Investing in a 401k is an important part of planning for your financial future. However, it’s important to understand the rules and regulations surrounding your 401k before you start investing. One of the most important things to understand is the contribution limits that govern how much you can put into your 401k each year. Let’s break down everything you need to know about 401k contribution limits.
2023 401k Contribution Limit
In 2023, the annual contribution limit for a 401k account is $22,500. This limit applies to all contributions made by the employee, employer, or any other person or entity on behalf of the employee. It also includes both pre-tax and Roth contributions. If you are age 50 or older, you are allowed to make additional catch-up contributions of up to $7,500 per year. These limits apply only to contributions made in one calendar year and do not accumulate over multiple years.
Employer-Sponsored Retirement Plan Contributions
When an employee participates in an employer retirement savings plan, employers may match employees’ pre-tax contributions. Employer contribution amounts can vary depending on the employer. For example, some employers match up to 100% of employee contributions, while others may only match up to 25%. The employer match does not count towards the annual contribution limit, meaning it can be added without exceeding the yearly cap.
That said, maximizing contributions to reach the maximum employer match is an excellent way to supercharge your retirement. This essentially works like free money you can use toward building your retirement goals. A good rule of thumb is always contribute enough to get the full employer match.
Highly Compensated Employee
The IRS defines highly compensated employees as those “in the top 20% of earners in your company or related companies.” If your annual compensation exceeds $135,000, you will be considered a highly compensated employee and must adhere to different 401(k) contribution limits.
401(k) Contribution Limits for Highly Compensated Employees
The highly compensated employee (HCE) limit caps contributions at no more than 2x the average employee deferral percentage rate (ADP). This means non highly compensated employees may contribute 6%, while a highly compensated employee can contribute up to 12%. Employer matching contributions don’t count towards this limit.
How To Maximize Your Contributions
When maximizing 401(k) contributions as an HCE, contribute enough money to get the full employer match if your company offers one. This will ensure you maximize your employer’s contribution before increasing your contribution amount. Once that goal has been met, consider increasing your contribution amount incrementally until you reach the maximum allowed by law. This can enable you to get the most out of your retirement savings while still staying within legal limits. Additionally, if you want to save even more money but are limited by HCE restrictions on 401(k)s, consider investing in other retirement accounts like a Roth IRA, Roth 401 k or SEP IRAs, which do not have contribution limits for HCEs.
Tax Implications of Exceeding the Limit
Should you exceed the limits mentioned above, you may be subject to tax penalties from the IRS. The penalty is 10% on any excess contributions over either limit. Therefore, it’s important to stay within limits, so you don’t incur unnecessary taxes or penalties from the IRS.
Benefits of a 401k
For those considering investing in a retirement savings plan, the 401k is an attractive option due to its potential for long-term growth and tax benefits.
Tax Advantages of a 401k
One of the main draws of a 401k is its tax benefits. Contributions made into a 401K account are tax-deductible from federal income taxes in most cases. This means when you contribute money to your plan, it will reduce your taxable income for that year and thus lower your overall tax burden and increase the amount of money available for retirement savings. Additionally, you don’t pay taxes on any earnings from investments within a 401K account until they are withdrawn from the account at retirement age. This allows investors to take advantage of long-term growth without worrying about taxation.
Long-Term Growth Potential
The longer you leave money in a 401k, the more time it has to compound and grow. This means even small amounts of money can turn into big returns with enough time and patience. Additionally, if you have access to various investment options within your 401k plan (such as stocks and bonds), you can diversify your portfolio and potentially increase overall growth over time.
While it’s never too late to get started investing in a 401k, its attractive growth potential also means it’s never too early to get started as well. Opening an account earlier gives your investments time to grow and can be a wise investment decision.
Investing in a 401K is a great way to save, supplement retirement plans and take advantage of long-term tax benefit. However, it’s important to understand the rules governing a tax-advantaged retirement account to ensure you stay within legal limits when contributing funds to them. Knowing what these limits are—and understanding how they work—is essential in helping you reach your retirement goals.
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