Contributing to a 401k plan can be a great way to build a foundation for your financial future. For many individuals, putting pre-taxed dollars toward their eventual retirement while simultaneously earning extra interest sounds like a deal to jump on—and for lots of people, it is! But before you start stowing away all of your extra cash, it’s important to be aware of the restrictions that determine how much you can add to your 401k fund. You read that right—there are specific limits that the IRS places on 401k contributions to level the playing (and saving) field for all workers.
In this post, we’ll discuss the 401k 2020 limits and how they’ll impact your saving efforts depending on your employer and income range, then share some valuable insights so you can make the most of your 401k. To navigate to a specific topic, use the links below. Or, read all the way through for a more detailed view.
Basic 401k Contribution Limits 2020
According to IRS.gov, the 401k contribution limit for 2020 is $19,500 for employees under the age of 50 who participate in 410k, 430b, most 457 plans, and the federal government’s Thrift Savings Plan.
So, what exactly does this mean for employees enrolled in these programs? Every year, the IRS rolls out their guidelines for retirement savings contributions, limiting the amount any individual can invest into their 401k account in a given tax year. Sometimes the limits change, and other times they’re extended from the previous year—we’ll discuss the difference between 401k contribution limits in 2019 vs. 2020 a little later on in this post.
For tax year 2020, most 401k contributors can invest up to $19,500 into their plan. Keep in mind, this number also applies if you have multiple 401k accounts, whether they’re classified as traditional or Roth. In other words, you can contribute to several 401k funds throughout the 2020 tax year, but in total, your contributions cannot exceed the 2020 401k contribution limit of $19,500. Note: contributions to IRAs are not factored into this amount.
However, there is an exception to the rule for certain savers. The IRS allows 401k participants aged 50 or older to exceed the $19,500 limit as incentive to “catch-up” on their retirement savings. The catch-up contribution limit for 2020 is $6,500. This means that eligible individuals can contribute up to $26,000 to their 401k fund during the 2020 tax year.
Why are there limits on 401k contributions?
It’s my retirement savings and I’ll invest it all if I want to, right?! As you’ve learned so far, that’s not quite the case; but why does the IRS place these limitations on 401k contributions in the first place?
One of the biggest benefits of opening up a 401k plan is the tax benefits consumers get when they contribute funds. 401k plans are considered “tax-deferred” accounts, which allow individuals to store away their earned dollars without having to pay taxes today; however, the funds will be taxed when withdrawn from the account. Because 401ks offer tax benefits, the IRS places a cap so that higher earning individuals don’t receive greater access to tax relief programs than average workers.
What happens if you exceed the contribution limit?
401k plan participants who exceed the contribution amount will be penalized by having to pay taxes twice on the excess amount, unless corrected before the filing deadline. This is also known as an “excess deferral.”
Here’s how the double tax penalty breaks down:
The excess contribution will be included in the individual’s taxable income in the tax year that it was contributed;
It will also be taxed a second time when it is withdrawn from the account.
The good news is, if you’ve caught the error before the filing deadline, you can resolve it and avoid facing penalties from the IRS. To rectify an excess contribution, you’ll want to alert your plan administrator or employer as soon as possible so that your W-2 can be adjusted and your excess contribution can be returned to you before taxes are due. The IRS refers to this process as “corrective distribution.”
401k 2020 Limits for Employers
Another awesome benefit of 401k retirement plans is the possibility of having your employer help fund your future retirement plans. Not all employers participate in 401k matching, but the average match amount weighs in at 4.3% of pay, which can be a pretty substantial addition to your retirement savings.
Plus, matching contributions can work out in favor of your employer, too:
Employer contributions are considered tax deductible on the employer’s federal income tax return to the extent that the contributions do not exceed the limitations.
Elective deferrals and investment gains are not currently taxed and enjoy tax deferral until distribution.
Because the Internal Revenue Service also offers tax benefits to employers who contribute to employee 401k programs, they also place a limit on how much money employers can invest in employee 401k plans.
The 2020 IRS 401k contribution limits for employers must be the lesser of 100% of an employee’s pay or $57,000, not including catch-up contributions.
401k 2020 Limits for Highly Paid Employees
In addition to limits for employers and the average worker, the IRS also places limitations on employees who they consider to be “highly compensated employees (HCEs).”
Highly compensated employees are characterized as:
Individuals who owned 5% or more in a business at any point during the current tax year, or the preceding year, regardless of how much they were compensated.
Individuals who earned more than $125,000 if the preceding year was 2019 and $130,000 if the preceding year was 2020.
Or, earned within the top 20% of employees when ranked by compensation.
To ensure that these high earners don’t disproportionately benefit from 401k benefits when compared to average earners, the IRS runs a “non-discrimination test.” This test helps determine how much HCEs can contribute to their 401k plans. To pass the test, the average contributions of highly-compensated employees must not be higher than 2% of the average contributions of non-highly compensated employees.
401k Contribution Limits 2019 vs. 2020
As we mentioned, the 401k contribution limits can be adjusted annually, and they happened to increase in 2020. Let’s take a look at how the 2020 401k contribution limits stack up to 401k contribution limits in 2019:
The maximum employee elective deferral in 2019 was $19,000 in 2019 and raised to $19,500 in 2020.
Catch-up contributions increased from $6,000 in 2019 to $6,500 in 2020.
Total maximum contribution rate from all sources increased by $1,000 to reach $57,000 for tax year 2020.
Maximum contributions from all sources, including catch-up, for participants 50 and older went from $62,000 in 2019 to $63,500 in 2020.
Highly compensated employee limits were unchanged.
Investing in a 401k plan can be a great way to lay the foundation for your comfortable retirement. With tax benefits, the opportunity to earn compound interest, and the possibility to build up your savings with help from your employer, there are several advantages to this financial tool. But before you begin to invest your hard-earned dollars, it’s important to consider the guidelines put forth by the IRS.
To review, the 401k contribution limits for 2020 are:
$19,500 for general employee contributions.
An additional $6,500 for employees eligible for catch-up contributions (50 years or older).
$63,500 for total contributions from all sources, plus catch-up contributions for eligible workers.
If you’ve maxed out your 401k, but want to keep saving, you may want to look toward other savings options, like emergency funds or IRAs (traditional or Roth) that won’t break the IRS’ contribution guidelines. Not abiding by the contribution limits could result in some not-so-fun consequences outlined by the IRS, so it’s essential to keep track of your investments and rectify any errors ASAP.
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