To a certain extent, 401(k) regulations allow employers to determine what is defined as "eligible compensation/pay" for contributions to a 401(k) plan. For instance, some plans may include overtime pay in the definition of compensation for salary deferral purposes, while others may not. Indeed, many may only include so-called "straight time pay"; i.e., earnings from working normal hours.

Key Takeaways

  • What kind of income can count towards a 401(k) retirement plan is dictated by the employer who sponsors the plan.
  • A company's retirement plan document usually outlines how they define employee compensation to be used for salary deferrals.
  • Retirement plans can vary with some companies might include overtime pay while others might only include straight time pay.

Understanding 401(k) Contributions And Compensation

The definition of what compensation should be included for salary deferral is laid out in the 401(k) or retirement plan documents. Depending on the plan, the definition of eligible compensation will be outlined in the plan, and it can vary from one plan to another.

For example, assume that the plan does not include overtime in the definition of compensation and limits your salary deferral to 10% of your compensation. If you earn $10,000 as regular (straight time) pay and $1,000 in overtime, you would be allowed to defer up to $1,000 to your 401(k) because your limit will be 10% of your straight time pay.

Wrongfully Excluding Compensation

Employers can make mistakes by excluding certain forms of compensation if they’ve selected a plan that should cover all forms. Often, mistakes are made on the employer's end by excluding such compensation as commissions, overtime, or bonuses.

Mistakes made by employers using the wrong compensation can be expensive to fix. 401(k) and other retirement plans generally include one of three options for defining compensation. The first is W-2 wages. The second is 3401(a) wages, which is all compensation subject to federal income tax. The third is 415 safe harbor, which is not used for taxation but includes pre-tax salary deferrals. 

These three options can include or exclude certain forms of compensation. This can include fringe benefits, such as reimbursements, moving expenses, or deferred compensation. Other exclusions can include pay earned before the employee became plan-eligible. As well, compensation paid to highly-compensated employees can be excluded.

401(k) Contributions

Money contributed to 401(k) plans are subject to limits set by the Internal Revenue Service (IRS). The annual contribution limit for 401(k) accounts is $19,500 in 2020 and 2021. Those 50 and older can contribute an extra $6,500 for both 2020 and 2021, called a catch-up contribution.

Including the employer’s contributions to an employee’s account, there’s a $57,000 combined employer-employee limit for contributions for 2020 ($63,500 for those eligible for catch-up contributions). For 2021, the total contribution limit is $58,000 ($64,500 including catch-ups). 

Special Considerations

The general rule of thumb is to contribute at least 10% of your gross income to your 401(k). In some cases, employers will offer a matching contribution. In that case, it’s advised to contribute enough to get the maximum matching contribution. For example, the typical match is 3%, or of the employee’s first 6% contribution.

If you cannot contribute as much as you would like to, all is not lost. If you have extra funds you want to save in a tax-advantaged retirement account, you may consider contributing to an individual retirement account (IRA).

There are traditional IRAs and Roth IRAs. The contribution limit on IRA contributions for tax years 2020 and 2021 is $6,000, with a $1,000 catch-up contribution for those 50 or older.