Limits on Contributions or Benefits

Favorable tax treatment gives employees a strong incentive either to receive compensation that they plan on saving for retirement in the form of contributions to pension or profit-sharing plans or to contribute as much of that amount as possible to an IRA. High-income employees have the resources to save a larger share of their income than do low- and middle-income employees; hence, they are in a position to claim a larger share of overall tax advantages than the share of taxes they pay in the first place. Although nondiscrimination rules are designed to extend more of those advantages to low- and middle-income workers, even a "nondiscriminatory" benefits formula could result in large losses of revenue for the government if the wealthy were allowed to contribute without limit. To constrain the tax advantages received by the highest-income individuals and the associated losses of revenue, the Congress has enacted several limits on contributions and benefits. Some of those limits apply to all qualified plans; some apply only to plans that accept tax-deferred contributions by employees; and others apply only to IRAs.

Limits on Qualified Plans in General

Three limits on contributions and on benefits that may be funded by qualified contributions apply to all qualified plans. All three limits, which are discussed below, increased in 2002 because of provisions in EGTRRA and have been indexed for inflation since then. Indexing causes the limits to increase whenever the act of applying the rate of inflation to a base year (2002 in this case) results in a change greater than a certain increment. The following amounts represent indexed values in 2006, along with the corresponding indexing increments:

• No more than $210,000 of compensation may be taken into account when calculating allowable contributions or benefits. That amount is indexed for inflation in increments of $5,000. (Before EGTRRA, the limit was $170,000 and indexed in $10,000 increments.)



• "Annual additions" to all of an employee's defined-contribution plans cannot exceed the lesser of 100 percent of compensation or $42,000. That amount is indexed for inflation in increments of $1,000. Annual additions consist of contributions by employers and employees (the latter also being subject to limits, as described below), as well as amounts that are redistributed from the forfeited accounts of unvested participants who have left the plan. (Before EGTRRA, the limit was the lesser of 25 percent of compensation or $35,000, with the dollar limit indexed in $5,000 increments.)



• The normal benefit funded by a defined-benefit plan may not exceed the lesser of 100 percent of the average for the three consecutive years of highest compensation or $170,000. (Before EGTRRA, the dollar limit was $140,000.) The dollar limit is indexed for inflation in increments of $5,000.

Regardless of the allowable contribution on behalf of any given participant, an employer can deduct no more than 25 percent of total employee compensation as pension or profit-sharing contributions. Among other things, that restriction effectively prevents employers from simultaneously offering the maximum benefits through both defined-benefit and defined-contribution plans.⁽¹⁾ (Before EGTRRA, most defined-contribution plans were subject to an even more restrictive limit on deductions--15 percent of compensation.)

Limits on Tax-Deferred Employee Contributions

In addition to the limits on overall contributions, separate dollar limits apply to employees' discretionary contributions to most types of defined-contribution plan. (SEPs are the exception; they are not subject to a separate dollar limit, but are subject to a limit of 15 percent of compensation instead of the limit--100 percent of compensation--that applies to other defined-contribution plans.) EGTRRA increased those limits, phasing in hikes in $1,000 increments over five years and thereafter--that is, beginning is 2007--indexing them for inflation in $500 increments. EGTRRA also introduced "catch-up" contributions, which effectively raise the limits for contributors ages 50 and older. The table below summarizes the limits in 2001, before the enactment of EGTRRA, and in 2002 and 2006, one year and five years respectively, after the law took effect.

Maximum Annual Employee Contributions (In dollars)