401(K) Plans - Deferrals And Matching When Compensation Exceeds The Annual Limit

401(k) plans are a popular retirement savings vehicle that allows employees to contribute a portion of their pre-tax income to their retirement accounts, with potential employer matching contributions enhancing their savings. When discussing “401(k) plans - deferrals and matching when compensation exceeds the annual limit,” it is essential to understand how these plans operate under scenarios where an employee’s compensation surpasses the annual contribution limits set by the Internal Revenue Service (IRS).

The IRS establishes annual limits on how much an individual can contribute to their 401(k) plan each year. For example, in 2024, the elective deferral limit is $23,000 for employees under 50 years of age and $30,500 for those 50 and older, due to catch-up contributions. When an employee’s compensation exceeds these limits, the maximum amount they can defer into their 401(k) plan is still capped by these IRS limits. However, any earnings or additional compensation beyond the limit will not increase their deferral capacity.

On the other hand, employer matching contributions are subject to different rules. Employers often match a percentage of employee contributions up to a certain limit. If an employee’s compensation exceeds the annual limit, the matching contributions from the employer are still based on the employee’s deferral up to the maximum percentage outlined in the plan. The match is typically calculated based on the employee’s contributions relative to their eligible compensation up to the annual limit. For high earners, this means that the employer’s matching contributions will be capped at the IRS deferral limits or plan-specific limits, even if their total compensation exceeds these thresholds.

In summary, “401(k) plans - deferrals and matching when compensation exceeds the annual limit” highlights the interplay between IRS-imposed contribution limits and the way employer matching contributions are calculated, ensuring compliance with regulatory caps while still providing valuable retirement benefits.

When participating in a 401(k) plan, employees can benefit from tax-deferred contributions and potential employer matching. However, the ability to defer compensation and receive matching contributions is subject to annual limits set by the IRS.

401(k) Contribution Limits

For 401(k) plans, the IRS sets annual contribution limits which include both employee deferrals and employer contributions:

• Employee Deferral Limits: For 2024, employees can contribute up to $23,000 if under age 50. Those aged 50 and older can contribute an additional $7,500 as a catch-up contribution, raising the total to $30,500.

• Employer Matching: Employers may match employee contributions up to a certain percentage of their salary. However, total contributions (employee deferrals plus employer match) must not exceed the annual limit set by the IRS, which for 2024 is $66,000 (or $73,500 including catch-up contributions for those 50 and older).

Handling Excess Compensation

If an employee’s total compensation exceeds the annual limit:

• Excess Contributions: Contributions above the IRS limit must be corrected to avoid tax penalties. Excess contributions should be withdrawn to avoid double taxation, as they are taxable in the year they are contributed.

• Annual Limit Adjustments: Employees should monitor their contributions and any employer matches to ensure that total contributions do not exceed the annual limits.

Tax Implications and Penalties

• Taxable Income: Contributions to a 401(k) are made on a pre-tax basis, reducing taxable income for the year. However, excess contributions are taxable and could incur penalties.

• Penalty for Excess Contributions: If excess contributions are not corrected by the tax-filing deadline, a 6% penalty applies to the excess amount. This penalty applies annually until the excess is corrected.

Examples of Contribution Calculations

Example 1: If an employee under age 50 contributes $25,000, with a $10,000 employer match, the total contribution is $35,000. This is below the $66,000 limit, so no excess contribution issues arise.

Example 2: For an employee aged 50 or older who contributes $25,000, with a $15,000 employer match, the total contribution is $40,000. This is also under the $73,500 limit, so there are no excess contribution issues.

Correcting Excess Contributions

• Procedure: To correct excess contributions, the employee must withdraw the excess amount and any earnings on it by the tax-filing deadline to avoid penalties.

• Reporting: Corrected excess contributions must be reported on the tax return for the year in which the excess contributions were made.

Managing contributions and understanding the limits of a 401(k) plan is crucial for maximizing benefits while avoiding unnecessary tax penalties. Regularly reviewing contribution levels and consulting with a tax advisor can help ensure compliance with IRS regulations.