401k Contribution and Catch up Limits

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Perhaps the single most important retirement account available to employees today is their 401k plan. In this article we're going to discuss the current (2007 / 2008) 401k contribution limits, including catch-up limits, pre-tax and total contributions limits, as well as the limits that apply to highly-compensated employees.

Background of 401k Contribution Limits

If you've been procrastinating or short changing your 401k plan, 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.

Additional Resources

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 a bit of good news for investors willing to leverage these plans in their retirement portfolio. Starting a couple of years ago, the contribution limits started to jump up quickly and in 2009 will continue to be indexed to inflation.

Pre-Tax 401k Contribution Limits

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

2004 - $13,000
2005 - $14,000
2006 - $15,000
2007 - $15,500
2008 - $15,500
2009 - $15,500 plus an index for inflation ($500 increments)

As the table above demonstrates, in 2009 contribution limits that apply to 401k plans will be indexed for inflation - a type of cost-of-living index. Those limits will move up in $500 increments.

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

Pre-Tax 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 contribution limits on a pre-tax basis as shown below:

2004 - $3,000
2005 - $4,000
2006 - $5,000
2007 - $5,000
2008 - $5,000
2009 - $5,000 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 2009 and can increase in $500 increments. In 2008, the catch-up limit remains at $5,000.

Employer Contribution Limits

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

That means an employee with a total compensation package of $100,000 can contribute $15,500 in 2008 on a pre-tax basis and their employer can contribute another $6,000 for a total of $21,500. If you're 50 or older, then you can contribute another $5,000 pre-tax bringing the total to $26,500.

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 contribution $10,000 to their 401k plan and the employer matches 50 cents on the dollar then the total contributions to the plan would be $15,000 in that calendar year.

Highly-Compensated Employees

Some employees are subject to second form of contribution limit. If you're classified as a "Highly Compensated" employee, you may be subject to contribution limits based on your employer's overall 401k participation rates. If your salary is above $100,000 in 2007 / 2008, 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 pre-tax 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 pre-tax contributions, this becomes your total 401k contribution - which also has a limit.

In 2008, the total that can be contributed to a 401k plan is $46,000 or 100% of your compensation - whichever is less. In 2009, this total 401k contribution limit will be indexed to inflation and can move up in $1,000 increments. In 2007, the total that could be contributed was $45,000.

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.

There are no doubts the rules for qualified retirement plans such as 401k plans are complex. Your plan administrator should have documentation outlining the 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.

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