Internal Revenue Code 401(a)(17): The Compensation Limit

Internal Revenue Code Section 401(a)(17) sets a maximum limit on the amount of an employee’s annual earnings that can be considered for retirement plan purposes. This regulation is designed to prevent tax-advantaged retirement plans from providing a disproportionate share of benefits to the highest-paid individuals within a company. By capping the compensation used in benefit calculations, the rule promotes a more equitable distribution of retirement contributions and benefits across the entire workforce.

The Annual Compensation Limit

For 2025, the Internal Revenue Service (IRS) has set the maximum compensation for retirement plan calculations at $350,000, an increase from the $345,000 limit in 2024. The IRS is required by law to review this limit annually and adjust it for cost-of-living increases to keep pace with inflation. These adjustments are announced in the fall for the upcoming calendar year.

This compensation cap must be applied to a wide array of tax-qualified retirement plans to maintain their status. These plans include:

• Defined contribution plans like 401(k)s, 403(b)s, and profit-sharing plans
• Defined benefit pension plans
• Simplified Employee Pension (SEP) IRAs

Defining “Compensation” for the Limit

While the IRS sets the annual limit, the specific types of pay that count toward it are defined within the plan’s legal document. The plan document must clearly state which definition of compensation it uses. This chosen definition must be applied uniformly to all participants for all plan purposes.

Plans commonly adopt one of several standard, IRS-approved “safe harbor” definitions. The most frequent is W-2 compensation, which includes the total wages, tips, and other compensation reported in Box 1 of an employee’s Form W-2. Another common choice is Section 3401(a) wages, which covers all payment for services performed by an employee.

A third option is Section 415 safe harbor compensation, a more expansive definition that adds back certain pre-tax salary deferrals, such as those to a 401(k) or cafeteria plan. Regardless of the base definition, plans usually include salary, wages, overtime, commissions, and bonuses. Depending on the plan’s terms, items like taxable fringe benefits, expense reimbursements, or deferred compensation might be excluded.

Application of the Limit in Plan Operations

The practical effect of the 401(a)(17) limit is to constrain the compensation base used for determining both employee and employer contributions. This ensures that calculations for all employees, regardless of their total pay, are performed on a level playing field up to the established annual cap.

Consider an employee with an annual salary of $450,000 who elects to defer 5% of their pay into a 401(k) plan. For 2025, the plan can only recognize the first $350,000 of that individual’s salary. The employee’s contribution is therefore 5% of the $350,000 limit ($17,500), not 5% of their full $450,000 salary.

This same principle applies to employer contributions. If the company provides a 100% match on the first 4% of employee deferrals, the match for this employee would be based on the capped compensation, totaling $14,000 (4% of $350,000). Similarly, a 3% profit-sharing contribution would be $10,500, which is 3% of the $350,000 limit.

The compensation limit is a factor in the annual nondiscrimination testing required of most 401(k) plans. Tests like the Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) compare the contribution rates of highly compensated employees (HCEs) to those of non-highly compensated employees (NHCEs). For testing purposes, the compensation of any HCE earning above the annual cap is reduced to the 401(a)(17) limit, preventing skewed results.

Special Considerations and Compliance

The compensation limit must be prorated for a short plan year—a plan year of fewer than 12 months, such as when a plan is first created or terminated. For an employee who participates for only a portion of a full 12-month plan year, like a new hire, the full annual limit applies.

Failing to correctly apply the compensation limit is an operational error that can jeopardize a plan’s tax-qualified status. An IRS discovery of such a mistake during an audit could lead to consequences like plan disqualification. The IRS provides correction programs, such as the Employee Plans Compliance Resolution System (EPCRS), allowing plan sponsors to voluntarily correct these errors, restore compliance, and avoid the most severe penalties.