IRS – How Your Employer Match Contributions Affect Your 401k LimitsPublished:
Does employer match count towards the 401k limit?
Here’s another one to retire to: The way your employer matches affect your 401k limits.
An employer match is a benefit that some companies offer as part of their 401k retirement savings plan. It works by the employer matching a percentage of the employee’s contribution to their 401k account. For example, a common employer match is for employers to contribute 50 cents for every dollar an employee contributes up to a certain percentage of their salary. This can be a valuable savings tool as it helps employees increase their retirement savings and potentially maximize their contributions up to the annual limit set by the IRS. But, does employer match count towards the 401k limit? Let’s explore this question further.
What is an employer match?
An employer match is a type of contribution that some companies offer to their employees as part of a 401(k) retirement savings plan. Essentially, an employer match helps employees save for retirement by matching a percentage of their contributions to the plan. This can be hugely beneficial for employees as it can help them increase their retirement savings over time.
There are different types of employer match plans that companies may offer. Some employers may match a certain percentage of their employees’ contributions up to a maximum. For instance, a company may match 50% of an employee’s contribution up to a maximum of 6% of their salary. Other companies may match contributions up to a certain percentage of the employee’s salary. For example, an employer may match 100% of an employee’s contributions up to 3% of their salary.
Employer matching contributions can make a significant difference in an employee’s retirement savings. For example, let’s say an employee earns $50,000 per year and contributes 6% of their salary to their 401(k) plan. If their employer matches 50% of their contributions up to a maximum of 6%, that would amount to an additional $1,500 per year in contributions. Over the course of 30 years, assuming a 7% annual return on investment, those employer contributions alone could grow to over $116,000.
Employer Matching Contributions Explained
Employer matching contributions are a popular feature of many retirement plans, particularly qualified plans offered by employers. These plans are designed to help employees save for retirement while providing significant tax benefits for both employers and employees. One of the key components of these plans is salary deferrals, where employees choose to reduce their taxable income by contributing a portion of their salary to the plan. Employers may then choose to match a portion of these contributions to help employees build their retirement savings even faster.
Qualified Plans for Employers
Qualified plans are a popular option for employers looking to offer retirement benefits to their employees. These plans meet specific requirements under the Internal Revenue Code, which allows for tax advantages for both the employer and the employee.
There are different types of qualified plans available for employers to choose from, including 401(k) plans, profit-sharing plans, and defined benefit plans. 401(k) plans are perhaps the most well-known type of plan, allowing employees to contribute a portion of their salary on a pre-tax or after-tax basis. Employers may have the option to match a portion of these contributions, up to a certain limit.
Profit-sharing plans, on the other hand, provide employers with more discretion on when and how much to contribute. These contributions may be based on a percentage of profits or allocated using a specific formula.
Defined benefit plans, also known as pension plans, provide a specific benefit to employees upon retirement, based on factors such as salary and years of service. This type of plan typically requires more administrative work and may be more expensive for employers to maintain.
Salary Deferrals for Employees
Salary deferral is when an employee chooses to contribute a portion of their salary to their 401(k) plan on a pre-tax basis. There is a limit on the amount of money an employee can contribute to their 401(k) plan through salary deferrals each year. This limit is set by the IRS and can change from year to year. In 2021, the limit is $19,500. However, highly compensated employees may have a lower limit on their elective deferrals.
Highly compensated employees are those who meet certain conditions set by the IRS. For the 2021 plan year, the IRS defines a highly compensated employee as someone who earned more than $130,000 in the previous year or owns more than 5% of the company sponsoring the plan. For highly compensated employees, the elective deferral limit may be reduced to ensure that the plan does not discriminate in favor of highly compensated employees.
Tax Benefits of Employer Matching Contributions
One of the significant advantages of employer matching contributions to a 401(k) plan is the tax benefits. Employer matching contributions are made on a pre-tax basis, which means that the money is taken from the employee’s salary before taxes are calculated, reducing their taxable income. This reduction in taxable income can result in a lower income tax bill for the employee, providing immediate tax benefits. In the next section, we’ll discuss the tax benefits of employer matching contributions in greater detail, including how they can provide long-term tax advantages.
Pre-Tax Basis and Taxable Income Reduction
One of the main advantages of participating in a 401(k) plan is the ability to make pre-tax contributions, which have significant tax benefits. When an employee makes a pre-tax contribution to their 401(k) plan, the contribution is deducted from their salary before taxes are calculated. This means that the amount of the contribution is not included in the employee’s taxable income, resulting in a reduction in their overall tax bill.
Employers can also offer other pre-tax deductions, such as health and life insurance premiums, which can further reduce an employee’s taxable income. When combined with pre-tax contributions to a 401(k), these deductions can result in significant savings for employees come tax time.
