You can save a substantial amount of money in a workplace retirement plan
like a 401k, and with those high limits you're able to really get
some tax benefits today or possibly set yourself up nicely for later.
So let's spend the next couple minutes talking about exactly how that maximum
works because there are a couple of different ways to get money into
a plan, a couple of different sources, then we'll also chat about the
annual limits currently and the taxation and a couple of other items.
This might be helpful if you're fortunate enough to be able to contribute
up to the max or if you just want to know exactly how
these things work because it can be helpful to have that information.
By the way, this applies to many workplace retirement plans, not just 401k
plans but a lot of 403b, TSP, some 457 plans, etc. You certainly
want to triple check with your employer and your plan administrator or the
various retirement plan vendors to find out exactly what the rules are for
your plan because each plan can be different depending on the employer,
but the maximum limits can apply to a variety of different plans.
This does not apply to those IRA based plans though, so a simple
IRA or a SEP IRA is going to work quite a bit differently,
so look up different rules for those. And what I'd say is that
not everybody reaches the maximum contribution limit every year, but clients
are often surprised at exactly how much they can put into these plans
on a yearly basis, and especially if you're self employed you might really
have a lot of latitude in terms of setting up a plan that
lets you make some really powerful contributions like mega backdoor Roth
contributions for example. As a refresher, there are two basic ways for
money to go into a 401k plan, so those are employee contributions and
employer contributions. The employee contribution is an amount that you
decide to put in out of your pay, so you sign up and
you say take x percent or take a couple hundred bucks a month,
couple thousand bucks a month, whatever the case may be, that's your employee
salary deferral contribution. The other source of money is employer money,
so that might be if your employer chooses, and it's not necessarily required,
your employer would choose to match your contributions perhaps up to a certain
limit, they might make profit sharing contributions, they might be required
to make other types of contributions to keep the plan running nicely,
but whatever the case may be that money comes from the employer.
As you can see here, the employer money is always going to be
pre tax money and that's because the IRS basically says if somebody got
a deduction for making these contributions then the money will eventually
have to be taxed when it comes out of a retirement plan and
your employer often gets a deduction because it's an employee benefit expense,
so that's even the case with non profits,
it just has to go in as pre tax type money and would
generally be taxed when it comes back out. But the employee contribution,
and by the way the employee contribution is always 100% immediately vested,
that is money that you earned and decided to put into the plan,
so that's your money. You can't necessarily pull it out right away when
you want to. There are rules on that, you know, you may need
to terminate employment or get a loan or a hardship withdrawal or something
like that. I have other videos on those topics, but the employer money
might have a vesting schedule. You might need to work at your employer
for a certain number of years to be 100% vested in that money,
and the employee money is always 100% immediately vested. That money can
go in as either pre tax or Roth. You might even have the
option to make voluntary after tax contributions in some plans. That's not
necessarily a widespread feature that everybody has available, but those
are the three basic types of employee contributions. You've got your pre
tax traditional contribution that will reduce your taxable income for the
year that you make the contribution, and then you would typically pay taxes
on that money when you take it out of a pre tax account.
The other one is a Roth contribution, and sometimes that's listed as after
tax, but it's different from the voluntary after tax. The Roth contribution
does not give you a reduction in your income today,
but if you meet all of the IRS requirements then when you pull
that money out later in retirement it can be tax free income.
That can be really helpful, not only because you don't have to pay
taxes on it, but it might have less of an impact on your
social security taxation, for example, or your Medicare premiums or qualifying
for other types of things on your tax return. So that's one reason
to consider Roth. And then if you do have that voluntary after tax
contribution, what typically happens the goal is to put that money in there
and then convert it more or less immediately over to Roth so that
it can grow tax free until you need to spend that money.
That's usually not available in plans because it makes the plans fail certain types of tests.
