Do employer contributions affect 401k limits?

A 401(k) is an employer-sponsored plan that allows employees to contribute part of their paycheck for retirement. The employee must decide how much to contribute, but it should not exceed the IRS contribution limit. These contributions are deducted automatically from your paycheck and deposited to your 401(k) account. If the employer offers a match, you should collect the free money to max out your 401(k) contributions.

The employer contribution does not affect your 401(k) contribution limit. However, the IRS places a cap on the total employee and employer contributions made to a 401(k) in a specific year. For 2021, the total contributions to a 401(k) should not exceed $58,000, or $64,500 if you are above age 50.

401(k) Employee Contribution Limits for 2020 and 2021

If your employer offers a 401(k) plan, you can join the retirement plan, and start saving for your retirement. However, you can only contribute to the 401(k) up to a certain limit. In 2020 and 2021, you can contribute to the 401(k) account up to $19,500 per year, and this limit includes the salary deferral and any contributions made to a Roth 401(k). If you have multiple 401(k)s, the cumulative contributions to the 401(k)s should not exceed the IRS limit. However, if you have an IRA, the IRA contributions do not count towards the 401(k) limit. If you are above age 50, the IRS allows you to contribute an extra $6,500 to speed up your retirement savings. This increases your total 401(k) contribution to $26,000.  

Employer Contribution Limits

One of the perks of a 401(k) plan is the ability to collect an employer’s match. If your company offers a match, you should find out if you are eligible to receive the benefit. Some employers allow employees to start collecting the match immediately after joining the company, or after working in the company for a specific number of months. The employer may match $0.5 to $1 of every dollar you contribute to the 401(k) account up to 6% of your salary. 

The employer can contribute to your 401(k) regardless of how much you contribute, but there is a cap on the total contributions. For 2021, the cap on the total employer and employee contribution is $58,000. If you are age 50 or older, the total contribution increases to $64,500 ($58,000 + $6,500 catch-up contribution). The total employee and employer contributions should not exceed 100% of an employee’s annual pay.

Contribution Limit for Highly Compensated Employees

Some 401(k) plans may provide additional contribution limits for highly compensated employees (HCE). For a 401(k) plan to remain ERISA-compliant, HCEs in the plan cannot contribute 2% more than the non-highly compensated employees. For example, if regular employees contribute 5% of their salary to 401(k), an HCE cannot contribute more than 7% of their cumulative salary.

For an employee to qualify as a highly compensated employee, they must meet certain conditions. They must own 5% or more of the business sponsoring the 401(k) plan during the past year and must exceed the annual compensation limit provided by the IRS. For 2021, they must have earned $130,000 or more from the company sponsoring the 401(k) plan.

Traditional 401(k) vs. Roth 401(k) Contributions

If you have a traditional 401(k) and Roth 401(k), these retirement accounts have different tax treatments. With a traditional 401(k), you will get a tax break on your income when you contribute to the retirement account. For example, if your annual salary is $50,000, and you contribute to a 401(k) up to the allowed limit of $19,500, your taxable income will be $30,500.

In contrast, if you contribute to a Roth 401(k), you will not get a tax break. This is because a Roth 401(k) is funded with after-tax money, meaning that you contribute money on which taxes have been taken out. If you take a distribution from a Roth 401(k) after attaining retirement age, you won’t pay any income taxes on the distribution. Also, if your employer offers a 401(k) match, the matching contributions cannot be added to a Roth 401(k). Instead, the employer contributions are added to a traditional 401(k). 

What Happens If You Contribute Too Much to 401(k)?

If your 401(k) contributions exceed the allowed IRS limit, you must take immediate action to avoid double taxation. Once you discover that you made excess contributions, you should notify the plan sponsor or your employer immediately. The IRS requires that participants must notify the 401(k) plan by March 1 of the following tax year.

The 401(k) plan should make a corrective distribution and return the excess distribution, plus any additional earnings attributable to the excess contribution by April 15. Your employer will be required to update your W-2 form to reflect the excess distribution. If the excess contribution had some earnings, you will receive Form 1099-R to report the earnings paid to you.

If the employer does not refund the excess contribution by April 15 of the following tax year, you could be taxed twice. You will owe income tax on the excess contribution in the year when you made the excess contribution, and when the corrective distribution is made.