Given that a 401(k) retirement plan can be such an effective way to shelter money from taxes, building wealth as your dividends, interest, and rents pour in and get reinvested without a single penny being diverted to the IRS, Congress, understandably, put limits on the amount of money you can contribute each year. Otherwise, a successful business owner, executive, actor, physician, or musician could put millions upon millions of dollars in their 401(k) plan each year, all but avoiding income taxes. This, in turn, would make the burden of funding essential government services, such as defense and infrastructure, fall squarely on the shoulders of the lower and middle classes.
The Three Types of 401(k) Contribution Limits
The downside of this otherwise sensible policy is that calculating how much money you are allowed to put into a 401(k) can be a bit tricky. As a result, you have to be extremely careful not to exceed the 401(k) contribution limits in effect in any given year. What makes the limits somewhat more complicated than those on a Traditional IRA or Roth IRA is the fact that, for all intents and purposes, there are three different types of limits placed on your 401(k) contributions.
- The Elective Deferral 401(k) Contribution Limit represents the amount of money that the owner of the 401(k) account can contribute from his or her own paycheck. In 2012, this part of the 401(k) limit was set at $17,000. In future years, it will increase in $500 increments based upon changes in the inflation rate.
- The Catch-Up 401(k) Contribution Limit represents additional money that workers over 50 years old can contribute toward their retirement savings. As of 2012, this figure is set at $5,500.
- Additional 401(k) Contribution Limits represent a "catch all" rule. Basically, the grand total of all elective deferral contributions, plus catch-up contributions, plus any money added to the account by the employer in matching funds or bonus systems, etc. cannot exceed the lesser of 100% of your compensation or $50,000 in the year 2012. For this calculation, income is limited to $250,000 for 2012.
That last bit is important. Essentially, it means that the most money you can get into a 401(k) in any given year is $50,000. Of that, only $17,000 can come from you saving out-of-pocket through your own paycheck deductions. If you are 50 or older, you can add another $5,500 to that amount (or $22,500 in total). The other $33,000 or $27,500, depending upon your age and whether or not you qualify for the catch-up contribution, must come from your employer. Very few employers offer generous enough 401(k) packages to take advantage of those kinds of limits.
For a best case scenario: If you are a self-employed business owner working only with your spouse, it might be possible to create a 401(k) plan that is structured so your family can put aside $100,000 a year in tax-deferred shelters. Over a long career of 30 or 40 years, the riches you would build up could very easily reach into the tens of millions of dollars.
What Happens If You Exceed the 401(k) Contribution Limits In Place During the Year?
If you contribute more money to your 401(k) account than you are permitted, you have until April 15th to tell the plan to return the cash to you. This overpayment is referred to an excess deferral. If you received a tax deduction, you will have to give it back upon withdrawing the excess deferral but you shouldn't be subject to the additional 10% early withdrawal penalty.
It is your responsibility to catch excess 401(k) contributions, not your employer's. If you don't remove the excess before the tax filing deadline in the year in which the error is made, you will face stiff penalties, a form of double taxation, and might even have your entire retirement plan reclassified as non-qualified, which would have enormous financial implications if you have built a decent-sized nest egg.
The 401(k) Contribution Limits Might Be Different for Highly Compensated Employees
If you qualify as a so-called highly compensated employee, which means making more than $115,000 from your employer in 2012, you might have a lower 401(k) limit than you otherwise would. The reason? Congress wanted to make sure 401(k) plans weren't just used to benefit higher-ups in the management structure. As a result, the total percentage of 401(k) assets held by highly compensated employees cannot exceed certain thresholds (in technical terms, the total 401(k) savings of highly compensated employees cannot exceed 125% of the average deferral percentage of all eligible non-highly compensated staff in any given calendar year).
In other words, you might find yourself facing lower contribution limits because the other employees at your firm didn't save as much money as they should have been saving. It is unfortunate, but that is the way the rules are written.
Talk to a Retirement Specialist, Tax Attorney, Qualified Accountant, and / or Human Resources If You Have Questions
The rules and regulations surrounding retirement plans are notoriously complex. If you make a mistake, it could significantly hurt your family's finances. If you think you might have done something wrong, or are in danger of violating one of the provisions governing your retirement plan, talk to the right people and get the problem solved as soon as possible.