IRS Code Section 404: Deduction Limits, ESOPs, and Excess Contributions

Under IRS Code Section 404, employer plan deduction limits work on two tracks: for qualified retirement plans, the employer generally deducts contributions in the year paid but only up to a statutory ceiling; for non-qualified deferred compensation, the deduction waits until the employee actually reports the money as income. The ceiling for defined contribution plans is 25% of covered payroll. For defined benefit plans, the ceiling is set actuarially. Anything over the limit carries forward and can trigger a 10% excise tax.

Defined Contribution Plans: The 25% Ceiling

Employer contributions to profit-sharing plans, 401(k) plans, and other defined contribution arrangements share one annual cap: 25% of the total compensation paid during the year to employees covered by the plan.¹ Matching contributions, non-elective contributions, and profit-sharing contributions all count against this single ceiling.

The compensation base includes wages, salaries, and professional fees paid to covered employees, but each individual’s compensation is capped at $360,000 for 2026.² An employer with ten employees each earning $400,000 calculates the 25% limit against $3.6 million, not $4 million.

Employee elective deferrals sit outside the cap. The amounts workers redirect from their own paychecks are always deductible by the employer regardless of the 25% ceiling, but those deferrals are still counted in the compensation base used to figure the 25%.¹ Salary deferrals never lose their deduction, in other words, but they do affect how much additional employer money is deductible.

A separate rule under IRC Section 415(c) caps total annual additions to any one participant’s account at $72,000 for 2026.³ This runs independently of Section 404. An employer can stay under the 25% deduction ceiling and still violate the per-participant cap, so both need tracking.

Deposit Deadline

To deduct a contribution for a given tax year, the employer must deposit it no later than the due date of its federal income tax return, including extensions.¹ A calendar-year corporation on extension can deposit as late as October 15 of the following year and still claim the deduction on the prior year’s return. Miss that date, and the deduction moves to the year the contribution actually arrives.

Defined Benefit Plans: Actuarially Determined Limits

Defined benefit plans promise a specific benefit at retirement, so the deduction math cannot rely on a flat percentage. The maximum deductible amount depends on the plan’s funding status as calculated by an enrolled actuary.

For a single-employer plan, the deductible limit is the greater of two figures: the minimum required contribution under IRC Section 430, or the sum of the funding target, target normal cost, and a cushion amount, reduced by the current value of plan assets.¹ The minimum required contribution is the floor: enough to keep the plan on track to pay all promised benefits.⁴

The cushion amount is what gives employers room above the minimum. It equals 50% of the funding target plus an adjustment for expected future compensation or benefit increases. That headroom lets sponsors front-load contributions in profitable years and build a buffer against later investment losses or demographic shifts. Contributions above the maximum deductible amount are not deductible in the current year.

Because the calculations require projections about mortality, investment returns, and turnover, the plan’s enrolled actuary certifies the numbers annually on Schedule SB, filed with Form 5500.⁵ Without that certification, the deduction has no substantiation if challenged.

Sponsoring Both Plan Types

An employer that maintains both a defined benefit plan and a defined contribution plan covering at least one shared employee faces a combined cap. Total deductions across both plans cannot exceed the greater of 25% of covered compensation, or the amount needed to meet the defined benefit plan’s minimum funding requirement.¹ The defined benefit component of the combined limit is never less than the excess of the plan’s funding target over its current assets.

The combined cap has three practical exits. It does not apply if defined contribution plan contributions (other than employee elective deferrals) stay at or below 6% of covered aggregate compensation. It does not apply when no single employee participates in both plans. And multiemployer plan contributions are excluded from the combined calculation entirely.⁶

Non-Qualified Deferred Compensation

Non-qualified plans follow a different timing rule entirely. The employer gets no deduction when it sets money aside or promises to pay. The deduction arrives only in the tax year the employee actually includes the compensation in gross income.¹ This matching principle keeps the employer’s tax benefit and the employee’s tax cost in the same year.

For unfunded arrangements, which are just a company promise to pay later, the timing is clean: the employer deducts when it pays and the employee reports the income. Most executive deferred compensation works this way. Funded arrangements, where the employer places assets in a trust or escrow, add complexity. The deduction is available only when the employee’s rights become both vested (no longer subject to a substantial risk of forfeiture) and transferable. Until both conditions are met, the deduction stays locked even if the employer has already parted with the cash.

Non-qualified plans covering multiple employees require separate account tracking for each participant.¹ That per-participant record lets the IRS verify exactly when each employee’s deferred pay becomes taxable and, in turn, when the employer can deduct it.

