What is a 401k? 

Background of 401k Contribution Limits

If you've been procrastinating, or short-changing your 401k plan, then there is a bit of good news for you.  Part of the Restoring Earnings to Lift Individuals and Empower Families (RELIEF) Act of 2001, now allows you to start building-up that retirement account, and in some cases catch-up on some lost time.

For quite some time, the 401k contribution limits had suffered from a lack of attention.  Specifically, they were moving up each year at too slow of a pace.  Even those investors that contributed faithfully to these accounts, and at the plan limits, were not seeing enough growth to ensure a financially secure retirement.  But that's no longer a problem today.

401K Contribution Limits

The recent changes in 401k contribution limits are good news for investors willing to leverage these plans in their retirement portfolio.  Starting back in 2004, the contribution limits started to increase quickly, and in 2012 will continue to be indexed to inflation.

Pretax 401k Contribution Limits

Let's take a quick look at the individual pretax contribution limits set by the IRS in the recent past, and over the next few years:

2007 - $15,500

2008 - $15,500

2009 - $16,500

2010 - $16,500

2011 - $16,500

2012 - $16,500 plus an index for inflation ($500 increments)

As the table above demonstrates, in 2012 contribution limits that apply to 401k plans will be indexed for inflation; a type of cost-of-living index.  These limits can move up in $500 increments in the future.

For those of you that had been putting off retirement planning, and have reached age 50 or over, there is an added benefit in the form of a catch-up provision.

Pretax 401K Catch Up Limits

A catch up limit is just what it sounds like, the current 401k rules allow for plan participants that reach age 50 before the calendar year is over to make additional catch up contributions on a pretax basis as shown below:

2007 - $5,000

2008 - $5,000

2009 - $5,500

2010 - $5,500

2011 - $5,500

2012 - $5,500  plus an index for inflation ($500 increments)

As was the case with the "standard" contribution limits, the "catch-up" contribution limits will continue to be indexed for inflation in 2012, and can increase in $500 increments.  In 2011, the catch up limit remains at $5,500.

Employer Contribution Limits

In addition to the contribution limits appearing in the tax law, there can be employer imposed contribution limits to 401k plans.  The contribution limit for employers is set at 6% of the employee's pretax compensation.

That means an employee with a total compensation package of $100,000 can contribute $16,500 in 2011 on a pretax basis, and their employer can contribute another $6,000 for a total of $22,500.  If you're 50 or older, then you can contribute another $5,500 pretax bringing the total to $28,000.

Matching Contributions

In addition to the elective deferrals made by employees, an employer may also offer their employees matching 401k contributions.  Usually an employer's match is limited to a percentage of an employee's pre-tax contribution.

For example, if an employee decides to contribute $10,000 to their 401k plan, and the employer matches 50 cents on the dollar, then the total contribution to the plan would be $15,000 in that calendar year.

Highly Compensated Employees

Some employees are subjected to a second contribution limit.  If you're classified as a "Highly Compensated" employee, then you may be subjected to contribution limits based on your employer's overall 401k participation rates.  If your salary is above $110,000 in 2010 or 2011, then you may need to contact your employer to see if any additional limits apply to you.

For a highly compensated employee, the total of your elective deferrals and contributions made for you by your employer under a section 401k plan or SARSEP can be no more than 125% of the average deferral percentage (ADP) of all eligible non-highly compensated employees in a calendar year.

If the total contributed to the plan is in excess of the amount allowed under the ADP test, then any excess contributions must be either distributed back to the employee or re-characterized as after-tax employee contributions.  For example, the contribution can be distributed to an employee, and then contributed by the employee right back into the plan.

Highly compensated employees must report these excess 401k contributions as taxable income on IRS Form 1040, line 7.  An employee should receive a Form 1099-R in any year in which an excess contribution is distributed to them.

After-tax / Total 401k Contributions

In addition to the pretax or tax-deferred contributions you can make to your 401k plan, your plan may also allow employees to make after-tax contributions.  When after-tax contributions are added to pretax contributions, this becomes your total 401k contribution, which also has a limit.

In 2010, the total that can be contributed to a 401k plan is $49,000 or 100% of your compensation, whichever is less.  In 2011, this total 401k contribution limit could have been indexed to inflation, and could have moved up in $1,000 increments.   However, the 2011 limit remains the same at $49,000.

Access to Contributions

Earnings on all contributions are considered tax-advantaged, and fall under the 401k withdrawal guidelines.  However, after-tax contributions are considered fully accessible to the employee since taxes have already been paid on that money.

The rules for qualified retirement plans such as 401k plans are complex.  Your plan administrator should have documentation outlining the exact rules that apply to your particular employer's plan.  That document should explain these limitations, as well as other rules or regulations that might apply.