As physicians, many of us find ourselves so engrossed in our daily tasks that we forget to prioritize our financial health.
It’s vital to ensure you’re prepared for the future and your retirement. One of the primary ways to achieve this is through 401(k) contributions.
Understanding the Basics of a 401(k)
A 401(k) is a retirement savings plan sponsored by an employer. It lets employees save and invest a piece of their paycheck before taxes are taken out. This money will sit in the savings account tax-free until the account holder decides to withdraw it from the account.
Many people don’t understand the difference between a 401(k) account and an individual retirement account (IRA.) The major difference between a 401(k) and a traditional IRA is that a 401(k) is employer-sponsored and an IRA is available to people regardless of employment status. You can set up IRA contributions through financial institutions like banks, credit unions, and brokerage firms.
Contributions to a traditional 401(k) are made with pre-tax dollars, meaning you won’t pay taxes on the money you contribute now. However, when you withdraw funds in retirement, those distributions will be taxed as ordinary income.
Some employers offer a Roth 401(k) option in addition to a traditional 401(k). With a Roth 401(k), contributions are made with after-tax dollars, but withdrawals in retirement are tax-free assuming certain conditions are met. We will discuss Roth 401(k)s and traditional 401(k)s more later.
401(k) Contribution Limits for 2023
Each year, the Internal Revenue Service (IRS) evaluates and sometimes adjusts the contribution limits for 401(k) accounts. These adjustments are based on a variety of factors, such as inflation. As we transitioned from 2022 to 2023, there were noteworthy changes to the 401(k) contribution amount limits.
Employee Contribution Limits
|2022 Limit||2023 Limit|
|Employee Contribution Maximum||$20,500||$22,500|
|Catch-Up Contributions (50 and older)||$6,500||$7,500|
In 2022, the maximum annual amount that an employee could defer from their salary to their 401(k) plan was $20,500. For people 50 years old and older, they could defer $27,000 each year with catch-up contributions. Catch-up contributions are additional deferrals that people 50 and above may make to help them reach savings goals as they near retirement.
In 2023, an employee can now contribute $22,500 to their 401(k), and people 50 years old or above can contribute $30,000. This limit increase is due to a number of factors, including inflation and the IRS’s efforts to help Americans save more money for retirement.
Employer Contribution Limits
|2022 Limit||2023 Limit|
|Employee and Employer Contribution Maximum||$61,000||$66,000|
|Total Employee and Employer with Catch Up Contribution Limits||$67,500||$73,500|
Employers often match a percentage of an employee’s contribution as a part of the benefits package. This means an employer will give “free money” as a reward and incentive for employees to save for retirement.
For 2023, the total contributions an employer and employee may make to a workplace retirement plan are $66,000, which is up from 2022’s $61,000 limit. Accounting for additional catch-up contributions, an employee over 50 can contribute up to $73,500 with matching contributions from their employer.
Employers may choose to make contributions to employees’ 401(k) accounts in a number of ways including:
- Matching Contributions: The most common type of contribution, where employers match the employees contribution up to a certain percentage of their salary.
- Non-Elective Contributions: Independent of whether an employee contributes, the employer provides a set percentage of the employee’s salary.
- Profit-Sharing Contributions: Depending on the company’s profitability, a variable amount is contributed.
While annual limits for individual contributions are cumulative across multiple 401(k)s, employer contributions are specific to the company’s sponsored plan. This means if you participate in multiple plans over the course of one calendar year, each employer can max out their contributions.
Traditional vs. Roth 401(k)
Both 401(k)s and individual retirement accounts are available as traditional or Roth accounts. Roth and traditional 401(k)s have the same employee and employer contribution limits, but there are some important differences, such as tax advantages.
Traditional 401(k)s allow you to make pretax contributions. This allows you to reduce your taxable income for the year by however much you contribute to your account.
For example, let’s say you make $70,000 per year. If you contribute $7,000 to your traditional 401(k), your taxable income will drop to $63,000 for that tax year. Contributing to a traditional 401(k) is a popular way for taxpayers to reduce their taxable income for the year.
The catch is you will end up paying taxes on the money when you withdraw it from the account in retirement. The money is tax-deferred, meaning you will pay taxes on it eventually.
Similar to a Roth IRA, Roth 401(k)s require that you pay taxes on your contributions up front, but you won’t have any tax burdens when you enter retirement.
Because you are making after-tax contributions with a Roth 401(), you will not be able to claim any tax deductible on your gross income. This means that if you are making $70,000 and contribute $7,000 to a Roth 401(k), your taxable income will remain the same.
