Key Points
Types of Contributions
Regardless of the type of 401(k) plan established, there are four types of contributions that may be made:
Funds contributed at the employee's direction through salary reduction or bonus deferral. Employees are not taxed on elective contributions, and earnings grow tax-deferred until withdrawn. Elective contributions and their earnings are 100% immediately vested. The IRS requires all 401(k) plans to include elective contributions — the other three types are optional.
Additional funds set aside by the employee from after-tax dollars. These contributions are included in the employee's taxable income in the year made, but earnings grow tax-deferred inside the plan. Like elective contributions, voluntary after-tax contributions are 100% immediately vested.
Funds added to an employee's account by the employer — typically as an incentive to encourage participation. Some employers match dollar-for-dollar; others match 50¢ or 25¢ per dollar. There is no required formula as long as total contributions stay within permissible limits. Employer matching contributions are subject to vesting requirements and withdrawal restrictions. Employees are not taxed on matching contributions until funds are withdrawn. Employers receive a current tax deduction.
Funds contributed by the employer that are not tied to employees' elective contributions. Most employers base these on profits or allocate them in proportion to employee salaries. Nonelective contributions are subject to vesting requirements and withdrawal restrictions, and are not currently taxable to employees.
American Saddle Works has a 401(k) plan allowing employees to defer up to 6% of salary. Employees may also contribute up to 6% in after-tax dollars. The company matches the first 6% dollar-for-dollar and the second 6% at 50¢ on the dollar. A profit-sharing contribution is allocated in proportion to salaries. Employees vest in matching and profit-sharing contributions after three years (cliff vesting).
Kyle Miller earns $32,000. He contributes 9% of salary. The company makes a $2,500 profit-sharing allocation to his account.
Elective contribution (6% × $32,000) = $1,920
Voluntary after-tax contribution (3% × $32,000) = $960
Matching contribution (100% of $1,920 + 50% of $960) = $2,400
Nonelective (profit-sharing) contribution = $2,500
Total contributions: $7,780
Kyle's elective and voluntary contributions ($2,880) are immediately vested. The employer contributions ($4,900) vest under the plan schedule.
Contribution Limits
Employees who participate in a 401(k) plan are subject to three types of limits on contributions. The tax code also limits the amount of compensation that may be used in calculating contributions.
Each employer's plan document outlines the maximum amount employees may contribute, expressed as a percentage of compensation. This is an internal plan limit that may be more restrictive than the statutory limits below.
The total annual additions to an employee’s 401(k) account from all sources (elective, voluntary, matching, nonelective, and forfeitures) may not exceed the lesser of:
- 100% of the employee’s compensation, or
- $72,000 (2026, inflation-adjusted).
This is the same limit that applies to all qualified defined contribution plans.
A separate aggregate limit applies to the total elective deferrals an employee may make across all plans allowing elective contributions — including 401(k) plans, 403(b) annuities, and SARSEPs. For 2026, this limit is $24,500. The limit applies per person, not per plan or per employer.
An employee defers $15,000 to the 401(k) plan of Employer A and $10,000 to a 403(b) plan of Employer B, for a total of $25,000. This exceeds the 2026 limit of $24,500 by $500. The excess $500 is included in the employee’s taxable income for the year. If not withdrawn by April 15 of the following year, it will be taxed again upon distribution.
Employees age 50 and older may make additional catch-up contributions above the regular deferral limit. Catch-up contributions are exempt from the standard elective deferral limit. The 2026 catch-up rules:
| Age Group | Regular Deferral | Catch-Up | Total Maximum |
|---|---|---|---|
| Under age 50 | $24,500 | — | $24,500 |
| Age 50–59 and 64+ | $24,500 | $8,000 | $32,500 |
| Age 60–63 (super catch-up) | $24,500 | $11,250 | $35,750 |
Only the first $360,000 of each employee’s compensation (2026) may be taken into account when calculating matching or nonelective contributions. This prevents the plan from disproportionately favoring highly paid employees.
An employer matches contributions dollar-for-dollar up to 4% of compensation. Employee A earns $400,000 and makes elective contributions of 4% ($16,000). The employer may only contribute $14,400 (4% × $360,000 cap) — not the full $16,000 match. Employee B earns $500,000 but may only defer $24,500 (the flat dollar limit); the employer’s match is still capped at $14,400 (4% × $360,000).
Tatiana earns $78,000 and participates in Kwik Copier’s 401(k). She defers 5% as an elective contribution ($3,900) and 6% as a voluntary after-tax contribution ($4,680). The plan provides a dollar-for-dollar match ($3,900). A profit-sharing contribution of $5,400 is allocated to her account, along with $1,000 in forfeitures from departing employees.
Elective contribution: $3,900 • Matching contribution: $3,900 • Voluntary contribution: $4,680 • Nonelective contribution: $5,400 • Share of forfeitures: $1,000
Total additions: $18,880
Tatiana’s $3,900 elective deferral is well below the $24,500 limit. Total additions of $18,880 are well within the $72,000 annual additions limit and 100% of her $78,000 compensation. All limits are satisfied.
Tax Treatment of Contributions
Elective, matching, and nonelective contributions are generally excluded from the employee’s taxable income provided they do not exceed the applicable limits and pass the nondiscrimination tests. Technically, elective deferrals are treated as employer-provided even though withheld from the employee’s paycheck.
Elective contributions are excluded from federal income tax withholding but are included in the Social Security and FUTA wage base. Voluntary after-tax contributions are made from compensation already subject to income tax; the employee cannot deduct them.
