How Does a 401(k) Plan Work?
Individuals who want to save for retirement may have the option to invest in a traditional 401(k) or Roth 401(k) plan offered by their employer. Both are named for the section of the U.S. income tax code that created them, and both offer tax advantages, either now or for the future.
A 401(k) plan is the most common kind of defined contribution retirement plan. You make a decision how much or what percentage of your salary you want to contribute, and the amount is deducted from your paycheck and put into your account automatically.
Investing in Your 401(k)
Your company serves as “plan sponsor” for your 401(k), and hires one or more companies to administer the plan and oversee its investments. Payroll deductions are sent directly to the company administering your plan. Investment options are offered and you are responsible for deciding how to invest your money from among those options.
Roth vs Traditional 401(k)
With a traditional 401(k), you defer income taxes on contributions and earnings. With a Roth 401(k), your contributions are made after taxes and the tax benefit comes later: your earnings may be withdrawn tax-free in retirement.
Annual Contribution Limits
According to the IRS:
Two annual limits apply to contributions:
- A limit on employee elective deferrals; and
- An overall limit on contributions to a participant’s plan account (including the total of all employer contributions, employee elective deferrals, and any forfeiture allocations).
Deferral limits for 401(k) plans
Limits are adjusted annually and can be found on the IRS website.
Deferral limits for a SIMPLE 401(k) plan
The limit on employee elective deferrals to a SIMPLE 401(k) plan is:
- Limits are adjusted annually and can be found on the IRS website.
- The amount may be increased in future years for cost-of-living adjustments.
- These restrictions may further reduce the maximum allowable elective deferrals:
- Your plan’s terms may impose a lower limit on elective deferrals.
- If you are a manager, owner, or highly compensated employee, your plan might need to limit your elective deferrals to pass nondiscrimination testing.
Plan-based restrictions on elective deferrals
- These restrictions may further reduce the maximum allowable elective deferrals:
- Your plan’s terms may impose a lower limit on elective deferrals
- If you are a manager, owner, or highly compensated employee, your plan might need to limit your elective deferrals to pass nondiscrimination tests
Catch-up contributions for those age 50 and over
If permitted by the 401(k) plan, participants age 50 or over at the end of the calendar year can also make catch-up contributions. The additional elective deferrals you may contribute are
- Limits are adjusted annually and can be found on the IRS website.
- These amounts may be increased in future years for cost-of-living adjustments
- You don’t need to be “behind” in your plan contributions to be eligible to make these additional elective deferrals.
Catch-ups for participants in plans of unrelated employers
If you participate in plans of different employers, you can treat amounts as catch-up contributions regardless of whether the individual plans permit those contributions. In this case, it is up to you to monitor your deferrals to make sure that they do not exceed the applicable limits.
The rules relating to catch-up contributions are complex and your limits may differ according to provisions in your specific plan. You should contact your plan administrator to find out whether your plan allows catch-up contributions and how the catch-up rules apply to you.