The Internal Revenue Service (IRS) determines how much 401(k) plan participants can defer into their plan accounts, but many plan participants sometimes fail to fully understand or keep these deferral limits top of mind. Participants exceed 401(k) deferral limits for a variety of reasons. While the filing deadline for on-time tax filers has passed for 2022, now is a good time to discuss deferral limits so that plan sponsors and participants can avoid any last-minute scrambling to correct issues in 2023.
2022 Deferral Limits
Each year, the IRS sets limits on how much plan participants can defer into their 401(k) plan accounts. In 2022, the limit on employee elective deferrals for all qualified 401(k) plans is $20,500 — a $1,000 increase from 2021. Participants aged 50 or older can add a catch-up contribution of up to $6,500 for a total deferral limit of $27,000.
The limit on employee elective deferrals to a SIMPLE 401(k) is $14,000 in 2022, an increase of $500 from 2021. Participants aged 50 or over in a SIMPLE 401(k) can make a catch-up contribution of up to $3,000 in 2022. The total defined contribution limit for 2022, which includes employer contributions, is set at $61,000, or $67,500 for eligible participants taking advantage of catch-up contributions.
Related Read: 2022 Employee Benefit Plan and Transportation Limits
Common causes of deferral limit issues
Pandemic-related workforce issues have continued to disrupt organizations and may contribute to the risk that participants may exceed deferral limits. Common reasons for employees exceeding deferral limits include the following:
- Many participants exceed deferral limits simply because they are not aware of the rules. For example, some employees may choose to contribute a percentage of their pay that automatically places them over the limit.
- Participants may leave a company, join another company and fail to understand that their deferral contributions made to both plans put them over the limit.
- When organizations merge or are acquired, participants may be unaware of resulting changes and service providers may not consolidate participants properly.
- Payroll vendors may not cap limits correctly.
- When an employee receives a bonus, a deferral percentage may be automatically deducted and directly deposited into the 401(k) account.
Consequences of exceeding deferral limits
Ultimately, it is the participant’s responsibility to understand and abide by the rules on deferral limits. But employers play an important role in educating participants to help prevent issues and correct an excess should the situation arise.
When an error occurs, the participant first needs to determine where the excess occurred — especially if multiple accounts are involved. Once the participant determines this, the plan sponsor must distribute the excess deferral to the employee and report it as taxable income in the year it is deferred and the year it is distributed on Form 1099-R. The IRS provides examples and more details in its 401(k) Plan Fix-It Guide.
If a participant exceeds the deferral limit and the mistake is corrected prior to April 15 of the year following the year of deferral, there is no early withdrawal penalty. However, if the participant does not fix the error before filing his or her individual tax return, the participant will have to pay a “double tax” — once in the year they over-contributed and once in the year the cash was taken from the plan. Late withdrawals may also be subject to a 10% penalty tax, a 20% withholding tax and require special spousal consent. If the excess contribution is made as a Roth deferral, which is funded with after-tax dollars, the participant may have to pay taxes on the associated earnings.
Employers can get nicked, too. If the excess contributions are not taken out by the required due date, plans can be disqualified and would need to go through the Employee Plans Compliance Resolution System (EPCRS).
Avoiding overages altogether
Financial planning can be challenging even for the most attentive employees. For this reason, it can be helpful to over-communicate about deferral limits, including on election forms, standard plan notices, plan statements and regular employee correspondence. Some participants can change their deferral election based on the provisions set in the plan document, so having constant reminders can help them stay compliant.
Better communication with service providers can also help. Plan sponsors should check in with service providers at least annually to ensure that the proper cap is in place — especially in years when deferral limits change. Plan sponsors can also work with service providers to alert participants when they are approaching a deferral limit threshold.
Insight: Set limits to IRS standards
Plan sponsors are permitted to use deferral thresholds that are lower than what the IRS prescribes. For example, plan sponsors may set a threshold of 85% of an employee’s pay as a contribution ceiling in the plan document. But even when this sort of threshold is imposed, some employees can still cross the IRS limit — for example, if 85% of an entire salary is contributed. Because it is so difficult to foresee every situation, it is typically best to stick to the IRS thresholds and instead focus your efforts on areas like better communication with plan participants.
For more information, contact Jim Pellino at [email protected] or 312.670.7444. Visit ORBA.com to learn more about our Employee Benefit Plans Services.