It is very important that you build a foundation for your financial future. And contributing to a 401K plan can assure that. If you are fortunate enough to have an employer that offers a 401(K) Plan. It can be one of the easiest and most effective ways of saving for your retirement. 401(K) Plans enable you to put a portion of your pay automatically into your account. But also comes with some restrictions on how much you can contribute.
Every year, normally in October or November. The Internal Revenue Service (IRS) reviews and sometimes adjusts. The maximum contribution limits for 401(K) plans, individual retirement accounts (IRAs). And other retirement savings vehicles. Currently, the IRS update of the contribution limits for. 401(K) plans in 2020 on Nov 6, 2019, increased the employee contribution from $19,000 – $19,500.
- The catch-up contribution rose to $6,500
- The limit on combined employer/employee contributions also rose to $57,000.(with the addition of a catch-up contribution. The limit went to $63,500)
401 K Contribution Limits 2020 Vs. 2019
As earlier stated, the 401 K contributions limits. Are adjusted annually and have increased in 2020. Here is how the 2020 401 K contribution limits stack up to 401K contributions limits in 2019:
- Firstly, for 2019, the maximum employee elective deferral was $19,000, in 2020, it is raised to $19,500.
- Secondly, in 2019, the catch-up contributions were. $6,000 but has increased to $6,500 in 2020.
- The total maximum contribution rate. All sources has increased by $1,000 to hit $57,000 for the tax year 2020.
- From $62,000 in 2019 for maximum contributions from all sources. Including catch-up. For participants 50 and older. It has increased to $63,500 in 2020.
- Highly compensated employee limits remain unchanged.
Employer Contribution Rules
Employees are encouraged to take advantage of employer-matched 401(K) Plans: free money. This is because employers who match employees’ contributions often do so between 3% and 5% of the employee’s salary. Thus if you make $50,000 and contribute 5% of your salary ($2,500) and yours. Employer matches that 5%, you’ll be adding $5,000 to your balance each year.
The 401(K) as earlier stated, has an annual total contribution limit, which caps the combined amount you and your employer can contribute. In 2020, your total 401(K) contributions from yourself. And your employer cannot exceed $75,000 or 100% of your compensation. Whichever is less. The limit rose from $56,000 in 2019.
Limits for Highly Paid Employees
There is a test by the IRS that helps employers who sponsor 401(K) plans asses each year whether employees are taking part in their plan at levels that are proportionate to the employees’ compensation. If the test determines that people across compensation levels are not taking part in a manner the IRS sees proportionate, the employee contribution levels for highly compensated employees can be lowered. When this happens, your employer may be required to return some of your excess contributions.
What Happens When You Exceed the Contribution Limit?
If it happens that a 401K plan participants exceed the contribution amount. They will be penalized by having to pay taxes twice on the excess amount, except corrected before the filing deadline. This is also called the ‘excess deferral’.
This is how the double tax penalty breaks down:
- Firstly, the excess contribution gets included in the individual’s taxable income in the tax year for which it was contributed.
- Secondly, it also gets taxed a second time, when it is withdrawn from the account.
Thankfully, if you’ve caught the error before the filing deadline. You can resolve it and avoid facing penalties from the IRS. In order to rectify an excess contribution, you’ll have to alert your plan administrator or employer as soon as possible, so that your W-2 can be adjusted, and your excess contribution can be returned to you before taxes are due. This is referred to by the IRS as ‘corrective distribution’.