Many executives believe that they're maxing out their 401(k) contributions year after year. However, due to the IRS' 401(a)(17) limitation of $285,000 in income and the impact it has on both individual and company contributions to a 401(k), many of these corporate professionals unknowingly miss out on thousands of dollars in potential contributions.
What are the 401(a)(17) Income Limits?
There is a fairly unknown rule known as the 401(a)(17) contribution limits that keep many corporate professionals from fully maxing out pre-tax contributions to their 401(k). The 401(a)(17) rules set a maximum on compensation that can be used to contribute to a 401(k) and many other types of retirement plans.
Specifically, the 401(a)(17) rules only allow super-savers to use the first $285,000 of income to save into a qualified retirement plan, like a 401(k). Once someone begins making over $285,000 a year, there can no longer be contributions made to their company’s 401(k) plan. An important thing to note is that once this income threshold is reached, both the individual AND their company are prohibited from making contributions to the company 401(k).
Exceptions to the 401(a) limits
There are exceptions to the 401(a)(17) earnings limit rules whereby a company can allow their employees to consider income past the $285,000 when making contributions to retirement plans. Few organizations actually permit these exceptions as it regularly messes up anti-discrimination testing, which causes bigger problems for the organization.
How Could The Income Limits Affect You?
We started working with a new client that almost completely missed out on maxing out his 401(k) contributions for the year, despite thinking he was set up to max it — all due to the 401(a)(17) limitations.
This particular client was a high-income executive from one of Houston's leading oil companies aiming to max out his contribution to his company's 401(k). He had a long career with the company and was grossing over $600,000 annually between base pay and bonus.
It's important to note that the 401(a)(17) limits take total income into account, including any bonuses or commissions received in addition to a salary.
He knew that for the 2020 year the max amount he could put into the 401(k) is $26,000, as he is over age 50, and that his company's 401(k) contribution of 8% would max out at $22,800 of additional contributions to his 401(k). Luckily for him, he visited us at the beginning of the year.
Originally, he took his maximum employee contribution amount and divided it by his expected benefit eligible compensation (salary + expected bonus) to determine how much to contribute pre-tax from his paycheck.
|Maximum Employee 401(k) Contribution Amount
||Total Compensation||Pre-Tax Contribution Percentage of Income|
His assumption was that if he set his pre-tax contribution to his 401(k) to 4%, then he would max out by year-end; however, this would prove to be a crucial error. Why? Because after his bonus and salary reached the $285,000 limit, both he and his employer were prohibited from making additional contributions to his 401(k).
Since this saver set his contribution to 4%, he would have only contributed $11,400 (= $285,000 * 4%) into his plan— potentially missing out on $14,600 of pre-tax contributions he could have made into the plan! After we sat down with him and showed him his 401(k) statement, he realized that due to the same error in prior years, he had missed out on thousands of dollars in tax-beneficial savings.
(For the 2020 year, the maximum pre-tax contribution for someone over age 50 is $26,000. This increased from 2019's maximum, which was $25,000.)
Income Limits Affect Employer Contributions to Your 401(k)
The 401(a)(17) limits apply not only to employee contributions but also to employer contributions. Once you earn over the benefit eligible contribution limit ($285,000 for the 2020 year), your employer is no longer able to put money into your 401(k). Many employers will set up non-qualified retirement plans so they can continue making contributions even if they cannot direct them to the 401(k), such as:
- At Chevron, the company continues to contribute the 8% but allocates the 8% for every dollar of income earned over and above the $285,000 limit to the Retirement Restoration Plan (RRP).
Learn more about maximizing savings for Chevron employees
- At Shell Oil, the organization continues their 10% contributions over the limit to the Provident Fund Benefit Restoration Plan (PF BRP).
Learn more about maximizing savings for Shell employees
- At BP, the company continues to contribute 7% but deflects them to another savings plan, the Excess Compensation Plan (ECP), with more stringent provisions.
Learn more about maximizing savings for BP employees
These non-qualified retirement plans have additional limitations and restrictions making them a nice benefit, but less attractive than traditional 401(k)’s. If you have a non-qualified plan, there are many considerations you should assess leading up to and before electing a retirement date to maximize your benefits and minimize taxes.
Ensure You Get Your Maximum 401(k) Contributions
This super-saver could have easily ensured he maxed out his contribution to the 401(k) by slightly adjusting his formula. When determining his formula for 2020 contributions, he should take the 2020 max contribution limit of $26,000 and divide it by the 2020 income earnings limit of $285,000.
For 2020 contributions for those over 50, $26,000 / $285,000 = 9%
For 2020 contributions for those under 50, $19,500 / $285,000 = 7%
Both the maximum contribution and earnings limits are inflation-adjusted annually. Both limits utilize the same cost of living adjustment, so in most cases, the percentage deferral stays the same from year to year.
Generally speaking, if you are a high income earner and are subject to the 401(k) earned income limits, you will not be able to contribute to your 401(k) proportionally throughout the entire year.
How do Income Limits Impact After-Tax and Roth Contributions
If you are aiming to max out both pre-tax and after-tax contributions to the 401(k), it’s important to ensure that you're maxing out contributions to the after-tax source prior to hitting the earnings limit. When doing the math, remember to take the maximum that you can contribute to the after-tax source and divide by the earnings limits.
For example, our super-saver can contribute $14,700 to the after-tax source in 2020 using the assumptions from our earlier example. To ensure that he can max out contributions to the after-tax source in his 401(k), he will need to defer 5% (= $14,700 / $285,000) in addition to the pre-tax contribution before reaching the income limit.
Oftentimes, we see high earners make contributions to their 401(k) over the first half to three quarters of the year. Once they have hit the earnings limit, their net paycheck goes up as they can no longer make contributions to their company 401(k). It’s important to realize that if you are a high earner you will have lumpy take-home pay, with lower earnings at the start of the year than the end.
As part of our comprehensive asset management and planning process, we sit down with clients annually to review projected compensation and employee benefit plans, educating you on your options and assisting you in making the changes necessary to optimize your specific situation. At Willis Johnson & Associates, we work with our clients to ensure they get their company's full 401(k) contribution, max out their pre-tax and after-tax contributions, take advantage of backdoor Roth IRAs to ensure they are on track for success, and facilitate after-tax roll-outs from the 401(k) to get the maximum amount of savings. If you have any questions about the 2020 contribution and compensation limits, please contact your advisor, or schedule a free consultation with one of our experts.