401k Contribution Limits
The 401k contribution limit numbers among the simpler, more straightforward retirement fund rules: An employee may contribute up to 100% of his annual earnings or the IRS’s annual limit—whichever is the least.
401k contribution limits for employees
In 2008, the IRS set the 401k contribution limit at $15,500—not counting catch-up privileges for employees over fifty years of age. An employee who made $15, 500 in 2008, could contribute the whole amount; but, as soon as he got that raise to $15,501, he had to exempt that extra dollar from the contribution. If the employee accidentally invested that extra buck, he has until April 15, 2009, to pull it back out, or he will face stiff penalties, taxes, and other sanctions.
If however, the employer matches the employee’s contributions, then the employee must reduce his share to avoid violating the limit. In many cases, the employer will provide a 1:1 match for veteran employees, so that, this year, employees may contribute no more than $7750.
In 2008, employees over fifty may add an extra $5000 to their 401k contributions under the Catch-Up provisions. And other employees within three years of mandatory retirement at 65 get even more Catch-Up allowances.
The 401k contribution limits increase annually at the rate of at least $500, and they are indexed for inflation, so that they may increase even more, but they will not decrease.
And all employee contributions are exempt from income tax until they are distributed, so that most 401k participants receive substantial tax refunds each year.
Special 401k contribution limits for High Compensation Employees (HCE’s)
Recognizing that the 401k contribution limits for wage earners would discourage 401k participation by executives who would achieve very little significant tax advantage from sheltering or deferring a small percentage of their earnings, Congress made special provisions for High Compensation Employees. Carefully monitored for wage and salary equity, companies must account for its proportions of HCE’s to rank-and-file workers. And HCE’s enjoy considerably higher 401k contribution limits proportional with their higher salaries.
In 2008, HCE’s may defer 100% of their earnings or $46,000—whichever is less. Same rule of thumb as wage-earners’ restrictions. In 2009, the limit will go up to $49,000, and it will continue going up by at least $500 per year; these 401k contribution limits are indexed for inflation, so they may go higher, but they cannot go lower.
The law also makes special provisions for employees who make more than $100,000, but most professionals making six-figures or more prefer the advantages of Roth IRA’s, which take no taxes at the time of their distribution.
401k contribution limits for self-employed workers
Self-employed workers generally will achieve greater growth with Independent Retirement Accounts, but they may establish 401k’s for themselves if they choose. The key to effective management of a 401k in a sole proprietorship is the business owner’s provision for paying himself a salary, because that provision makes administration and accounting considerably simpler.
The sole proprietor’s 401k contribution limit is 25% of his eligible income. If he files Schedule “C,” he may contribute 25% of his net income according to that schedule.