401(K): Brief Overview
A 401(k) is a type of tax-qualified retirement savings account regulated by the Internal Revenue Code in the United States. The 401(k) is a deferred compensation plan that requires an employee to contribute a portion of their wages to the account on a pretax basis. Also referred to as elective contributions, these deferred wages are not subject to income tax withholding at the time of contribution; the wages are not reflected on the employee’s Form 1040 since they are not included in the taxable wages on the individual’s Form W-2. That being said, the wages are subject to Medicare, social security and federal unemployment taxes.
A contributor in a 401(k) may begin to withdraw funds after reaching the age of 59.5 years. The 401(k) is widely regarded as the traditional retirement plan for American workers; the 401(k) was first created in the early 1980s as an alternative to the pension, which was paid by employers. Employer contributions with a 401(K) will vary, but in general the account shifts the burden for retirement savings to the individual worker.
401(K) Contribution Limits:
The Internal Revenue Service places 401 K contribution limits, which effectively places a cap on the amount of funds a worker can contribute to their retirement plan. Moreover, the employee’s elective contributions may be limited according to the terms of their particular 401(k) plan. All 401(K) contribution limit information is listed under Publication 525 in the Internal Revenue Service’s Taxable Nontaxable Income; employers must refer to Publication 560 (Retirement Plans for Small Business).
The maximum limit on the total yearly pre-tax—a figure known as the 402(g) limit—was $15,500 in 2008 and $16,500 for the taxable years of 2009 to 2011. This figure will be increased to $17,000 in 2012; 401(k) contribution limits are indexed for inflation, which increases the increments by $500.
Employees over the age of 50 can provide “catch up” contributions of up to $5,000 for 2008 and $5,500 for the following years up to 2011. Limits for future “catch up” contributions are also adjusted for inflation in increments of $500. For eligible plans, an employee may elect to contribute a percentage of their salary as a Roth 401(k) contribution, on a pre-tax basis, or a combination of the two; however, the total of the two contributions amounts cannot exceed the 401(k) contribution limits in a single calendar year. The 401(k) contribution limits do not apply to post-tax non-Roth elections.
If an employee contributes over the maximum pre-tax/Roth limit to a 401(k) account in a given year, the excess—along with the deemed earnings for the contribution—will be withdrawn or corrected by April 15th of the following year. Violating 401(k) contribution limits typically occurs when an individual switches jobs mid-year and the most recent employer does not enforce the 401(k) contribution limits on behalf of their employee. If the violation of the 401(k) contribution limits is not noticed in time, the employee will be required to pay tax on the excess contribution and the tax will effectively be doubled as the late corrective contribution is required to be reported again as income.
There are also maximum 401(k) contribution limits that apply to all employee and employer 401(k) contributions in a calendar year. These 401(k) contribution limits—which are established in section 415 of the IRS tax code—are the lesser of 100% of the employee’s total pre-tax pay or $46,000 for 2008 and $49,000 for 2009 to 2011. Government employers in the United States are barred from offering a 401(k) plan to their employees, unless they were established before May of 1986.