How Do Tax Laws for 401(k) Plans Affect You?

Employer-sponsored 401(k) plans have long been popular with investors because of their tax benefits. While these accounts have been available since 1978, tax reforms have resulted in changes to Internal Revenue Service (IRS) regulations regarding 401(k) accounts, mostly involving contribution limits. Staying on top of ongoing changes in 401(k) rules can help you maximize your plan contributions.

Understanding 401(k)s

One of the most popular options for employer-sponsored retirement savings plans is the 401(k) plan. Traditional 401(k) contributions are made with pre-tax dollars, meaning they reduce your taxable income and can lower your tax bill.

Also, the money in your 401(k) grows on a tax-deferred basis. In other words, you don't pay taxes on the investment earnings over the years. However, you pay income taxes on your distributions or withdrawals.

Thus far, these two key features of 401(k) plans have not been subject to changes despite various tax reforms, which has been a boon to savers. Earners often will be in a lower tax bracket in retirement when they withdraw their 401(k) funds than they are at the time of contribution, meaning that they'll pay taxes on their withdrawals at a lower rate.

However, there are penalties for early withdrawals. If you take money from the account before you reach age 59½, the IRS will charge a 10% penalty plus income taxes on the withdrawal.

401(k) Contribution Limits

The IRS sets a maximum annual contribution limit for 401(k) plans. However, the IRS allows for a catch-up contribution that enables older workers to contribute more to their accounts, which helps if you didn't contribute as much when you were younger.

• For 2022, you can contribute up to $20,500 of pre-tax income to a 401(k). If you are 50 or older, you can contribute another $6,500, which is called a catch-up contribution.
• For 2023, you can contribute up to $22,500 of pre-tax income to a 401(k). If you are 50 or older, you can contribute another $7,500 in catch-up contributions.

Increases to these contribution limits are made for cost-of-living adjustments that are tied to the Consumer Price Index (CPI). The CPI measures the pace of rising prices in the economy—called inflation.

If the CPI doesn't increase enough to warrant a $500 increase, there will be no change in the contribution limit, which is why there isn't an increase in the COLA every year.

Employer Matching Limits

Some employers make an additional contribution to a 401(k) that matches the amount their employees contribute up to a certain percentage or dollar limit.

The employer match varies and also applies to those who are self-employed. A self-employed individual can contribute to their own account as both an employee and an employer.

When including employer contributions, the maximum amount that can be contributed by both the employer and the employee is as follows:

• In 2022: $61,000 ($67,500 including catch-up contributions).
• In 2023: $66,000 ($73,500 including catch-up contributions).

The limits above do not include any catch-up contributions by an employee. The total amount contributed must be less than 100% of your compensation.

Highly Compensated Employees (HCEs)

Contribution limits get more complex for workers who are labeled HCEs by the IRS. When 401(k)s were established, a rule was put in place to limit the disparity between how much a firm's highest-paid employees could contribute compared to its lowest-paid employees.

As a result, at any individual company, the average amount of contributions for those who qualify as HCEs can be no more than 2% greater than the average amount of contributions for those who are not HCEs.

The yearly income that constitutes "highly compensated" is subject to cost-of-living adjustments and therefore changes over time. An HCE is someone who made more than $135,000 in 2022 and $150,000 in 2023. Individuals are also considered HCEs if they own more than 5% of the business at any time during the tax year in question.

Implications for HCEs vary from employer to employer. If the average contribution amount for non-HCEs at a particular firm is 5% of their income, the average contribution amount for all HCEs at the firm can generally be no more than 7%.

Every year, 401(k) plans must run nondiscrimination tests to make sure everyone is in compliance. If you think you might qualify as an HCE, check with your employer's human resources department for guidance on how much to contribute.

The Bottom Line

Changes are continually made to the tax code, and when they impact IRS regulations governing 401(k) plans, they can also impact your contribution limits and financial goals. Keeping tabs on ongoing changes to 401(k) plan rules can set you up for increased savings and a more comfortable retirement.

Frequently Asked Questions (FAQs)