401(k) Plans in 2020 and 2021

Another nice feature of 401(k) plans is the employer match. Many employers will match their employee contributions either on a dollar-for-dollar basis or on a percentage basis. For example, an employer might contribute $0.50 for every dollar the employee contributes to their 401(k) account. This amounts to an instant 50% return on the employee's investment.

In order for an employer to set up a 401(k) plan, they have to comply with about four rules. The first rule is that the plan must be written down. That means all of the participation rules and matching contribution limits must be spelled out.

The second rule has to do with safekeeping the fund. The company must provide for a trust fund for the plan's assets. In practice, this trust can be provided by the company itself or by other entities such as a brokerage house. The intention here is the money needs to be managed in a professional and secure manner. This rule dovetails nicely with the third employer requirement: There needs to be a recordkeeping database.

The final employer rule is a simple one to follow. All of the information explaining how the plan works needs to be shared with the potential participants or employees.

The IRS has established several strict ground rules for the way 401(k) plans are run, but they've also left some leeway for employers in terms of participation rules. So while the exact 401(k) rules of participation are somewhat flexible, there are generally three rules all employers must follow:

• In order to participate in a 401(k) plan, the employee must be age 21 or older.

• Employees may be required to work for the company for at least one year before participating.

• If the employee is also covered by a collective bargaining agreement, and they've negotiated on this benefit in good faith, then as part of that negotiation process, the union employees may not be eligible for participation.

For the calendar years 2020 and 2021, the employee can contribute up to $19,500 on a pre-tax basis. In 2022, employees' contributions will be determined via an index of inflation, and can move up in $500 increments. Individuals 50 or older by year end are also eligible for the catch-up contribution discussed later in this article.

Note: Updated contribution limits are generally available in mid to late October.

Anyone reaching the age of 50 or more by December 31st is eligible for an additional catch-up contribution. Employees can make an additional - $6,500 in 2020 and 2021 - contribution to their 401(k) plan on a pre-tax basis. In 2022, the catch-up contribution will be indexed to inflation and can rise in $500 increments.

We mentioned earlier that employers had some flexibility around the participation rules they establish. Each year, the employer's 401(k) plan must pass a test the IRS conducts to ensure robust participation in the plan. Essentially, the IRS wants to ensure the benefits of the plan are flowing to both highly-compensated employees as well as rank-and-file members of the company.

This annual audit is one of the reasons employers make matching contributions. Whereas many of the highly-compensated employees may have discretionary income that allows them to set money aside for retirement, the same cannot be said for some of the rank-and-file employees. In order to improve participation among the sector of employees that are unsure if they can afford to invest in the plan, the matching contribution is often the deciding factor.

Finally, the total of all contributions to an employee's 401(k) plan, including matching funds, catch-up provisions, and the employee's pre-tax and after-tax contributions, cannot exceed 100% of the employee's compensation or $57,000 in 2020 and $58,000 in 2021.