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The Short Answer

Should I Invest Part of My Bonus in My 401(k)?

Karen Wallace

Q: Should I elect to put my bonus into my 401(k)? I've heard conflicting advice, but I don't understand the downside.

A: You're thinking along the right lines here--the goal in retirement savings is to sock away as much as you can reasonably afford to. (In other words, don't rack up credit card debt in the present trying to save for the future.) 

But one potential issue with investing a percentage of your bonus, especially if you are a higher-income employee maxing out your 401(k), is that it might cause you to hit your annual contribution limit--currently $18,500 ($24,500 if you are 50 or older)--before the calendar year is up. And if you hit the $18,500 cap too early in the year, you could miss out on company matches in the later months. 

Essentially, there's a sweet spot in terms of 401(k) contribution percentage, where (depending on your salary) you are not exceeding the annual IRS contribution limit before the end of the calendar year, which will also allow you to also nab the full employee match. If your plan provider doesn't provide one, you can try one of many online calculators to help figure out your sweet spot.

But also be aware that not all plans work this way--some plans match aftertax contributions or include provisions that "true up" or reconcile the employer contribution to make sure employees get the maximum potential match. If you're not sure how your plan works, ask your benefits department or consult the plan document.

Q: Can you be phased out of contributing to a 401(k) if you make too much money?

A: No, and yes (sort of). It's not quite the same as an income limit, such as what a Roth IRA imposes, but it is possible to have too much compensation to contribute. 

As discussed above, the maximum amount of pretax salary contributions an employee can make in 2018 is $18,500 ($24,500 if over age 50). Total contribution, which means the contributions from the employee plus contributions from the employer (such as a 401(k) match), cannot exceed $55,000 ($61,000 for savers over 50). 

How this all comes together depends on the terms of your plan. Some 401(k) plans allow you to contribute to your 401(k) until you've contributed a total of $18,500, even if you've already made more than $275,000 in compensation for the year. (If you make $480,000, or $40,000 per month, you will have earned $275,000 in year-to-date compensation sometime in June).

In other cases, you cannot contribute when you've earned more than the $275,000 limit, which means you would have to stop contributing in June. If this is the case with your plan, you will want to make sure you right-size your contribution so you can take full advantage of your 401(k).

The rules pertaining to matches are more straightforward, however. Any amount over $275,000 cannot factor in to the bonus calculation. 

Here's how the IRS explains this: Say your plan matches 50% of the first 5% of your salary you contribute. Let's say you earn $400,000. Plugging in the numbers, you would expect to get a match of $10,000 ($400,000 x 5% / 2). However, you can only factor in up to $275,000 of compensation when applying the matching formula for 2018, so the maximum employer match you can get is $6,875 ($275,000 x 5% / 2). 

Q: Part of my 401(k) contribution was returned to me even though I didn't go over the maximum contribution limit. What gives?

A: It sounds like you may have run into a situation where you are considered a highly compensated employee, and your 401(k) plan fails nondiscrimination tests. 

If your annual salary is $120,000 or more, you are considered a highly compensated employee by the IRS. (This threshold did not change in 2018.) In some cases, the definition is broadened to include a stipulation that the employee is also in the top 20% of employees when ranked by compensation. You would also qualify as a highly compensated employee if you own more than 5% of the company, regardless of your compensation. 

401(k) plans are required to pass certain tests that prove they do not discriminate against lower-income employees. A so-called nondiscrimination test compares the 401(k) salary deferrals and contributions of highly compensated employees to those of nonhighly compensated employees, to ensure that the contributions made by and for rank-and-file employees are proportional to contributions made by and for owners and managers (highly compensated employees). 

That's kind of confusing, right? In a nutshell, if the participation rate of highly compensated employees is much higher than the nonhighly compensated employees' participation rate, the plan will fail. The purpose of this test is to make sure that high earners and company owners are not benefiting disproportionately from the tax breaks that come along with investing in the plan while the nonhighly compensated employees are not taking advantage of them, director of personal finance Christine Benz explains

One way companies can correct a failed nondiscrimination testing is to refund a portion of highly compensated employee's 401(k) contributions. If this happens in your case, be aware that this refund amount, assuming it went into a traditional 401(k), would be taxable in the year in which it was received, along with any investment earnings on that excess contribution amount. 

If this happened to you, you missed out on taking full advantage of your tax-sheltered options through no fault of your own. Benz's article explores some alternative savings vehicles for highly compensated employees and runs through some options you can suggest to your employer that might help fix the problem with its 401(k) plan.