401(k) Rules – Contribution Limits, Catch-Up Contribution Rules, Vesting Rules, 401k Eligibility Rules


If you are working for a large organization and do not have a 401(k) retirement plan, or if you already have one but are not familiar with the many rules that mandate 401k plans, this article is for you! We discuss 401k contribution limits, catch up rules for people over 50 years of age, vesting rules as well as things you have to be eligible for before you can contribute to a 401(k). We will cover most of the 401k rules but in order to get a comprehensive list of rules, you need to ask your 401k administrator as each company has its own set of customized rules regarding 401(k) contributions, limits and vesting rules.

401(k) Eligibility Rules

The purpose of 401k retirement plans is to provide workers with an income when they retire, so they are not fully dependent on the country’s pension system. A 401(k) plan is a tax-deferred compensation plan that will pay out a set annuity each month upon retirement at the age of 65. Most employees prefer to have biweekly payroll deductions from their pay checks on a pre-tax basis that go directly towards 401k contributions. All monies contributed to a 401k plan grow tax-deferred until withdrawn during the age of 65 when it will be taxed. For any withdrawals before the age of 59 and ½ (premature withdrawals), there is a 10% penalty.

In order to contribute to a 401(k), you have to pass the contribution eligibility rules. Here they are:

i) Employees must be over the age of 21 to contribute to a 401(k) plan – Don’t ask why?

ii) Some companies require new employees to perform 1 year’s service before they are eligible to contribute to employer sponsored 401k plan. This is known as a vesting rule.

iii) Employees hired by a collective bargaining agreement will have most likely negotiated their 401k eligibility, matching percentages, etc before they were hired by the company.

To administer, offer and maintain a 401(k) plan, the employer must meet the following 4 requirements.

I) The plan must be in writing

II) All plan assets must be located in a trust fund. A trust fund in common law terms is an arrangement where retirement assets including cash, property and intangible assets are managed by one person (plan administrator) for the benefit of all workers who contribute.

III) There must be a database of all records.

IV) All important information, year-end net worth statements, comprehensive list of rules and guidelines must be provided to employees participating in the plan each year.

Employer Matching Contributions

The Internal Revenue Service (IRS) has formulated a test that is conducted each year to make sure the owners of the organization and the service level employees are both using the 401(k) plans for contributions, and that there is no gaps left, and the owners are not taking advantage of service level employees. In order to satisfy this test by the IRS, most employers are looking to make their 401(k) plans fair for both the highly compensated employees such as the CEOs and VPs as well as low level employees and managers. This is done via employer matched contributions. Most employers prefer to contribute 50 cents on every $1 of contributions made by their employees. This makes the 401(k) plan a fair one for both high level and low level employees, and satisfies the IRS test. Also, an employer matched contribution provides an instant return on investment (ROI). This provides an incentive for employees to save for their retirement which is exactly the whole purpose of 401(k) retirement plans.

401(k) Contribution Rules and Limits

The total of both employer match and employee contributions to a 401(k) plan are subject to the following rules for the years 2007 to 2009.

) Total contributions may not exceed 100% of the employee’s compensation.

ii) Total contributions are limited to $45,000 in 2007, $46,000 in 2008 and $49,000 in 2009. iii) From 2010 and onwards, total contribution limits will be indexed with inflation and will be move in increments of $1000 a year.

Furthermore, employees are subject to the following contribution limits.

i) For 2007 and 2008, the total contribution an employee can make is $15,500 (on a pre-tax basis). This limit is increased to $16,500 for 2009.

ii) Beginning 2010, contribution limits will be indexed with inflation and will move in increments of $500 a year.

Catch Up Contribution Rules

Catch Up contribution rules apply to people who are 50 years of age and over. In order to help them save faster for retirement as they have less # of contribution years, the IRS allows them to make extra contributions on top of the regular contributions they make. These are known as 401(k) catch up contributions. In 2008, catch up contribution limit was $5000, and for 2009 it is $5,500. This means that an employee over 50 years of age can contribute $16,500 + $5,500 = $22,000 to their 401(k) plan in 2009.

401(k) Vesting Rules

In salary deferral plans, any money placed in to a 401(k) plan is immediately 100% vested. This means the money belongs entirely to the employee and cannot be lost for any reason. This also entitles the employee to take the money with him if he leaves the company + any investment gains – any investment losses and fees. However in traditional 401(k) plans, the employer will decide how employee contributions are vested. Vesting refers to the number of years of service an employee must perform before earning the right to capture all of his accrued contributions.