IRC 404: Employer Contribution Rules and Tax Deduction Limits

Employers offering retirement benefits must follow tax rules to ensure contributions are deductible and compliant with IRS regulations. Internal Revenue Code (IRC) Section 404 governs these deductions, setting limits on how much an employer can contribute. Understanding these rules helps businesses maximize deductions while staying within legal boundaries.

Employers must consider the types of retirement plans, deduction limits, timing requirements, and how IRC 404 interacts with other tax provisions.

Types of Employer Contributions

Employers contribute to retirement plans through defined contribution plans, defined benefit plans, and nonqualified plans. Each has different tax implications under IRC Section 404.

Defined Contribution Plans

A defined contribution plan creates individual accounts for employees, with contributions from the employer, employee, or both. Common examples include 401(k) plans, profit-sharing plans, and money purchase pension plans. Employer contributions may be based on a percentage of salary or a fixed formula, and the final benefit depends on investment performance.

Employers often match employee contributions, such as 50% of the first 6% of salary contributed. Contributions are subject to annual IRS limits. In 2024, the total contribution limit, including employer and employee contributions, is $69,000 ($76,500 for employees aged 50 and older with catch-up contributions). These plans offer tax benefits—employers can deduct contributions within limits, and employees enjoy tax-deferred growth.

To ensure fairness, plans must pass nondiscrimination testing, such as the Actual Deferral Percentage (ADP) test. If they fail, corrective distributions or additional contributions may be necessary.

Defined Benefit Plans

A defined benefit plan guarantees employees a specific retirement benefit based on years of service and salary history. Employers fund these plans based on actuarial calculations to ensure sufficient assets for future obligations.

Funding requirements are determined by actuarial valuations, considering factors like retirement age, life expectancy, and investment returns. Employers must meet minimum funding standards under the Employee Retirement Income Security Act (ERISA) to prevent underfunding. If a plan falls short, additional contributions may be required, and penalties can apply.

These plans are insured by the Pension Benefit Guaranty Corporation (PBGC), which provides a safety net in case of plan termination, though coverage limits apply. Defined benefit plans are often used by businesses seeking substantial tax deductions, as contribution limits are generally higher than those for defined contribution plans. Deductible contributions must comply with IRS guidelines based on actuarial assumptions.

Nonqualified Plans

Nonqualified retirement plans do not have to meet the same regulatory requirements as qualified plans, offering greater flexibility. They are often used to provide deferred compensation for executives and key employees beyond qualified plan limits. Examples include Supplemental Executive Retirement Plans (SERPs) and deferred compensation arrangements under IRC Section 409A.

Unlike qualified plans, employer contributions to nonqualified plans are not immediately deductible. Deductions are taken when the employee receives the benefit, aligning with the timing of taxable income recognition. Employers typically fund these plans through general assets or rabbi trusts, which provide some security but remain subject to company creditors in bankruptcy.

Because these plans are not subject to contribution limits or nondiscrimination rules, they are often structured to attract top talent. However, they must comply with strict deferral election rules and distribution restrictions to avoid penalties. Failure to meet Section 409A requirements can result in immediate taxation, a 20% penalty, and interest charges.

Deduction Limits

Employers must adhere to IRS deduction limits under IRC Section 404. These limits vary based on the type of plan and contribution structure.

For defined contribution plans, deductible employer contributions cannot exceed 25% of the total compensation paid to eligible employees. Compensation is capped at $345,000 per employee for 2024, which may limit contributions for highly paid employees.

For defined benefit plans, deduction limits depend on actuarial calculations rather than a fixed percentage of compensation. Employers can deduct contributions necessary to meet funding requirements. Contributions exceeding these amounts may be subject to excise taxes. Special rules apply to plans covering a single participant, where deductions are tied to projected benefits.

Employers sponsoring both defined contribution and defined benefit plans must consider deduction limits. Generally, total deductions are capped at the greater of 25% of compensation or the required contribution for the defined benefit plan. However, if the defined contribution plan consists solely of elective deferrals, this combined limit does not apply, allowing greater flexibility.

Timing Requirements

Employers must time retirement plan contributions correctly to qualify for deductions in the intended tax year. Contributions must generally be made by the due date of the employer’s tax return, including extensions. For calendar-year corporations, 2024 contributions must be deposited by October 15, 2025, if an extension is filed. Partnerships and sole proprietorships follow similar deadlines.

Cash method taxpayers deduct contributions in the year payments are made, while accrual method taxpayers may deduct contributions in the year accrued, provided they are paid by the tax return deadline. This distinction is important for businesses using accrual accounting, as they can accelerate deductions by making contributions after year-end but before filing. Proper documentation of accrued liabilities is needed to support deductions if audited.

Late contributions can result in lost deductions for the intended tax year, requiring financial statement adjustments and potentially increasing taxable income. SIMPLE IRAs and SEP IRAs have specific deposit deadlines that differ from traditional pension plans. Missing deadlines can lead to penalties or disqualification of tax benefits. Employers should coordinate with financial institutions and plan administrators to ensure timely deposits, particularly for profit-sharing or discretionary contributions.

Interaction With Other Tax Sections

IRC Section 404 interacts with multiple tax provisions that affect how businesses structure and report retirement contributions. One key connection is with Section 162, which governs the deductibility of ordinary and necessary business expenses. While employer contributions to qualified plans fall under Section 404, other compensation-related expenses—such as nonqualified deferred compensation—may be subject to Section 162, affecting when and how deductions are claimed. Employers must distinguish between these provisions to avoid misclassification and IRS scrutiny.

Another interaction occurs with IRC Section 280G, which addresses golden parachute payments. If an employer provides large retirement contributions as part of a severance or change-in-control package, Section 280G may limit deductions and trigger a 20% excise tax on the recipient. Employers structuring executive compensation packages should evaluate how retirement benefits fit within broader compensation strategies to mitigate tax liabilities.