When it comes to retirement, we all think of contributions to 401K plans. Many employers offer 401K plans to their employees for retirement savings. Contributions towards these plans are automatically withdrawn from your salary and invested in the funds you choose.
Many times, employers offer to match a portion of what you save, usually between 4% and 6% of your pay. This offer makes it an attractive retirement savings avenue.
In case of a traditional 401K plan, the employer takes out the contributions pre-tax, which means the amount of contribution reduces your taxable income, thereby reducing the tax amount you’ll owe at the end of the year. Just a side note here: you will still pay payroll taxes on your 401K contributions. Conversely, when you take out distributions from your 401K plan, you will have to pay income tax on the distributions at the tax rate that applies when you take the money out. The advantage is that if your current tax rate is high compared to the estimated tax rate when you retire, then you will pay less tax on the contributed amount. The disadvantage is that you will pay tax on the earnings accumulated in your traditional 401K as you take them out.
However, in the case of a Roth 401K though, the contributions are not pretax, so they do not reduce your taxable income. But conversely, when you take the money out of your Roth 401K you will not pay tax on the amount contributed and you will not pay tax on any earnings in your Roth 401K. But you will pay tax on any employer matching contributions, which will go into a separate traditional 401K account.
401K Contribution Limits
It is important to note that these contributions do have limits. There is a limit on how much you, as an employee can contribute and there is an overall limit on contributions towards your account that includes contribution by you, your employer matching and elective deferrals. The IRS taxes any excess contributions not withdrawn by April 15th at a rate of 6% per year for each year the excess contribution amount remains in the account.
In a recent news release, IRS announced an increase to these limits. For 2022 you, as an employee can contribute up to $20,500 while keeping the combined contribution limit towards your 401K plan to the lesser of 100% of your compensation or $61,000. It is important to note that the IRS has not announced any change in the catchup contribution amount available to you if you are 50 years and above. It remains at $6,500 for 2022.
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This material is for informational purposes only. It does not constitute tax, legal or accounting advice.