I started working with a new client that completely missed out on maxing out his 401(k) contributions for the 2018 year when he thought he was set up to max it—all due to the 401(a)(17) limitations. He contributed $11,000 instead of the $24,500 maximum he could put in pre-tax in 2018, which cost him a significant amount in tax savings.
Who Misses Maxing Out Their 401(k)?
This particular client was a high income earning corporate executive from Chevron aiming to max out his contribution to the Chevron Employee Savings Investment Plan. He had a long career at Chevron and was grossing over $600,000 annually between base pay and bonus. (I see this same issue with many corporate professionals I work with, including those from Shell, BP, Marathon, BMC and others.)
He knew that for the 2018 year the max amount he could put into the 401(k) is $24,500, as he was over age 50. At the beginning of the year, he took that number and divided it by his expected benefit eligible compensation (at Chevron this is cash compensation not including stock); $24,500 / $600,000 = 4%. His assumption was that if he set his pre-tax contribution to his 401(k) to 4%, then he would max out by year-end.
It wasn’t until we sat down with him in January of 2019 and showed him his 2018 401(k) statement, that he realized he missed out on additional tax savings he could have had.
(For the 2019 year, the maximum pre-tax contribution for someone over age 50 is $25,000.)
There is a fairly unknown rule regarding 401(a)(17) contribution limits that prevented the Chevron saver from fully maxing out his pre-tax contribution to his 401(k). The 401(a)(17) rules set a maximum on compensation that can be used to contribute to a 401(k) and many other types of retirement plans. Specifically, the 401(a)(17) rules only allow the Chevron saver to use the first $275,000 of income to save into a qualified retirement plan. Once the saver started making over $275,000 a year ($280,000 in 2019), he can no longer make contributions to his company’s 401(k) plan.
Since this saver set his contribution to 4%, he was only able to put in $11,000 (= $275,000 * 4%) into the plan—missing out on $13,500 of pre-tax contributions he could have made into the plan!
(There are exceptions to the 401(a)(17) earnings limit rules whereby a company can allow their employees to consider income past the $275,000 when making contributions to retirement plans, but few allow it, as it regularly messes up anti-discrimination testing, which causes bigger problems.)
How to Ensure You Max Your Contributions
The saver at Chevron could have easily ensured he maxed out his contribution to the 401(k) by slightly adjusting his formula. He should take the max contributions of $24,500 for 2018 and divide it by the income earnings limit of $275,000 for 2018.
For 2018 contributions for those over 50, $24,500 / $275,000 = 9%
For 2018 contributions for those under 50, $18,500 / $275,000 = 7%
For 2019 contributions for those over 50, $25,000 / $280,000 = 9%
For 2019 contributions for those under 50, $19,000 / $280,000 = 7%
Note that both the max contribution and the earnings limit are inflation adjusted annually. Both limits utilize the same cost of living adjustment, so in most cases, the percentage deferral stays the same from year to year.
Generally speaking, if you are a high earner and subject to the 401(k) earned income limits, you will not be able to contribute to your 401(k) proportionally throughout the entire year. Often, we see high earners make contributions to their 401(k) over the first half to three quarters of the year. Once they have hit the earnings limit, their net paycheck goes up as they can no longer make contributions to their company 401(k). It’s important to realize that if you are a high earner you will have lumpy take-home pay, with lower earnings at the start of the year than the end.
After-Tax and Roth Contributions are also Affected
Do also note that all employee deferrals are affected by the earnings limits. This includes Roth 401(k) contributions and Non-Roth After-Tax 401(k) contributions.
If you are aiming to max out pre-tax and after-tax contributions to the 401(k), it’s important to also ensure are you maxing out contributions to the after-tax source prior to hitting the earnings limit. When doing the math, remember to take the max that you can contribute to the after-tax source and divide by the earnings limits.
For example at Chevron, in 2018 the after-tax limit for most employees is $15,500. To ensure you are able to max out your contribution to the after-tax source in your 401(k), you have to defer 6% (= $15,500 / $275,000) in addition to the pre-tax contribution.
Your Employer Contribution is Also Capped
The 401(a)(17) limits apply not only to employee contributions but also to employer contributions. Once you earn over the benefit eligible contribution limit ($280,000 for the 2019 year), your employer is no longer able to put money into your 401(k). Many employers will set up non-qualified retirement plans so they can continue making contributions even if they cannot direct them to the 401(k).
At Chevron, the company continues to contribute the 8% but allocates the 8% for every dollar of income earned over and above the $280,000 limit to the Retirement Restoration Plan (RRP). At Shell Oil, they contribute the 10% over the limit to the Provident Fund Benefit Restoration Plan (PF BRP).
These non-qualified retirement plans have additional limitations and restrictions making them a nice benefit, but less attractive than traditional 401(k)’s. If you have a non-qualified plan there are many considerations you should asses leading up to and before electing a retirement date to maximize benefit and minimize taxes.
How We Help
As part of our comprehensive asset management and planning process, we would sit down with you annually and review your compensation and benefit plans, educating you on your options and assisting you in making the changes necessary to optimize your specific situation. We get to know you and formulate a plan to assist with your savings goals taking into account taxes, investments, and your employer’s compensation and benefit options. Things are always changing and we understand that as time goes on, your personal finances get more complex. We believe that if you are not looking at the full picture, then you are likely leaving money on the table. That is why our promise to clients is that we are continuously planning on your behalf. If you would like to meet with one of our advisors or are interested in receiving more information regarding our services, please contact us at (713) 439-1200 or click here to submit a request.