It is essential to save a portion of the money you make to be able to retire at a reasonable age and have the time and money to carry out lifelong aspirations. You hear all the time to contribute to a 401(k) plan, but why are there contribution limits at only $18,000 a year?
Plainly speaking, there are limits in place so the wealthy don’t benefit more than the average person. For many, contributing $18,000 or even more than $10,000 is not possible. The cap of $18,000 creates a smaller variance between wealthy individuals and the average person. Another reason there are limits is due to the amount of tax revenue the IRS is willing to defer. In the case of a traditional 401k contribution, you are receiving a tax deduction on your contributions. In other words, the government is lending you the annual taxes due on the money you choose to save. The limits represent how much tax revenue they are willing to forego, just to encourage you to save your own money. Contributions to a 401(k) can provide significant reductions in a person’s annual income tax burden.
There are exceptions to the limit of $18,000 in 401(k) contributions per year. If an individual is over the age of 50, they can contribute an extra $6,000 annually (commonly known as catch-up contributions). Also, employer’s matching contributions do not count towards the maximum contribution limit of $18,000. In addition, there is an overall cap, which for total contributions from all sources, must not exceed the lesser of the employee’s compensation or $54,000.
There is also Non-Discrimination Testing, which are limitations against highly compensated employees ($120,000 or more) the IRS put in place to encourage equal participation across all compensation levels. For employers to have a “qualified retirement plan” status, contributions from highly compensated employees must not exceed a certain percentage of the average contribution made by non-highly paid employees.
While the average person may not like the fact they can only contribute $18,000 annually to their 401(k), these limits are in place so we are all on the same level playing field. Although you are capped at $18,000 for your 401(k), there are many other platforms to invest in such as an IRA or Roth IRA. Be sure to do your homework when it comes to retirement to make sure there is plenty in the nest when your retirement date comes around.