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If you are thinking about making 401k deferrals for 2011, there are a few things you may need to know. Of course, there are many details that will be specific to your plan, but this article should cover almost all of the broader issues.
First, a 401k is a defined contribution qualified retirement plan. It allows you the participant the ability to postpone the act of receiving earned income. Instead, that earned income is diverted to an account. This is the contribution. This choice to divert income away from yourself and into the plan reduces your taxable income (and the tax associated with it) for a later day.
401k tax law also allows assets in your account to grow tax deferred. This means all growth, dividends, and interests on your investments are shielded from income tax…..as long as they stay in the account.
401k Match
Every year, a 401k plan must pass a test. Part of the test ensures that this 401k plan is not some scheme set up by the highly compensated employees for the benefit of the highly compensated employees only. Everyday employees must be participating as well, so say the IRS authorities.
Therefore, to motivate the everyday employee to participate, employers will often offer a 401k match. This match is often too hard to resist and consequently the employee begins to contribute. With the everyday employees contributing, the highly-compensated employees are then allowed to make tax-reducing contributions into their own accounts.
Generally, employers will match an employee’s contributions…up to a point.
To illustrate, let’s say Ashley, the payroll clerk, makes $30,000 per year and the match is up to 5% of Ashley’s income, dollar for dollar. Ashley wants to contribute “to the match”. So she defers $1,500 which is 5% of her income per year. This deferral is now payroll deducted into her account.
But, let’s not forget the employer’s pledge. The employer’s 401k match of 5% equals another $1,500 into Ashley’s account. This means that Ashley is now saving 10% of her income for retirement! Irresistible, uh? Yes, take the match. You contribute $1 and your employer contributes $1 to your account. 100% return on your money (as in Ashley’s case) is hard to beat!
My standard 401k advice to clients is to do just what Ashley did. Contribute “to the match”. If your employer has a safe harbor 401k and offers employees dollar for dollar matching on the first 3% and then 50% on the next 2%, contribute 5%. This approach gets you an additional 4% for every 5% deferred.
If your employer does not offer a match, think about other options first. Consider a Roth IRA or Traditional IRA. If additional funds are available after Roth IRA or Traditional IRA contributions, then 401k contributions may make sense.
401k Maximum Contributions
The IRS limits how much you can contribute every year, and almost every year it changes. For 2012 the maximum annual 401k contribution is $17,000. If you’re at least 50 years old or older, the maximum annual 401k contribution is $22,500. The difference (unchanged in the IRS's recent verdict) of $5,500 is called a 401k catch up contribution. The catch up is just what it sounds like. It gives those that need a “catch up” a little boost a few years before retirement.
The 401k contribution amount for 2012 and years thereafter will be adjusted for inflation in increments of $500 and 403b (similar to 401k, except generally reserved for non-profit organizations) maximum contributions limits (also called elective deferrals) are the same as 401k contributions for 2011. 403b contribution limits will also be adjusted in 2012 for inflation as well.
401k Contributions Deadline
Employer contributions must be made to each employee's account by the employer's tax-filing deadline (including extensions).
You Decide
Remember, you get to decide the annual contributions you make, within IRS 401k maximum contribution limits. Again, the general idea is to contribute “to the match”. This complimentary gift is just too attractive to leave behind.
After reading this article, it may be a good time to confirm your contributions. Are you contributing what you specified when you first signed up? Do you have a grasp on the employer’s match? Has your personal financial situation changed? Do you need more tax breaks? It’s always a good idea to get to know your 401k and the specific choices available in your plan.
Hire 401kFundAdvice as your personal 401k investment advisor!