $72,000 (2026, inflation-adjusted).
This limit applies to all contributions — regardless of whether contributed by the employer or employee. If a participant’s compensation is $72,000 or more, annual additions are limited to $72,000. Participants earning less than $72,000 are limited to 100% of their compensation.
Employee #1 earns $300,000 — maximum annual addition: $72,000 (dollar cap applies).
Employee #2 earns $80,000 — maximum annual addition: $72,000 (dollar cap applies).
Employee #3 earns $50,000 — maximum annual addition: $50,000 (100% of compensation applies).
The tax code limits the amount of compensation that may be considered when calculating contributions. Only the first $360,000 (2026, inflation-adjusted) of each participant’s compensation may be taken into account. This rule prevents discrimination against lower-paid employees.
Bette Goodwin earned $500,000 and participates in a qualified plan with a 10% contribution rate. The employer’s contribution for Goodwin must be based on $360,000 — so the contribution is $36,000 (10% × $360,000), not $50,000 (10% × $500,000).
For contribution calculation purposes, compensation is measured before any employee elective deferrals to 401(k), SARSEP, TSA, or similar plans are deducted.
Maria Rodriguez earns $35,000 and also contributes $5,000 to the employer’s 401(k) plan. If the defined contribution plan calls for a 10% contribution rate, the employer’s contribution is $3,500 (10% × $35,000 pre-deferral compensation), not $3,000 (10% × $30,000 post-deferral).
The term “annual additions” is the sum of:
- employer contributions,
- employee contributions (mandatory and voluntary, but not rollovers or loan repayments), and
- forfeitures allocated to the participant’s account.
When a participant leaves and is not fully vested, the nonvested portion is a forfeiture — it remains in the plan (the law does not allow forfeitures to revert to the employer). In most profit-sharing plans, forfeitures are reallocated to remaining participants. In pension plans, forfeitures typically reduce employer contributions in subsequent years. In either case, forfeitures count as annual additions.
Brandon Summers was 60% vested when his profit-sharing account was valued at $50,000. When he was terminated, he received $30,000 (60% × $50,000). The remaining $20,000 was forfeited to the remaining plan participants.
The deduction limit for defined contribution plans is 25% of the total compensation paid to the employer’s eligible workforce. Contributions in excess of the deductible amount are subject to a 10% penalty tax, imposed each year the excess remains in the plan.
The compensation of all employees participating in a profit-sharing plan totals $500,000. The company may contribute and deduct up to $125,000 (25% × $500,000) for the year, to be allocated among participants.
Unlike IRAs and SEPs, savings in a qualified plan may be used to purchase life insurance, provided it is “incidental” to the plan’s primary purpose of providing retirement savings. The IRS tests for incidental status:
- Whole life insurance: premiums must be less than 50% of the employer’s contributions (plus forfeitures) to the participant’s account.
- Term or universal life insurance: premiums must be less than 25% of the employer’s contributions (plus forfeitures).
Bill Carson has $10,000 allocated to his account in a defined contribution plan. Therefore, less than $5,000 may be used to purchase whole life insurance, and less than $2,500 may be used to pay premiums on term or universal life.
As a general rule, qualified plan assets must be held in a trust. An exception exists for insurance contracts issued by an insurance company, which may be purchased directly by the plan or through the trust.
Defined Benefit Plans
Rather than limiting contributions, the tax code limits the maximum annual benefit that a defined benefit plan may provide. The maximum annual benefit payable is the lesser of:
- 100% of the participant’s average compensation in the highest three consecutive years of employment as an active participant, or
- $290,000 per year (2026, inflation-adjusted).
As with defined contribution plans, the employer may only consider compensation up to the cap of $360,000 (2026).
Goodwin Sprague earns $60,000 a year and participates in a defined benefit plan providing 20% of compensation. After 20 years of service he retires at age 65. He will receive $12,000 per year (20% × $60,000) for life — a “defined” benefit paid regardless of investment performance.
