If your long-term goal is to enjoy a comfortable retirement, the 401(k) plan is a great way to get there.
“There are two types of people out there,” says Michael Silver, CEO of Baron, Silver, Stevens Financial Advisors in Boca Raton, Florida. “There are the ones that spend first and save whatever’s left. They generally struggle in retirement because there’s never anything left. Then there are the people that save first and spend whatever’s left. They tend to have a successful retirement.”
With a 401(k) plan, employees have the opportunity to pay themselves first by making substantial annual contributions toward retirement. It’s just a matter of initially setting up a payroll deduction to contribute to your 401(k) and choosing investments, and then updating your preferences maybe once a year. You can stash away quite a bit more in a 401(k) than in an IRA.
401(k) contribution limits in 2020
For 2020, the 401(k) limit for employee salary deferrals is $19,500, up from $19,000 in 2019. This 401(k) contribution limit is imposed by the Internal Revenue Service, which generally makes cost-of-living adjustments in the fall of each year.
Employer matches don’t count toward this limit and can be quite generous.
The 401(k) contribution limits also apply to other so-called “defined contribution plans,” including:
- 403(b) plans, available to education and non-profit workers.
- Most 457 plans used by state and local government employees.
- The federal government’s Thrift Savings Plan.
Employers often provide a matching contribution, so if you don’t take advantage of this, you’re rejecting free money. But you may not be immediately entitled to that money.
While your contributions are always vested in the plan, meaning they are immediately credited to your account, employers sometimes impose time restrictions on their contributions to provide an incentive for workers to stick around.
“As an employer, you’re looking to dangle a carrot to keep your employees working with you, and you want them to have that feeling that you are sharing in their retirement, and that’s what vesting can do,” Silver says.
Typically, a 401(k) plan may offer an employer match of 50 cents on the dollar, up to 6 percent of a worker’s salary, which would be the equivalent of 3 percent of compensation. To take advantage of the full match, employees would have to defer 6 percent of their salary toward the 401(k) plan. Some plans are more generous, offering a 6 percent total match or more. Be sure to take advantage of the employer’s match because that’s free money to you — and a guaranteed return on your investment.
Employers have a higher contribution ceiling
The employer’s 401(k) max contribution limit is much more liberal. Altogether, the maximum that can be contributed to your 401(k) plan between both you and your employer is $57,000, up from $56,000 in 2019. That means an employer can potentially contribute much more than you do to your plan, though this is not the norm.
The salary cap for determining employer and employee contributions for all tax-qualified plans is $285,000. Even at that level, the employer would have to contribute a hefty amount to reach the $57,000 limit.
Traditional versus Roth 401(k)
Some employers offer both a traditional 401(k) and a Roth 401(k). With a traditional 401(k) plan, you can defer paying income tax on the amount you contribute. In other words, if you earn $80,000 and contribute the maximum $19,500, your earnings for the 2020 tax year would be $60,500. With a Roth 401(k) plan, you don’t get an upfront tax break, but when it’s time to withdraw that money in retirement, you won’t owe any tax on it. All your accumulated contributions and earnings come out tax free.
Investing in both types of plans provides you with tax diversification, which can come in handy in retirement.
If you have access to both a Roth and a traditional 401(k) plan, you can contribute to both, as long as your total contribution to both doesn’t exceed $19,500.
Can I contribute 100 percent of my salary to a 401(k)?
If your earnings are below $19,500, then the most you can contribute is the amount you earn. It should also be noted that a 401(k) plan document governs each particular plan and may limit the amount that you can contribute. This applies especially to highly compensated employees, which in 2020 is defined as those earning $130,000 or more or who own more than 5 percent of the business.
Sponsors of large company plans have to abide by certain discrimination testing rules to make sure highly compensated employees don’t get a lopsided benefit compared to the rank and file. Generally, highly compensated employees cannot contribute higher than 2 percentage points of their pay more than employees who earn less, on average, even though they likely can afford to stash away more. The goal is to encourage everyone to participate in the plan rather than favor one group over another.
There is a way around this for companies that want to avoid discrimination testing rules. They can give everyone 3 percent of pay regardless of how much their employees contribute, or they can give everyone a 4 percent matching contribution. “When you couple the tax benefits with the match and the forced savings, it’s generally the best way somebody can save for retirement,” Silver says.
Perks for older investors
If you happen to be 50 or older, you’re entitled to make “catch-up” contributions by adding an additional $6,500 for a total contribution of $26,000 in 2020. The total maximum that can be tucked away in your 401(k) plan, including employer contributions and allocations of forfeiture, is $63,500 in 2020, or $6,500 more than the $57,000 max for everyone else. Forfeitures come from an account in which company contributions accumulate from departing employees who weren’t vested in the plan.
401(k) plan limits
|Maximum salary deferral for workers||$19,500||$19,000|
|Catch-up contributions for workers 50 and older||$6,500||$ 6,000|
|Annual limit for both workers and employers||$57,000||$56,000|
|Annual limit for workers 50-plus and employers||$63,500||$62,000|
|Annual compensation limit||$285,000||$280,000|
|Highly Compensated Employees||$130,000||$125,000|
How to claim your retirement savings
Normally, getting at your money can be difficult, and the rules are often imposed by the plan design rather than regulations.
For instance, regulations allow you to access the money by:
- Taking out a loan.
- Getting a hardship withdrawal before age 59 ½.
- Waiting until age 59 ½.
While most plans do have loan provisions, many don’t allow hardship withdrawals, and some plans require that a person be terminated before accessing their money, even if they are 59 ½ or older.
However, in these days of COVID-19, the recently enacted Coronavirus Aid, Relief, and Economic Security Act, or CARES Act, has made it easier to get at your money – up to $100,000 in loans or distributions, if the plan allows. These withdrawals must be made before the end of 2020.
Unless you’re really in a bind, Silver advises against taking a distribution or a loan. While you can avoid the 10 percent early distribution penalty, you still have to pay income tax on any distribution (though not if you take out a loan). The new law enables you to spread the taxes out over three years, and you also have the option to repay the money and get your tax money back if you file amended returns.
Featured image by Nancy Honey of Getty Images.