Contributing to your 401(k) plan lets you exclude the contributions from your taxable income for the year and defer your taxes until you take withdrawals. However, you can't contribute more than the annual limit or you lose the deduction benefit. In addition, the limits differ if you are at least 50 years old.
Salary Deferral Limit
The first limit on your deductible contributions is the restriction on how much you can defer each year out of your salary. As of 2012, you can't defer more than $17,000 into your 401(k) plan. In addition, no matter how much you make, you can't defer more than your salary. For example, if you only made $15,000 working for the company, you could only defer $15,000 into the 401(k) plan even if your annual contribution limit is higher.
One of the advantages of a 401(k) plan is that your employer can also make contributions on your behalf. However, this necessitates a second limit: the total contributions - both yours and your employer's - can't exceed a specified limit. For 2012, the limit is $50,000, but the IRS updates it annually for inflation. For example, if you contribute $17,000 and your employer puts in $33,000, that's fine. However, if you contribute $10,000 and your employer puts in $41,000, you are $1,000 over the second limit even though you met the first limit.
If you're 50 or older, you're eligible for a special extra contribution on top of the ordinary limits. As of 2012, this is limited to $5,500, but like the other limits, the IRS changes it to keep pace with inflation. For example, if you're 50 or older in 2012, you can contribute up to $22,500 out of your salary and the total of your contributions plus your employer's contributions can go as high as $55,500.
Excess Contributions Penalty
If your 401(k) contributions exceed either of the two limits, the IRS penalizes this by essentially taxing the money twice. First, when you put the money in the 401(k), you have to include it in your taxable income that year. However, you don't get credited with making a nondeductible contribution, so you'll pay taxes on the money a second time when you eventually take distributions. To avoid the penalty, you have to withdraw the excess by April 15 of the following year.
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