Understanding 401(k) contribution limits

Many Americans contribute to workplace 401(k) plans in order to save for retirement. Often, employers offer a matching contribution, which is a good way for employees to boost their total compensation.

The US Bureau of Labor Statistics noted in 2021 that 67% of private industry workers had access to retirement plans, including 401(k) plans, in 2020.

Knowing how much you can save will go a long way to meeting your retirement savings goals.

Understanding 401(k) contribution limits

The 401(k) started as a tax-friendly way for employees to save for their retirement goals. Limits on how much employees can save on their own were created to keep higher-earning employees from taking greater advantage of the tax-sheltered savings compared to the average employee.

For 2023, the annual 401(k) contribution maximum for employees younger than age 50 is $22,500. Tim Steffen, director of advanced planning at Baird Financial Advisors, said that’s up from 2022’s limit of $20,500. “A $2,000 increase is pretty substantial in this world, which is a reflection of the higher inflation we’ve all been experiencing,” he said.

At the beginning of the year in which an employee turns age 50, they are eligible for a so-called “catch-up” 401(k) contribution, which for 2023 is $7,500. For someone who is age 50 or older, their annual 401(k) contribution limit totals up to $30,000 this year.

In November 2023, the Internal Revenue Service (IRS) increased 2024’s 401(k) contribution limits by $500, to $23,000. The catch-up contribution limit remained unchanged.

Basics of 401(k) contributions

All 401(k) contributions must be made during the calendar year. Most employer-sponsored retirement plans give employees flexibility with their contributions, allowing them to adjust their deferrals throughout the year, said Ara Diloyan, director of wealth management at Sentinel Group. That’s different from other employee benefit plans such as health insurance, where open enrollment occurs once a year.

To motivate greater employee savings, some companies may have an escalating matching program. This is sometimes called a “stretch” match, where the more an employee saves, the more the employer matches, to a certain amount.

“Let’s say you put in 5%, they’ll match, with 3%. If you do 7%, they’ll give you 5%. So you want to make sure you’re really conscious of how much you’re saving, and if you can afford to do so, certainly put at least the minimum amount to get the full contributions from the company. Otherwise, you’re leaving free money on the table,” he said.

Contribution limits for employees

Depending on a person’s income, reaching the $22,500 contribution limit could be tough. Before you start saving, draw up a budget to see how much you can afford to save. As you earn more money, you can afford to continue to increase your savings.

Automatically increasing contributions can help you reach your savings goals and fight the inertia many people encounter when saving. One recommendation for retirement savings is to contribute between 10% and 15% of your pay, which is a big jump if you’ve just started saving. Diloyan recommends incremental increases using a 401(k) plan’s auto-escalation feature. For example, if a person ultimately wants to target saving 10% in two years, they could incrementally increase their savings goal by two percentage points a quarter until they reach 10%.

Another way to increase contributions is to save part of merit raises you may receive, said Nicole Birkett-Brunkhorst, senior wealth planner at U.S. Bank Private Wealth Management. Provided you’re able to maintain your standard of living on your current pay, she suggests increasing your 401(k) contributions by half of the merit increase.

Understanding combined employee and employer contribution limits

For 2023, the combined employee and employer contribution limit is $66,000, sometimes referred to as the “415 limit,” which is a reference to the IRS code section 415(c). The employee limit includes the $22,500 contribution limit, but does not include the $7,500 catch-up contribution, Steffen said. For someone over age 50, the combined limit is $73,500. For 2024, the combined contribution limit increases to $69,000 ($76,500 with the catch-up contribution).

The employer limit includes any dollars included in the matching program and any profit-sharing money that a company may offer employees. It’s rare that a company’s contribution will make up the difference from the employee contribution to hit the combined limit.

Birkett-Brunkhorst said employees who are thinking of leaving their employers should be aware of their company’s vesting schedule. All the money an employee contributes to a 401(k) is their money; however, some companies have a vesting schedule, which is a graduating scale of how long it takes for matching contributions to completely belong to the employee. Plan documents will outline a vesting schedule, and these can range from immediate vesting to three years of service or as long as six years, according to the IRS.

