Tax deductible contributions to 401(K)

Employee Contribution Limits: The IRS maximum allowed 401K contribution will stay the same as 2009′s 401K contribution maximum at $16,500. The 401K catch-up contribution for those over 50 years old will also stay the same at an additional $5,500 over the standard.

Employer Contribution Limits: In addition to the contribution limits appearing in the tax law, there can be employer imposed contribution limits to 401k plans.  The contribution limit for employers is set at 6% of the employee’s pre-tax compensation. That means an employee with a total compensation package of $100,000 can contribute $16,500 in 2011 on a pre-tax basis, and their employer can contribute another $6,000 for a total of $22,500.  If you’re 50 or older, then you can contribute another $5,500 pre-tax bringing the total to $28,000.

Highly-Compensated Employees: Some employees are subjected to a second contribution limit.  If you’re classified as a “Highly Compensated” employee, then you may be subjected to contribution limits based on your employer’s overall 401k participation rates.  If your salary is above $110,000 in 2010 or 2011, then you may need to contact your employer to see if any additional limits apply to you. For a highly-compensated employee, the total of your elective deferrals and contributions made for you by your employer under a section 401k plan or SARSEP can be no more than 125% of the average deferral percentage (ADP) of all eligible non-highly compensated employees in a calendar year. If the total contributed to the plan is in excess of the amount allowed under the ADP test, then any excess contributions must be either distributed back to the employee or re-characterized as after-tax employee contributions.  For example, the contribution can be distributed to an employee, and then contributed by the employee right back into the plan.

Highly-compensated employees must report these excess 401k contributions as taxable income on IRS Form 1040, line 7.  An employee should receive a Form 1099-R in any year in which an excess contribution is distributed to them.

After-Tax / Total 401k Contributions: In addition to the pre-tax or tax-deferred contributions you can make to your 401k plan, your plan may also allow employees to make after-tax contributions.  When after-tax contributions are added to pre-tax contributions, this becomes your total 401k contribution, which also has a limit. In 2010, the total that can be contributed to a 401k plan is $49,000 or 100% of your compensation, whichever is less.

Access to Contributions: Earnings on all contributions are considered tax-advantaged, and fall under the 401k withdrawal guidelines.  However, after-tax contributions are considered fully accessible to the employee since taxes have already been paid on that money.

The rules for qualified retirement plans such as 401k plans are complex.  Your plan administrator should have documentation outlining the exact rules that apply to your particular employer’s plan.  That document should explain these limitations, as well as other rules or regulations that might apply.

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