Separately, IRC Section 409A governs the timing of distributions and deferral elections for these plans. Violations impose immediate income inclusion, a 20% additional tax, and interest at the underpayment rate plus one percentage point on the employee.⁷ The employer is not the taxpayer for those penalties, but a 409A failure that forces early income inclusion also accelerates the employer’s Section 404 deduction into that same year.

ESOP-Specific Rules

Employee Stock Ownership Plans get their own treatment. When an ESOP borrows to buy company stock, employer contributions used to repay loan principal are deductible up to 25% of the compensation paid to ESOP participants for the year.¹ Contributions applied to interest on that same loan are fully deductible with no percentage cap.

S corporations cannot use these special ESOP rules.¹ An S corporation sponsoring an ESOP follows the standard defined contribution rules, with the regular 25% ceiling applying to all contributions.

What Happens When You Exceed the Limit

Going over is not fatal, but it carries a cost.

For defined contribution plans, any contribution above the 25% cap carries forward and is treated as contributed in the succeeding tax year.¹ The carryover is still subject to the 25% ceiling that following year, so if the employer also makes a full deductible contribution then, the excess keeps rolling. Defined benefit plan excesses carry forward the same way.

A nondeductible contribution to a qualified plan also triggers a 10% excise tax under IRC Section 4972.⁸ The employer pays it on the total nondeductible amount at year-end, and prior-year nondeductible amounts that have not yet been deducted or returned keep accumulating in the base. Left unresolved, the tax compounds year after year. The employer reports and pays it on Form 5330, due by the last day of the seventh month after the end of its tax year.⁹

Employers that catch contribution errors can correct them through the IRS Employee Plans Compliance Resolution System, which offers a self-correction path for smaller failures, a voluntary correction program requiring IRS approval for larger ones, and an audit-based track for problems surfaced during examination.¹⁰ Fixing an error before an audit costs significantly less than waiting for one to expose it.

Underfunding a Defined Benefit Plan

The opposite problem, contributing too little to a defined benefit plan, also carries a penalty. Missing the minimum funding standard under Section 430 triggers a two-tier tax under IRC Section 4971. The first tier is 10% of the aggregate unpaid minimum required contributions for all plan years unpaid at year-end. If the shortfall is not corrected within the taxable period, a second tier of 100% of the unpaid amount applies.¹¹ The second tier is calibrated to make funding the plan cheaper than paying the penalty.

Self-Employed Contributions

Section 404 also governs deductions for the plan contributions self-employed individuals make for themselves. The 25% ceiling applies, but the base is net earnings from self-employment reduced by both the contribution itself and the deductible portion of self-employment tax. The effective limit works out to roughly 20% of net self-employment income before the plan deduction.

The deduction goes on Schedule 1 of Form 1040, line 16, as an adjustment to gross income rather than as a Schedule C business expense.¹² It reduces adjusted gross income but not self-employment income, so it does not lower the self-employment tax.

Foreign Plans Are Governed Separately

Contributions to foreign deferred compensation plans do not fall under Section 404. They are deductible only under IRC Section 404A, which imposes comparability and nondiscrimination standards roughly mirroring those for domestic qualified plans.¹³ Employers with overseas operations and employees covered by local retirement arrangements need to test those plans against 404A to preserve the deduction.

1
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
2
Internal Revenue Service. COLA Increases for Dollar Limitations on Benefits and Contributions
3
Internal Revenue Service. 2026 Amounts Relating to Retirement Plans and IRAs, as Adjusted for Changes in Cost-of-Living
4
Office of the Law Revision Counsel. 26 USC 430 – Minimum Funding Standards for Single-Employer Defined Benefit Pension Plans
5
U.S. Department of Labor. Single-Employer Defined Benefit Plan Actuarial Information
6
Internal Revenue Service. Combined Limits Under IRC Section 404(a)(7)
7
Office of the Law Revision Counsel. 26 USC 409A – Inclusion in Gross Income of Deferred Compensation Under Nonqualified Deferred Compensation Plans
8
Office of the Law Revision Counsel. 26 USC 4972 – Tax on Nondeductible Contributions to Qualified Employer Plans
9
Internal Revenue Service. Form 5330 – Return of Excise Taxes Related to Employee Benefit Plans
10
Internal Revenue Service. Updated IRS Correction Principles and Changes to VCP Outlined in EPCRS Revenue Procedure 2021-30
11
Office of the Law Revision Counsel. 26 USC 4971 – Taxes on Failure to Meet Minimum Funding Standards
12
Internal Revenue Service. Schedule 1 (Form 1040) – Additional Income and Adjustments to Income
13
Office of the Law Revision Counsel. 26 USC 404A – Deduction for Certain Foreign Deferred Compensation Plans