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401(k) plans are mainly viewed as a way for employees to save for retirement on a tax-advantaged basis. However, they can also offer significant tax benefits to employers. Among them is the ability to take a tax deduction for plan contributions. Understanding these deductions can help you optimize your business’s bottom line.
In general, the deduction rules for 401(k) plan contributions are basic:
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- Limits – the maximum a business can deduct each tax year; and
- Timing – when contributions must be deposited to be deductible.
Knowing these rules allows you to maximize your business’s deductions for 401(k) plan contributions while bolstering retirement savings for you and your employees.
Deduction Limits for 401(k) Plan Contributions
401(k) plan contributions come in two basic types – employer contributions and elective deferrals. Different deduction limits apply to each type.
Employer Contributions
Employer contributions include matching or non-elective contributions, along with safe harbor contributions. The maximum deduction limit for employer contributions is 25% of the total compensation for all eligible employees.
For example, Liz is a small business owner and her total payroll for all eligible employees is $600,000, which includes Liz’s compensation of $200,000. Her business can deduct up to $150,000 (600,000 x 25%) for employer contributions made to the 401(k) plan.
There is no individual deduction limit for employees. However, employers must allocate a deductible contribution among eligible employees based on the terms of their 401(k) plan. For example, Liz's allocation of the $150,000 contribution could be up to the 415 limit ($69,000 for 2024) if allowed by her plan, assuming the allocation can pass nondiscrimination testing.
|
Total Aggregate Payroll |
Maximum Deduction Limit |
Total Deduction Amount |
Liz’s Contribution Allocation* |
Remaining Deduction Amount |
|
$600,000 |
25% |
$150,000 |
$69,000 |
$81,000 |
|
* Deduction limit does not affect an individual's ability to receive contributions equaling more than 25% of their compensation. |
||||
Elective Deferrals
Elective deferrals are contributions made to a plan at the election of an employee, in lieu of receiving those amounts as cash compensation. Like cash compensation, elective deferrals are fully deductible and do not count towards the 25% maximum deduction limit for employer contributions.
Continuing the example above, Liz is over the age of 50 and defers the maximum amount of $30,500 ($23,000 + $7,500 in catch-up) into her 401(k) plan for 2024. Her $30,500 elective deferral (along with any elective deferrals by other eligible employees) does not affect the $150,000 deduction limit (600,000 x 25%) for employer contributions.
|
Total Aggregate Payroll |
Maximum Deduction Limit |
Total Deduction Amount |
Liz’s Elective Deferral |
Remaining Deduction Amount |
|
$600,000 |
25% |
$150,000 |
$30,500 |
$150,000 |
Special Rules for Self-Employed Individuals
Owner-employees of a partnership or sole proprietorship (or an LLC taxed as either) are considered “self-employed individuals” for 401(k) plan purposes. If you are a self-employed individual, your deduction limit for a given year will be based on your earned income. Earned income includes employer contributions for a particular year, but generally does not include elective deferrals. Your 401(k) provider and accountant should coordinate efforts to properly calculate earned income and your deduction limit.
Deduction Timing for 401(k) Plan Contributions
In order to take a business deduction for a given year, the contributions must be paid to the plan within a certain time. Similar to the deduction limits, different deadlines apply to employer contributions and elective deferrals.
Employer Contributions
An employer can generally deduct employer contributions made after the plan year but before the due date of the employer’s tax return, including extensions. To do so, the employer must treat the employer contribution as having been made in that plan year for allocation purposes and pay the contribution by the tax return due date even if the return has already been filed.
Going back to the example, Liz’s business is taxed as a S-Corp and has a safe harbor 401(k) plan. The safe harbor contribution for 2024 equals $18,000. For her S-Corp to deduct that contribution in 2024, it must be paid to the plan by March 15, 2025 (the tax filing deadline for S-Corps). If Liz extends the filing deadline to September 16, 2025, she has until that date to pay the contribution to the plan.
Retroactive Plan Adoption
What if no 401(k) plan existed before the end of the tax year? No problem. Similar to an IRA, you can start a plan and make deductible contributions after the tax year has ended if you act before the due date of your business’s tax return, including extensions.
Suppose that Liz’s S-Corp business did not have a 401(k) plan. For 2023, she extended her business tax filing deadline to September 15, 2024. As the deadline nears, Liz talks to her accountant about reducing her 2023 business taxable income. She is informed that she can retroactively start a plan for 2023 and deduct employer contributions for that year from her 2023 business taxable income as long as the contributions are allocated to eligible employees based on 2023 compensation and paid to the plan by September 15, 2024.
Elective Deferrals
Elective deferrals are deductible in the same tax year as the paycheck they were withheld from. Employers cannot allow retroactive deferrals based on compensation that employees have already been paid in cash - let alone take a deduction for such deferrals. When an employer withholds elective deferrals from a paycheck, they must deposit the amount into the plan as soon as possible.
Special Rules for Self-Employed Individuals
SECURE 2.0 allows certain self-employed individuals to make retroactive deferrals to a new 401(k) plan adopted after year-end. An individual who wholly owns an unincorporated business (a sole proprietor) elect to defer earned income in the prior year if:
-
- There are no other employees.
- A 401(k) plan is adopted after year-end.
- The retroactive deferrals are only made for that first plan year.
Some Basic Education Can Mean Big Tax Savings!
401(k) plans offer valuable tax benefits to both employees and employers. One of the most valuable employer benefits is the deductibility of plan contributions.
Maximizing these deductions - and optimizing your business’s bottom line – is easy when you understand their rules. They boil down to limits and timing.
