The pension can see your W-2. It cannot see the distribution.

An S corporation owner will often describe the year in one number. The practice cleared six hundred thousand dollars, or the consulting firm had its best March, or the draw has been steady since January. That number is useful for the household and for the bank. It is usually the wrong number for a retirement plan. A qualified plan does not read the K-1 the way a shareholder does. For a shareholder who works in the business, the plan is built on wages. Distributions, however large and however well earned, are not compensation the formula can use.

That distinction is the whole briefing. If the wage is thin and the distribution is thick, the illustration will come back smaller than the conversation that produced it. The actuary did not miss the profit. The document is not allowed to pretend the profit was pay. Sterling Pension Group sees this at the start of almost every S corporation design, and it is cheaper to settle it in March than to discover it in December, after payroll for the year is already closed.

What the plan is allowed to count

An owner who works for an S corporation is paid in two different ways. Wages are paid through payroll, reported on Form W-2, and subject to employment tax. Distributions are a return of already-taxed earnings, generally not subject to employment tax, and reported to the shareholder on Schedule K-1. Both can be legitimate. Only one of them is plan compensation.

For a shareholder-employee, compensation for a qualified plan is the pay the plan document defines, which in practice means W-2 wages, adjusted the way the document says to adjust them. Typical adjustments are small: elective deferrals that were excluded from the W-2 box the payroll report shows, certain pre-tax benefits, or a car allowance the definition does not treat as pay. They are not an invitation to add the distribution. The Ninth Circuit and the IRS have both refused the idea that an S corporation dividend can be restated as pension compensation because the owner would have preferred it that way. Reasonable compensation is a separate duty. Officers who perform services are supposed to take wages for those services. A plan does not repair a wage that was set too low, and a wage that was set only to minimize employment tax will cap the retirement plan at the same time.

This is not a cash balance quirk. It is the same rule for a defined benefit plan, a cash balance plan, a profit-sharing contribution, and the elective deferral in a 401(k). The deferral has to come out of wages. There is no mechanism to defer a percentage of a distribution. If payroll has already been run at a token salary, there is nothing left in the year to defer from unless you actually pay more wages.

Partners in a partnership are different, and law firms that are true partnerships should not borrow this rule by accident. A partner's earned income is a self-employment figure, not a W-2. This briefing is about the S corporation, including the professional corporation that elected S status. If you are unsure which one you are, look at whether you received a W-2 from the practice last year. That piece of paper is the plan's starting point. The comparison of SEP, 401(k), and pension designs is worth reading only after that starting point is honest.

The 2025 dollar limits, and what they are not

The limits in force for 2025 were announced in IRS news release IR-2024-285 on November 1, 2024. They are also collected on the IRS page of cost-of-living adjustments for retirement plans. None of them converts a distribution into wages.

The elective deferral limit is $23,500. A participant who is age 50 or older, and who is not using the higher band below, may also make a catch-up contribution of $7,500. A participant who attains age 60, 61, 62, or 63 during 2025 may instead make a catch-up of $11,250. That higher figure replaces the $7,500. It is not added on top of it. Catch-up contributions generally sit outside the annual additions limit. The annual additions limit itself, the ceiling on employer and employee contributions other than catch-up, is $70,000. An individual retirement account is a separate personal account, with a 2025 limit of $7,000, and it is not a way to pour the S corporation distribution into a qualified plan.

Two further limits matter more to an owner than the deferral figure. The compensation that a plan may take into account under section 401(a)(17) is capped at $350,000. Wages above that cap do not increase the benefit formula, the allocation, or the deduction arithmetic that depends on capped pay. And the defined benefit limit under section 415(b) is a maximum annual benefit of $280,000, not a maximum deposit. The IRS explains the shape of that benefit limit, including reductions when payments start early or participation is short, on its page for defined benefit plan benefit limits. A contribution illustration that is larger or smaller than $280,000 can still be inside the law. The benefit, once converted to the form the statute measures, is what is capped.

Publication 560 is the IRS primer for small-business retirement plans. It is worth handing to a bookkeeper who has been told, incorrectly, that "the owner's total income" is the input. It will not design the plan. It will stop the wrong number from being typed into the census.

An illustration is not a ceiling, and a distribution is not pay

Consider two owners, both of S corporations, both describing a very good year. These figures are illustrative. They are not IRS maximums, not quotes, and not results for any client.

The first owner expects about $180,000 of W-2 wages and about $400,000 of distributions. The plan can see $180,000, subject to the document's definition. It cannot see $580,000. A defined contribution allocation generally cannot exceed 100 percent of compensation, and the $70,000 annual additions limit is a further ceiling, not a promise that $70,000 will fit on top of a thin wage. Elective deferrals consume part of that $180,000 and part of the $70,000. A cash balance or defined benefit credit still has to be supportable by the wage, by the benefit limit, and by the deduction rules your CPA applies. The large distribution may be the point of the S election. It is not pensionable compensation.