Unlike defined contribution plans, a defined benefit plan does not have separate individual accounts for each participant. Employer contributions are pooled and benefits are paid out upon retirement or other triggering events.
To earn the full benefit, a participant must generally have at least 10 years of service. Benefits are reduced proportionally for shorter service periods — multiply the limit by a fraction equal to years of service (or plan participation) divided by 10.
Lena Hayworth retires at age 65 after earning an average of $140,000 per year. She worked for the employer for 4 years and participated in the defined benefit plan for 3 years (due to the one-year service requirement). The plan’s defined benefit is 100% of compensation. Her reduced maximum benefit is the lesser of:
• $290,000 (2026 dollar limit) × 3/10 = $87,000
• 100% of $140,000 × 4/10 = $56,000
Hayworth’s maximum annual benefit is $56,000.
A de minimis exception allows a participant to receive up to $10,000 per year without regard to the 100% of compensation limit, provided the participant does not also participate in a defined contribution plan maintained by the same employer. This limit is also reduced proportionally for fewer than 10 years of service.
Defined benefit plans start with the conclusion (the promised retirement benefit) and work backwards. An actuary determines how much the employer must contribute today to meet that obligation. The two main types of benefit formulas are:
- Flat benefit formula: pays a fixed amount or a flat percentage of compensation at retirement, regardless of years of service. Example: $100 per month, or 2% of average compensation per month.
- Unit benefit formula: takes length of service into account. Retirement benefits are calculated by multiplying compensation by a percentage for each year of participation.
A plan provides 3% of annual compensation for each year as a participant. An employee joins at age 30, earns $10,000/year until age 50, then earns $20,000/year until age 65:
• 3% × $10,000 × 20 years = $6,000
• 3% × $20,000 × 15 years = $9,000
• Total annual retirement benefit = $15,000
Either formula may include a cost-of-living adjustment provision to increase future benefits and offset the effects of inflation.
There is no fixed percentage of compensation limit for deductions to a defined benefit plan. Instead, the overall limit is the “full funding limitation” — the difference between the plan’s accrued liability to participants and the current value of plan assets.
A minimum funding standard requires employers to contribute a minimum amount to avoid underfunding. If contributions fall short, an accumulated funding deficiency results, triggering a 5% penalty tax. If the deficiency is not corrected after IRS notice, an additional 100% penalty may be imposed.
A plan has an accrued liability of $1,000,000 and plan assets of $950,000. The full funding limitation is $50,000. The employer must contribute that amount to avoid the 5% penalty tax — and that is also the maximum deductible contribution for the year.
The same 25% and 50% incidental tests apply. An alternative test is also available: the life insurance death benefit may not exceed 100 times the expected monthly retirement benefit or the policy’s cash value, whichever is greater. If the monthly retirement benefit is $200, the policy face amount cannot exceed $20,000.
To be deductible, the employer’s contribution must be made to a qualified plan that was in existence at the end of the employer’s tax year. However, the actual contribution may be made by the employer’s tax filing deadline (plus extensions).
A hotel established a qualified plan on December 31. As a calendar-year corporate taxpayer, it can make its contribution up to the March 15 filing deadline (or later, if an extension is granted) and claim the deduction for the prior tax year.
When an employer makes an excess contribution to a qualified plan, the excess is subject to a nondeductible 10% penalty tax per year while it remains in the plan. The penalty can be avoided if the excess (plus earnings) is withdrawn within 2½ months after the close of the plan year.
An employer erroneously contributed $4,000 more than was allowable. The penalty tax is $400 (10% × $4,000). As a calendar-year taxpayer, the employer can cure the excess by withdrawing it (plus earnings) by March 15 of the following year — 2½ months after year-end.
Integration with Social Security
Integration is the process of coordinating a qualified plan with Social Security. It allows an employer to take credit for its Social Security tax contributions (OASDI) when determining plan contributions or benefits — effectively treating the qualified plan and Social Security as a single combined retirement program. Employers are not required to integrate, but if they do, the plan must still not discriminate in favor of highly compensated employees.