Not all employers offer Roth 401(k) accounts because they can complicate taxes. If your employer offers a 401(k) match, some plans may require that they add it to a pre-tax account, such as a traditional 401(k). Some plans may allow you to save employer contributions to the Roth account, but you will need to check with your financial institution and employer.
Limits for Highly Compensated Employees
Highly compensated employees (HCEs) might find their ability to contribute to their employer-sponsored 401(k) hindered based on certain limits set forth by the IRS.
The IRS defines highly compensated employees based on two main criteria:
- Company Ownership: An individual who owns more than 5% of the business at any time during the current or previous fiscal year is considered an HCE.
- Compensation: An individual who earned more than a specific annual compensation in the preceding year is considered an HCE. These limits change with inflation, so it’s important to always check the income limits. For 2023, you are an HCE if you earned more than $150,000.
Highly compensated employees are not allowed to contribute more than 2% more of their salary to their 401(k) than the average non-HCE. For example, if the average non-HCE at your company contributes 4% of their salary to a 401(k), an HCE cannot contribute more than 6% to their 401(k).
Why are HCE limits different?
The main reason the IRS sets different rules for HCEs vs. non-HCEs is to make sure that plans don’t favor the companies high earners over the rest of the workforce. If a retirement plan offers too much benefit to the HCEs, it could lose its tax-qualified status. That’s why many employers are especially strict when it comes to contributing to a 401(k) as an HCE.
A company may navigate HCE contribution restrictions in the following ways:
- Safe Harbor 401(k) Plans: A Safe Harbor 401(l) allows employers to bypass certain non-discrimination tests by mandating specific employer contributions, such as a match or non-elective contribution.
- Automatic Enrollment: Companies can implement automatic enrollment for new employees, which boosts participation rates and can help even out average contribution percentages between HCEs and non-HCEs.
- Financial Education: Emphasizing the importance of contributing to a 401(k) through financial education can increase the participation and contribution rates among non-HCEs.
How to Contribute to a 401(k)
1. Start contributing to your 401(k) right away.
When it comes to saving for retirement, always remember to pay yourself first. Saving for retirement is one of the best personal finance decisions you can make.
2. Take advantage of your employer’s match.
Employer match contributions are “free money” that you should take full advantage of. Make sure you set your deferral limit to take advantage of these matching contributions. Otherwise, you’re leaving money on the table.
3. Take advantage of target-date funds.
Investment options offered by your 401(k) plan can be overwhelming. If you find yourself inundated with investment options, consider choosing a target-date fund aligned with your ideal retirement timeline. These funds are a great option for hands-off investors who want to make the most of their retirement funds.
4. Increase your contributions regularly.
Always check the contribution limits at the start of each tax year and make adjustments to ensure you’re making the most of your annual traditional and Roth contributions.
5. Understand the vesting period for your employer’s match.
A vesting period refers to the amount of time an employee must stay at a company before they get full ownership of the employer-contributed funds. The main purpose of vesting periods is to incentivize employees to stay with the company for longer. If you leave your employer before you’re fully vested, you may forfeit all or some of your employer-contributed funds.
6. When you switch jobs, roll over your 401(k).
Each year, thousands of people misplace or forget to rollover their retirement savings from jobs that they leave. If you like your current 401(k), be sure to keep up with it and check it regularly. Be sure to roll it over when you leave a job to make sure you don’t lose track of your retirement savings.
Frequently Asked Questions
What happens if I contribute more than the annual contributions limit?
If you save more than the maximum contribution limits in a single tax year, you may end up paying taxes twice on your money. You will pay taxes on the money over the limit when you contribute, and you will pay taxes on it again when you withdraw your contributions in retirement.
Does the 401(k) limit include the employer match?
The $22,500 contribution limit ($30,000 including catch-up amount) does not include the employee matching contribution. However, the $66,000 limit (also known as the all-sources limit) does include employer contributions.
What happens if I make contributions in excess of the annual limit?
Also known as excess deferrals, contributions made in excess of the annual 401(k) limit must be corrected by distributing the excess contributions out of the account. You should contact your HR department to ensure this is done before April 15 of the following year. Otherwise, the money could be subject to double taxation – once in the year of deferral and again when the money is distributed from the account.
Navigating the world of retirement planning can be challenging for physicians and non-physicians alike. Given your typically higher income bracket and unique financial situation, it’s important to understand the complexities and nuances of 401(k) contributions.
By staying informed about the current 401(k) contribution limits and adjusting your savings appropriately, you have the opportunity to build a stable financial future for your retirement years.