Those voluntary after-tax contributions can mess that up
because it is typically the people who are better off who are
making those contributions, and if the folks who are less well off aren't
contributing nearly as much that can cause some problems. But if you do
have a solo 401k or an individual 401k because you're self employed then
you may be able to set up a plan that does that where
you can make those voluntary after tax contributions and do a mega backdoor
Roth strategy. By the way, I'm Justin Pritchard, and I help people plan
for retirement and invest for the future, and in the description below you're
going to find some links to some of the things we're talking about
here as well as some resources that are just general retirement planning
information. I think you'll find all of that really helpful so be sure
to check that out. This is also a good time for a friendly
reminder. It's just a short video. We can't cover everything here so please
triple check all of this with your CPA, your employer, your plan administrator
before you take any action. It really is important. We've also got the
catch up contribution and that is for those who are age 50 or
older in the year in which they contribute. So if you reach 50
in November that's fine you can still do a catch up contribution for
that year. So that goes on top of all of the other maximums. So
we've talked about the different types of contributions. Let's get into
some actual dollar amounts here and we'll talk about 2023 because 2022 is
more or less over but the total limit of all the different sources
that could go into your 401k for you would be $66,000 before the
catch up contribution. So if you are 50 or over you can add
the $7,500 catch up contribution on top of that $66,000. That's quite a
bit of money and many people don't make it there. However,
if you are a high income earner or your employer is particularly generous
you can certainly hit that limit and wish that you could contribute more.
That's a nice problem to have. When most people are thinking about the
maximum 401k contribution they're typically thinking about the salary deferral
contribution or how much they can put in out of their own pay and that
is again $22,500 for year 2023. The reason I keep mentioning the year
is that these limits typically increase periodically to keep up with inflation
or or to at least try to keep up a little bit with
inflation so the limits are going to change every year. You definitely want
to keep track of that especially if you're trying to make those maximum
contributions because you may need to notify your payroll department or
HR or whoever does all of that that they need to increase your
contributions if the limit increases. So let's walk through a quick example.
Let's say you make $85,000 per year and you're going to max out
your 401k so for 2023 you're doing that $22,500 salary deferral.
Your employer matches your contributions dollar for dollar up to four percent
of pay, let's say, that's what's called a safe harbor contribution.
It helps them pass those tests and you're over 50 so you qualify
for a catch up contribution so your total additions to the plan for
the year would consist of the salary deferral of $22,500 plus employer matching
of $3,400 plus your catch up contribution of $7,500.
If the annual limit was $66,000 or it's actually $73,500 once we add
in the catch up because you're over age 50
that leaves $40,100 until you actually hit the maximum of $66,000 or $73,500.
So you have $40,100 of room. Now there might not be any opportunity
for you to make that contribution and if that's the case then that
extra room would go unused and that's again often the case for many
people. They don't hit the plan limit each year but if your employer
decided to make additional profit sharing contributions that's the maximum
that you could receive or if your plan allowed these voluntary after tax
contributions then that's how much you could put in under that bucket of
money and potentially convert that over to Roth money for a mega backdoor
Roth strategy. So that's the basics of the maximum contribution in your
401k. Now let's get into some frequently asked questions that trip people
up sometimes and the first question is does the employer contribution affect
how much you as an employee can put in and in most cases
the answer is no. So let's say you've got that salary deferral limit
of $22,500 per year and your employer puts in $5,000 of matching contributions
let's say. That would not reduce the amount that you're allowed to put
in. You could still do the full $22,500.
Now in some cases, and this is really for really high income earners
we're talking hundreds of thousands of dollars here, in some cases those
employer contributions can take up so much space that you don't really need
to make the full employee contribution so why would you put money in
if they're going to put it in for you. So in those cases
it doesn't necessarily mean you couldn't contribute but what happens is
you don't need to. So in those cases the amount that you contribute
out of your own pay is generally reduced but again that's a pretty
rare case. How about IRA contributions? So if you contribute let's say $7,000
to an IRA is that going to reduce what you can put into
your workplace 401k plan? Again the answer is generally no here.
That's not going to affect it at all. They are separate limits.
There's an IRA contribution and there's a 401k salary deferral contribution
limit and contributing to the IRA is not going to affect your 401k.
Next, do you have separate limits for Roth and pre tax salary deferral
contributions? So if you've got your $22,500 limit could you do $22,500
to Roth and $22,500 to pre tax? Unfortunately the answer is no.
So that dollar limit is let's call it 100%
of your limit and then you can split up your contributions however you
want if your plan allows Roth contributions. So you might do 100%
of it over to Roth, you might do 100% pre tax,
50 50, 70 30, 30 70, whatever it is that seems to make
sense for you is what you can do but you don't get to
double the limit. That brings to mind another question people often ask
is that if I make Roth contributions will I get matched and will
those count for the matching calculation? And the answer is yes.
So don't worry about you know using up or wasting some of that
matching contribution if you contribute to Roth because they will match
your Roth contributions if there is a match. How about when you work
multiple jobs or if you're self employed and you have an individual 401k,
a solo 401k plan, how does that work with all of these 401k maximums?
