LAST REVIEWED Dec 10 2020 8 MIN READ
By The Human Interest Team
A 401(k) is a common type of retirement account in which you contribute savings that come out of your paycheck before you pay income tax. Most commonly, an employer sponsors the employee’s 401(k), but you can also open an individual 401(k) if you are self-employed or your employer does not offer this benefit. Each year, you can save up to the max 401(k) contribution established by the Internal Revenue Service. Even if you are new to investing, a 401(k) offered through your employer is a powerful and simple way to put money away for your retirement lifestyle.
Current 401(k) Contribution Limits
An individual younger than age 50 can contribute $19,500 to his or her 401(k) account in 2020 and 2021. Individuals older than age 50 can make an annual catch-up contribution, bringing their annual max 401(k) contribution to $26,000 per person. The catch-up contribution for people age 50 and older usually increases by about $500 per year. The standard contribution is usually subject to the same cost-of-living increase. Every autumn, the IRS reviews the max 401(k) contribution limits and makes changes as necessary.
This 401(k) max contribution limit includes funds you divert from your salary to your retirement savings as well as deposits made to any Roth Individual Retirement Account (IRA). Other types of retirement accounts, including 457 plans, federal Thrift Savings Plans, and 403(b) plans are typically subject to the same limits. SIMPLE retirement accounts are currently subject to an annual contribution threshold of $13,500.
Highly Compensated Employees (HCE) earn above a certain high-income threshold and may be required to follow stricter 401(k) contribution limits. The IRS uses an actual deferral percentage test for these employees to prevent them from taking unfair advantage of the tax benefits associated with these plans. These restrictions are most common for plans that receive contributions only from HCEs.
Employer Contribution Limits
Many employers match a percentage of their workers’ 401(k) contributions as a valuable employee benefit. For example, your employer may contribute $1 or fifty cents for every dollar you put into your retirement account. This applies to both traditional and Roth 401(k)s. Employer contributions are also subject to 401(k) limits. Currently, the maximum 401(k) contribution for employers is the lower of 100% of the employee contribution or $57,000. This increases to $63,500 for workers older than 50.
Solo 401(k) Limits
If you are self-employed or if your company does not sponsor a 401(k), you can fund your own plan through financial institutions that offer solo 401(k) accounts. However, you must pay the fees associated with these investments, typically including a one-time start-up fee as well as a monthly account maintenance fee. You must also pay fees on the specific stocks and bonds you purchase with your 401(k) investments.
Individuals who open a solo 401(k) are allowed to contribute up to employer limits rather than individual limits. That means you can put up to $57,000 in your solo 401(k) each year, or $63,500 if you are older than 50.
Keep in mind that you can only invest money in your solo 401(k) from your own salary as a self-employed business person or from your business income less half the amount you pay in self-employment tax. The current threshold is 20% of your self-employment income, so you may not be able to max out your solo 401(k) if you make less than $280,000 annually.
How a 401(k) Account Works
Through your 401(k) plan, you can invest your savings in various stocks, bonds, and funds. Some types of investments require active management by professionals who decide how to invest the money on your behalf, while others, such as index funds, do not require active management. These so-called passive funds have lower fees than active funds, so they may be a better choice for those who want to maximize retirement savings.
Once you turn 59 1/2, you can withdraw your 401(k) savings to fund your lifestyle in retirement. Early withdrawals are subject to 10% IRS penalties (for example, $10,000 on an account worth $100,000). When you reach the age of 72, you must take Required Minimum Distributions from your 401(k) account. The amount of this distribution depends on your expected lifespan and the total amount of money in your account.
In addition to 401(k) limits, eligible individuals, depending on their income, can also make tax-advantaged contributions to other types of retirement accounts. These include Individual Retirement Accounts (IRAs) and Roth IRAs.
Traditional vs. Roth 401(k)
Most 401(k) plans sponsored by an employer are either a traditional or a Roth plan. These accounts differ in how the account owner pays taxes. In a traditional 401(k), you pay taxes when you retire. In a Roth account, taxes are due when you invest your money. In other words, the money for your retirement comes out of your paycheck after you pay income taxes on those funds, not before. However, you enjoy a deferred tax benefit because you can withdraw the money in retirement without paying income tax.
Think about when your tax burden will likely peak to determine whether a traditional or Roth 401(k) account is most appropriate for your needs. If you have not been working for very long, you will probably be in a higher tax bracket when you retire and should consider a Roth 401(k).
If you are near the apex of your career, a traditional 401(k) account may be a better choice because you will likely land in a lower tax bracket after you retire. You may also want to opt for a traditional 401(k) if you like the idea of getting your tax payments out of the way long before you retire. Want the best of both worlds? You can even divide your maximum 401(k) contributions between traditional and Roth accounts each year to optimize your tax advantages.
At Human Interest, we specialize in 401(k) plans for small and medium-sized businesses. We offer flexible, customized plans designed to give employees the biggest chance to build their retirement savings. Complete our online form to learn more and get started today.
The Human Interest Team
We believe that everyone deserves access to a secure financial future, which is why we make it easy to provide a 401(k) to your employees. Human Interest offers a low-cost 401(k) with automated administration, built-in investment advising, and integration with leading payroll providers.