Contributing to your company-sponsored 401(k) is one of the easiest ways to make sure you’re set up when your golden years arrive. By starting early and maximizing your contributions, you’ll give yourself ample time to take advantage of the unique magic of compound interest — which, given enough years, can turn even modest savings into impressive cushions.
However, it’s important to remember that there are limits to how much you can sock away in a retirement plan, 401(k)s included. Furthermore, those limits have recently changed. Here’s what you need to know.
2020 401(k) contribution limits
Here’s a quick look at the IRS’ updated 401(k) contribution limits for 2020.
Type of Contribution
$57,000 or $63,500 with catch-up contributions
As you can see, the total contribution limit ($56,000) is broken down into different contribution methods, including elective deferrals — i.e., your own regular 401(k) contributions automatically taken out of your paycheck — as well as catch-up contributions and employer contributions, which are frequently made via an employer match program.
Let’s go over how each type of 401(k) contribution works in detail.
Employee contributions: the lifeblood of your 401(k)
The bulk of your 401(k) is likely to be made up of what the IRS calls “elective deferrals” — the percentage or dollar amount you contribute to your 401(k) from your wages each pay period.
Note that 401(k) contributions can be made either pre-tax or post-tax, depending on what kind of account you have. In a traditional 401(k), your contributions are tax-deductible and won’t count toward your taxable income for the year in which you make them. They will, however, be taxed when you withdraw them later.
In a Roth 401(k), on the other hand, your contributions will count as taxable income but won’t be taxed when you take them out. Furthermore, Roth 401(k)s are not subject to the same required minimum distribution rules as their traditional counterparts, said Malik S. Lee, a certified financial planner at the Atlanta-based Felton & Peel financial advisory firm.
“Most employers’ plans have Roth 401(k)s, but a lot of people don’t know to ask for it,” said Lee. Roth 401(k)s are “one of the hidden gems” you might find in your onboarding documentation, so be sure to read your paperwork carefully.
How employer contributions can maximize your stash of cash
Maximizing your 401(k) is the best way to rest assured you’ll be set when the time comes for retirement. In most cases, the easiest way to do that is to take advantage of your employer’s 401(k) match.
A match program works exactly as advertised: Your employer will “match,” dollar for dollar, the money you put into your 401(k) up to a certain percentage of your income, generally between 3% and 6%.
That might not seem like much, but it’s free money. Given the incredible power of compound interest, that small match can work out to a lot of money over time.
For example, let’s say you were making $50,000 and contributed 5% of your salary toward your 401(k). That works out to an annual contribution of $2,500. Now let’s say your employer matched up to 3%, which works out to an additional $1,500. You’ve just bumped your contribution from $2,500 to $4,000 — almost doubling your savings with zero additional effort. Pretty cool, huh?
Your employer also can make contributions outside of a matching program. For instance, the company might contribute a percentage of your overall salary regardless of how much you elect to pay in or a percentage of its annual profit. You have less control over these contributions, but they add to your total and count toward the limit.
Catch-up contributions: are you eligible?
If you’re age 50 or over, you’re eligible to make “catch-up contributions,” which means you can electively defer an additional $6,500 per year without incurring any tax penalties.
If you got a late start saving for retirement or were unemployed — and therefore unable to contribute to your 401(k) for a while — it makes good financial sense to make catch-up contributions to maximize your retirement savings.
However, if you’ve been steadily saving and already have a significant nest egg built up, it might make more sense to seek out alternative investment options, which can diversify your overall portfolio, said Lee. A financial advisor with fiduciary responsibility can help you decide which option is best for your personal goals.
What happens if you go over the limit?
Given the generosity of the 401(k) maximum contribution limit, it’s rare to exceed it. In fact, Lee said he hasn’t seen this financial faux pas happen in his career.
Although saving too much for retirement might sound like an oxymoron, if you do somehow exceed the limit, the tax benefits that make these accounts so powerful will stop working in your favor. In fact, you’ll be penalized by paying taxes twice: The excess contributions will count toward your taxable annual income, and they’ll be taxed when you withdraw them.
If you do overshoot the contribution limit, you should ask your account custodian to withdraw the excess amount by April 15 of the following year. Because it’s done to keep your account within the IRS guidelines, this money will not be subject to the 10% early withdrawal fee you would incur otherwise. It’s important to keep in mind, however, that any income earned on the excess deferral will be taxed as regular income.
Contributing to your 401(k) is an important step to take toward a well-deserved rest after a fulfilling career. Be sure to stay within the contribution limits to maximize your returns and minimize your taxes.