The perks of 401(k) plans are many: They offer tax-deferred savings, employer matches, and a consistent, reliable way to ramp up your retirement planning. But does that mean you should make the maximum contribution?
With an employer-sponsored plan, your 401(k) contributions are deducted from your paycheck, pre-tax, which automates and accelerates your retirement savings — certainly a no-brainer.
But what takes a little more brain work? Determining exactly how much is the right amount to contribute in a given year. Should you contribute the minimum (usually 3%) to get the employee matching contribution (also known as free money), or contribute the maximum pre-tax amount?
The answer, of course, lies in your specific financial situation. Often your age will play a role, as well. Whatever phase of your financial life and retirement planning you are in, one of your top goals will be to minimize tax liabilities while maximizing your earning potential. Sometimes, maxing out your 401(k) will fit that bill, but other times, you may want to look at other priorities or investment opportunities.
What are the contribution limits for 2021?
If you’re under the age of 50 and on an employee-sponsored plan, then the maximum allowable pre-tax contribution is $19,500.
If you’re 50 or older, you’re allowed an additional $6,500 as a catch-up contribution, for a total of $26,000.
Note that these caps do not include any employer match that you receive — that’s all money that you can contribute out of your own earnings.
In addition, some employers allow special after-tax salary deferrals to a 401(k) plan. If this applies to you, or if you have a solo or individual 401(k) or SEP retirement plan, then there’s an overall limit for 2021 of $58,000 (up $1,000 from 2020).
To max out or not to max out?
Maxing out your 401(k) makes the most sense when you don’t have any higher priority personal financial goals: You’re free of high interest credit card or other debt, and have already built up a significant nest egg.
When it comes to wealth management, the long-term picture is important. Yes, retirement savings should be prioritized and is one of the best places to put your extra cash. However, it’s key to remember that there are a number of other pieces of your financial life that you want to also make sure are in place.
While those priorities may seem conflicting, they’re actually not. It’s all about timing.
Some younger investors, for example, may be better off contributing the minimum amount required to get the employer match, while they sock away other savings to build an emergency fund and a down payment on their first home. As they meet those latter financial goals, they’ll be in a place to increase their 401(k) contributions.
But assuming you have all your other financial ducks in a row and have the income to contribute what you need on a monthly basis to max out (that’s $1,625 per month if you’re younger than 50; $2,166 if you’re older than 50), then doing so can be a great way to save for retirement.
When might it be best to look at options beyond maxing out your 401(k)?
Not every 401(k) plan is created equal. Some come with high fees attached or lack in quality investments. If you work with a wealth advisor, then they are an excellent resource to help you understand the ins, outs, pros and cons of your particular 401(k) plan, and can help you know whether or not you should make the maximum contributions based on your bigger picture.
He or she also has the expertise to recommend other investing options based on your goals, including tax-advantaged options like traditional IRAs and Roth IRAs. With a traditional IRA, you contribute pre-tax money, where it grows tax-free as long as you leave it in the account. With a Roth, you invest funds post-tax, and withdraw them later tax-free.
Both types of individual retirement accounts have different maximum contribution limits and other requirements, so again, a discussion with your wealth advisor is the best course of action.
