Why are 401(k) contributions limited?

Contributions to 401(k) retirement savings plans are limited as a way of preventing highly compensated employees from reducing their income tax burdens beyond a certain level. In addition, the IRS restricts contributions as a means of promoting plan participation across all earnings levels.

Current Contribution Limits

For the 2015 fiscal year, the maximum amount employees can contribute to a 401(k) or other qualified retirement savings plan is $18,000. In addition, the IRS encourages those who are over the age of 50 to bulk up their savings in the years leading to retirement by allowing catch-up contributions of $6,000 annually. The maximum annual contribution for those over 50 is $24,000.

Your employer's contributions are also limited based on your compensation. The total contributions to your 401(k) in 2015 cannot exceed $53,000, or 100% of your compensation, whichever is less. If you are eligible to make catch-up contributions, this total increases to $59,000.

These limits apply to all contributions to traditional or Roth 401(k), 401(b), SIMPLE or SARSEP plans. If you participate in more than one retirement plan, the total contribution to all plans, including employer deferrals and matching, must not exceed $53,000 for those under 50. For those over 50, additional catch-up contributions cannot exceed $6,000 across all plans.

Income Tax

Contributions to standard 401(k) accounts are made with pretax dollars, meaning any payroll deferrals made to your account are not taxed until withdrawal, after retirement. Employer contributions are also tax-deferred.

Contribution limits prevent employees and employers from overly minimizing their income tax burden. Without the contribution limit, an employee with a very high salary could reduce the amount of income tax he pays each year by deferring the majority of his compensation to a traditional 401(k). Though income tax must still be paid upon withdrawal, the employee is likely in a much lower tax bracket after retirement. Contribution limits ensure highly paid individuals are not able to avoid paying the applicable tax rate by falsely deflating their earnings during working years.

Example

Assume an employee earns $150,000 annually. For the sake of simplicity, further assume he is subject to a 30% income tax based on his earnings. Without a cap on 401(k) contributions, he is able to defer $120,000 to his 401(k), thereby reducing his taxable income to $30,000. This drops him to a 15% income tax bracket, reducing his tax burden from $45,000 to $4,500 for the year.

After retirement, he elects to withdraw only the amount that keeps him in this lower tax bracket. By spreading the $120,000 deferral across four annual $30,000 distributions, he pays only $22,500 in income tax on his $150,000 salary, rather than the original $45,000.

Leveling the Playing Field

Another reason for the limit on contributions to 401(k) plans is to encourage equal participation among employees at different pay levels. Because those who earn more have greater opportunities to contribute to retirement plans, the IRS imposes additional limitations on the total amount of contributions that can be made by highly compensated employees relative to other employees in the same plan.

To ensure those who earn higher salaries are not benefiting unfairly, the IRS imposes a nondiscrimination test to verify both high- and low-wage earners are participating equally. Under this regulation, the total contribution to the account of a highly compensated employee, including elective employee deferrals and employer contributions, must not exceed 125% of the average deferral rate of all non-highly paid employees.

If this requirement is not met, excess contributions are returned and must be included as taxable income for the year, even if it means the employee's annual contribution is reduced below the $53,000 limit. This prompts highly compensated employees, such as management and executives, to encourage plan participation among the rank and file. If the average employee contributes actively to his 401(k), then highly compensated employees are less likely to suffer this additional restriction.