Many people use their employer-sponsored 401(k) plans to make up the bulk of their retirement savings. These plans represent tax-free money employees can save and invest today to fund their retirement. Of course, Uncle Sam has some requirements for granting tax-exempt status to that money in the here and now. Each year, those expectations are subject to change, which means it is vitally important for employees to review the new IRS rules to keep their 401(k) plans in his good graces.
What is a 401(k)?
The 401(k) is an employer-sponsored retirement plan that allows employees the opportunity to invest a small amount of their pretax income toward their retirement. This money remains untaxed until you withdraw it from your retirement account.
In the beginning, Congress designed 401(k) plans to operate as supplements to organizational pension plans. Today, however, few companies offer pensions. Some employers may match employee contributions, up to a certain amount, though even that is not a given.
The U.S. government has strict limits as to how much of your income you can contribute to your 401(k). Understanding these contribution limitations can spare you from getting in hot water and incurring financial penalties from your dear old Uncle.
401k Contribution Limit Changes from 2019 to 2020
Some 401k plans offer the option of contributing before and after-tax dollars to the 401(k). Not all do. However, if yours allows that benefit, it is worth considering, especially for people who are approaching retirement age.
The good news for the contribution limit changes from 2019 to 2020 is that they have increased. Both the standard contribution limit and the catch-up limit (additional investments people over the age of 50 can make) have increased by $500 each. That means the standard 401(k) contributions have gone from $19,000 to $19,500, and catch-up contribution limits have improved from $6,000 to $6,500 for employees 50 years of age and older.
People who are using catch-up investments can now invest a total of $26,000 for the year in their pretax 401(k) plans, rather than the $25,000 maximum they faced in 2019.
For those who can invest after-tax dollars in their 401(k) plans, the rules are different. You may continue to invest your pretax income with the same limits listed above. However, you may contribute additional income into your 401(k) in amounts up to $57,000 (up from $56,000) or 100 percent of your total income, whichever of these numbers is lower.
For people working for employers who offer matching contributions, these contributions represent a portion of your 401(k) investment but can be seen as “free” money since they do not count toward your contribution limit.
Types of 401(k) Plans
The term “401(k)” has become a sort of catch-all term that refers to different types of employer-sponsored retirement savings plans. There are several types of these plans available. Unfortunately, since employers sponsor these plans, you are limited to the options your employer provides. They may include any one or more of the following:
- Safe harbor
The exception is the Simple 401(k). If your employer offers the simple 401(k) plan, it may not provide any additional 401(k) plan options.
Understanding 401(k) plans, how they operate, and their contribution limits can help you plan for retirement more thoughtfully and with fewer risks of penalties, fines, and more.
Individuals can review the November 6, 2019 announcement issued by the IRS for additional information.