IRC Section 404: Employer Deduction Limits for DC, DB, and ESOP Plans

Under IRC Section 404, an employer’s deduction for contributions to retirement and deferred compensation plans is capped: 25% of participant compensation for defined contribution plans like 401(k)s and SEP-IRAs, an actuarially calculated amount for defined benefit plans, and a matching-year rule for non-qualified deferred compensation. Contributions above the limit carry forward to later years, but any nondeductible amount still in the plan at year end triggers a 10% excise tax under Section 4972.¹

Two Threshold Conditions Every Contribution Must Meet

Before any percentage or dollar cap comes into play, the contribution has to clear two gates. It must qualify as an ordinary and necessary business expense under Section 162, meaning it represents reasonable compensation for services the employees actually performed.² An inflated contribution untethered from the value of services rendered fails this test.

The second gate is timing. Section 404 allows the deduction only in the year the contribution is actually paid to the plan, whether the employer uses cash or accrual accounting.³ Booking an accrual on December 31 and funding months later does not preserve the current-year deduction.

One exception matters in practice. A contribution made after the taxable year ends is treated as paid on the last day of the prior year if the employer allocates it to that prior year for plan purposes and the money reaches the trust no later than the tax return due date, including extensions.⁴ For a calendar-year filer on extension, that deadline can run to October 15 of the following year.

The 25% Limit for Defined Contribution Plans

For 401(k) plans, profit-sharing plans, stock bonus plans, and SEP-IRAs, the employer’s deduction cannot exceed 25% of the total compensation paid or accrued during the taxable year to all employees participating in the plan.³ The cap is an aggregate one, covering employer matching contributions, non-elective contributions, and profit-sharing allocations across every defined contribution plan the employer maintains for the same group.

How Compensation Is Measured

The compensation base generally tracks the Section 415 definition, covering wages, salary, bonuses, and other earned income. For 2026, the maximum compensation counted for any single participant is $360,000.⁵ Anything above that is ignored when running the 25% math. Separately, total annual additions to a single participant’s account, including all employer contributions, employee contributions, and forfeitures, cannot exceed $72,000 for 2026 under Section 415(c).⁶

Where Elective Deferrals Fit In

This is where employers commonly miscalculate. Employee elective deferrals, the salary-reduction amounts employees put into their 401(k), do not count against the 25% deduction limit. Section 404(n) excludes them from the deduction caps and from the calculation of remaining room for other contributions.³ At the same time, elective deferrals stay in the compensation base used to compute the 25% limit. The effect: they enlarge the pool that drives the cap without eating into it.

How the Deduction Works for Defined Benefit Plans

Defined benefit plans do not use the clean percentage formula. Under Section 404(o), the maximum deductible contribution is an actuarially driven figure that changes every year with the plan’s funding status. It equals the greater of two amounts, and a qualified actuary must certify the calculation using IRS-mandated interest rates and mortality tables.³

Minimum Required Contribution

The first amount is the plan’s minimum required contribution under Section 430. When plan assets fall short of the funding target, the MRC equals the target normal cost for the year plus shortfall amortization charges and waiver amortization charges.⁷ When assets meet or exceed the target, the MRC is the target normal cost reduced by the surplus. The employer can always deduct at least this amount, so funding requirements never collide with deduction limits.

Funding Target Plus Cushion

The second amount lets the employer accelerate funding. It equals the funding target, plus the target normal cost for the year, plus a cushion amount, minus the current value of plan assets. The cushion is 50% of the funding target plus expected increases in benefits or compensation for future plan years. This gives the employer room to build a buffer against later downturns without losing the deduction. The larger of the two figures is what the employer deducts. Anything contributed above that is nondeductible and potentially exposed to excise tax.

The maximum annual benefit a defined benefit plan can pay any single participant in 2026 is $290,000 under Section 415(b).⁶ That per-participant cap indirectly restrains deductible contributions by limiting how large the plan’s obligations can grow.

When One Employer Sponsors Both Plan Types

An employer running a defined benefit plan and a defined contribution plan that share at least one common employee runs into Section 404(a)(7), the combined-plan rule. Without it, an employer could stack full deductions from each plan and shelter a disproportionate share of income.

The combined deduction limit is the greater of:⁸

25% of the total compensation paid or accrued during the year to all participants in either plan, or
The DB plan’s minimum funding amount, meaning the greater of the MRC under Section 430 or the excess of the funding target over plan assets.

In practice, contributions needed to keep the defined benefit plan properly funded stay deductible even when they push the total above 25%. Whatever room remains after accounting for the DB minimum goes to the defined contribution plan.

The PBGC-Insured Plan Carve-Out

A large exception removes the combined limit for most private-sector sponsors. Any single-employer defined benefit plan covered by the Pension Benefit Guaranty Corporation, which includes most private-sector DB plans, is excluded from the combined limit calculation.³ Multiemployer plans are excluded on the same basis. When the DB plan is outside the combined calculation, the employer deducts up to the full Section 404(o) amount for the DB plan and the full 25% of compensation for the DC plan independently.

