A 401k plan gives you tax breaks for saving for your retirement. Even better, your employer can add substantial contributions. The money in a 401k plan isn’t taxable until you withdraw it. Investment earnings are not taxed as long as they remain in the account. The Internal Revenue Service does set annual limits on the amounts you and your employer may contribute.
401k Contribution Basics
For 401k plans, your contributions are referred to as elective deferrals. Elective means the contributions are voluntary. When you make a contribution to your 401k plan, the money is not subject to income taxes and won’t be taxed until you withdraw the funds. Typically, the terms of the 401k plan restrict your ability to withdraw contributions once they are made until you retire or leave your job. Employers have the option of contributing additional money. The amount an employer adds must be stated in the plan agreement.
The IRS established an elective deferral limit for employees of $17,000 in 2012, up from $16,500 in 2011. Contribution limits are adjusted periodically for changes in the cost of living. Employees age 50 and over may add up to $5,500 each year in catch-up contributions, which are also exempt from income taxes. The total amount an employee contributes may not be more than what she earns for the year.
When employers add matching contributions, they are based on a percentage of what you contribute. For example, a 401k plan might stipulate your employer will add 75 percent of the amount you contribute. If you contribute $8,000, your employer adds another $6,000, bringing the total contribution to $14,000. The maximum for employer contributions as of 2012 was $33,000. Added to the $17,000 an employee can contribute, this brings the overall maximum to $50,000 per year. The $50,000 limit does not include catch-up contributions. Employers may impose a vesting period for contributions they make. This means all or part of an employer’s contributions may be rescinded if you leave your job before the vesting period is complete.
Designated Roth Contributions
You can choose to make designated Roth contributions to a 401k if your plan offers this option. Designated Roth contributions are made with after-tax dollars, so you can’t deduct them from your taxable income. However, both the contributions and earnings attributable to them are tax-free when withdrawn after you reach age 59 1/2 and the designated Roth account is at least five year old. An employee may make all or part of his contributions as designated Roth contributions. Employer contributions may not be designated as Roth contributions.