Limitation on Elective Deferrals

There is a limit on the amount of elective deferrals that a plan participant can contribute to a traditional or safe harbor 401(k) plan.

• The limit is $14,000 for 2005, and increases to $15,000 for 2006.
• The limit is subject to cost-of-living increases after 2006.

Generally, all elective deferrals made by a participant to all plans in which he or she participates must be considered to determine if the dollar limits are exceeded.

Limits on the amount of elective deferrals that a plan participant can contribute to a SIMPLE 401(k) plan are different from those in a traditional or safe harbor 401(k).

• The limit is $10,000 for 2005 and 2006.
• The limit is subject to cost-of-living increases after 2006.

Although, general rules for 401(k) plans provide for the dollar limit described above, that does not mean that a plan participant is entitled to defer that amount. Other limitations may come into play that would limit a plan participant’s elective deferrals to a lesser amount. For example, the plan document may provide a lower limit or the plan may need to further limit a plan participant’s elective deferrals in order to meet nondiscrimination requirements.

Catch-up contributions. For tax years beginning after 2001, a plan may permit participants who are age 50 or over at the end of the calendar year to make additional elective deferral contributions. These additional contributions (commonly referred to as catch-up contributions) are not subject to the general limits that apply to 401(k) plans. An employer is not required to provide for catch-up contributions in any of its plans. However, if a plan does allow catch-up contributions, it must allow all eligible participants to make the same election with respect to catch-up contributions.

If a plan participant participates in a traditional or safe harbor 401(k) plan and is age 50 or older:

• The elective deferral limit increases by $4,000 for 2005 and $5,000 for 2006.
• The limit is subject to cost-of-living increases after 2006.

If a plan participant participates in a SIMPLE 401(k) plan and is age 50 or older:

• The elective deferral limit increases by $2,000 for 2005 and $2,500 for 2006.
• The limit is subject to cost-of-living increases after 2006.

The catch-up contribution a participant can make for a year cannot exceed the lesser of the following amounts:

• The catch-up contribution limit, above, or
• The excess of the participant's compensation over the elective deferrals that are not catch-up contributions.

Participation in plans of unrelated employers. If an eligible participant participates in plans of different employers, he or she can treat amounts as catch-up contributions regardless of whether the individual plans permit those contributions. In this case, it is up to the participant to monitor his or her deferrals to make sure that they do not exceed the applicable limits.

Example: If Joe Saver, who’s over 50, has only one employer and participates in that employer’s 401(k) plan, the plan would have to permit catch-up contributions before he could defer the maximum of $18,000 for 2005 (the $14,000 regular limit for 2005 plus the $4,000 catch-up limit for 2005). If the plan didn’t permit catch-up contributions, the most Joe could defer would be $14,000. However, if Joe participates in two 401(k) plans, each maintained by an unrelated employer, he can defer a total of $18,000 even if neither plan has catch-up provisions. Of course, Joe couldn’t defer more than $14,000 under either plan and he would be responsible for monitoring his own contributions.

The rules relating to catch-up contributions are complex and a plan participant’s limits may differ according to provisions in the specific plan.

Treatment of excess deferrals. If the total of a plan participant’s elective deferrals is more than the limit, a plan participant can have the difference (called an excess deferral) returned to the participant from any of the plans that permit these distributions. A plan participant must notify the plan by April 15 of the following year of the amount to be paid from the plan. The plan must then pay the participant that amount plus allocable earnings by April 15 of the year following the year in which the excess occurred.

Excess withdrawn by April 15. If a plan participant withdraws the excess deferral for 2005 by April 15, 2006, it is includable in the participant’s gross income for 2005, but not for 2006. However, any income earned on the excess deferral taken out is taxable in the tax year in which it is taken out. The distribution is not subject to the additional 10% tax on early distributions.

Excess not withdrawn by April 15. If a plan participant does not take out the excess deferral by April 15, 2006, the excess, though taxable in 2005, is not included in the participant’s cost basis in figuring the taxable amount of any eventual distributions from the plan. In effect, an excess deferral left in the plan is taxed twice, once when contributed and again when distributed. Also, if the entire deferral is allowed to stay in the plan, the plan may not be a qualified plan.

Reporting corrective distributions on Form 1099-R. The plan must report corrective distributions of excess deferrals (including any earnings) on Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.

Additional limits. There are other limits that restrict contributions made on a plan participant’s behalf. In addition to the limit on elective deferrals, annual contributions to all of a participant’s accounts - this includes elective deferrals, employee contributions, employer matching and discretionary contributions and allocations of forfeitures to participant accounts - may not exceed the lesser of 100% of the participant’s compensation or a specific dollar limitation. The dollar limitation is $42,000 in 2005, $44,000 in 2006. In addition, the amount of compensation that can be taken into account when determining employer and employee contributions is limited. In 2005, the compensation limitation is $210,000; for 2006, the limit is $220,000.

Plan definitions. The rules for compliance with the above limits are complex and may be subject to different definitions. For example, a plan may define “compensation” for certain limitations as “W-2 compensation.” For other purposes, the plan may use a definition of compensation that excludes bonuses and overtime.