Chapter 15
Making Contributions
IN THIS CHAPTER
Seeing how much you can save
Having contributions made for you
Getting the timing right
The people in power — from legislators to employers to you — know that investing in a retirement plan is smart. However, those same legislators and employers set some limits on how much you can put into a retirement savings account. On the plus side, the employer, at least, may make deposits into your account while you work for them, and eventually, those employer contributions become yours.
This chapter goes through the limits on how much you and your employer can put into your account and talks about when an employer’s contributions can become yours.
Checking Out How Much You Can Contribute
“How much can I contribute to my retirement plan?” seems like a fairly simple question. However, the answer isn’t as straightforward as you may think. The federal government sets limits on contributions, but your 401(k) plan is allowed to be more restrictive. Also, high-income earners may have their contribution levels capped due to special restrictions required by law. (I explain rules for highly compensated employees in more detail in Chapter 12.)
Gauging the limits of the law
The federal dollar limit for pre-tax salary deferrals is probably the best-known 401(k) limit (not to mention a mouthful to say!). Despite its scary title, this limit is easy to understand. It’s the cap on how much income you can have your employer put into the 401(k) rather than into your paycheck. In 2021 the limit is $19,500, plus an additional $6,500 catch-up contribution if you’re age 50 or older. The limits rise in $500 increments due to inflation and occur as often as inflation warrants.
The 2021 IRA limits are $6,000 if you’re under age 50. If you’re 50 or older, you can put in an additional $1,000 catch-up contribution.
Another federal limit to be aware of is the percentage-of-pay limit. This limit applies to all contributions made to your 401(k) by you and your employer, as well as to all contributions to other defined contribution plans, such as profit-sharing plans or 403(b) plans. These contributions can’t total more than 100 percent of your pay, or $58,000 for 2021, whichever is less. The $58,000 limit is expected to rise periodically with inflation.
The 100-percent-of-pay limit includes catch-up contributions, but the $58,000 dollar limit does not.
Seeing what Uncle Sam allows (he’s extra generous if you’re 50 or older)
Your contribution limit to a 401(k) plan in 2021 is $19,500. This maximum increases in $500 increments for inflation periodically. These may be all pre-tax or Roth contributions or a combination of the two. (Pre-tax contribution refers to money taken out of your paycheck before you pay federal income taxes — it reduces your taxable income so that you pay less federal income tax for the year.) Roth contributions can also be taken out of your paycheck, but you pay tax on the amount, so your taxes aren’t reduced.
The $19,500 contribution limit applies only to your contributions and doesn’t include contributions from your employer. The 2021 combined employee/employer contribution limit is $64,500.
In the year that you hit the big 5-0 and every year thereafter, you can make an additional pre-tax or Roth contribution, known as a catch-up contribution, which raises your total possible contribution by $6,500 in 2021. The catch-up limit increases in $500 multiples for inflation periodically. Why the special tax break? You can speculate that it’s because Uncle Sam is well over 50 himself (look at his white hair, after all). In reality, Congress approved this extra tax break to help workers who may not have contributed much to their own retirement savings early on, particularly workers, typically women, who stepped out of the work force to raise children or care for ailing relatives.
A small number of 401(k) plans allow you to make after-tax contributions. You can’t deduct these contributions from your income tax, but you can benefit from them in another way — the gain on your investment isn’t taxed every year. It grows tax deferred, and you pay income tax only on the investment gains when you withdraw them. Please note that after-tax contributions are not the same as Roth 401(k) contributions. However, you may be able to achieve a better result by making Roth contributions because the investment gains are never taxed if you follow the applicable rules.
Some small businesses offer what’s known as a SIMPLE (Savings Incentive Match Plan for Employees) IRA plan. These plans have fewer administrative requirements for the employer, but the trade-off is lower contribution limits ($13,500 under age 50 plus an additional $3,000 age 50 and over in 2021) than for 401(k)s. Safe Harbor 401 and Qualified Automatic Contribution Arrangement (QACA) 401(k) plans also have fewer administrative requirements for the employer but allow the higher 401(k) contribution limits presented here. I explain Safe Harbor, QACA 401(k)s, and SIMPLE IRAs in Chapter 18.
Paying attention to the percent-of-pay limit
Believe it or not, you can contribute all your wages to your retirement plan if you don’t earn more than about $60,000. The combined employee/employer limit is 100 percent of your pay with a $64,500 maximum. (This includes the $6,500 catch-up contribution.) However, your employer may set a lower percentage in its plan.
In reality, you can’t contribute a full 100 percent of your salary, even if your employer doesn’t make a contribution, because you must pay Social Security taxes, and possibly state and local taxes, on your income before making your 401(k) contributions. You may also have other pre-401(k) pay deductions for medical coverage or contributions to a Section 125 flexible benefits plan.
But, if you can afford to do so, you may be able to contribute quite a chunk of your pay as long as you remain under the limit. If you’re a lower-income saver, or if you start a second career after earning a military, police, or other pension, being able to contribute a higher percentage can be a real plus for you. For example, if you retired from the military with a pension that covers most or all of your everyday expenses, but you became bored and decided to go back to work part-time earning $14,000, you can contribute the entire amount after other deductions.
