The 401(k) plan allows you to contribute up to $18,000 of your salary to a special account set up by your company. Future contribution limits will be adjusted for inflation. Keep in mind that individual plans may have lower limits on the amount you can contribute. In addition, individuals age 50 and older who participate in a 401(k) plan can take advantage of “catch-up” contributions of an additional $5,500.
401(k) plans now come in two varieties: Traditional and new Roth-style plans. A traditional 401(k) plan allows you to defer taxes on the portion of your salary contributed to the plan until the funds are withdrawn in retirement, at which point contributions and earnings are taxed as ordinary income. In addition, because the amount of your pretax contribution is deducted directly from your paycheck, your taxable income is reduced, which in turn lowers your tax burden.
The tax treatment of a Roth 401(k) plan is different. Under a Roth plan, contributions are made in after-tax dollars, so there is no immediate tax benefit. However, plan balances grow tax-free; you pay no taxes on qualified distributions.Both traditional and Roth plans require that distributions be qualified. In general, this means they must be taken after age 59 (or age 55 if you are separating from the employer whose plan will be making the distributions), although there are certain exceptions for hardship withdrawals, as defined by the IRS. If a distribution is not qualified, a 10% IRS penalty will apply in addition to ordinary income taxes on all pretax contributions and earnings.
If your plan permits, you can make contributions in excess of the current limit of $18,000 ($24,000 if over age 50), as long as your total contribution is not more than 100% of your pretax salary, or $45,000, whichever is less. That means if your salary is $100,000, you can contribute up to $45,000 total to your 401(k) plan during that year. In the case of a traditional 401(k), however, only the first $18,00 ($24,000 if over 50) of your contributions can be made pretax contributions over and above that amount must be made after taxes and do not reduce your salary for tax purposes. (see the latest Traditional and Roth IRA Limits here)
