401(k) Max Deduction
The IRS sets a maximum limit on how much your 401(k) max deduction, or contribution, can be each tax year. The amount for the 2007 and 2008 tax years have already been decided.
The 401(k) retirement plan is named after a provision of the IRS code. It is designed for employees to have a retirement plan that they can use to put off paying income tax on a portion of their income until after their retirement age. The money is deducted from your paycheck and deposited with the 401(k) plan administrator. The money is not considered taxable income in the year it is paid into the plan. Any earnings from this money or money previously contributed to the plan are exempt from taxes as well. However, there is a 401(k) max deduction established each tax year.
In both the 2007 and 2008 tax years, this maximum contribution is $15,500. People over the age of 50 are allowed an additional $5000 per tax year as “make up” deductions if they either started the plan late or did not make maximum contributions in the past. In some 401(k) plans, employers make matching contributions, but these do not count against the maximum contribution of the individual.
Employers also have the right to limit the contributions of employees. When an employer imposes a limit on contributions, it takes precedence over the established IRS limits. For example, if an employee earns $50,000 in a year and the employer limits plan contributions to 10% of income, the maximum amount that can be contributed is $5000 despite the fact this is considerably below the maximum contribution allowed by the IRS.
Most tax experts encourage people to contribute up to the maximum amount whenever possible. The fact that the contributed amount is not subject to tax means that it is subtracted from your taxable income. It does not appear on the W-2 form. This reduction in income can result in a substantial tax savings beyond the savings realized on the contributed amount. Also, earning of a 401(k) plan can be substantial on long term plans and the earning are not subject to taxation until distribution is made.
If you are planning on having the maximum amount allowed deducted from your pay and contributed to a 401(k) plan, you sure be sure that your budget allows this. There is a substantial penalty for withdrawing funds before the age of 59 and a half. This penalty is in addition to the tax liability. It is possible to withdraw funds without penalty in cases of extreme and documented emergencies. So, emergencies do not have to be figured in your budgeting process, but you must not leave yourself in a position where withdrawals must be made to meet routine expenses. This would totally negate the advantages of the plan.