If your long-term goal is to enjoy a comfortable retirement, the 401(k) plan is a great way to get there.
“It’s much easier to start saving for retirement now so that the retirement accounts have time to grow versus waiting to save for retirement, where you would need to save much more than if you had started a decade before,” says Katie Brewer, CFP, the founder of Your Richest Life, a financial planning firm focusing on Gen X and Gen Y.
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 and 2021
For 2021, the 401(k) limit for employee salary deferrals is $19,500, which is the same amount as the 401(k) 2020 limit. Employer matches don’t count toward this limit and can be quite generous.
However, the total contribution limit, which includes employer contributions (and after-tax contributions, if your employer offers that feature), has increased to $58,000 in 2021, up from $57,000 in 2020.
On top of these amounts, workers aged 50 and older can add up to $6,500 more annually as a catch-up contribution.
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.
|401(k) plan limits||2021||2020||Change|
|Maximum salary deferral for workers||$19,500||$19,500||none|
|Catch-up contributions for workers 50 and older||$6,500||$6,500||none|
|Total contribution limit||$58,000||$57,000||+$1,000|
|Total contribution limit, plus catch-up contribution||$64,500||$63,500||+$1,000|
|Compensation limit for figuring contributions||$290,000||$285,000||+$5,000|
|Compensation threshold for key employee nondiscrimination testing||$180,000||$180,000||none|
|Threshold for highly compensated employee nondiscrimination testing||$130,000||$130,000||none|
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.
“A company match is a way that your company will save for retirement on your behalf, but only if you save the minimum amount to get the match,” Brewer says. “It’s free money that requires that you put a certain amount into retirement to get the free money.”
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) maximum contribution limit is much more liberal. Altogether, the most that can be contributed to your 401(k) plan between both you and your employer is $58,000 in 2021, up from $57,000 in 2020. (Again, those 50 and older can also make an additional catch-up contribution of $6,500.) 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 $290,000. Even at that level, the employer would have to contribute a hefty amount to reach the $58,000 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 a year and contribute the maximum $19,500, your taxable earnings (assuming no other deductions) for the 2021 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 during 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 as an employee doesn’t exceed $19,500.
In addition to the Roth and traditional 401(k), some employers also offer an “after-tax plan,” allowing you to save up to the total annual limit of $58,000. With this account you can put away money after-tax and it can grow tax-deferred in your 401(k) account until withdrawal, at which point any withdrawn earnings become taxable.
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 2021 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.
What percent should I contribute to a 401(k)?
Brewer suggests that your contributions should be based on a percentage of your income, depending on your age. She recommends that you stash away between 10 percent and 15 percent of your gross income if you’re in your 20s and 30s, or if you started saving during those years. If you’re behind in retirement savings in your 40s and 50s, Brewer encourages you to set aside between 15 percent and 25 percent of your income.
“If you’re not saving anything for retirement right now and want to get started, start with at least 3 percent to get going,” Brewer says. “Increase your contribution by at least 2 percent each year — and do a larger increase in years where you get a big raise — until you hit your target savings percentage.”
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 2021, which is the same as the contribution limits from 2020. The total maximum that can be tucked away in your 401(k) plan, including employer contributions and allocations of forfeiture, is $64,500 in 2021, or $6,500 more than the $58,000 max for everyone else. Forfeitures come from an account in which company contributions accumulate from departing employees who weren’t vested in the plan.
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 without a bonus penalty by:
- Taking out a loan.
- Getting a hardship withdrawal before age 59 ½.
- Waiting until age 59 ½.
- Leaving your employer in the year you turn 55 or after
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.
Last year, due to COVID-19, the Coronavirus Aid, Relief, and Economic Security Act, or CARES Act, made it easier to get at your money – up to $100,000 in loans or distributions, if the plan allows. These withdrawals had to be before the end of 2020. If you took a hardship loan in 2020, you can avoid paying the 10 percent penalty on the money, as well as take the option to repay the loan tax-free over the next three years. Consider consulting with a tax professional as you prepare your taxes if you’re in this position, since it involves filing amended returns.
Unless you’re really in a bind, Brewer advises against taking a distribution or a loan. There’s no replacing time in the market, she points out, and consistent saving over time is one of the best ways to build wealth for the future.