What Are the IRC 415(b) Limitation Rules?

Internal Revenue Code (IRC) Section 415 establishes limits on the contributions and benefits for a participant under a qualified retirement plan. While Section 415 covers both defined contribution plans and defined benefit plans, often called traditional pensions, the regulations for each are distinct. The specific rules under IRC Section 415(b) apply exclusively to defined benefit plans. These plans promise a specific benefit to an employee at retirement, typically calculated based on factors like salary and years of service, and the 415(b) limitations impose a ceiling on the maximum annual pension a retiree can receive.

The Core Limitation Rules

The maximum annual benefit a participant can receive from a defined benefit plan is governed by a dual-test system under IRC Section 415(b). A retiree’s benefit is restricted to the lesser of two distinct limits: a specific dollar amount set by the federal government or a percentage of the participant’s earnings.

The first part of the test is an absolute dollar limit, which is adjusted annually for inflation by the Internal Revenue Service (IRS). For 2025, the maximum annual benefit is $280,000. The second part of the test limits the annual benefit to 100% of the participant’s average compensation for their highest three consecutive years of earnings. This compensation-based limit is often the constraining factor for individuals with more moderate earnings over their careers.

Consider a highly compensated executive whose plan formula calculates an annual pension of $300,000 and whose high-three average salary was $400,000. Although their benefit is less than their average compensation, it exceeds the 2025 dollar limit of $280,000. Therefore, their maximum permissible annual benefit would be capped at $280,000.

Conversely, imagine a long-serving employee whose plan formula yields an annual pension of $90,000. If their highest three-year average compensation was $85,000, their benefit would be limited by this compensation figure. Even though $90,000 is well below the $280,000 dollar limit, the 100% of compensation rule applies, and their maximum annual benefit is restricted to $85,000.

Adjustments to the Annual Benefit Limit

The absolute dollar limit established under Section 415(b) is not a static figure for every individual; it serves as a baseline that is adjusted based on several factors. These adjustments tailor the limit to the specific circumstances of the retiree, primarily their retirement age and their length of service with the employer sponsoring the plan.

An adjustment is based on the age at which a participant begins receiving their pension benefits. If benefits commence before the participant reaches their Social Security normal retirement age (currently between 66 and 67 for most workers), the $280,000 dollar limit is actuarially reduced. Conversely, if a participant delays retirement and begins receiving benefits after their Social Security retirement age, the dollar limit is actuarially increased.

A modification is tied to the participant’s years of service and participation in the plan. The dollar limit is phased in over a 10-year period. A participant must have at least 10 years of plan participation for the full dollar limit to apply. For each year of participation less than 10, the limit is reduced by 10%. For example, a participant with only seven years of participation would be subject to 70% of the full dollar limit. A similar 10-year phase-in rule applies to the compensation limit based on years of service.

Finally, the IRS implements cost-of-living adjustments (COLAs) to the dollar limit itself. As mandated by IRC Section 415(d), the agency reviews the limit annually and increases it to keep pace with inflation. For instance, the limit was increased from $275,000 in 2024 to $280,000 in 2025 to reflect economic changes.

Calculating the Participant’s Average Compensation

The second prong of the Section 415(b) limitation, the compensation test, requires a precise calculation of a participant’s earnings. This is not based on a simple salary figure from a single year but on an average over a specific period.

For the purposes of this rule, “compensation” is specifically defined in Treasury regulations under Section 415. It generally includes wages, salaries, and fees for professional services. It typically encompasses bonuses and overtime but excludes certain items like employer contributions to a plan of deferred compensation, distributions from a pension plan, and other forms of non-taxable income.

The calculation itself uses the participant’s average compensation for the three consecutive calendar years during which they had the highest aggregate earnings from the employer. This is often referred to as the “high-three” average. For example, if an employee’s highest compensation was earned in 2022 ($80,000), 2023 ($85,000), and 2024 ($90,000), their high-three average would be $85,000.

Consequences of Exceeding the Limit

If the IRS determines that a defined benefit plan has violated the IRC Section 415(b) limitations, it can lead to plan disqualification. This outcome affects both the employer sponsoring the plan and every participant.

Should a plan be disqualified, the trust holding the plan’s assets would lose its tax-exempt status, and its earnings would become taxable. Employer deductions for contributions to the plan could be deferred or lost entirely. For participants, the value of their vested accrued benefits could become immediately taxable as ordinary income, even if they have not yet retired or received any payments.

Defined benefit plan documents are almost universally drafted to prevent such violations from occurring. These legal documents contain specific language that automatically restricts or caps a participant’s accrued benefit to ensure it complies with the Section 415(b) limits as they exist in any given year. This built-in safeguard prevents the plan from promising or paying a benefit that would jeopardize its qualified status, making actual disqualifications for this reason rare.