The principle of saving money in a piggy bank that you learned as a child becomes even more valuable as you save for your retirement years. Your 401(k) plan replaces your piggy bank, and the goal of saving for retirement replaces your childhood goal of saving for a toy. In both cases, your diligence merits a reward, but when it comes to saving in your 401(k) plan, you receive a two-fold reward – less tax liability and more take-home pay – before you even receive your funds at retirement.
How 401(k) Plans Work
A 401(k) plan is a workplace retirement savings option. Unlike manually depositing money in a savings account at your bank (or even transferring funds online, for example, from your checking account into a savings account), you can simply authorize your employer to make payroll deductions from your paychecks.
Payroll deductions represent the contribution of a portion of your wages into your 401(k) account. You don’t pay income tax on your 401(k) contributions, which means you’re contributing the full amount of your payroll deductions into the plan. An exception is the Roth 401(k) plan, into which you contribute after-tax dollars.
Types of 401(k) Plans
There are various types of 401(k) plans, each with its own set of rules. These include traditional 401(k) plans, SIMPLE 401(k) plans and safe harbor 401(k) plans. Find out from your employer the plan that your company offers.
Regardless of the type plan you have, a 401(k) offers a way to save for retirement with tax benefits, as long as your employer is in compliance with the rules of a qualified plan. Qualified plans must be properly worded in accordance with tax law, and your employer must properly administer them.
Benefits of 401(k) Plans
Each contribution you make to your 401(k) account reduces your annual tax liability (the income tax you owe). You can’t take an actual 401(k) tax deduction on your tax return for the contributions you make to your account, because you receive a tax-deduction benefit with each pre-tax contribution you make.
You may also be able to increase your take-home pay because 401(k) contributions reduce the tax-withholding amount from each of your paychecks. Your employer withholds money from each of your paychecks to pay your federal income tax bill that’s due each year. But when you make 401(k) contributions, the amount of each contribution is deducted from your taxable income, which decreases your taxable income. The lower your taxable income, the lower your tax bill will be.
Annual 401(k) Employee Contribution Limits
For tax year 2019, an employee may contribute up to $19,000 to a 401(k) plan. This contribution is known as a salary deferral, because you are setting aside – deferring – part of your salary for your retirement. This amount represents a cost-of-living adjustment of $500 from 2018’s contribution limit of $18,500.
Employees over the age of 50 may contribute an additional $6,000, for a total of $25,000. This additional $6,000 allowance is called a “catch-up contribution.” These 401(k) contribution limits may be subject to annual employee compensation limits.
Annual 401(k) Employee Compensation Limit
The annual compensation limit for tax year 2019 is $280,000 (up from $275,000 in 2018). Some 401(k) plans specify that an employee may no longer make salary deferrals when his compensation reaches this annual limit. For example, a 401(k) plan may specifically state that an employee’s salary deferrals are based on his first $280,000 of compensation (the 2019 annual limit). In this case, as soon as his salary reaches this amount, he can no longer contribute to the plan – even if he has not reached the 2019 annual contribution limit of $19,000.
For example, let's say Jim’s annual salary is $336,000 ($28,000 monthly paycheck), and he’s 45 years old. He’ll reach the $280,000 annual compensation limit in October ($28,000 per month x 10 months). If he contributes $1,600 each month to his 401(k), he’ll have contributed a total of $16,000 by October ($1,600 per month x 10 months).
Even though he has not reached the annual $19,000 contribution limit, his salary compensation limit prohibits him from making additional contributions to reach the $19,000 cap. If, however, Jim’s 401(k) plan did not specify that his salary deferrals must stop when he reaches the annual compensation limit, he can continue making contributions until he reaches the annual contribution limit.
Annual 401(k) Employer Matching Contributions
You’ll see your contributions grow even faster if your employer participates in a matching-funds program. All 401(k) plans do not offer employer matching contributions, so you’ll have to check with your employer to see which specific plan is offered at your workplace. If your employer does offer matching funds, you’ll realize your biggest 401(k) savings by maximizing your employer’s matching contributions.
For example, let's say Jane’s 401(k) plan matches 100 percent of her contributions up to 5 percent of her salary. If Jane makes $150,000 each year, her employer’s maximum contribution is $7,500 ($150,000 x 5 percent). Jane needs to contribute $7,500 to receive her employer’s maximum 401k contribution limit of $7,500.
Total Employee and Employer Contributions
The total of your 2019 401(k) contributions plus your employer’s matching contributions must equal the lesser of 100 percent of your salary or $56,000. (This is $1,000 more than 2018’s total contribution limit of $55,000.) This amount does not include the catch-up deferral of $6,000.
Multiple 401(k) Plan Contributions
You can contribute to more than one 401(k) plan during a tax year. Examples when this may happen include if you change jobs during the year and you had a 401(k) plan with your former employer as well as a different 401(k) plan with your current employer, or if you work more than one job at a time (each with a 401(k) plan).
But you’re not allowed the maximum contribution for each 401(k). Your annual tax-free deferred salary contribution must be the total of your contributions to all your retirement plans, including 401(k) plans.
Penalty for Excess 401(k) Contributions
If you contribute more than the maximum contribution to your 401(k) that's allowed during a tax year, the overage is called an “excess deferral.” Taxpayers are penalized for exceeding the limits, even though the employee’s plan administrator/employer is responsible for adhering to the rules of the specific plan it offers. If, however, you contribute to multiple 401(k) plans in a tax year, it’s easier to lose track of your collective contributions.
If a mistake or oversight occurs that causes you to have an excess deferral, you can fix it without paying a penalty. But the overage must be removed from your 401(k) and returned to you by April 15 of the year following your excess deferral. If the overage is not returned to you by this date, you’ll be doubly taxed – once for the year you made the deferral and again when you receive your distribution.
401(k) Plans Income Tax Treatment
Most types of 401(k) plans are funded with pre-tax dollars. This means that you pay no income tax on your contributions until you receive the funds at retirement.
An exception is the Roth 401(k), which you fund with post-tax dollars. When you receive Roth 401(k) distributions, you'll pay no income tax on those funds because you were taxed on the money before it went into your retirement account.