Employees who exceed the elective deferral limit and do not correct the error face the following:
- The excess is taxed in the year of contribution as ordinary income.
- If not withdrawn by April 15 of the following year, the excess is taxed again when eventually distributed from the plan.
- Any excess remaining in the plan after April 15 is subject to the same premature withdrawal penalties as any other elective contribution if distributed before age 59½.
If the excess spans two or more unrelated employers, neither plan is disqualified. If the excess occurs under a single plan or related-employer plans, the plan(s) will be disqualified unless corrective action is taken by April 15.
The employee must notify the relevant employer(s) of the allocation of the excess by March 1 of the year following the excess.
Joseph Blough is an engineer at Futurtek Instruments and also teaches at Engineer Institute. Both companies maintain 401(k) plans. In 2026, Joseph defers $16,000 to Futurtek’s plan and $9,000 to the Institute’s plan, for a total of $25,000 — $500 over the 2026 limit of $24,500.
Joseph must include $500 in his 2026 taxable income. In February 2027, while preparing his return, he decides to withdraw the $500 (plus allocable earnings) from the Institute’s plan before April 15, 2027. He notifies the Institute by March 1, 2027. The $500 is included in his 2026 return; the earnings on the excess are included in his 2027 taxable income. By withdrawing before April 15, Joseph avoids being taxed on the $500 a second time.
Within limits, an employer may deduct elective, nonelective, and matching contributions as employee compensation, provided total compensation is “reasonable.” Deductions are allowed for the plan year if contributions are deposited no later than the employer’s tax filing deadline (including extensions).
Employee contributions (elective and voluntary) must be deposited as soon as they can reasonably be segregated from the employer’s general assets — but no later than the 15th day of the month following the month in which they were withheld.
The employer may deduct contributions up to 25% of total eligible employee compensation as a business expense. This 25% limit applies to the employer’s entire payroll of all eligible employees, not just individual workers. Elective, matching, and nonelective contributions all count toward this employer deduction ceiling.
Contributions in excess of the 25% limit are made from after-tax profits and are subject to a 10% excise tax on the excess amount.
Effects on Other Benefits
Many employee benefits are keyed to compensation. An employee who elects to defer a portion of compensation under a 401(k) plan may inadvertently reduce entitlement to other compensation-linked benefits — such as defined benefit pension accruals, group life insurance, or disability coverage.
Dwayne Schroeder earns $40,000 per year and elects to contribute 6% ($2,400) to E-Z Rental’s 401(k) plan. E-Z also maintains a pension plan paying 80% of final compensation. If the pension plan defines compensation as salary net of elective deferrals, Schroeder’s pension is based on $37,600 ($40,000 − $2,400). His annual pension is reduced by $1,920 (80% × $2,400).
The IRS permits pension plans to either include or exclude elective contributions from the definition of compensation for benefit computation purposes. Plans that exclude elective deferrals are not considered discriminatory for that reason alone.
Social Security computes benefits based on the full wage base including elective deferrals, so 401(k) contributions do not reduce Social Security benefits.
For an arrangement to qualify as a 401(k) plan, an employer may not condition any of the following benefits on whether an employee does or does not make elective deferrals (other than matching contributions):
- benefits under a defined benefit plan,
- nonelective employer contributions under a defined contribution plan,
- the availability, cost, or amount of health benefits,
- vacations or vacation pay,
- life insurance,
- plan loans,
- financial planning services,
- subsidized retirement benefits,
- stock options, and
- dependent care assistance.
ABC Corporation maintains a cash or deferred arrangement for all employees. It also has a nonqualified deferred compensation plan for two executives, Bob and Ray, who may participate only if they do not make elective deferrals under the CODA. Because participation in the nonqualified plan is conditioned on the decision not to defer, the CODA does not qualify as a 401(k) plan.
Separate Accounting & Vesting
401(k) plans must maintain a separate account for each participant showing employer and employee contributions. Gains, losses, and other credits or charges must be allocated on a reasonable and consistent basis — not in a manner that discriminates in favor of highly compensated employees.
Employers who wish to simplify accounting by maintaining only one account per employee must treat all contributions as 100% immediately vested.
The tax code requires full and immediate vesting for the following amounts in a 401(k) plan:
- employee elective contributions,
- voluntary after-tax employee contributions,
- rollover contributions from other qualified plans, and
- any contributions used in calculating employees’ actual deferral percentages (ADPs) for nondiscrimination testing.
All income earned on these contributions must also be fully and immediately vested. All other contributions (employer matching and nonelective) and their earnings may be vested under a deferred schedule — either 5-year cliff or 3-to-7-year graded vesting (as discussed in Chapter 1).
Eunice has participated in Penobscot’s 401(k) since 2000 under a 3-to-7-year graded vesting schedule. After four years of participation (through the end of 2003), she is 40% vested in employer contributions. Her total account balance is $11,177. Her elective contributions and earnings ($4,154) are 100% vested. She is 40% vested in the matching and nonelective contributions and earnings ($7,023), entitling her to $2,809. Upon termination she receives $6,963 and forfeits $4,214, which remains in the plan for reallocation.
If a 401(k) plan is top-heavy (key employee accounts exceed 60% of total plan assets), vesting must be accelerated:
- 3-year cliff vesting (instead of 5 years), or
- 2-to-6-year graded vesting (instead of 3-to-7 years).
If a plan reverts from top-heavy to regular status, the vesting schedule may revert to the slower schedule — but any benefits already vested under the top-heavy schedule remain vested with the employee.