Well the first thing to know is that the salary deferral limit is
generally limited to just one per taxpayer per year so that $22,500 for
the year 2023, again you could do that once whether you put it
in one plan or the other you split it between the two that
limit you typically only get once. There is an exception that is if
you have a 457 plan so that might be available to let's say
city employees and in that case it's possible to double up but for
most of the people out there there is only one limit per taxpayer allowed.
The employer contribution is a little bit different so in that case you
can potentially hit the maximum twice and this depends on what types of
money the sources of contributions we're talking about but it is possible
to hit the overall plan limit of $66,000 twice. That can get really
complicated. We're not going to get into a deep example here but what
I would say is check with your CPA, talk with your employer and
your plan administrators, let everybody know what's going on and what you're
trying to accomplish and then they can tell you if it's possible to
do that. So if you have really high earnings let's say again we're
talking hundreds of thousands of dollars and you have a solo 401k and
maybe a retirement plan elsewhere it could be possible just through employer
contributions to max both of those out or maybe you do some employee
contributions in one of them or the other but the thing to remember
is number one it's complicated you have to check on this.
Number two is if the employers are considered related in the IRS's opinion
then you wouldn't necessarily get to double that maximum so they have to
be completely unrelated employers. And by the way other types of retirement
plans might be treated separately as well so if you have a defined
benefit or a pension plan any money that goes into that is not
going to affect your 401k plan maximum, typically there may be some interplay
there so again you have to talk to the plan administrator make sure
you understand all the moving pieces but in many cases those types of
contributions don't count against you. Now let's get into some limitations
on how much you can contribute because you might not be allowed to
reach the 401k maximum so even if you wanted to you have the
earnings and everything like that you might not be allowed to contribute
the maximum to your 401k because of certain situations. The main issue here
is probably going to be non discrimination tests. These plans have to benefit
everybody in the workforce at your employer so it can't just benefit the
owners or the highly compensated people or the key employees for example
it really has to benefit everybody so that is an attempt to make
it fair for everybody and to offer access to everybody. But in some
cases if people don't contribute enough if let's say the lower earning employees
don't contribute enough to the plan then a plan could fail these non
discrimination tests. It's pretty easy to fix if you add a safe harbor
to the plan and the employer does a certain type of match or
a certain type of contribution this can easily be remedied but not all
employers do that so if your plan is failing these non discrimination tests
what might happen is you might get a refund at some point because
they say you contributed too much. Another potential limitation might be
if the plan document for whatever reason has some sort of limitation in
there it's usually a relic of a really old plan design and there's
not necessarily a good reason for that anymore so it can again typically
be updated but just be aware that that might happen. So what if
your employer doesn't offer a 401k plan but you really like these high
annual limits and you wish that you could contribute up to the maximum
what can you do about that? The ability to contribute to a workplace
plan typically relies on your employer and it's a choice if they choose
to offer that to employees it takes a little bit of administrative expense
and time and energy a bit of risk as well so not every
employer is going to do that. You can certainly ask your employer to
start a plan and let them know that you're interested maybe talk with
some other employees and perhaps volunteer to help be on a committee with
vendor selection and investment selection and plan design and all that so
that you can take a little bit off the plate of your employer
that might or might not fly but it's always worth a try all
they can do is say no but if you don't end up getting
a plan then you may need to just save money elsewhere so a
couple of options for that include a taxable brokerage account that's just
a very simple way to go about it you have to put money
somewhere and if you don't have a lot of choices with nice tax
features then that's a perfectly good option you put the money in it's
very flexible you can use very similar investments and invest for long term
growth or be conservative or whatever you want to do in there the
other option is to use of course IRAs or individual retirement accounts
if you're eligible to use those and use all of the different features
of those because depending on your income and a lot of other things
that can get a bit complicated but that's definitely worth looking into
and you might be able to put money into an HSA or a
health savings account those are really powerful accounts because they're
triple tax exempt so the contribution goes in in a pre tax manner
it reduces your income and then the growth inside of there is tax
deferred and then when you take the money out eventually, assuming you meet
all of the IRS requirements, you use it on qualified health care expenses
etc, then in that case the money would come out tax free so
it's similar to the tax free treatment of a Roth, but really just
for health care expenses and you get a deduction when you put the
money in if you qualify to, so look into that check on the
rules and see if that's an option. I hope you found this helpful.
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