Special Rules for S-Corps with Employer-Sponsored Retirement Plans
By Michael Ruger, CFP®
Partner and Chief Investment Officer at Greenbush Financial Group
S-Corporations can be an excellent structure for small business owners, especially from a tax perspective. But when it comes to retirement plans—such as 401(k)s and profit-sharing plans—S-Corps play by a slightly different set of rules compared to other business entities. Understanding these differences is critical for maximizing retirement savings and avoiding unpleasant surprises.
In this article, we’ll cover:
How compensation is defined for S-Corp owners in a retirement plan
Why relying too heavily on distributions can limit retirement savings
The impact of employer contributions for S-Corp owners with staff
Timing considerations for employee deferrals in S-Corps versus pass-through entities
A practical example that shows how these rules work in real life
W-2 Wages Drive Retirement Contributions for S-Corp Owners
Here’s the key difference:
Partnerships and sole proprietorships – Contributions are based on total pass-through earnings from the business.
S-Corporations – Contributions are based only on W-2 wages paid to the owner.
This matters because many S-Corp owners try to minimize their W-2 salary and take more of their income in shareholder distributions. Distributions avoid payroll taxes, which can be a big tax advantage. But retirement plans only look at W-2 wages when calculating contribution limits.
Example: High Income, Low W-2
Suppose an S-Corp owner earns $500,000 total income, but only pays themselves $100,000 in W-2 wages.
Maximum employer contribution = 25% of W-2 wages = $25,000
Add employee salary deferral = up to $23,500 (2025 limit, or $31,000 if age 50+)
Total = roughly $48,500 (or $56,000 with catch-up)
That’s far below the 2025 annual addition limit of $70,000 ($77,500 with catch-up). By keeping W-2 wages artificially low, the owner unintentionally caps their retirement contributions.
The Ripple Effect on Employees
If the owner sets their employer contribution at 25% of W-2 compensation, that percentage generally applies to eligible employees as well.
In our example, if the owner receives a 25% contribution on $100,000 ($25,000), employees may also need to receive a large employer contribution for the plan to pass testing.
For a company with multiple employees, this can become a very expensive retirement plan design.
Timing of Deferrals: Another S-Corp Quirk
Another important difference involves the timing of employee salary deferrals:
S-Corp owners are on payroll, so any employee deferrals must be processed through payroll no later than the final paycheck in December. If you wait until after year-end, it’s too late to make employee deferrals for that tax year.
Partnership or sole proprietor owners may have more flexibility, since contributions can often be made up to the tax filing deadline (with extensions) and still count toward the prior year.
Translation: If you’re an S-Corp owner, don’t wait until tax season to think about retirement contributions. Deferrals need to be in place before December 31st.
Key Takeaways for S-Corp Owners
Only W-2 wages count toward retirement contributions, not shareholder distributions.
Keeping W-2 wages too low may limit your ability to maximize contributions.
Large employer contributions for the owner can trigger equally large contributions for employees.
Employee salary deferrals must run through payroll and be completed by the last December paycheck.
Careful planning throughout the year—not just at tax time—is essential.
If you’re an S-Corp owner considering a retirement plan, make sure your payroll and compensation strategy aligns with your retirement savings goals. The right plan design can help you strike a balance between tax efficiency today and meaningful retirement wealth in the future.
About Michael……...
Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.
Frequently Asked Questions (FAQs)
How do retirement plan contributions work for S-Corporation owners?
For S-Corp owners, retirement contributions are based only on W-2 wages—not total business income or shareholder distributions. This makes salary decisions especially important for maximizing 401(k) or profit-sharing plan contributions.
Why can keeping W-2 wages low hurt retirement savings for S-Corp owners?
While taking more income as shareholder distributions can reduce payroll taxes, it also limits how much you can contribute to a retirement plan. Employer contributions are capped at 25% of W-2 wages, so a lower salary means smaller allowable contributions.
How do employer contributions for owners affect employees in an S-Corp retirement plan?
If an owner contributes a high percentage of their W-2 income (such as 25%), nondiscrimination testing may require giving the same percentage to eligible employees. This can significantly increase plan costs for businesses with multiple staff members.
When must S-Corp owners make 401(k) salary deferrals?
Employee deferrals must be processed through payroll no later than the final paycheck of the year. Unlike partnerships or sole proprietors, S-Corp owners cannot make deferrals after December 31 for the prior tax year.
Can S-Corp owners include distributions when calculating 401(k) contributions?
No. Only W-2 wages qualify for retirement plan contribution calculations. Distributions from the S-Corp are not considered “earned income” for 401(k) or profit-sharing purposes.
What steps should S-Corp owners take to maximize retirement contributions?
Plan ahead by setting a reasonable W-2 salary that supports both tax efficiency and contribution goals. Coordinate payroll timing, plan design, and employee testing requirements with your tax advisor and retirement plan administrator early in the year.
