Saving for retirement can be done in a variety of ways. Mainly it’s just important that you start as early as possible! And if you’re a company owner it’s critical to give your employees the opportunity to save for retirement in the first place.
However, one of the best ways to save for retirement is through a 401k plan at work. It’s even better if you can reach the allowed max 401k contribution limits.
Although it may seem daunting, for participants saving is really just a question of having some basic knowledge, a lot of discipline, and knowing the rules of the game. For employers, they need to make sure they have the best 401k plan possible to help boost their employee’s retirement outcomes.
Here are 7 things that you need to know about making the max 401k contribution for 2019 so that you can build a large nest-egg and have the retirement of your dreams.
1. Contributions Can Be Made Pre-Tax To Traditional 401k Or After-Tax To A Roth 401k
With a traditional 401k, you contribute pre-tax dollars to the plan. Imagine that you make $5,000 per month gross pay and you decide to contribute 10% of your wages to the traditional 401k plan. Since a traditional 401k is funded with pre-tax dollars, 10% of the $5,000 earned ($500) will be invested in the plan. The remaining $4,500 will be subject to the applicable federal and state taxes.
Many 401k plans today provide for a Roth contribution. The Roth 401k is always funded with after-tax dollars, but the Roth enjoys several other tax benefits such as tax-free withdrawals, tax-deferred growth, and no required minimum distributions.
Sticking with our example above, if you participate in a Roth 401(k) plan, your $5,000 paycheck will be fully taxed. If you elect to contribute 10% of your to a Roth 401k, $500 will be contributed to the 401k plan.
2. Max 401k Contribution Limits For Those Under Age 50
401k limits are set by the IRS and are adjusted periodically by Congress to account for the inflation-related cost of living increases.
If you are under age 50 (and you are not going to turn 50 this calendar year) you can contribute a maximum of $19,000 to your traditional 401k or Roth 401k for 2019.
3. Max 401k Contribution Limits For Those Age 50 Or Older
If you are age 50 or older (or you are going to turn 50 this calendar year) you are eligible for 401k catch-up contributions. Yes, the government truly wants you to save for retirement, especially if you’re getting closer to retirement age. Therefore, those 50 or older can contribute $19,000+$6,000 for a total of $25,000 into their 401k plan in 2019.
Why does the government set max 401k contribution limits?
401k limits are set to ensure that the wealthiest in our country don’t get too much in tax benefits. For example, if there were no max 401k contribution limitations set, someone earning $500,000 a year could defer the entire amount effectively erasing all current taxable income. Later when they retire they could withdraw that amount over time when they’re in a lower tax bracket. This would provide far too great of tax benefits to that high-income earner.
Keep in mind that the government will get their tax dollars either this year (which occurs with after-tax Roth contributions) or in the future (as with traditional pre-tax 401k contributions).
For 2019, 401k maximum contributions were increased, from the previous max of $18,500. Catch-up contributions were not increased for 2019.
You may be wondering, ‘What if I want to exceed the allotted 401k contribution limits?’ Keep reading and you’ll find out about non-deductible after-tax 401k contributions.
4. 401k Annual Additional Limits
If you are an employee participating in a Roth or traditional 401k, you are entitled to make either the $19,000 or $25,000 (if over age 50) yearly contribution limits.
If you are fortunate enough to be in a situation in which your employer makes contributions for you (as in a Safe Harbor 401k, profit sharing arrangement, pension plans, or an employer match) you still can make up to the max 401k contributions.
In other words, the contributions made on behalf of the employer do not count against your individual 401k contribution limits.
Your 401k plan may allow for non-deductible after-tax 401k contributions which could allow you to exceed the yearly 401k limits. Some plan participants may purposely (assuming that the plan allows for this) surpass normal pre-tax and Roth contribution limits because the IRS will allow you to later convert those excess contributions to a Roth IRA.
The catch is the excess 401k contributions (above the normal max contribution limits of $19,000 and $25,000 for catch-up) are not tax deductible but will be tax-free when rolled over into the Roth IRA and when you begin withdrawing from the Roth.
This can be more advantageous than simply converting a 401k into a Roth.
If you are a plan sponsor, it is important you know some additional information regarding annual limits:
- Understand and use the defined annual compensation limit to calculate additional compensation (such as an employer match)
- Understand the difference between HCEs and NHCEs
- Understand 401k nondiscrimination tests and how the results of the tests can affect how much employees can contribute to their 401k
Even though these items seem unrelated, they eventually come together to possibly (and negatively) affect the max 401k contributions limits.
