Qualified retirement plans like 401(k) plans encourage employees to save money for their own retirement by giving them a current tax break if they participate in their employer’s plan and make contributions to their 401(k) account. Specifically, employees can defer salary amounts they contribute to their account, which reduces their taxable income and, hence, their federal income taxes.

But these salary deferrals aren’t unlimited. The federal government restricts the amount of money employees can contribute each year to their 401(k) accounts. As a plan sponsor, it’s important you understand and stay up to date on 401(k) limits – what employees can defer from their own paychecks as well as the total allocations from all sources, including the employer.

401(k) Contribution Limits History: Changes Over the Years

The annual 401(k) employee contribution limit has changed significantly over the years. 401(k) plans as we know them today were introduced in 1978. In 1982, the salary deferral limit (and total annual addition limit) was $45,475. In 1983, the limit was reduced to $30,000. In 1987, while the annual addition limit remained at $30,000, the deferral limit was slashed to $7,000.

Since then, the limit has risen steadily to account for rising inflation. For the past two years, the annual employee contribution limit has stood at $18,000 or 100 percent of pay, whichever is less. The annual addition limit, which includes deferrals as well as employer matching contributions and other types of contributions, is currently $53,000 or 100 percent of pay, whichever is less.

Catch-up Contributions Allowed for Employees 50 and Older

In 2002, Congress recognized the special challenges faced by older workers when it came to saving as much money as possible before they retired. That’s when “catch-up” contributions were introduced for these workers. In 2016, employees who are age 50 or over can contribute an additional $6,000 to their 401(k) account, or a total of $24,000. The total annual addition limit for employees age 50 or over currently stands at $59,000 or 100 percent of pay, whichever is less.

Cost of Living Adjustments and Employee Contribution Limits for HCEs

Going forward, the employee contribution limit and total annual addition limit may be subject to cost-of-living adjustments (COLAs) each year. Employee contribution limit adjustments are made in $1,000 increments, while total annual addition limit adjustments are made in $1,000 increments, both based on COLAs. Adjustments to contribution limits based on COLAs (if any) are usually announced in October for the following year.

In addition, there is a limit to the amount of an employee’s annual compensation that’s considered when figuring 401(k) contributions. This limit, which is currently $265,000, may also be adjusted annually based on inflation. While this in and of itself isn’t a true contribution limit, it can end up limiting Highly Compensated Employees’ (HCEs’) contributions if contributions are based on percentages.

Hard vs. Soft Contribution Limits

It’s important to keep in mind that these are hard contribution limits. In certain scenarios, soft contribution limits might also come into play.

For example, if a 401(k) plan is in danger of failing the ADP nondiscrimination test – which is administered to ensure that a plan does not discriminate in favor of HCEs – HCEs might not be able to defer up to the full $18,000 annual deferral limit that year. Similarly, there are other nondiscrimination tests which could preclude an HCE from receiving the total annual addition limit of $53,000.

In this scenario, adopting a safe harbor 401(k) plan may enable you to avoid ADP testing. This, in turn, would enable HCEs to defer their full employee contribution and receive their total annual addition limits.

Is Your Business and Its Key Employee Maximizing Retirement Savings?

It’s important to work with a retirement plan consultant and third party administrator who understand the details involved in annual 401(k) contribution limits and total annual addition limits. Failure to understand these intricacies can lead to employees not realizing their full 401(k) benefits – or worse yet, employees deferring too much money and having to receive refunds of salary deferrals.

The professionals at ACG specialize in designing and administering 401(k) and other retirement plans to meet the goals of your business and its key employees. From custom profit sharing plans to cash balance plans, ACG will work with you to find additional tax savings strategies and compensation planning opportunities.