Employers whose DB plan is not PBGC-insured, typically smaller professional service firms and church plans, are stuck with the combined limit in full. In that case, DC plan contributions above 6% of DC plan participant compensation count toward the 25% combined cap.

Self-Employed Contribution Calculation

Self-employed individuals contributing to their own SEP-IRA, solo 401(k), or other qualified plan face a wrinkle that regular employers do not: the deduction itself reduces the income figure the deduction is based on. The IRS resolves that circularity through a reduced contribution rate.⁹

Start with net earnings from self-employment on Schedule C or Schedule K-1. Subtract the deductible portion of self-employment tax. The result would be “plan compensation,” but the contribution has to come out of that figure too. To break the loop, divide the plan’s contribution rate by one plus that rate: a 25% rate becomes 20% (0.25 ÷ 1.25).¹⁰ Apply that reduced rate to net earnings after the SE tax deduction; the result is the maximum deductible contribution for your own account. The same $360,000 compensation cap and $72,000 annual addition limit apply. Publication 560 includes worksheets and a rate table for common contribution percentages.

ESOP Dividends Under Section 404(k)

C corporations sponsoring an Employee Stock Ownership Plan get a deduction that sits outside the normal Section 404(a) limits. Under Section 404(k), certain dividends paid on employer stock held by the plan are separately deductible in addition to the regular contribution deduction.¹¹

The deduction covers dividends that are:

Paid in cash directly to participants or their beneficiaries.
Paid to the ESOP and distributed in cash to participants within 90 days of the plan year’s close.
Reinvested in employer stock at the participant’s election.
Used to repay loans the ESOP took out to acquire employer securities.

The dividends must be reasonable, and the IRS can disallow the deduction where dividends look structured to avoid taxation rather than benefit participants. S corporations cannot claim this deduction because they do not pay corporate-level income tax.

Non-Qualified Deferred Compensation Follows a Different Rule

Deduction rules for non-qualified deferred compensation plans work on a different principle. The employer’s deduction is allowed only in the year the compensation is included in the employee’s gross income, not when the employer sets money aside or makes a promise to pay.³ This matching rule blocks employers from claiming a current deduction for compensation the employee will not report as income for years.

For unfunded NQDC arrangements, which is what most top-hat plans and deferred bonus programs are, the employer deducts when the benefit is actually paid out. For funded arrangements where the employer contributes to a trust, the deduction is available when the employee’s interest vests and becomes taxable. Either way, the benefit must no longer be subject to a substantial risk of forfeiture. Plans covering multiple employees require separate accounts tracking each individual’s accrued benefit, vesting status, and distribution timing.

Going Over the Limit: Carryovers and the Excise Tax

Contributions above the applicable deduction limit are not lost. They carry forward to future years and can be deducted then, subject to the future year’s limit, taken in chronological order with the earliest excess absorbed first.¹¹ For defined contribution and combined plans, the carryforward deduction plus the current-year deduction together still cannot exceed 25% of that year’s compensation.

The 10% Excise Tax on Nondeductible Amounts

Waiting for the carryforward to work through has a cost. Any nondeductible contribution still in the plan at the end of the employer’s taxable year triggers a 10% excise tax under Section 4972.¹ The tax is assessed annually on the cumulative nondeductible amount until it is absorbed by future deduction limits or returned to the employer. It is reported and paid on IRS Form 5330.¹²

Election to Exclude DB Contributions

Defined benefit plans get meaningful relief here. An employer can elect to exclude DB plan contributions from the nondeductible calculation entirely, except for multiemployer plans whose contributions exceed the full-funding limitation.¹ With the election, the 10% excise tax reaches only the excess in the defined contribution plan. When the election is made, the combined-plan deduction limits are applied first to DC plan contributions before any DB plan amounts.

1
Office of the Law Revision Counsel. 26 U.S. Code 4972 – Tax on Nondeductible Contributions to Qualified Employer Plans
2
Office of the Law Revision Counsel. 26 U.S. Code 162 – Trade or Business Expenses
3
Office of the Law Revision Counsel. 26 U.S. Code 404 – Deduction for Contributions of an Employer to an Employees Trust or Annuity Plan and Compensation Under a Deferred-Payment Plan
4
Internal Revenue Service. Issue Snapshot – Deductibility of Employer Contributions to a 401(k) Plan Made After the End of the Tax Year
5
Internal Revenue Service. COLA Increases for Dollar Limitations on Benefits and Contributions
6
Office of the Law Revision Counsel. 26 U.S. Code 415 – Limitations on Benefits and Contribution Under Qualified Plans
7
Office of the Law Revision Counsel. 26 U.S. Code 430 – Minimum Funding Standards for Single-Employer Defined Benefit Pension Plans
8
Internal Revenue Service. Combined Limits Under IRC Section 404(a)(7)
9
Internal Revenue Service. Self-Employed Individuals – Calculating Your Own Retirement Plan Contribution and Deduction
10
Internal Revenue Service. Publication 560 – Retirement Plans for Small Business
11
Office of the Law Revision Counsel. 26 USC 404 – Deduction for Contributions of an Employer to an Employees Trust or Annuity Plan and Compensation Under a Deferred-Payment Plan
12
Internal Revenue Service. Form 5330 Corner