Let’s look at the annual compensation limit for 2019, which was raised to $280,000. This figure will be used in the calculation to determine employer matches if offered typically in the form of matching contributions or profit sharing contributions.
Employers use matches, which are essentially “free money” to the employee used to recruit and retain employees. It also encourages retirement savings.
Encouraging plan participants to save in the 401k is beneficial for employees of all compensation levels, and for the plan as a whole (especially for small businesses, as you will find out.)
How much can an employer contribute to my 401k?
The only rule regarding max 401k employer contributions is that employee + employer contributions are maxed out at the lesser of either $56,000 ($62,000 if over 50) or 100% of employee salary for 2019. Therefore, many employers will take the max $56,000 and subtract the possible $19,000 that an employee can contribute, leaving a total of $37,000.
Plan sponsors must use the defined annual compensation limit ($280,000) to determine matching amounts. For example, imagine that a 401k plan offers a match of 50% on employee deferrals up to 6% of employee wages, which will be capped at $280,000 (even if the employee makes more). 6% of $280,000 = $16,800 and 50% of $16,800= $8,400 which will be the employer match amount in this example.
If an employee makes $310,000 the max value of $280,000 must still be used. If an employee makes $125,000, then the calculation will be as follows: 50% x (6% x $125,000) = $3,750.
The wording is important here. If the plan says that a 50% match up to 6% of deferrals on the first $250,000 (as an example), then the employee can only contribute to the 401k up until $250,000 in compensation has been made.
If the employee was deferring a percentage based on a salary of $310,000 and wanted to reach the max 401k contribution limit of $19,000 (which would be attained by contributing roughly 6% of compensation per month assuming total compensation of $300,000), that employee would not be able to continue to contribute once $250,000 in compensation was reached.
Therefore, in this example, the employee’s total compensation would be below the max allowed. Thus, employer contributions can vary widely based on the plan document and stipulations.
HCEs vs NHCEs
An HCE is a Highly Compensated Employee, and is one that:
- Is compensated (includes all forms of compensation) with more than $120,000/year (if the previous year was 2018) or more than $125,000 (if 2019 was the previous year)
- Or, if a company chooses, is designated as part of the top 20% in terms of compensation within the company in the previous year (even if the top 20% earns less than the above yearly compensation)
- Or, owns (or owned at any time in the current or preceding year) more than 5% interest in the business – regardless of actual compensation
- Or is related (a spouse, parent, grandparent, or child) to the owner
- Or if a total aggregate of 5% ownership or more is reached between the employee and the above relatives
If an employee does not meet the above criteria, then he or she is considered to be a “rank-and-file” or non-Highly Compensated Employee (NHCE).
The ‘previous year’ stipulation above is important because an employee hired this year, who may eventually make more than $125,000 next year, is not an HCE for this year.
Looking at HCEs and NHCEs becomes very important when performing the required annual 401k compliance testing, which is necessary to pass in order to keep the 401k active and legal.
NDTs were put in place as a way to measure whether or not a particular 401k plan has been favoring HCEs over NHCEs. Before 401k contributions limits and NDTs, plan participants could contribute as much as desired to the 401k plan plus receive employer matches, which of course was easy to do for HCEs.
NDTs were put in place to prevent high earners from benefitting disproportionately compared to lower earners within a plan.
Small businesses are more prone to failing NDTs. NDTs are affected negatively by low NHCE participation. Low NHCE participation limits HCE contribution ability.
Therefore, annual contribution limits can, in some plans, not be a straight forward as simply setting a raw number value as a limit.
5. If You’re An HCE You May Breach The Limits And Be Refunded
As an HCE, you are subject to additional contribution limitation factors that are out of your control and you, therefore, may not be able to contribute the full $19,000 to the 401k, as mentioned above.
How could this be? Plan participants are covered by law with a max 401k contribution, right?
This is why non-discrimination tests are so important, for both employees and plan sponsors, because if NDT fails, then HCEs are further limited in terms of max 401k contributions.
Actually, the amount that an HCE can contribute to their 401k depends on the level of participation of NHCEs (both participation and how much NHCEs are contributing to the plan).
NDTs are performed using the previous year’s data, so HCEs may not know if their company failed the NDTs until 1 year after the fact. If a plan fails non-discrimination testing, HCEs will receive a refund of the excess contributions.
The refund will count as taxable income, will increase your tax burden, and decrease 401k growth potential and ultimately your retirement savings plan. A failed NDT is stressful and costly for both employees and the employer.
If you do receive a refund, talk with your financial planner and your plan administrator. Possible options may be to use the refund to pay off 401k loan debt, to contribute to a traditional IRA, invest into a taxable investment account, or to make a charitable and tax-deductible donation. Also, see how your employer is going to rectify the failed NDT and within what time period.
