In this month's Monthly Financial Jargon series, as we near the end of the year, we want to focus on a key investing strategy that is frequently misconstrued when it comes to retirement account contributions: maxing out.
You have most likely heard the advice to work towards maxing out your 401(k) or other tax-advantaged employer-sponsored retirement account. Maxing out your 401(k), or retirement plan equivalent like a 403(b), for example, in a given year means you hit the annual IRS limit allowed for pre-tax contributions in your employer-sponsored retirement account. For 2020, the contribution limit for employees who participate in a 401(k), 403(b), most 457 plans, and the federal government’s Thrift Savings Plan (TSP), is $19,500. If you are age 50 or older, you may contribute an additional $6,500 catch-up contribution for a total contribution limit of $26,000 in 2020. These same limits apply for 2021. Be mindful of these limits and know what you are contributing annually.
Hitting the annual IRS contribution limit can be easily confused with hitting the contribution limit to qualify for a company match, but know that these two limits are very different. Hitting the contribution limit to qualify for your company match, if one is available, does not mean you have maxed out your 401(k) contributions for the year. The misconception between the employer match and IRS limit involves people believing they are maxing out their employer-sponsored plan because they are contributing enough to receive the company match; however, in reality, they are most likely missing out on the opportunity to contribute up to the IRS limit. The IRS contribution limit will always be greater than the company match level, and confusing these two limits can result in employees missing out on potential contributions and complementary benefits.
Many people do not max out their employer-sponsored retirement plans. According to a recent Vanguard report, out of the employees in the plans Vanguard manages, only about 13% hit the annual contribution limit in 2019. This low statistic may partly be a result of the “maxing out” misunderstanding. Put simply: If there is a company match available, the limit you need to hit to qualify for it will always be lower than the IRS contribution max, so make sure you are not overlooking the opportunity to contribute more to your employer-sponsored plan.
The important question many people have is: “Should I max out my 401(k)?” The answer to this question varies for everyone and is dependent on your unique financial situation. The simple answer: If you have a solid financial foundation in place, and you have high-quality investment options in your employer-sponsored retirement plan, maxing out your annual contributions most likely makes sense. On the opposite end of the spectrum, if you are still working on other pieces of your financial life like paying off debt or you are not pleased with the investment options available in your company plan, maxing out your contributions may not be the prudent move to make. For example, paying off high-interest debt, building up and adequately funding your emergency savings, and working towards a big financial purchase like buying a house may be the wiser places to save before you look to max out your 401(k) contributions.
That being said, before being told to max out your employer-sponsored retirement plan, you have most likely received the advice to, at a minimum, contribute enough to your 401(k) or equivalent plan to obtain the maximum company match. If you are not doing so, make sure you increase your contributions to receive the company match, so you do not miss out on this free money. Additionally, keep in mind that your employer match does not count toward your annual 401(k)-contribution limit. For example, if you max out and contribute $19,500 to your 401(k) in 2020, and your employer adds an additional $4,000 via the company match, you are still within the IRS contribution limits.
As stated above, your unique financial situation is important to evaluate prior to making the decision regarding whether or not to max out your employer-sponsored retirement plan contributions. In this same vain, remember that your 401(k) is only one potential retirement savings vehicle. If you max out your 401(k) contributions, you can still augment your retirement savings with other tax-advantaged retirement accounts like traditional or Roth individual retirement accounts (IRAs) that allow you to contribute up to $6,000 annually for 2020 and up to $7,000 if you are age 50 or older for 2020. These same limits apply for 2021. IRAs offer their own set of benefits and provide you with greater control over your investment options, so keep these accounts in mind when it comes to supplementing your annual retirement savings.
Additionally, if you have a high-deductible health plan (HDHP) with a Health Savings Accounts (HSAs), the latter serves as a valuable savings vehicle with a $3,550 contribution limit for single coverage and $7,100 for family coverage in 2020, and $3,600 for single coverage and $7,200 for family coverage in 2021. While qualified medical expenses are always eligible for tax-free distributions, at age 65, you can also withdraw money from your HSA as ordinary income to help fund everyday expenses in retirement. Lastly, you may consider leveraging a taxable account to save further, as these accounts have more accessibility to assets than retirement accounts and allow you to save beyond IRS contributions limits.
If you misconstrue maxing out as contributing enough to obtain your employer match, you may be missing out on significant contributions in your employer-sponsored plan up to the IRS limits. Keep in mind that the general rule of thumb for financial success is to save at least 15% of your annual income for retirement throughout your career. If you are not quite at the financial level to save 15%, make sure you are, at the very least, contributing the minimum needed to receive your company match, if one is provided. It is prudent to evaluate your 401(k)-contribution percentage on an annual basis or when you receive a salary increase to make any needed adjustments and to ensure your percentage coincides with your retirement savings goals.
Monthly Financial Jargon: The world of finance and investments is notorious for its extensive use of jargon. With a goal to enhance financial literacy and make the world of money more transparent, we have our “monthly jargon” articles that focus on debunking financial terms that are often used sans explanation.
Questions and/or interested in how this applies to your financial life?
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