One of the great things about a 401(k) plan is the tax deduction. When you make contributions to your Traditional 401(k), you get a tax break.
Investing in your 401(k) gives you the chance to benefit two ways. You lower your taxable income based on your contributions. On top of that, you’re saving for retirement and taking advantage of compound returns.
Because you have tax-advantaged returns, your money grows more efficiently over time.
However, because the government offers this benefit, you can’t put all the money you want into a 401(k) — there are 401(k) contribution limits.
Here’s what you need to know before you start putting money into your retirement account.
1. 401(k) contribution limits for 2017
Every year, the IRS takes a look at the economy and measures inflation. If the IRS thinks the cost of living has risen enough to justify it, the amount of money you are allowed to put into a 401(k) account goes up.
For 2017, you can put up to $18,000 into your 401(k) as an employee — that’s $1,500 a month. This applies to both Traditional 401(k) and Roth 401(k) accounts.
That’s a pretty good chunk of change. If you max out your contributions for 20 years, you could end up with $889,921, assuming an annualized return of 8 percent, according to the Student Loan Hero investment calculator.
2. Catch-up contributions
If you are 50 years or older, you can make an additional “catch-up” contribution of $6,000 per year. This is one way to boost your tax deduction and supercharge your efforts if you are getting close to retirement.
Again, this catch-up contribution limit applies to Roth 401(k) accounts as well as Traditional accounts.
3. Employer contributions
One of the benefits of the 401(k) is that an employer can match the contributions to your retirement account.
This is often called a “match.” Your employer might match your contributions up to a certain amount. For example, your employer might offer a 100 percent match on up to five percent of your income. This is a dollar-for-dollar match when you contribute up to five percent of your income.
If you make $3,500 per month, five percent of your income is $175. With a 100 percent match, your employer would also contribute $175 per month. This brings the total contribution to your 401(k) up to $350 a month.
It gets even better: The employer portion doesn’t count as part of your contribution limit. The maximum 401(k) contribution for 2017 is a combined $54,000 for you and your employer or 100 percent of your salary, whichever is less.
If you contribute the full $18,000 to your 401(k), your employer could decide to contribute up to $24,000 (to make 100 percent of your $42,000 salary). But how much your employer contributes is up to them.
4. Solo 401(k)
It’s not uncommon for someone to be self-employed today. So it’s possible to set up a solo 401(k) account.
However, your 401(k) contribution limits are cumulative. Your total contribution limit is set across all of your 401(k) accounts. If you contribute $12,000 to your employer’s plan, you only have room to contribute $6,000 to your solo 401(k).
5. Deducting 401(k) contributions on your taxes
Here’s where it’s important to differentiate between the types of 401(k) plans you may have. A Roth 401(k) doesn’t come with a tax deduction, and anything you contribute to a Roth account is made with after-tax dollars. Instead, your money grows tax-free and you can withdraw it in retirement without paying taxes.
Your contributions to a Traditional 401(k) are fully deductible. That means you get a dollar-for-dollar reduction on your taxable income for your contributions. If you make $50,000 a year and contribute $7,000 to your 401(k), your income, for tax purposes, will be $43,000 a year.
When you’re in a higher tax bracket, your 401(k) contributions can have a big impact. Say you are a single filer in the top tax bracket and earn $420,000 a year. If you make the maximum 401(k) contribution of $18,000 a year, that drops your income to $402,000 a year. That would put you in the smaller bracket, reducing the taxes you owe even further.
The IRS takes over-contributions to your 401(k) plan very seriously. If you’re in that situation, the IRS expects you fix the issue by Tax Day of the following year. If you pay too much into your 401(k) account in 2017, you have until Tax Day 2018 to fix the problem.
According to the IRS, the extra amount is removed from your 401(k) amount and then added to your gross income for that year. If you contributed an extra $1,000 to your 401(k) in 2017, it should be added to your income for 2017. This can increase your tax bill.
On top of that, any interest the contribution earned also has to be withdrawn from your retirement account and added to your income. However, the IRS says that the interest is added as income based on the year it was taken out of the account.
If your plan administrator removes the money in 2018 for an over-contribution in 2017, the contribution itself will “count” toward 2017 income. But the amount of interest earned on the extra contributions will be added to your 2018 income.
If you run into this problem, the IRS encourages employees to contact their plan administrator for help fixing the issue. However, for most employees, this isn’t a problem. Most plan administrators prevent over-contributions from happening. You are most likely to run into this issue if you change jobs during the year, making contributions to two different plans.
Start making 401(k) contributions ASAP
Even if you can’t make the maximum 401(k) contribution, you should start putting money into your retirement account as soon as you can. Every little bit helps, and 401(k) contributions are one of the easiest ways to start investing and growing wealth for your future.
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