6. If You Have Multiple 401k Plans From Various Employers The Limit Is Still The Same Across All Plans
Exceeding the contribution limit will be a costly mistake as you will be taxed on excess contributions in the year that they are made. You will also be taxed later when you make a withdrawal on your 401k in retirement (all traditional pre-tax 401k withdrawals are taxed, by the way).
You may have multiple 401k accounts if you change jobs at some point during the year or have multiple jobs (such as 2 part-time jobs) that make you eligible for 401k plan participation.
If it is the case that you simultaneously have a 401k (or two) and a 403b, SARSEP, or a SIMPLE IRA, you still must adhere to the annual 401k limits.
Again, the max contribution limits for 2019 are a total of $19,000 if under age 50 and a total of $25,000 if over age 50. If for example, you have a 401k and a 403b, you could contribute $10,000 to the 401k and $9,000 to the 403b (plus catch-up 401k contributions if applicable). You cannot contribute $19,000 to both.
7. Your Income And 401k Plan Participation Will Affect Your IRA Deductibility If You Plan On Funding An IRA As Well
Many people have the desire to save and invest beyond just their 401k plan and do so with either a Roth IRA or a traditional IRA.
As you know, one of the benefits of the traditional 401k and the traditional IRA is the tax-advantaged status of these arrangements; the contributions are not taxed initially, these contributions can, therefore, be larger and grow tax-free. Once the owner begins to receive distributions in retirement, the appropriate taxes are paid.
Since these arrangements are tax-deferred, the contributions made within a given year can be deducted from that year’s tax liability, but certain criteria may limit deductions. To be clear, Roth IRA contributions are never deductible.
Deductibility is determined by:
- Income level (specifically, your adjusted gross income (AGI) level)
- Participation (by you and/or a spouse) in a work-sponsored retirement plan
- Marital status and tax filing status
You are considered to be covered by a plan if your employer or your spouse’s employer:
- Has a defined contribution plan
- 401k, profit sharing plan, or a stock-bonus and money purchase pension plan AND you or your spouse contributed to the plan in the tax year
- Has an IRA plan
- SEP, SARSEP, or SIMPLE IRA AND you or your spouse made a contribution in the tax year
- Has a defined pension plan AND you or your spouse is eligible to participate
The possible scenarios are:
You (and a spouse, if applicable) are not covered by a workplace retirement plan:
You can take the full deduction up to the contribution limit regardless AGI
You are single and you are covered by a workplace retirement plan:
If your AGI is less than $64,000 you can take the full deduction up to the contribution limit
If your AGI $64,000 but less than $74,000, you can take a partial deduction
If your AGI is greater than $74,000, you cannot take a deduction
You are married and only you are covered by a workplace retirement plan:
-If filing jointly or you are a qualified widower:
If your AGI is less than $103,000 you can take the full deduction
If your AGI is more than $103,000 but less than 123,000 you can take a partial deduction
If your AGI is above $123,000 you cannot take a deduction
-If filing separately
You can take only a partial deduction if your AGI is less than $10,000
You cannot take a deduction if your AGI is over $10,000
You are married and only your spouse is covered by a workplace retirement plan:
-If you are filing jointly
If your AGI is less than $193,000 you can take the full deduction up to the contribution limit
If your AGI is more than $193,000 but less than $203,000 you can take a partial deduction
If your AGI is more than $203,000 then you cannot take a deduction
-If filing separately
You can take only a partial deduction if your AGI is less than $10,000
You cannot take a deduction if your AGI is over $10,000
You should also know about the max Roth and traditional IRA contributions limits for 2019:
- The total max contributions to either type of IRA is $6,000 if under age 50 and $7,000 if 50 or older
- This does not include any values rolled over into an IRA
Income and marital status limit Roth IRA contributions. For 2019, the income limits are:
- Full contribution limit
- If your modified AGI is less than $122,000 and you are single
- If you modified AGI is less than $193,000 and you are married, filing jointly
- A limited amount
- If you are married, filing jointly, and your modified AGI is more than $193,000 but less than $203,000
- If you are single and your modified AGI is more than $122,000 but less than $137,000
- If you are married but filing separately and your modified AGI is less than $10,000
- You are not eligible to contribute
- If you are married, filing separately and your modified AGI is more than $10,000
- If you are married, filing jointly, and your modified AGI is more than $203,000
- If you are single and your modified AGI is more than $137,000
You are not alone in this process! Whether you need help answering questions, planning, or setting up a 401k, we will make sure you get the best 401k possible. Contact us so that we can help you today.