Rules and Regulations on Your 401k Contributions
Written by Yun Yang   


The recent changes in 401(k) contribution limits are a bit of good news for investors willing to leverage these plans in their retirement portfolio.  The contribution limits has jumped up quickly recent years, and in 2011 will continue to be indexed to inflation, which means an increase of the limits.


Pre-Tax 401(k) Contribution Limits

Individual pre-tax contribution limits in 2010 is $16,500. In 2011, contribution limits that apply to 401(k) plans will be indexed for inflation, a type of cost-of-living index.  Those limits will move up in $500 increments. Thus the contribution limits in 2011 is going to be $16,500 plus an index for inflation ($500 increments).


Pre-Tax 401(k) Catch Up Limits

The current 401(k) rules allow for plan participants that reach age 50 before the calendar year is over to make additional catch up contribution. The limit of such contribution on a pre-tax basis is $5,500 in 2010, and is going to be $5,500 plus an index for inflation ($500 increments) in 2011.


Employer Contribution Limits

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 obtain the contribution of at most $6,000 from his/her employer.


Highly-Compensated Employees

If you're classified as a "Highly Compensated" employee, earning a salary above $110,000 in 2009 / 2010, 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 401(k) plan or Salary Reduction Simplified Employee Pension plan (SARSEP) can be no more than 125% of the average deferral percentage (ADP) of all eligible non-highly compensated employees in a calendar year.


After-Tax / Total 401(k) Contributions

In addition to the pre-tax or tax-deferred contributions you can make to your 401(k) 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 401(k) contribution, which also has a limit. In 2009, the total that can be contributed to a 401(k) plan is $49,000 or 100% of your compensation, whichever is less.  It remains the same in 2010.


How Much Should I Contribute?

First of all, try to contribute at least enough to qualify for your company's maximum matching contribution. The matching contributions from your employer will probably offer the best return-on-investment you’ll ever get. Failure to get the full employer match is the equivalent of throwing retirement savings away. If you're lucky to have an employer match available to you, be sure to take advantage of the opportunity.  Read Employer Matching Programs for more details on this topic.

How much more to contribute after that? There is no simple single answer. Given the plans' valuable tax breaks, it makes sense to invest the maximum if you can. The drawback is that if the tax rate rises in the future, you'd be avoiding low tax bill today for a higher one tomorrow. However, it’s still a perfectly acceptable strategy for most people to contribute the maximum to their 401(k), since it is a very simple and convenient way of investment, and you would still benefit from the tax-free compounding of gains before you withdraw your money.

If you don’t want to invest to your 401(k) account to the maximum, instead, you want to find a good way to hedge against the possibility of higher tax rates in the future, it will be good strategy to use the money you would have contributed beyond the match to open up a Roth IRA. The Roth IRA has a lot of extra advantages like the ability to make early withdrawals for a variety of reasons, as well the ability to never make any withdrawals and leave it to your heirs still compounding away. If you still have money left to save after fully funding the Roth, put that money back into your 401(k).



 
Last Updated on Wednesday, 22 December 2010 06:16