A 401k plan serves as the primary source of retirement savings for many people. Employees can elect to have a portion of their wages contributed to their 401k plan on a pre-tax basis. These contributions are also called elective deferrals. Employers sometimes match a percentage of the employee's 401k contributions as an employment benefit. Tax is deferred on 401k plans until the money is withdrawn.
Types of 401k Plans
Most people with a 401k have a traditional plan. Under traditional 401k rules, employers must meet specific nondiscrimination requirements, and employees may be subject to a vesting schedule for employer contributions. In a safe harbor 401k plan, employees immediately become fully vested in employer contributions, and employers avoid the nondiscrimination requirements of traditional 401k plans. A SIMPLE 401k caters to small businesses--those with 100 or fewer employees. As with the safe harbor 401k, employees immediately become fully invested in employer contributions. SIMPLE is an acronym for savings incentive match plan for employees.
401k Contribution Maximums
Limitations exist on the amount of wages an employee can contribute to a 401k plan. For 2010 and 2011, the Internal Revenue Code limits elective deferrals to $16,500 for traditional and safe harbor 401k plans, and to $11,500 for SIMPLE 401k plans. The individual 401k plan might impose other limits, such as a certain percentage of income, that could result in a lower contribution maximum. A plan may permit catch-up contributions for employees age 50 and over; the 2010 and 2011 maximum additional catch-up contribution is $5,500 for traditional and safe harbor 401k plans, and $2,500 for SIMPLE 401k plans. Contributions from all sources can not exceed 100 percent of the employee's compensation or, for 2010 and 2011, $49,000, whichever is less.
Tax on 401k Contributions
Employee elective deferrals to a 401k plan are not subject to federal income tax, but Social Security and Medicare taxes still apply. Employer contributions to a 401k plan are not included in taxable income. Tax is assessed on 401k distributions from both employee and employer pre-tax contributions.
Excess 401k Contributions
If 401k contributions exceed the limits, the plan may permit withdrawal of the excess. Excess contributions withdrawn by April 15 of the following year count as taxable income for the year they were made, and earnings on the excess amount are taxable in the year the contribution was withdrawn. Excess contributions that are not withdrawn by April 15 of the following year also count as taxable income for the year they were made. In addition, these excess contributions are taxed a second time when the money is withdrawn.