Heeding limits on your personal IRA
The only limit on IRA contributions is the $6,000 you’re allowed to contribute annually for 2021. When you’re 50 or older, you get to make an extra catch-up contribution of $1,000.
Your earned income must be at least as much as your IRA contribution. If you contributed more than you earned, you need to withdraw the excess contributions by your tax deadline to avoid a penalty.
The amount you’re eligible to contribute may be reduced or eliminated if your taxable income is too high or if your spouse is covered by a 401(k). Check Chapter 2 for more info.
IRA-based employer-sponsored retirement plans such as a SEP-IRA and a SIMPLE-IRA have different contribution limits. See Chapter 18 for information on those small business plans.
Maxing Out Matching Contributions
Many employers match the funds you put into your 401(k) up to a certain percentage or amount. The amount of money you receive from your employer depends on how much you contribute, so it makes sense to contribute enough to get the most possible.
Your employer sets the matching rate as well as the limit of how much it will match and the vesting schedule for the employer contributions. The match rate may be as little as 10 cents (or less) for each dollar you contribute up to a percentage of your salary.
The most common matching rates are 25 cents or 50 cents for each dollar you contribute, usually up to 6 percent of your salary. Some employers match dollar-for-dollar, and a few have even higher matches.
If you can’t afford to contribute the full amount matched by your employer now, start with a lower percentage and increase your contribution rate as soon as possible to reach the full amount. The easiest time to do this is when you get a raise. Increase your contribution rate by 1 percent every time you get a raise. You don’t have to stop there, either. It always makes sense to contribute as much as you possibly can.
If you’re married, you and your spouse can each contribute the maximum amount to get the full match in your plans. If you can’t afford to do that, consider the following options:
- See which plan has the higher match and best vesting schedule and put what you can into that plan.
- Decide who’s likely to stay long enough to qualify for the vested employer contributions and consider pooling your contributions to that plan to get the full match.
- Consider which plan has better investment options, and, if you expect to tap your 401(k) plan resources in the future, which one permits in-service withdrawals or loans. You can then contribute more to the plan that offers the best options.
There’s no delicate way to put this, so I’m just going to say it: If you think there’s a chance that you won’t stay married, you may be better off continuing to fund your own 401(k) to the extent possible rather than putting some of your money toward your spouse’s 401(k) plan. Divvying up retirement accounts after a divorce can be tricky.
Timing Is Everything
When you put money into your retirement account isn’t quite as important as how much you put in, but timing can make a difference. The next sections talk about timing issues for 401(k)s and IRAs.
Spreading out your 401(k) contributions
How you time your contributions is important. Some people like to contribute more to their 401(k) early in the year to ensure that they reach the maximum before, say, having to think about buying holiday gifts at the end of the year. This is sometimes referred to as front-loading the 401(k). The potential problem with this strategy is that it can cause you to lose some of your employer matching contributions. Before you decide to go with this strategy, ask your employer about its timing for depositing matching contributions. Many employers only make these deposits during the pay periods when you contribute to the plan because it’s easier for them. If this is how your plan works, you’ll lose out by front-loading.
For example, say your employer matches 50 cents on the dollar, up to 6 percent of your salary. If you earn $150,000 and you contribute at least $9,000 (6 percent of your salary), you should receive an employer match of $4,500. Now, say you want to contribute the full $19,500 permitted in 2021, and you want to do it early in the year. You fill out your form indicating that you want to contribute 20 percent of your pay every pay period. You’re not allowed to contribute $30,000 to a 401(k), so you’ll be forced to stop contributing partway through the year when you reach the $19,500 limit, unless you are at least age 55 and eligible to make a catch-up contribution. (You’ll get there after you’ve earned $97,500, because 20 percent of $97,500 is $19,500.) Say your employer stops making matching contributions then, because you’re no longer making contributions at that time. You will have received only 3 percent of $97,500 in matching contributions, or $2,925, which is lower than the $4,500 you would’ve received if you had spread out your contributions evenly over the year. By using this strategy, you lose $1,575 of employer contributions.
In this case, it makes more sense to reduce your contribution rate so that you contribute for the entire year and still hit the $19,500 limit. In this instance, 13 percent would be the percentage to use (13 percent of $150,000 equals $19,500).
Spreading out your IRA contributions — or not
The deadline for making IRA contributions is the date you file your tax return for that year. So, you can put money into your IRA for the previous year up until April 15.
The fact that you can doesn’t mean you necessarily should. Participants in 401(k) plans have contributions deducted from their pay each pay period. Following this pattern with your IRA contributions makes sense. Saving each pay period is much easier than making one lump-sum contribution for most workers.
You can’t make payroll deduction IRA contributions unless your employer sets up a payroll deduction IRA plan; however, you can have money transferred from your bank account into your IRA each pay period. You can set a more flexible schedule if it makes more sense to transfer funds once a month or once a quarter, so long as you make the contributions.
Making periodic deposits is a good idea if you are serious about contributing to an IRA for your retirement and/or some other purpose such as buying your first home. Periodic contributions can also reduce your investment risk because you are buying shares throughout the year when shares are both higher and lower. April 15 may or may not be a good time to invest a lump-sum contribution.