For many Americans, employer-sponsored 401(k) plans comprise the bulk of personal retirement savings. These plans allow investing with pre-tax funds so that employees can help fund their retirement.
However, to enjoy these tax-deferred privileges, there are a few requirements that must be met – and those requirements are subject to change from year to year.
Employees using 401(k) plans need to review these rule changes annually to see if you need to adjust their 401(k) contribution practices. These are some of the changes you can expect concerning 401(k) plans for 2021.
What is a 401(k)?
The 401(k) is an employer-sponsored retirement plan that allows you to invest a portion of your pre-tax income toward your retirement. The money remains untaxed until you withdraw it from your retirement account, presumably at a tax rate that is well below your current tax rate.
Initially, the intention was that 401(k) plans would operate to help supplement organizational pension plans. Unfortunately, few companies are still offering pensions, so their 401(k) has become the primary source of retirement savings for millions of Americans.
Some employers will match employee contributions up to a specified percentage, though that is not guaranteed. Regardless, Uncle Sam has placed strict limits on how much of your income you can contribute toward your 401(k). Failing to work within those limits could result in unpleasant fines and penalties.
401(k) Contribution Limit Changes from 2020 to 2021
Not all 401(k) plans are the same. Some allow employees the opportunity to invest both pre- and post-tax dollars in their 401(k), while others do not. If you have the ability, it is wise to consider doing so. This is especially the case for people approaching retirement age.
While limits for employee pre-tax contributions increased by $500 from 2019 to 2020, the limits remain steady for 2021 at $19,500. However, those who are age 50 and over can contribute an additional $6,500 (also the same amount as in 2020) as a “catch-up” contribution.
People making catch-up contributions have the same limits in 2021 as they did in 2020: an investment total of $26,000. This was, however, an increase over 2019 limits that were $1,000 lower at $25,000.
The annual additions paid to an individual’s account can be no greater than 100 percent of the employee’s compensation or $58,000 ($64,500 with catch-up contributions). This represents an increase of $1,000 over 2020 contribution limits.
Depending on their circumstances, people who have 401(k) plans under two unrelated employers in 2021 are eligible to defer a total of $26,000 (the same as 2020). This is true even if they are not generally eligible for catch-up contributions. However, it is up to the employer to keep up with your contributions in this case. You should consult with your plan administrator to determine specific rules regarding catch-up contributions.
If your employer matches a portion of your 401(k) contribution, you might look at it as “free money,” at least in the eyes of the IRS. It does not count toward your contribution limit. You will, however, be taxed on this when you withdraw the funds.
Types of 401(k) Plans
Many people use the term “401(k)” as a catch-all phrase when referring to various retirement saving plans. There are many different plans available. Unfortunately, since these are all employer-sponsored plans, you don’t have the final say in which type of 401(k) plan you use.
Your plan may be any one or more of the following:
- Roth
- Safe Harbor
- Solo
- Traditional
- Simple
There is one exception, however. If your employer offers a Simple 401(k) plan, it cannot provide any additional options for 401(k) plans. The better you understand your 401(k) plans, contribution limits, and tax implications, the better prepared you will be to avoid unnecessary fines and penalties.