401(k) Rules and Limits

Common Rules for 401(k) Plans

There are three main types of employer-sponsored 401(k) plans, each of which has its own rules and contribution limits. Traditional 401(k) plans are the most common, followed by safe harbor 401(k), and Simple 401(k) plans. While each type of plan offers ways to save a substantial amount of money for retirement, it's important to remember that employers can also set additional rules for participation to which you will be bound.

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Three of the most common rules for 401(k) plan participation are that the employee be at least 21 years of age, that he or she has completed one year of service, and that the vesting schedule may be as long as seven years. (The vesting schedule is the amount of time it takes for the employee to realize the full value of the employer's contribution to his or her account.) Regardless of the plan your employer chooses or the rules he or she sets in place, the plan cannot discriminate against older workers. And, regardless of the type of plan offered, it's always best to begin making contributions as early as possible. The longer you are able to put away, the more money you'll be able to save for a financially secure retirement.

Traditional 401(k) Plans

With a traditional 401(k) plan, all eligible employees (those who are over the age of 21, those who have completed one year of service, etc.) make regular contributions through payroll deductions. The employer has the option to make contributions on behalf of the employee. This is known as a matching contribution. Only the employer portion of the account is subject to the vesting schedule. In other words, the employee is always 100% vested in his or her own contributions. Employer contributions are typically a percentage of the employee's contribution. For example, an employer may contribute a 100% match on up to 6% of an employee's salary. In this example, an employee making $75,000 per year who contributes 10% of his or salary ($7,500) would receive a matching contribution of $4,500 (100% of 6% of $75,000).

Employer contributions must meet specific nondiscrimination requirements. Employers are expressly forbidden to contribute more to one employee's account than another's. In order to ensure compliance, an employer must perform the Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests each year to verify that the money contributed by the employee and the employer's matching contributions do not discriminate against lower compensated employees.

Safe Harbor 401(k) Plans

Safe harbor 401(k) plans are similar to traditional 401(k) plans in that they are employer sponsored. The major difference is the vesting schedule. Safe harbor plans allow for full and immediate vesting of employer contributions as soon as they are made. Another significant difference from the employer's point of view is that Safe harbor 401(k) plans are not subject to the yearly Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests. This can significantly reduce the compliance costs of managing the plan.

An employer of any size can offer either a traditional or safe harbor plan. Either of these plans can also be offered in conjunction with other employee compensation plans, such as stock-option plans and profit sharing plans.

Simple 401(k) Plans

A Simple 401(k) plan is specific to small businesses. It is not subject to the yearly Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests that apply to a traditional 401(k) plan. Like a safe harbor 401(k) plan, the employer must make contributions that are fully vested at the time they are made. A Simple 401(k) plan is available only to companies with 100 or fewer employees. Further, the employee must have received at least $5,000 in earned income from the employer in the previous calendar year. An important distinction between traditional and safe harbor plans and simple plans is that employees who participate in a Simple 401(k) plan can not receive other contributions or benefits under any of the other plans offered by the employer such as profit sharing plans.

Contribution Limits for Those Under Age 50

Whether your employer offers a traditional, safe harbor, or Simple 401(k) plan, there are limits to the amount of tax-deferred money you can contribute each year. In 2010 and 2011 the limit is $16,500 for traditional and safe harbor 401(k) plans. The limit on simple plans is $11,500. These limits apply the amount money that can be contributed and do not include matching contributions made by the employer.

Contribution Limits for Those Over Age 50

Participants who are age 50 and over may have the option to contribute what is known as the "catch up" amount. An employer neither has to allow the catch-up contribution nor provide a matching contribution. If your plan is a traditional or safe harbor 401(k), you can contribute an additional $5,500 in 2010 and 2011. If your plan is a simple Plan, you can contribute an additional $2,500 in 2010 and 2011. If your employer does not offer the option of contributing a catch-up amount, you may want to speak to a qualified financial planner in order to maximize tax-deferred savings in other ways.

Those fortunate enough to participate in the plans offered by two or more different employers are able to treat additional contributions as catch-up contributions regardless of whether the employers' plans allow for it. However, you must ensure that these contributions do not exceed the allowable limits. Because these rules as enforced by the IRS are rather complicated, it's usually a good idea to ensure compliance by meeting with a tax professional before making yearly contributions.

Additional Limits on Contributions

There are other rules required by the Internal Revenue Service that restrict the contributions an employer makes on an employ's behalf. In addition to the limits on contributions you make for yourself, in 2010 and 2011, the yearly contributions made to all of your 401(k) accounts, including the money you contribute, the money your employer contributes and any other discretionary contributions in any other accounts made on your behalf, may not exceed the lesser of 100% of your total compensation or $49,000. And, the amount of your total compensation that can be used to determine employer and employee contributions is limited in 2010 and 2011 to $245,000.

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