Insights on traditional and Roth 401(k) contribution limits

Most employers now offer both traditional 401(k) and Roth 401(k) options. The difference between the two is the tax treatment.

A traditional 401(k) allows employees to receive a tax deduction for their contributions, but when they take that money out in retirement, it’s fully taxable. The Roth 401(k) is the opposite of the traditional plan. Employees who contribute to a Roth 401(k) don’t receive a deduction for the amount they contribute, but those withdrawals in retirement will be fully tax-free.

Employees can split their contributions between these two retirement plans, or they can choose to fund one over the other. Regardless of their preference, the 401(k) contribution limits remain the same — $22,500 for workers under 50, while those over age 50 can contribute up to $30,000 if they decide to take advantage of the catch-up contribution.

Diloyan said some people get confused over the contribution limits between Roth individual retirement accounts, which are restricted to people below a certain income threshold, and Roth 401(k)s, which have no income restrictions on contributions.

The decision to contribute to a traditional or Roth 401(k) comes down to personal preference. The tax break employees get with a traditional 401(k) cushions the reduction in take-home pay.

For example, for every dollar an employee in the 25% tax bracket puts into a traditional 401(k), their take-home pay is reduced by only 75 cents. Once you figure out the percentage that you’re paying in taxes, you can really identify how much your contributions will reduce your paycheck.

Some people who are on the cusp of two tax brackets may decide to contribute a certain amount of savings to a traditional 401(k) to drop them down to a lower tax bracket and save the rest in a Roth 401(k) to benefit from tax-free growth.

Defining highly compensated employees in 401(k) contributions

The IRS wants to make sure that highly paid employees don’t unfairly benefit from the tax shelters offered by traditional retirement plans, so the agency has 401(k) limits for highly paid employees. The IRS defines highly compensated employees as company owners controlling more than 5% of the stock or capital during the current or previous plan years or individuals who were paid more than $150,000 in 2023.

Highly compensated employees are also often “key employees,” but there are subtle differences. A person is considered a key employee if they have 5% ownership, but the IRS also defines key employees as those who own more than 1% of the company and earn more than $150,000, or company officers receiving compensation of at least $215,000 in 2023.

If a 401(k) plan has more than 60% of value of the assets owned by highly compensated and key employees, then the employer has to pay a 3% benefit to lower-paid employees to pass annual nondiscrimination tests. That can be hard for a small business, so the IRS created “safe harbor 401(k) plans,” which allow employers to avoid these tests.

Safe harbor 401(k) plans must pay employees retirement benefits using one of three options: a basic match of 100% on the first 3% of employee contributions and a 50% match on the next 2%, be even more generous with an enhanced match, commonly 100% on the first 4% of employee contributions, or pay employees a minimum of 3% of their compensation, whether or not the employee contributes to the plan. Additionally, these employer contributions must be 100% vested.

Consequences of exceeding your 401(k) contribution limit

If you’ve stayed in your job for a full calendar year and elected to max out your 401(k) contribution limit, it’s unlikely that you’ll exceed the limit, as the plan record keepers, firms such as Vanguard and Fidelity Investments, keep a close watch on that, Steffen said.

There are two ways that you may exceed a contribution limit. The first is if you switch jobs during the calendar year and total contribution between both plans exceeds $22,500.

The second is if your employer’s plan allows after-tax contributions, which count against the $66,000 annual limit. After-tax contributions are not tax-deductible, and when you take money out of the plan, you will pay taxes on any growth in those contributions.

It’s possible to exceed the $66,000 limit if you don’t count your employer’s match or profit-sharing contributions when funding after-tax contributions. That’s possible because many companies’ profit-sharing contributions come during the beginning of the next year.

If you exceeded contributions, say, the total contribution was $70,000 instead of $66,000, the employer has to refund you the extra $4,000 in contributions plus earnings, Steffen said. Where that refunded money comes from is up to the record keeper, but it often is from the after-tax contribution.