How a 401k Plan Increases your Savings Opportunities under the Economic Growth & Tax Relief Reconciliation Act of 2001 (EGTRRA)

(April 24th, 2010)

Many baby boomers who are nearing retirement and even young people who are interested in saving as much as they can for retirement visit their financial advisors each year to see how much they can contribute to their 401k plans and other savings plan for the current & upcoming tax years. Effective 2002 and thanks to Economic Growth & Tax Relief Reconciliation Act of 2001 (EGTRRA), annual limits on 401k contributions were raised for this exact purpose. This allows working investors to contribute more tax-deferred contributions to their retirement plans and lower their current taxable income.

i) Saver's Tax Credit

As a bonus to increasing 401k contribution limits, Congress inserted a provision in the EGTRRA that permits investors to have a tax deduction for any contributions made to Individual Retirement Accounts (IRAs) and other employer sponsored retirement plans. This provision is enacted under the Saver's Tax Credit clause and helps offset the first $2,000 contributed to an individual's retirement plan. To be eligible for Saver's Tax Credit, a worker must meet all of the following requirements:

- Not a full time student
- Will be 18 years or over by the end of the tax year
- Not a dependent of another tax payer
- Does not earn annually more than prescribed limits (shown in the chart below).

The chart below outlines the percentage of Saver's Tax Credit an investor is allowed for making contributions to an Individual Retirement Account (IRA).

For example, an investor who is married and filing joint and has an income of less than $33,000 will be able to get a 50% tax credit on his first $2,000 contributed to an IRA. This means, that investor will get a $1,000 (50% x $2,000) tax credit.

Note: The Saver's Tax Credit was available from the years 2002 to 2006 under the Economic Growth & Tax Tax Relief Reconciliation Act (EGTRRA) and was made permanent under the Pension Protection Act of 2006 (PPA).

ii) IRA Contribution Limits Increased

Under the Economic Growth & Tax Tax Relief Reconciliation Act (EGTRRA), contribution limits to IRAs were increased and additional contributions by those people who are 50 years or over were allowed; these are known as 'catch up' contributions. Contribution limits to an IRA are shown below:

Note: Starting 2009, annual contribution limits will be increased by $500 to account for inflation.

iii) Salary Deferral Contribution Limits Increased

If you work for a company that provides a 401k plan, then you are probably making salary deferral 401k or Simple IRA contributions. If so, then there's good news for you because the contribution limits on these plans have also been raised thanks to the Economic Growth & Tax Tax Relief Reconciliation Act of 2001 (EGTRRA). You could now defer 100% of your compensation up to the stated dollar limit for that year. Making pre-tax salary deferral contributions to a 401k reduces your current taxable income which helps you in the short term. The drawback is that when you withdraw this money upon retirement, you will be taxed then. However, it makes sense that when you retire, you will be in a lower income tax bracket as you will not have a job and will be getting social security payments, thus the tax bill will be lower then.

a) Contribution Limits for Simple 401k or Simple IRA

b) Contribution Limits for 401k Plans

Note that while these above 401k limits are set by the IRS, your company may only allow you to contribute up to a certain percentage of your salary, e.g. 10%. If you earn say $80,000 salary, you can only contribute 10% x $80,000 = $8,000 for the year, even though the federal limit is $16,500. It is best to check with the HR advisor of your 401k plan for more information on this.

This article is not a full summary of the changes brought about by the Economic Growth & Tax Relief Reconciliation Act of 2001 to 401k plans; it is just a summary of its effects on IRA, 401k & SEP IRA/401k contribution limits. Stay tuned for more articles detailing the exciting changes brought about by the EGTRRA.