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How do 401(k) Plan Contributions Work?

Two of the advantages of participating in a 401(k) plan are: (i) elective deferrals to the plan and investment gains are not subject to federal income taxes until distributed from the plan and (ii) elective deferrals are always 100% vested.

In all 401(k) plans, participants can contribute through salary deductions and it is 100% elective. The employer can decide on the business’s contribution to participants’ accounts in the plan.

Employer and employee contributions and forfeitures (non-vested employer contributions of terminated participants) are subject to a per-employee overall annual limitation. This limit is the lesser of: 100 percent of the employee’s compensation, or $57,000 for 2020. In addition, the amount employees can contribute under any 401(k) plan is limited to $19,500 for 2020. This includes both pre-tax employee salary deferrals and after-tax designated Roth contributions (if permitted under the plan). All 401(k) plans may allow catch-up contributions of $6,500 for 2020 for employees age 50 and over.

401(k) plans are permitted to allow you to designate some or all of your elective deferrals as “Roth elective deferrals.”

Traditional 401(k) Plan

If the employer decides to contribute to the 401(k) plan, the employer has further options. The employer can contribute a percentage of each employee’s compensation for allocation to the employee’s account (called a nonelective contribution), it can match the amount the employees contribute (called a matching contribution), or it can do both.  Under a traditional 401(k) plan, you have the flexibility of changing the amount of employer contributions each year, according to business conditions.

Safe Harbor 401(k) Plan

Under a safe harbor plan, the employer can match each eligible employee’s contribution, dollar for dollar, up to three percent of the employee’s compensation, and 50 cents on the dollar for the employee’s contribution that exceeds three percent, but not five percent, of the employee’s compensation.

Alternatively, the employer can make a nonelective contribution equal to 3 percent of compensation to each eligible employee’s account. Each year, the employer must make either the matching contributions or the nonelective contributions. The plan document will specify which contributions will be made and this information must be provided to employees before the beginning of each year.

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