Understanding 401(k) Contribution Limits

How Much You Can Save Depends on Your Age, Other Factors

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A 401(k) retirement plan can be an effective way to build wealth while minimizing your tax obligation. Under these plans, any money you contribute is deducted from your taxable income and could save you hundreds of dollars in taxes each year. 

Congress put annual limits on the amount of money you can contribute. Otherwise, a person with very high income could put millions of dollars in their 401(k) plan each year, costing the government significant revenue. By placing limits on contributions, Congress can ensure that it is the middle class that benefits most from the tax advantages of 401(k) plans. 

The Three Types of 401(k) Contribution Limits

Calculating how much money you are allowed to put into a 401(k) can be a bit tricky. You have to be careful not to exceed the 401(k) contribution limits, and they sometimes change year-to-year. The limits are somewhat more complicated than those of a Traditional IRA or Roth IRA because there are three different types.

The Elective Deferral 401(k) Contribution Limit is $19,000 in 2019. This is the amount the owner of the 401(k) account can contribute from his paycheck.

The Catch-Up 401(k) Contribution Limit is $6,000 in 2019. This amount is the additional money that workers age 50 or older can contribute toward their retirement savings. Thus, a person age 50 or older can contribute up to $25,000 of their pay in one year.

The Defined Contribution Limit is $56,000 in 2019. The defined contribution limit is the total of all elective deferral contributions, catch-up contributions, and any money added to the account by the employer in matching funds or bonuses, and it cannot exceed the lesser of 100% of your compensation or $56,000 in 2019.

So if you're under 50, the most money you can put into a 401(k) in any given year is $56,000 but only $19,000 of that can come from your contributions. The other $37,000 would have to come from your employer, and very few employers offer generous-enough 401(k) packages for you to reach that limit.

Household or Family Contribution Limits

The contribution limits of a 401(k) are determined per employee, not per household or family. Each qualified employee has her own account, and the limits are based on her salary, not the total household income.

Since retirement plans aren't joint accounts, each spouse or family member with a qualified plan can make contributions to his or her own account. If you max out your contributions to your 401(k) in a given year, your spouse can still contribute to his account as well, up to the maximum allowed according to their salary and age.

Limits for High Earners

In some instances, certain high earners in a company might be held to a lower contribution limit or be required to return excess contributions if the retirement plan fails nondiscrimination tests. These tests have specific rules concerning who is highly compensated, who is a key employee, and how much they contribute.

The Actual Deferral Percentage test compares the contributions of highly compensated employees (HCEs) with non-highly compensated employees (NHCEs). A highly compensated employee is someone who makes more than $125,000 or owns more than 5% of the business. Broadly speaking, if the average percentage deferred by the HCE group exceeds that of the NCHE group by more than two percentage points, corrections must be made to close the gap. That might mean that highly compensated employees must reduce their contributions to meet the percentage, or the company may make contributions to the NHCEs.

The second test looks at total plan assets to see what percentage belongs to key employees and what belongs to everyone else. A key employee is an officer making more than $180,000, a 5% owner, or a 1% owner making more than $150,000. A plan must ensure that less than 60% of its assets are held by key employees or it is considered "top-heavy" and must pay contributions to the non-key employees.

What Happens if You Exceed the Limits

If you have enough cash to max out your 401(k) contributions, it can be a little challenging to determine how much to put aside each month without inadvertently putting in too much.

To calculate what percentage of your income to contribute to reaching the maximum amount, take $19,000 and divide it by your gross income. That will determine what percentage should be taken out of each paycheck and directed toward your 401(k) plan. If your income goes up during the year, you will have to adjust this figure accordingly. 

If you contribute more money to your 401(k) account than you are allowed, you have until April 15 to instruct the plan administrators to return the cash to you. This overpayment is referred to as an excess deferral. If you received a tax deduction, you will have to give it back upon withdrawing the excess deferral but you won't be subject to the additional 10% early withdrawal penalty

It is your responsibility, not your employer's, to catch excess 401(k) contributions. If you don't remove the excess before the tax filing deadline in the year in which the error is made, you will face stiff penalties. You might even have your entire retirement plan reclassified as non-qualified, which would have big financial implications if you have built a decent-sized nest egg.