A 401(k) plan might be the key that unlocks a more comfortable retirement. When you contribute to a 401(k), you enjoy significant tax benefits that encourage you to accumulate savings for your golden years. Generally, your 401(k) contributions are pre-tax, which means the IRS must wait to collect income tax until you withdraw money. The IRS sets 401(k) income limits on your annual contributions, and those limits increase over time to compensate for inflation.
General Limits to Contributions
If you participate in a traditional 401(k) plan, both you and your employer can make contributions to your account. You can contribute up to 100 percent of your compensation to a 401(k), subject to the statutory limits for the year. There are separate 401(k) employer contribution limits set each year. Employee elective deferrals are pre-tax contributions that reduce the year’s taxable income. Employer contributions can be made by one or more of these methods:
- Employer nonelective contributions that apply to all participating employees.
- Employer matching contributions based on each employee’s elective deferrals.
- Allocation of forfeitures, which are the nonvested portions of 401(k) accounts of employees who separate from the job. The employer recovers the forfeited amounts and allocates them to the other plan participants.
Employer contributions cannot exceed 100 percent of an employee’s compensation, are deductible for the employer and do not increase employee taxable income. Employer nonelective contributions are based on a percentage of each employee’s compensation, up to a maximum income that can be taken into account for the tax year. Income above this limit is disregarded. Distributions from a 401(k) are taxed as ordinary income, and withdrawals made before age 59 1/2 might trigger a 10 percent penalty tax unless an exception applies.
2018 401(k) Contribution Limits
For tax year 2018, the limit on employee elective deferrals is $18,500. If you’ve reached age 50, you can add another $6,000 in catch-up contributions. The overall contributions to an employee’s account in 2018 are limited to $55,000 (or $61,000 if you include catch-up contributions). 2018 employee income above $275,000 is disregarded when figuring employer nonelective contributions.
IRS 401(k) Limits 2019
Some of the 401(k) contribution limits are higher in 2019. The limit on employee elective deferrals is $19,000, but the catch-up contribution limit remains $6,000. The overall contribution limit to an employee’s account in 2019 increases to $56,000 (or $62,000 including catch-up contributions). The maximum employee income that can be taken into account when calculating employer nonelective contributions in 2019 is $280,000.
Other Cash Inflows
If you borrow money from your 401(k), repayments and interest payments are not contributions and are not included in the annual 401(k) contribution limits. Rollovers from IRAs and other qualified accounts are also treated separately from 401(k) contributions.
You might be able to make after-tax contributions to your 401(k), in either of two ways:
- After-tax contributions to your traditional 401(k) account, if allowed by your plan.
- After-tax contributions to a Roth 401(k) account, if available.
After-Tax Contributions to Traditional 401(k)
Some 401(k) plans allow you to contribute after-tax dollars to your traditional 401(k) account (not to be confused with a Roth account). The employee contribution limit doesn’t apply to these contributions, but the overall contribution limit does.
In Example 1, suppose Joe is under 50 years old in 2019 and has maxed out his pre-tax contributions ($19,000). Joe’s employer contributes $10,000 for a total of $29,000 of pre-tax contributions. Since the overall contribution limit is $56,000 and the employee $19,000 limit doesn’t apply to after-tax contributions, Joe can contribute up to another $27,000 (in after-tax income) to the traditional 401(k).
After-tax contributions to a traditional 401(k) can be withdrawn tax-free, but earnings on these contributions are taxable upon withdrawal. However, if you roll the 401(k) after-tax contributions into a Roth IRA, subsequent earnings grow tax-free (as long as you observe the distribution rules).
After-Tax Contributions to Roth 401(k)
Your 401(k) plan might include a separate Roth account to accept post-tax contributions. This option can be offered only in conjunction with a traditional 401(k) account, because employer contributions are pre-tax and can only be deposited to the traditional account. Both the employee and overall limits apply to the combined contributions to traditional and Roth accounts.
In Example 2, Joe makes the maximum 2019 employee contribution ($19,000) to his Roth account, matched by $10,000 in employer pre-tax contributions to Joe’s traditional account. The overall contributions of $29,000 are $27,000 less than Example 1’s because the employee contribution limit applies to a Roth 401(k) but not to post-tax contributions to a traditional account. Another difference is that the withdrawal of earnings from a Roth 401(k) is tax-free, as long as withdrawal rules are observed, whereas all earnings (and pre-tax contributions) withdrawn from a traditional account are taxed. In Example 2, Joe doesn’t have to roll over his Roth 401(k) to a Roth IRA to benefit from tax-free withdrawals of earnings.
Contribution Limits for Solo 401(k)
If you are a self-employed individual, you can open and contribute to a one-participant 401(k), also known as a Solo 401(k), in which you act as both employer and employee. However, a special calculation is required to determine the contribution limits for a Solo 401(k). You can contribute net earnings from self-employment up to the limit computed by taking into account two deductions:
- The deductible portion of your self-employment tax (i.e. Social Security and Medicare taxes).
- The deduction for your contributions to the 401(k) as both employer and employee.
The need for a special calculation to determine your contribution limit stems from the fact that your net earnings and the deduction for your contributions hinge on each other. Worksheets in IRS Publication 560, Retirement Plans for Small Business (SEP, SIMPLE and Qualified Plans), facilitate this computation.
When you open a Solo 401(k) plan, you specify the employer contribution rate. When computing maximum contributions for the tax year, you find the employer reduced contribution rate using the Rate Table for Self-Employed and the Rate Worksheet for Self-Employed.
For example, a 401(k) plan might specify employer contributions at the rate of 10 percent of your compensation. The reduced contribution rate derived from the rate table is 0.090909. You next fill out the Deduction Worksheet for Self-Employed, starting with your net profit, typically reported on Schedule C of Form 1040, Profit or Loss from Business (Sole Proprietorship), and then subtracting your deduction for self-employment tax as reported on Form 1040. You then follow the remaining steps on the Deduction Worksheet to determine your maximum deductible employer contribution. This amount, when added to the maximum allowed employee contribution for the tax year, gives you the overall contribution limit.
Employer Minimum Contributions
A safe harbor 401(k) is similar to a traditional one except it doesn’t have to meet certain tests regarding employer contributions for highly-compensated employees. Unlike traditional 401(k)s, a safe harbor plan requires employers to make certain minimum contributions. If the employer makes matching contributions, it must match dollar for dollar the first 3 percent of employee contributions, and 50 percent on the next 2 percent of employee contributions. If the employer makes nonelective contributions, the minimum amount is 3 percent of an employee’s compensation. In a safe harbor 401(k), minimum employer contributions are immediately vested.