Three key definitions govern integration:
- Taxable wage base: the maximum amount of earnings subject to Social Security contributions (OASDI) in a given year.
- Covered compensation: the average taxable wage bases over the 35 years ending with the year the employee reaches Social Security retirement age — used to calculate Social Security benefits.
- Integration level: the level of compensation above which the qualified plan’s contributions or benefits apply. The integration level may not exceed the taxable wage base.
Defined contribution plans may provide a higher contribution rate on compensation above the integration level than on compensation below it. The excess contribution rate above the integration level may not exceed the base rate by more than:
- twice the base contribution percentage, or
- the greater of 5.70% or the current OASDI tax rate (6.20%).
An integrated profit-sharing plan contributes 10% of compensation up to the taxable wage base and 15% on compensation above it. The 5% difference does not exceed the 5.70% maximum — the plan is properly integrated.
Mary North earns $40,000: contribution = 10% × $40,000 = $4,000.
Beth East earns $92,600: contribution = 10% × $80,400 = $8,040, plus 15% × $12,200 = $1,830, for a total of $9,870.
Defined benefit plans integrate by adjusting the benefit formula using either the excess approach or the offset approach:
- Excess plans provide a “basic” benefit to all employees and additional benefits to those earning above the integration level. The maximum excess benefit is ¾% (0.0075) of compensation per year of service, up to 35 years.
- Offset plans start with the “basic” benefit and reduce it based on the employee’s Social Security benefits. The maximum offset is ¾% (0.0075) of final compensation per year of service, but may not exceed 50% of the benefit that would have accrued without integration.
Nathan Hale retires with 10 years of service, earning $30,000 in his final years. His plan provides 25% of final compensation ($7,500/year) before the offset. The maximum allowable offset is: 0.0075 × 10 years × $30,000 = $2,250. Since $2,250 is less than 50% of $7,500, it is allowable. Nathan receives $7,500 − $2,250 = $5,250 per year.
Employee Contributions
Most qualified plans allow employees to make contributions, either voluntary or mandatory. Although employee contributions to most qualified plans are not tax-deductible, there is a strong incentive to contribute because earnings accumulate tax-deferred until withdrawn.
The law limits voluntary employee contributions to prevent the plan from becoming a tax-exempt savings account. The plan may permit contributions up to 10% of compensation. However, employee contributions count as annual additions, subject to the $72,000/$360,000 limits (2026). Only a portion of employee contributions is counted, specifically the lesser of:
- the employee’s contribution in excess of 6% of compensation, or
- one-half of the employee’s total contribution.
Sam White earns $100,000 and makes an $8,000 voluntary contribution. 6% of $100,000 = $6,000. His contribution exceeds 6% by $2,000 ($8,000 − $6,000). One-half of his contribution is $4,000. The lesser of $2,000 and $4,000 is $2,000 — only $2,000 of his $8,000 contribution counts against the annual additions limit.
Unlike voluntary contributions, mandatory contributions are not limited to a fixed percentage of compensation. However, if participation requires a mandatory contribution, some lower-paid employees may not be able to afford to participate, creating a potential discrimination issue.
Many employers provide matching contributions conditioned on the employee making contributions — treating the employee contribution as mandatory. This matching technique is frequently used in 401(k) plans and money purchase plans. Profit-sharing plans generally do not require mandatory employee contributions.
Top-Heavy Plans
A qualified plan is top-heavy when the value of the combined accounts (defined contribution) or accrued benefits (defined benefit) of key employees exceeds 60% of the total plan.
A key employee is any employee who, at any time during the plan year, was:
- an officer earning more than $235,000 per year (2026, inflation-adjusted),
- owned more than 5% of the employer, or
- owned more than 1% of the employer and earned more than $150,000 per year.
Bob Burns owns an advertising company with two employees. Employer contributions for the year: Burns (key employee) = $12,000; Employee #1 = $5,000; Employee #2 = $3,000. Total = $20,000.
