2 minute read
Retirement Savings Pitfall to Avoid
by Expert Contributor Jack Del Pizzo, CPA and Owner of Del Pizzo & Associates
Over the past 25 years, most employers stopped offering defined-benefit retirement plans that were funded solely by the employer. Meanwhile, the number of defined-contribution workplace plans funded primarily by workers exploded. As a result, many workers are now responsible for some or all of their retirement savings.
A 401(k) is currently a very popular employer-sponsored defined-contribution plan. It can be a "traditional” or a “Roth” 401(k) plan. A major boost to retirement savings is the fact that plan contributions and earnings in either type of plan grow tax-free as long as they remain in the plan.
In addition, a traditional 401(k) allows an upfront tax break because contributions reduce the employee's taxable salary. However, distributions from a traditional 401(k) are taxable at ordinary income tax rates in the year received. Conversely, contributions to a Roth 401(k) do not reduce the employee's taxable salary but plan distributions are generally tax-free, which creates the opportunity for huge retirement tax savings.
While financial planners generally encourage employees to contribute as much as possible to a 401(k), keep in mind that the annual contribution is limited. For 2021, the maximum employee contribution is limited to $19,500. An employee age 50 or older can contribute an additional $6,500, for a total of $26,000.
Changing jobs during the year can cause an employee to exceed the annual contribution limits, which exposes the employee to penalties and adverse tax consequences. For example, say an employee earning $300,000 a year changes employers on July 1, 2021. The employee elects to contribute 8% to each company's traditional 401(k). In prior years, the employer would stop 401(k) withholding when the employee reached the $19,500 maximum. In 2021, however, the new employer does not know how much the employee contributed to the prior plan. Each employer withholds 8% on the wages it pays, and a total of $24,000 is contributed for the employee in 2021.
It is the employee’s responsibility to notify the new employer of the excess contribution so corrective action can be taken. Failure to do so will subject the employee to penalties and potential double taxation of the excess contribution. Such adverse consequences can be avoided if as soon as employment with the second company commences, the employee notifies the new employer of the amount contributed to the prior 401(k) plan.
Expert Contributor Jack Del Pizzo, CPA and Owner of Del Pizzo & Associates
Marple Newtown's Expert CPA
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