Contributions

A qualified plan is generally funded by your contributions. However, employees participating in the plan may be permitted to make contributions.

Contributions deadline. You can make deductible contributions for a tax year up to the due date of your return (plus extensions) for that year.

Self-employed individual. You can make contributions on behalf of yourself only if you have net earnings (compensation) from self-employment in the trade or business for which the plan was set up. Your net earnings must be from your personal services, not from your investments. If you have a net loss from self-employment, you cannot make contributions for yourself for the year, even if you can contribute for common-law employees based on their compensation.

When Contributions Are Considered Made

You generally apply your plan contributions to the year in which you make them. But you can apply them to the previous year if all the following requirements are met.

1. You make them by the due date of your tax return for the previous year (plus extensions).
2. The plan was established by the end of the previous year.
3. The plan treats the contributions as though it had received them on the last day of the previous year.
4. You do either of the following.
   1. You specify in writing to the plan administrator or trustee that the contributions apply to the previous year.
   2. You deduct the contributions on your tax return for the previous year. (A partnership shows contributions for partners on Schedule K (Form 1065), Partners' Shares of Income, Credits, Deductions, etc.)

Employer's promissory note. Your promissory note made out to the plan is not a payment that qualifies for the deduction. Also, issuing this note is a prohibited transaction subject to tax. See Prohibited Transactions, later.

Employer Contributions

There are certain limits on the contributions and other annual additions you can make each year for plan participants. There are also limits on the amount you can deduct. See Deduction Limits, later.

Limits on Contributions and Benefits

Your plan must provide that contributions or benefits cannot exceed certain limits. The limits differ depending on whether your plan is a defined contribution plan or a defined benefit plan.

Defined benefit plan. For 2001, the annual benefit for a participant under a defined benefit plan cannot exceed the lesser of the following amounts.

1. 100% of the participant's average compensation for his or her highest 3 consecutive calendar years.
2. $140,000 ($160,000 for 2002).

Defined contribution plan. For 2001, a defined contribution plan's annual contributions and other additions (excluding earnings) to the account of a participant cannot exceed the lesser of the following amounts.

1. 25% of the compensation actually paid to the participant.
2. $35,000.

The maximum compensation that can be taken into account for this limit is $170,000.

For 2002, the percentage in (1) increases to 100% and the amount in (2) increases to $40,000. Also for 2002, the maximum compensation that can be taken into account for this limit is $200,000.

Excess annual additions. Excess annual additions are the amounts contributed that are more than the limits discussed previously. A plan can correct excess annual additions caused by any of the following actions.

• A reasonable error in estimating a participant's compensation.
• A reasonable error in determining the elective deferrals permitted (discussed later).
• Forfeitures allocated to participants' accounts.

Correcting excess annual additions. A plan can provide for the correction of excess annual additions in the following ways.

1. Allocate and reallocate the excess to other participants in the plan to the extent of their unused limits for the year.
2. If these limits are exceeded, do one of the following.
   1. Hold the excess in a separate account and allocate (and reallocate) it to participants' accounts in the following year (or years) before making any contributions for that year (see also Carryover of Excess Contributions, later).
   2. Return employee after-tax contributions or elective deferrals (see Employee Contributions and Elective Deferrals (401(k) Plans), later).

Tax treatment of returned contributions or distributed elective deferrals. The return of employee after-tax contributions or the distribution of elective deferrals to correct excess annual additions is considered a corrective payment rather than a distribution of accrued benefits. The penalties for early distributions and excess distributions do not apply.

These disbursements are not wages reportable on Form W-2. You must report them on a separate Form 1099-R as follows.

• Report the total distribution, including employee contributions, in box 1. If the distribution includes any gain from the contribution, report the gain in box 2a. Report the return of employee contributions in box 5. Enter Code E in box 7.
• Report a distribution of an elective deferral in boxes 1 and 2a. Include any gain from the contribution. Leave box 5 blank and enter Code E in box 7.

Participants must report these amounts on the line for Total pensions and annuities on Form 1040 or Form 1040A, U.S. Individual Income Tax Return.

Employee Contributions

Participants may be permitted to make nondeductible contributions to a plan in addition to your contributions. Even though these employee contributions are not deductible, the earnings on them are tax free until distributed in later years. Also, these contributions must satisfy the nondiscrimination test of section 401(m). See Notice 98-1 for further guidance and transition relief relating to recent statutory amendments to the nondiscrimination rules under sections 401(k) and 401(m). Notice 98-1 is in Cumulative Bulletin 1998-1.