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The Internal Revenue Code for the 401k plans (IRC Section 401k) is different than that for IRAs (which uses IRC 408).  The  IRS establishes maximum amounts that people can invest into 401k plans each year and the money inside a 401k plan benefits from the same kind of tax deferral that the IRS affords to funds invested in individual retirement accounts. IRS guidelines provide restrictions based on both dollar amounts and in some cases on  percentage of income.

Looking at history, the United States Revenue Act of 1978 included an amendment to Section 401k of the IRS tax code. The measure allowed employers to pay a portion of each employees pay into a tax-deferred compensation plan. In the beginning these plans were not synonymous with retirement accounts, but by 1980  a few companies drew up proposals to establish 401k retirement plans.  Many companies since then have reduced or discontinued defined benefit retirement plans because 401k plans are less expensive to operate.  As of 2011, the IRS allows taxpayers to contribute $16,500 into 401k plans and $22,000 for employees who are over the age of 50. Contributions to SIMPLE plans for business employers with less than 100 employees and no other plan in place,  have maximums of $11,500 and individuals over the age of 50 can invest $14,000. The IRS uses cost-of living calculations to change annual contribution limits.

Employers can match employee contributions without reducing the employee’s eligibility for salary deferral.  Most companies cap matching contributions at 50 percent of the amount invested by the employee. Other companies impose an overall maximum contribution equal to say 6 percent of the employees annual salary. The IRS allows employers to match contributions of only up to 3 percent in SIMPLE plans.  The IRS allows people to make annual contributions of up to $5,000 to Roth individual retirement accounts or $6,000 for people over the age of 50.  Roth IRA contributions do not impact 401k contributions or vice versa.  The IRS allows some people who participate in 401k plans to also make contributions to traditional IRA plans. As of 2011, single people earning less than $56,000 or married couples earning less than $90,000 can get a full deduction in a traditional IRA and still are able to deduct the $16,500 for their 401k accounts.  For higher earner their are phase out amounts and it is best to consult your CPA to determine their eligibility to participate in both plans.

The IRS uses contribution amounts when assessing tax deductions rather than account values. If you invest $16,500 and your investment falls in value to $8,000 during the same year, you cannot make additional contributions to bring your 401k back to the maximum. If you invest too much in a 401k plan, you must withdraw excess funds before April 15 following the calender year in which you invested. Over-the-limit contributions left in 401k accounts are subject to double taxation whic is never a good thing.

 


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