In addition to pre-tax contributions, employer-sponsored 401(k) plans also offer other tax advantages. For example, deductible employer contributions can reduce the company’s taxable income and provide an attractive benefit for employees. Tax-deferred elective deferrals and investment gains can also grow tax-free until distribution, providing additional long-term tax advantages.
One way in which a 401(k) plan can help reduce an employee’s taxable income is through employer matching contributions and elective salary deferrals. When an employee contributes to a 401(k) plan through an elective salary deferral, they reduce their taxable income by the amount contributed. In addition, employer matching contributions are also made on a pre-tax basis, resulting in an even greater reduction in taxable income for employees.
Understanding the 401k Limit
One of the unique features of 401(k) plans is the ability for participants aged 50 or over to make additional catch-up contributions beyond the standard annual contribution limits. Catch-up contributions allow older investors to boost their retirement savings in the years leading up to retirement. The extra contributions can be especially helpful for those who have fallen behind on their retirement savings goals or who have experienced setbacks in their retirement planning.
The catch-up contribution limits for traditional and safe harbor 401(k) plans are $6,500 for 2022 and 2023. This brings the total contribution limit for these types of plans to $20,500 for both years. On the other hand, SIMPLE 401(k) plans have a lower catch-up contribution limit of $3,000 for 2022 and 2023, which means the total contribution limit for these plans is $16,500 for both years.
It’s important to note that catch-up contributions are in addition to the standard elective deferral limits for 401(k) plans. For employees under the age of 50, the limit for elective deferrals is $19,500 for both 2022 and 2023. The total contribution limit, including catch-up contributions, elective deferrals, and employer contributions, must not exceed the greater of 100% of the employee’s salary or $58,000 for 2022 and $61,000 for 2023.
For those aged 50 or over, the total contribution limit increases to the lesser of 100% of the employee’s salary or $64,500 for 2022 and $67,500 for 2023.
Employee contributions are elective salary deferrals that allow employees to transfer a portion of their pre-tax income directly into their 401(k) account. Employer contributions, on the other hand, are made by the employer on behalf of the employee as part of the employee’s benefits package.
Employees can combine their elective salary deferrals with other contributions to reach the maximum contribution limit. As of 2022 and 2023, the maximum individual contribution limit for employees to 401(k) plans is $19,500 annually. For those aged 50 or over, the maximum individual contribution limit increases to $26,000 annually.
Employer contributions such as employer matching contributions can also be combined with employee contributions to reach the annual contribution limit. For example, an employer can offer a matching contribution that matches a percentage of the employee’s salary deferral. A common matching contribution is 50% of the employee’s salary deferral, up to a maximum of 6% of the employee’s salary.
Other types of employer contributions include non-elective contributions, which are made regardless of whether the employee makes a salary deferral, and profit-sharing contributions, which are made based on the company’s profits and are not guaranteed.
The total contribution limit, including both employee and employer contributions, must not exceed the greater of 100% of the employee’s salary or $58,000 for 2022 and $61,000 for 2023.
Excess Contributions and Withdrawal Penalties
Making excess contributions to a 401(k) plan can have serious consequences for participants. Excess contributions occur when a participant contributes more than the annual contribution limit set by the IRS. For 2022 and 2023, the annual contribution limit is $19,500 for individuals under 50 and $26,000 for those 50 and over.
The penalty for excess contributions is 6% of the excess amount for each year the excess contributions remain in the account. To avoid this penalty, participants must correct the excess contributions before the tax deadline.
To calculate excess contributions, participants should add up all of their contributions for the year, including any employee deferrals and employer contributions, and then subtract the annual contribution limit. Any excess amount is subject to the penalty.
To correct excess contributions, participants have two main options. The first option is to withdraw the excess and any earnings before the tax deadline, which is typically April 15th of the following year. This option will avoid the penalty, but participants will still owe income taxes on the earnings.
The second option is to apply the excess contributions to a future year’s contributions, if the plan allows. This option will also avoid the penalty, but participants will need to ensure they stay within the annual contribution limit going forward.
If participants fail to correct excess contributions in a timely manner, they may face additional income taxes in addition to the penalty. The excess amount will be included in their taxable income and subject to taxes at their ordinary income tax rate.
To avoid withdrawal penalties, participants can invest excess contributions into other tax-advantaged retirement accounts, such as a Traditional IRA or Roth IRA.
Deferred Taxes on Investment Earnings
There are a variety of investments that can be made within a 401k plan, including mutual funds, which are one of the most popular choices due to their diversification and professional management. Other investment options may include individual stocks, bonds, and exchange-traded funds (ETFs).
While the tax deferral aspect of 401k plans can be appealing, it’s important to remember that effective investing is still necessary to maximize savings for retirement. Participants should monitor their investment returns and adjust their strategies as needed to ensure they are making the most of their contributions. This may involve seeking guidance from a financial advisor or conducting research on different investment options.