By Christian Patterson, CFP®, Wealth Advisor
Welcome to our latest article, where we are diving into the world of smart financial planning to tackle a topic that is all about securing your future – 401(k) plans. Whether you are just starting your career or well on your way, understanding how 401(k)s work and the excellent perks they offer to help you Spend Life Wisely™.
Before we dive into the technical aspects, there are a few basic concepts to understand about 401(k)s.
Essential Concepts to Embrace:
Your Contributions: You have the power to decide how much of your paycheck goes into your 401(k) account. This is your chance to set a savings pace that suits your financial goals.
Employer Match: If your company offers to match a portion of your contributions, grab that opportunity! An employer match is essentially a free 100% return on the amount being matched.
Vesting: If your company matches your contributions, they might have a vesting schedule. This means that while the money you contribute is always yours, the employer match might take time to fully belong to you.
Investment Choices: Your plan provides various investment options – from conservative to growth-oriented – giving you the chance to create a diversified portfolio that matches your risk tolerance.
Tax Benefits: The money you put into your 401(k) is not taxed until you withdraw it, giving you a tax break now and letting your money grow without annual tax hassles. Some plans now allow for Roth contributions to 401(k)s allowing for tax free growth on the deposited funds. If you have both options available to you, it is worth consulting your financial advisor to determine which option is best for your specific circumstances.
Example:
Let us start off this article by considering an example of how someone can contribute to their 401(k) and reach the annual contribution limit, including elective deferrals, employer match, and after-tax contributions. These limits and regulations will be further expounded upon in detail at the end of the article.
Meet Sarah, a 45-year-old marketing director at a thriving tech company. She is a dedicated employee who understands the importance of planning for her retirement. Let us break down how Sarah maximizes her 401(k) contributions and reaches the annual limit.
Sarah's Situation:
Sarah's Strategy:
Elective Deferrals: Sarah decides to contribute the maximum allowed elective deferral of $22,500 from her pre-tax salary. This is a wise move as it not only reduces her taxable income for the current year but also helps to build her retirement savings.
At first glance, one might think that a 6% contribution rate would allow Sarah to reach the $22,500 elective deferral limit ($22,500 / $375,000 = 6%). However, knowing about the compensation limits the IRS imposes, Sarah realizes she must elect a 7% contribution rate ($22,500 / $330,000 = 6.82% rounded up) since the IRS is only considering her income to be $330,000 rather than the $375,000 she is actually earning when contributing to her 401(k) plan.
Employer Match: Sarah's employer offers a 100% match on the first 6% of her salary. However, since her salary is over the IRS compensation limit the match is only based on the first $330,000 of her income. Since Sarah is contributing at least 6% ($19,800), this ensures she receives the full employer match. This adds an additional $19,800 to her retirement account.
After-Tax Contributions: Sarah is aware that the total annual contribution limit for all sources (elective deferrals, employer contributions, and after-tax contributions) is $66,000. Sarah decides to contribute an additional $23,700 as an after-tax contribution to reach this limit.
Some plans will allow for what is known as a “mega backdoor Roth conversion”. This strategy allows for after-tax contributions in a plan to be converted to Roth and allowing a more favorable tax-free growth on the funds going forward.
The Calculation:
Sarah's Total Contributions:
By understanding the various limitations the IRS imposes, Sarah has managed to effectively maximize her 401(k) contributions even with her salary above the compensation limit. While the compensation limit affects her employer match eligibility, she can still contribute via elective deferrals and after-tax contributions to reach the overall contribution limit. In some cases, employers will offer what is known as a “401(k) Restoration Plan” in order to restore benefits that are lost due to high-earning employees having incomes over the compensation limit.
Understanding Contribution Limits:
There were several different limits and IRS regulations mentioned in the example above. Below you will find further explanation regarding elective deferral limits, the “415 limit”, and compensation limits that will help you in not only understanding Sarah’s example but also your own 401(k) plan and contributions.
Elective Deferrals: Each year, there is a maximum amount you can contribute to your 401(k) in what is known as an “elective deferral”. An elective deferral is the amount a 401(k) plan participant contributes to their account on a tax-deferred basis. For 2023, if you are below 50, the elective deferral limit is $22,500; if you are 50 or older, you can contribute an additional $7,500 “catch-up contribution” for a total of up to $30,000.
415 Limit: Do note, $22,500 (or $30,000 if 50 or older) is not the maximum amount that can be deposited into a 401(k) each year and is just the amount that can be saved on a tax-deferred basis. The maximum amount that can be deposited into a 401(k) plan when combining elective deferrals, employer match, and any after-tax contributions is often referred to as the “415 limit” (in reference to Section 415 of the Internal Revenue Code). For 2023, the maximum amount that can be contributed to a 401(k) across all sources is $66,000.
Compensation Limits: When making 401(k) contribution elections, it is also important to consider the annual compensation limit that the IRS uses when determining your 401(k) contributions. For 2023, this annual compensation limit is $330,000. In practice, this means that if you make more than $330,000 the IRS only considers your first $330,000 of income when you are making your 401(k) contributions.
Be sure to keep each of these figures in mind as you plan your contributions.
As always, individual circumstances can vary, and it is important to understand your specific plan's rules and consult with financial professionals to optimize your retirement savings strategy. Additionally, you should remain updated and informed on any changes to contribution limits and regulations that might impact your plan in the future.
Disclaimer: The information provided in this article is for educational purposes only and should not be considered as financial or legal advice. Please consult with your financial and tax advisors to determine plans for your individual circumstances.
Exencial Wealth Advisors is an SEC-registered investment adviser. Any references to the terms “registered investment adviser” or “registered,” do not imply that Exencial or any person associated with Exencial has achieved a certain level of skill or training.