Employer-sponsored 401(k) plans have long been popular with investors, because of the tax benefits they provide. While these accounts have been available since 1978, tax reforms have resulted in changes to IRS regulations regarding 401(k) accounts, mostly involving contribution limits. Staying on top of ongoing changes in 401(k) rules can help you maximize your plan contributions.
- 401(k) contributions are tax-deductible and tax-deferred, so you pay no taxes on contributions or gains until you withdraw the money.
- Tax rules limit how much employers and employees can contribute, with the amount being higher for workers age 50 than for those under 50.
- The average contribution for those who qualify as highly compensated employees can be no more than 2% greater than for those who are not HCEs.
- Tax reforms can change federal income tax brackets, tax rates, and income ranges, which can affect the tax deduction you get for 401(k) contributions.
One of the most popular options for employer-sponsored retirement savings plans is the 401(k) plan. Traditional 401(k) contributions are tax-deductible, which means they reduce your taxable income and can lower your tax bill. They are also tax-deferred, which means you make them on a pre-tax basis. You pay no taxes on the contributions you make to the account—or on the gains you made on the investments—until you withdraw the money.
Thus far, these two key features of 401(k) plans have not been subject to changes despite various tax reforms, which has been a boon to savers. Earners often will be in a lower tax bracket in retirement when they are withdrawing their 401(k) funds than they are at the time of contribution, meaning that they'll pay taxes on their withdrawals at a lower rate.
There are penalties for early withdrawal, however. If you take money from the account before you reach age 59 1/2, the IRS will charge a 10% penalty plus income taxes on the withdrawal.
Contribution Limits Before Age 50
The IRS often changes the limits on how much employees under the age of 50 may contribute to their 401(k) accounts. The contribution limit for persons under age 50 for tax year 2021 is $19,500 (unchanged from 2020).
Increases to these limits are made for cost-of-living adjustments that are tied to the Consumer Price Index (CPI). The CPI measures inflation and rises only in $500 increments, which is why there isn't an increase every year. If the CPI doesn't go up enough to warrant a $500 increase, there will be no change in the contribution limit. That is why the limit did not change from 2020 to 2021, for example.
These 401(k) rules do not impact an investor's ability to contribute to a different plan, such as a Roth IRA. Roth IRAs can be opened by any qualifying individual who does not earn more than the maximum income levels, which are $140,000 or more for individuals and $208,000 or more for married couples filing jointly.
Contribution Limits for Workers Age 50 and Older
The IRS allows for catch-up provisions that enable older workers to contribute even more to their accounts. This 401(k) allowance helps those who might not have contributed as much when they were younger to grow their account before they retire.
Like the standard contribution limit, the limit for catch-up contributions increases most years according to tax reforms governing 401(k) plans. For the tax year 2021, the catch-up amount is $6,500. This additional amount increases the total 401(k) contribution limit for workers age 50 and older to $26,000.
Employer Matching Limits
Some employers make an additional contribution to a 401(k) that matches the amount their employees contribute, up to a certain percentage or dollar limit. The match varies from employer to employer and also applies to those who are self-employed. A self-employed individual can contribute to their own account as both an employee and an employer.
For the 2021 tax year, the limit for combined contributions from employee and employer is $58,000. That does not include any funds contributed under the catch-up provision; the combined employee-employer limit for employees older than age 50 is $64,500.
Highly Compensated Employees (HCEs)
Contribution limits get more complex for workers who are labeled HCEs by the IRS. When 401(k)s were established, a rule was put in place to limit the disparity between how much a firm's highest-paid employees could contribute, compared to its lowest-paid employees. As a result, at any individual company, the average amount of the contributions for those who qualify as HCEs can be no more than 2% greater than the average amount of contributions for those who are not HCEs.
The yearly income that constitutes "highly compensated" is subject to cost-of-living adjustments and therefore changes over time. For the tax years 2021 and 2020, an HCE is someone who made more than $130,000, up from $125,000 for 2019 and $120,000 for tax years 2015 through 2018. Individuals are also considered HCEs if they own more than 5% of the business at any time during the tax year in question.
Implications for HCEs vary from employer to employer. If the average contribution amount for non-HCEs at a particular firm is 5% of their income, the average contribution amount for all HCEs at the firm can generally be no more than 7%. Every year, 401(k) plans must run nondiscrimination tests to make sure everyone is in compliance. If you think you might qualify as an HCE, check with your employer's human resources department for guidance on how much to contribute.
Income Tax Brackets
Tax reform can also cause changes in the federal income tax brackets, which are income ranges that are subject to taxes at different rates. For 2021, there are seven brackets ranging from 10% to a top rate of 37%. Dramatic changes in the income tax brackets don't occur often, and when they do, they don't directly impact your 401(k) contribution limits.
However, changes to the tax rates or income ranges can affect the tax deduction you get when you make 401(k) contributions, since your contributions reduce your taxable income. For example, as a result of the Tax Cuts and Jobs Act, the top income tax bracket is 37% for tax years 2021, 2020, 2019, and 2018, down from 39.6% in 2017. If you made a 401(k) contribution of $10,000 that was taxed at a rate of 25% in 2017, you would have saved $2,500 in taxes. If that same $10,000 was taxed at only 22% in 2018, you would have saved only $2,200, or $300 less.
The Bottom Line
Reforms are continually made to the tax code, and when they impact IRS regulations governing 401(k) plans, they also impact your contribution limits and deduction potential. Keeping tabs on ongoing changes to 401(k) plan rules can set you up for increased savings, a larger nest egg, and a more comfortable retirement.