How Will Potential Tax Law Changes to 401(k) Plans Affect You?

Understand How the New Tax Laws Could Affect Your Retirement

Employer-sponsored 401(k) accounts have long been popular with investors because of the tax benefits they provide. While they have been a stable option for a long time, there have been minor changes in recent years to IRS regulations regarding 401(k)s. Most of these involve contribution limits.

Understanding 401(k)s

One of the most popular options for employer-sponsored retirement savings is the 401(k). Contributions are tax-deferred, which means contributions are made on a pre-tax basis. No taxes are paid on the value of an account—including gains made on the investments—until the money is withdrawn. One of the reasons this can be appealing is because earners often will be in a lower tax bracket after retirement when they are withdrawing their 401(k) funds, meaning they'll pay at a lower rate than they would have at the time of contribution.

There are penalties for early withdrawal, however. If taking money from the account before age 59 1/2, the IRS will charge a 10% penalty in addition to income taxes on the money.

Contribution Limits Before Age 50

The IRS limits how much employees can contribute to their 401(k) accounts every year. The amount of that limit was increased to $19,000 for the tax year 2019 after being at $18,500 for 2018, $18,000 for 2016 and 2017, $17,500 for 2014 and 2015, $17,000 for 2013, and $16,500 for 2012.

Increases are tied to the Consumer Price Index (CPI), which measures inflation, and happen only in $500 increments. This is why there is not an increase every year. If the CPI does not go up enough to warrant a $500 increase, there will be no change in the contribution limit.

Note that these contribution limits do not impact an investor's ability to also contribute to a separate plan, such as a Roth IRA. Roth IRAs can be opened by any qualifying individual as long as they fall beneath the maximum income levels, which are $137,000 for individuals and $203,000 for married couples filing jointly, as of 2019.

Contribution Limits for Workers 50 and Older

The IRS allows what it calls a catch-up provision, enabling older workers to contribute more to their accounts. This helps to build value in the account for those who might not have contributed as much when they were younger. For the tax year 2019, the catch-up amount is $6,000, which is what it has been since 2014 when it was at $5,500.

This additional amount increases the contribution limit for workers older than 50 to $25,000 for 2019 from $24,500 in 2018. A worker who was 49 for the tax year 2018 would see a $6,500 increase in the limit from that year to 2019—the $500 increase in the standard contribution limit, plus the addition of the $6,000 catch-up provision for turning 50.

Employer Matching Limits

Some employers match a percentage of the funds their employees contribute. This amount varies from employer to employer, but it also applies to those who are self-employed. This means a self-employed individual could contribute to her own account as both a worker and an employer matching funds. For the 2019 tax year, the limit for combined contributions from employee and employer is $56,000, which represents a $1,000 increase over 2018. This does not include any funds contributed under the catch-up provision. So, the maximum employee-employer combined amount for employees older than 50 is $62,000, as of 2019.

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 provision 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. 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 cutoff amount for the tax year 2019 is $125,000, up from $120,000 for tax years 2015–2018, and $115,000 for 2014. An individual is also considered an HCE if he owns more than 5% of the interest in the business at any time during the tax year in question.

What this means for HCEs varies 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 be no more than 7%. Every year, 401(k) plans must run nondiscrimination tests to make sure everyone is in compliance. This means employees who think they might qualify as HCEs should check with their employer's human resources department for guidance on how much they should contribute.