Investing Retirement Planning 401(k) Plans How Do Tax Laws for 401(k) Plans Affect You? Understand How 401(k) Plan Changes Could Affect Your Retirement By Scott Spann Updated on December 17, 2022 Reviewed by Thomas J. Brock Reviewed by Thomas J. Brock Thomas J. Brock is a CFA and CPA with more than 20 years of experience in various areas including investing, insurance portfolio management, finance and accounting, personal investment and financial planning advice, and development of educational materials about life insurance and annuities. learn about our financial review board Fact checked by Emily Ernsberger In This Article View All In This Article Understanding 401(k)s 401(k) Contribution Limits Employer Matching Limits Highly Compensated Employees The Bottom Line Frequently Asked Questions (FAQs) Photo: SrdjianPav / Getty Images 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. Key Takeaways Traditional 401(k) contributions are made with pre-tax dollars, reducing your taxable income, and can lower your tax bill.401(k) contributions are tax-deferred, meaning you don't pay taxes on your earnings until you withdraw the money.Tax rules limit how much employers and employees can contribute, which is higher for workers aged 50 and over.The average contribution for those who qualify as highly compensated employees can be no more than 2% greater than for those who are not HCEs.Tax reforms can change contribution limits, tax rates, and income ranges, which can affect your 401(k). 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. Note These 401(k) rules do not impact your ability to contribute to a Roth IRA, but Roth IRAs come with maximum income limits. Roth contributions are allowed if you're a single tax filer earning less than $144,000 in 2022 ($153,000 in 2023) and $214,000 if you're married filing jointly ($228,000 in 2023). 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) What taxes are affected by a 401(k)? A 401(k) plan is an employer-sponsored retirement savings plan. 401(k) contributions are made with pre-tax dollars, meaning they're made before income taxes are deducted from your paycheck, reducing your taxable income. Also, your investment earnings grow tax-deferred, but you pay income taxes on your distributions or withdrawals. How much can I contribute to a 401(k) to maximize my tax savings? The IRS establishes an annual maximum contribution limit for 401(k)s.For 2022, you can contribute up to $20,500 to a 401(k), but if you are 50 or older, you can contribute another $6,500—called a catch-up contribution.For 2023, you can contribute up to $22,500 to a 401(k) and another $7,500 in catch-up contributions if you're 50 or older. Was this page helpful? Thanks for your feedback! Tell us why! Other Submit Sources The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy. The Urban Institute. "Do Low-Income Workers Benefit From 401(K) Plans?," Page 3. IRS. "401(k) Plan Overview." IRS. "Retirement Topics - Exceptions to Tax on Early Distributions." IRS. "Retirement Topics—401(k) and Profit-Sharing Plan Contribution Limits." IRS. "Chapter 8a Selected Topics Under Irc Section 415(C), Section 415(B), and Section 415(E), as Amended by Gatt, Sbjpa, and the Taxpayer Relief Act of 1997," Page 21. IRS. "COLA Increases for Dollar Limitations on Benefits and Contributions." IRS. "Cost-of-Living Adjustments for Retirement Items," Page 1. IRS. "Amount of Roth IRA Contributions That You Can Make For 2023." IRS. "2022 Limitations Adjusted as Provided in Section 415(d), etc.," Page 4. IRS. "Retirement Topics - 401(k) and Profit-Sharing Plan Contribution Limits." IRS. "Retirement Plans for Self-Employed People." IRS. "Retirement Topics—401(k) and Profit-Sharing Plan Contribution Limits." IRS. "401(K) Plan Fix-It Guide - the Plan Failed the 401(K) ADP and ACP Nondiscrimination Tests."