With pensions becoming more of a rarity in the U.S., 401(k) plans have emerged as the backbone of retirement planning for American workers. (See The Basics of a 401(k) Retirement Plan for an overview.) Yet evidence suggests that most workers aren’t taking full advantage of these tax-advantaged accounts. Here’s a look at whether – and when – it makes sense to put more of your salary into a 401(k) and what the annual limits are for your contributions.
Stopping at the Match
Only seven out of 10 individuals contribute to defined-contribution plans at work, according to the Vanguard Group, a prominent investment management firm. And those who do participate typically kick in 6% of their salary – the median amount in the Vanguard study.
There’s a reason why so many employees stop at this 6% threshold – it’s the point at which many businesses stop matching their workers’ contribution.
However, the government actually allows account holders to kick in quite a bit more than that. For 2015, the Internal Revenue Service (IRS) allows you to make up to $18,000 in elective deferrals to a 401(k) – or, in the case of employees at some nonprofit organizations, a 403(b) plan (see 403(b) Plan: Introduction for details).
Furthermore, it provides a catch-up provision for workers age 50 and over, allowing them to defer an additional $6,000 per year. If you happen to have more than one 401(k) or other defined-contribution plan, your total appropriation can’t exceed these annual amounts.
In addition to the cap on worker deferrals into a workplace-retirement plan, the government also places a ceiling on employer contributions to your account. But again, most Americans don’t come close to reaching that bar.
Total Contribution Limits
In 2015, the limit on total deferrals – the amounts both you and your employer put in – can’t exceed $53,000 (or $59,000 if you’re eligible for the catch-up feature). Each year, the government makes cost-of-living adjustments to contribution limits so these numbers are likely to go higher in subsequent years. Here's what you're permitted to contribute, as stated by the IRS:
Elective deferrals limit: $18,000
Additional catch-up allowance (if age 50 or over by year's end): $6,000
Total contribution limit (employee plus employer contributions): $53,000
Total contribution limit (if age 50 or over by year's end): $59,000
It’s worth keeping in mind that these limits don’t apply to every single U.S. worker. Some retirement plans may actually have caps on elective deferrals that are slightly lower than the amount permitted under IRS guidelines.
Companies also have to pass something called the nondiscrimination rule, which exists to make sure that those at the top don’t receive a disproportionate amount of 401(k) benefits. In some cases, a business may have to impose lower-than-normal contribution limits on highly compensated employees – those earning more than $265,000 in 2015 – in order to pass the test. For everyone else, the standard limits apply.
Maximize Contributions – or Not?
If you’re fortunate to have an employer that matches funds, feeding your 401(k) plan is pretty much a no-brainer. If you’re not maxing out what the company is willing to kick in, you’re leaving free money on the table.
But what if you don’t have a match, or you’ve reached the point where the company stops kicking in funds? Aside from their relatively high contribution limits, are these plans still the best place to park your retirement money?
That depends. Once you’ve exceed the company match, one alternative is to start funding an individual retirement account (IRA). Like the 401(k), an IRA allows you to contribute pre-tax money into the account, which grows on a tax-deferred basis until retirement. At that point, any withdrawals are subject to ordinary tax rates – again, like your 401(k) – unless you have invested in a Roth IRA. (See Roth vs. Traditional IRA: Which Is Right for You? and Maxing Out Your 40l(k) vs. an IRA or Roth IRA.)
One advantage of IRAs is a wider array of investment options. With a workplace plan, you’re typically limited to a few funds that are pre-selected by your employer. IRAs give you the flexibility to choose from more funds, or even buy individual stocks and bonds.
And if the funds in your 401(k) are riddled with large annual expenses, the ability to shop around for less expensive investments can be a big plus. Research has repeatedly shown an inverse correlation between management fees and investment performance.
A study by the investment research firm Morningstar, for example, found that no matter the asset class, the cheapest 25% of funds always outperformed the most expensive quartile. So it’s important to look under the hood and see how your 401(k) plan stacks up. As a rule of thumb, some experts say a cost of less than 1% annually means you’re in pretty good shape. (For more on this topic, see 401(k) Fees You Need to Know and The Hidden Fees in 401(k)s.)
Sticking with your employer’s plan can have advantages of its own, however. It’s certainly a simpler option for those who aren’t particularly investment savvy. And the fact that you can set up automatic deferrals from your paycheck makes it easier to stay on track with your retirement savings.
Also, if you have a retirement plan through work and your income reaches a certain threshold, you may not be able to deduct all of your contributions to an IRA (see This is How Much You Can Contribute to Your IRA). When that’s the case, you’ll likely obtain a bigger tax break from your 401(k) or 403(b).
The Bottom Line
Given the fairly high compensation limits on 401(k) plans, most workers can pitch in more than they currently do. As long as the investment options are good and the fees are reasonable, boosting your deferral can be a wise move in the long run.