Contributing to your 401(k) is one of the most important parts of setting yourself up for a financially secure retirement. However, you might think increasing your 401(k) contributions will significantly lower your take-home pay.
The good news is that your paycheck may not be impacted as much as you might expect. The reason is simple: tax advantages. Unless your 401(k) is a Roth plan, you contribute with pre-tax dollars.
For example, imagine you are contributing $500 per month to your 401(k) every month via payroll deduction. That means the money is subtracted from your paycheck, and you never see it. These contributions are made with pre-tax dollars, so the entire $500 goes into your 401(k) each month. But, say you decide to stop your contributions. The money will be added to your take-home pay instead, but you will have income tax withheld, so you will receive much less than $500.
In general, this is the advantage of pre-tax dollars going toward your future. However, there are some additional specifics we will cover for common types of 401(k) plans.
Traditional 401(k) Plans
Traditional 401(k) plans are one of the most common retirement plans in the U.S. With the traditional 401(k), you generally contribute to a plan through your employer via payroll deduction. Your employer might also make matching contributions, which may or may not require you to wait a certain number of years before you are fully vested.
The advantage of traditional 401(k) plans is that you contribute with pre-tax dollars. For instance, say your salary is $50,000, and you don’t make any 401(k) contributions. In that case, you pay income tax on the entire $50,000. But if you contribute $5,000 per year to your 401(k), you only pay income tax on your $45,000 of take-home pay. While your take-home pay will be reduced slightly, you’ll pay less income tax.
In addition to not paying tax on the money you contribute to your 401(k), you also don’t have to pay tax on investment returns. You do have to pay tax on withdrawal, however, at which point the money is taxed as income. Nevertheless, contributing to a traditional 401(k) will greatly reduce how much income tax you pay in your lifetime.
The contribution limit for traditional 401(k) plans for 2022 is $20,500, or $27,000 for those aged 50 and over. The $27,000 amount includes a $6,500 “catch-up” contribution.
Safe Harbor 401(k) Plans
A safe harbor 401(k) plan is similar to a traditional 401(k). For instance, the contribution limits are the same, including the catch-up contribution. Again, these contributions are made with pre-tax dollars, so your taxable income will be reduced by the amount you contribute. However, there are a few key differences in how safe harbor plans are structured.
There are multiple types of safe harbor plans, such as basic plans and enhanced plans. With basic plans, employers match 100% of contributions up to 3% of employee compensation, and 50% of contributions up to 5% of compensation. Enhanced safe harbor plans match 100% of employee contributions up to 4% of compensation.
Another key difference with safe harbor plans is that matching contributions are fully vested immediately. In other words, employees can’t be required to wait a certain number of years before they are fully vested; that happens as soon as money is contributed.
Lastly, these plans allow employers to avoid nondiscrimination testing. However, they must notify employees of certain things, such as how employees can make elections.
SIMPLE 401(k) Plans
While the other two plans mentioned here are generally for employees working for a large employer, SIMPLE 401(k) plans were created for small businesses. These plans are also not subject to nondiscrimination testing. In addition, they are similar to safe harbor plans in that matching contributions are immediately fully vested.
Contribution limits are different for SIMPLE plans than for the other types of 401(k) plans. In 2022, the elective deferral limit is $14,000 ($13,500 in 2021 and 2020; and $13,000 in 2019). These plans also include a “catch-up” contribution of $3,000.
For tax purposes, SIMPLE 401(k) plans are similar to traditional 401(k)s. You contribute with pre-tax dollars, reducing your taxable income by the amount you contribute.
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