401(k) contribution limits are limits placed by the U.S. Congress on the amount of money that employees can contribute toward their retirement plan. The contribution limits prevent high-salaried employees from reducing their tax burden beyond a certain level.
401(k) retirement plans are one of the ways that individuals can build their wealth for their retirement. The contributions are deducted from the individual’s taxable income, resulting in hundreds and thousands of dollars in tax savings.
Without the 401(k) contribution limits, some high-earning individuals could abuse the plan by contributing a high percentage of their incomes to the plan to generate more wealth.
Types of 401(k) Contribution Limits
There are three types of limits placed on 401(k) contributions. They include:
#1 The Elective Deferral 401(k) Contribution Limit
The elective deferral limit defines the maximum amount of money that individuals can annually contribute to the retirement plan from their paycheck. The limit was capped at $18,000 in 2017 and was raised to $18,500 in 2018. For individuals aged 50 years or older, the elective deferral was increased from $24,000 to $24,500.
#2 The Catch-up 401(k) Contribution Limit
The catch-up contribution limit covers the additional money that individuals over 50 can contribute towards their 401(K) retirement plan, above the elective deferral limit. The catch up 401(k) contribution is set at $6,000. The contribution limit encourages workers nearing their retirement to accelerate their savings plan.
#3 Additional 401(k) Contribution Limit
The additional contribution limit covers the total of the elective deferral contributions, catch-up contributions, and all the money added by the employer in matching funds or bonus system. The contribution limit cannot exceed the lesser of an individual’s total annual compensation or $55,000 for workers under 50, or $61,000 for workers aged 50 years and above. The total limit for all contributions was increased by $1,000 in 2018 compared to the value in 2017.
Participating in a 401(k) retirement plan enables employees to take advantage of employer contributions. The employer contributions were capped at $36,000 per year in 2017, and they were increased to $36,500 per year in 2018. The contributions comprise any employer matching of employee contributions and other elective employer contributions like employee bonuses made to the retirement plan, regardless of employee participation.
However, employer contributions are subject to the overall limit on the total contributions, which is $55,000 for workers below 50 and $61,000 for workers 50 and above.
Exceeding the 401(k) Contribution Limit
Some workers may be able to maximize their 401(k) contribution limits, but they will need to determine how much is too much. One way that an employee can know how much to contribute from their paycheck to the 401(k) plan is to divide the limit by their gross income. It will give the percentage of gross income that workers will contribute to the retirement plan without exceeding the allowed limit. If a worker’s annual contribution exceeds the allowed limit, he/she should inform the retirement plan to refund the excess contribution.
On some occasions, the employee may contribute the right amount but the employer’s matching contribution may exceed the 401(k) contribution limit. In such cases, the employee is responsible for informing the retirement plan of the excess contribution before April 15 of every year to receive a refund.
If the employee fails to inform the plan about the error, he/she will be penalized, and the revenues will be taxed twice. The retirement plan may also categorize the employee’s contribution as non-qualified, resulting in the loss of all their contributions.
Effect of 401(k) Contribution Limits on Income Tax
Contributions to the 401 retirement plan are deducted from gross income before taxation. This means that the payroll deferrals to the 401(k) account are not taxed until after retirement. The tax will be applied when employees withdraw their earnings after retirement, when they are likely in a lower tax bracket than they were during employment.
However, the contribution limits prevent high-salaried employees and employers from minimizing their tax burden by contributing a large proportion of their earnings to the 401(k) retirement plan.
Limitations of 401(k) Contributions
The main limitation with 401(k) contributions is the lack of employee participation. Although 401(k) is a qualified retirement plan that is offered through the employer, a large number of employees choose to stay out of the plan.
In 2005, the median value of 401(k) plan contributions was $18,433, which means that at least 50% of employees are not coming close to the maximum contribution. A large number of employees who are not participating in the plan are also missing out on the tax-deferred savings that participating employees enjoy.
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