Burns’ share: $12,000 / $20,000 = exactly 60%. The plan is not top-heavy — a plan must exceed 60% to be top-heavy.
If a plan is top-heavy:
- Accelerated vesting is required (see Vesting section below).
- Defined contribution plans must provide minimum employer contributions of at least 3% of compensation for all non-key employees (or the rate contributed for key employees if less than 3%).
- Defined benefit plans must provide a minimum annual retirement benefit of at least 2% of average annual compensation × years of service (up to 10 years) for non-key employees.
Tom Fairbairn has a top-heavy defined benefit plan. Minimum benefits for non-key employees:
• Employee #1: $50,000 comp × 5 years × 2% = $5,000/year
• Employee #2: $30,000 comp × 3 years × 2% = $1,800/year
• Employee #3: $50,000 comp × 10 years (capped) × 2% = $10,000/year
Vesting
Vesting refers to the employee’s ownership of the retirement savings in a qualified plan. Accumulated savings arise from employer contributions, earnings on employer contributions, employee contributions, and earnings on employee contributions. The vesting schedule determines the employee’s increasing ownership interest in the employer’s contributions over time.
When an employee is 100% vested, his or her right to retirement benefits becomes nonforfeitable. Vesting provides a powerful incentive to remain with the same employer.
An employee is 60% vested after three years of service. In a $10,000 defined contribution plan funded entirely by employer contributions, the employee owns $6,000. The remaining $4,000 may be forfeited if he or she terminates service. In a defined benefit plan paying $100/month at retirement, the employee is entitled to $60/month if he or she separates from service.
Employers must vest benefits no slower than one of these two schedules:
| Years of Service | 5-Year Cliff Vesting | 3-to-7-Year Graded Vesting |
|---|---|---|
| 1 | 0% | 0% |
| 2 | 0% | 0% |
| 3 | 0% | 20% |
| 4 | 0% | 40% |
| 5 | 100% | 60% |
| 6 | 100% | 80% |
| 7+ | 100% | 100% |
Under cliff vesting, an employee may be 0% vested for the first four years and 100% vested in year five. Under graded vesting, vesting phases in gradually from year three through year seven. Employers may accelerate these schedules but not slow them down.
Geoff Striker participated in a qualified plan for six years with a profit-sharing account of $20,000. Under 3-to-7-year graded vesting, he is 80% vested after six years. He is entitled to $16,000 (80% × $20,000).
Vesting schedules apply only to employer contributions and earnings on those contributions. All employee contributions (mandatory and voluntary) and earnings on them are 100% immediately vested at all times.
Top-heavy plans must comply with a more rapid vesting schedule:
- 3-year cliff vesting: 100% vested after 3 years (instead of 5), or
- 2-to-6-year graded vesting: vesting begins in year two and is 100% by year six (instead of year seven).
| Years of Service | Top-Heavy 3-Year Cliff | Top-Heavy 2-to-6-Year Graded |
|---|---|---|
| 1 | 0% | 0% |
| 2 | 0% | 20% |
| 3 | 100% | 40% |
| 4 | 100% | 60% |
| 5 | 100% | 80% |
| 6+ | 100% | 100% |
If a plan ceases to be top-heavy, it may revert to a slower vesting schedule — but any benefits already vested during the top-heavy period must remain vested.
As a general rule, qualified plans must be permanent. However, plans may be completely or partially terminated for valid business reasons. The most important consequence of any plan termination is that all participants immediately become 100% vested. Under a defined contribution plan, nonvested amounts are generally reallocated to remaining participants. Under a defined benefit plan, 100% vesting means non-vested benefits that would have reduced future employer contributions will instead be paid to the affected employees.
Oliver Stone has four years of service and is 40% vested in his $20,000 profit-sharing account. If the plan is terminated, Stone is entitled to the full $20,000 because he becomes 100% vested upon plan termination.