The second owner expects W-2 wages at or above the $350,000 cap, with additional profit distributed. The plan stops at $350,000 even if the W-2 is higher. That owner has given the formula the maximum compensation the statute allows it to see. Age, the benefit form, years of participation, and the staff census will decide what an illustration shows. The distribution still does not enter the formula. What changes is that the wage is no longer the constraint. Something else is: the benefit limit, the staff cost required to pass testing, or simply the cash the company can commit.

Owners sometimes ask whether a year-end bonus can repair a low wage. A bonus that is actually paid as wages, run through payroll, and included in the plan's compensation definition can raise the W-2. A bonus that is booked as a distribution cannot. The repair has to happen in the payroll system, in time for the deposits and the tax forms to match the census. Calling a December transfer a bonus in an email does not make it wages.

A related mistake is to treat last year's W-2 as this year's fact. If you raised the salary in January, the illustration should use the new run rate. If you cut it, the illustration should use the cut. Illustrative contributions on a stale wage are fiction, even when the arithmetic inside them is careful. The 2025 limits do not move to meet a disappointing W-2.

Why the wage decision belongs in the same meeting as the plan

Shareholder-employees often set the wage with only employment tax in view. A lower wage means less Social Security and Medicare tax, up to the point where the wage stops being reasonable for the work. That trade is real, and it is a CPA question, not a third-party administrator's question. The retirement plan changes the trade. Every dollar of wage you decline to pay is a dollar the pension cannot use. A defined benefit or cash balance contribution that would have been deductible against the practice can be larger than the employment tax you saved by keeping the wage down. Sometimes it is not. The only way to know is to put the projected W-2, not the projected "take-home," in front of the actuary and the CPA at the same time.

There is a floor as well as a ceiling. Compensation has to be reasonable for the services. A salary inflated in December solely to justify a pension contribution, with no relationship to the work, is not a planning technique. It is a problem for the employment-tax rules and for the plan. The same is true in the other direction: a token salary paid to someone who generates the firm's revenue is the fact pattern the IRS describes when it talks about S corporation officers recharacterizing wages as distributions. The plan briefing cannot tell you the reasonable number. It can tell you that the number you and your CPA defend is the number the plan will be forced to live with.

Self-employed owners who are not S corporation shareholders should not import this anxiety unchanged. A sole proprietor does not have a W-2 from the practice. Earned income is computed from the Schedule C, with the adjustments Publication 560 describes, and a self-employed cash balance design starts there. The principle is the same only in this sense: the plan sees compensation as the statute defines it for that entity, not the amount the owner feels the year produced.

If a 401(k) is paired with the pension, the deferral election has to be in place before the wages are paid. You cannot look at a finished W-2 in January and elect, retroactively, to have deferred $23,500 from checks that were already issued. Catch-up contributions follow the same payroll path. An owner who will turn 60 this year should tell the payroll provider, because the catch-up cap is $11,250 rather than $7,500, but only if the election and the cash are actually withheld. The higher limit is not a deposit you can invent after the year closes.

What we do with the wage, and what we do not

Sterling Pension Group LLC is a third-party administrator in West Hartford. We design and administer defined benefit and cash balance plans and we coordinate independent Enrolled Actuaries for the valuation and for the Schedule SB certification. We are not an actuarial firm. We do not set reasonable compensation, we do not sign the actuarial schedule, and we do not tell you how much of the profit to distribute. We will refuse to illustrate a contribution on a compensation figure we cannot trace to wages. That refusal is the service.

This briefing is not tax advice, legal advice, or actuarial advice. The deduction for a contribution, including the timing rule in section 404(a)(6), belongs with your CPA. The wage belongs with your CPA and, if there is any doubt about the services, with counsel. The certified numbers belong with the Enrolled Actuary.

What to do in the next two weeks

Pull the year-to-date payroll register for every shareholder who works in the business. Write down, separately, wages paid, wages you still intend to pay before year-end, and distributions. Do not add those columns together.

Send the wage column, not the sum, to whoever is sketching a plan. If you want a range rather than a single picture, ask for two illustrations: one at the wage you are actually on pace to pay, and one at a higher wage your CPA is willing to defend as reasonable. Label both as illustrations. Neither is an IRS cap, and neither becomes real until the payroll is run and the plan is adopted and funded on the rules that apply to your entity.

If a 401(k) deferral for 2025 is part of the design, confirm that an election is on file before the next paycheck. An owner who will be 60, 61, 62, or 63 this year should confirm that payroll is using $11,250, not $7,500, as the catch-up ceiling.

Then tell us what the W-2 will actually be. The useful first conversation is short: entity type, projected wages, age, and whether anyone other than the shareholder works there. We would rather have a smaller, accurate illustration in March than a flattering one that the payroll records will not support in December.