401k Limits

In the US 401(k) is a retirement savings plan that allows workers to invest the savings thus deferring income tax on the saved money until it is withdrawn. The employee nominates a portion of wages to be paid directly into the 401(k) account, which is known as “a contribution”. 401(k) plans are primarily employer sponsored and the employer can optionally choose to contribute additional amount, lesser than or equal to worker’s contribution, in the worker’s 401(k) account.

Most plans are participant-directed where the employee selects from a number of investment options. Usually the employee is able to re-allocate money between the investment alternatives any time. The name “401(k)” originates from the reference to the Internal Revenue Code section 26 U.S.C. § 401(k).

There are limits on contribution to the 401k plans from both the worker and the employer per year. Maximum limit on a total employee pre-tax deferral for that year is known as the “401(k) limit”. The 401k limits, changing each year to account for any inflation, were $15,500 for 2008 and increased to $16,500 for 2009 and 2010. For future years, it may increase in increments of $500. Additional pre-tax catching up contributions are allowed for workers 50 years or over. These were $5,000 in 2008 and $5,500 in 2009. Future “catch up” contributions could also get adjusted for inflation with $500 increments.

Employee’s contribution can be allocated as pre-tax contribution, after tax Roth contribution or combination of both, if the selected plan allows for it. Only condition is that the total 401(k) contributions should be under the “401(k) limit”. April 15 of following year is the deadline for withdrawing any excess funds. If this is not done, the employee will pay taxes on the excess and appropriate penalties. There are limits on the employer contributions as well. When added to worker’s contribution the total cannot exceed section 415 limits. This equals to whichever amount is lesser out of 100% of worker’s compensation or $49,000 in 2009. Employer matching contributions can be made on behalf of the selected Roth contributions, however the employer match must be made on a pre-tax basis.

401k plans and limits are applicable only to wage earners and non-government employees. Governmental employers in US cannot present 401(k) plans to their employees unless established before May 1986. Instead, they need to set up a section 457(g). Also, if you are an independent entrepreneur or self-employed person, self employed 401(k) plans are for you.

Because of Economic Growth and Tax Relief Reconciliation Act (2001), solo 401(k) plans came into being to aid independent entrepreneurs in retirement planning. Self employed 401(k) plans are meant for any solo operator. These include business owners, freelancers, sole proprietors, independent contractors and folks in company, corporation or partnership with limited liability. Higher extremity of the self employed 401(k) limits is determined by organization/business type. The amount fluctuates yearly, similar to 401k limits for wage earners. Self-employed persons could contribute up to $49,000 in 2009 while those over 50 could nominate up to $54,000.