The Annual Compensation Limit refers to the maximum annual salary that is considered for determining an employee's allocation of employer contributions, their own deferrals, and voluntary after-tax contributions in a 401(k) plan. This limit is set by the IRS and is adjusted each year and helps ensure that contributions made to your 401(k) plan are appropriately calculated based on the IRS guidelines.
For the year 2022, the Annual Compensation Limit is $305,000. This means that any portion of your salary above this limit is not taken into account for calculating contributions under the plan.
Let's consider an example to better understand how it works:
Suppose you earn $1,000,000 in 2022, and your company's 401(k) plan provides a match of 100% of employee deferrals up to a maximum of 5% of compensation. In this case, the company matching contributions will be capped at $15,250 (5% x $305,000), rather than $50,000 (5% x $1,000,000). The remaining $695,000 of your 2022 compensation is not considered for any purpose under the plan.