Maxing Out Your 401(k): Going All In vs. Simply Meeting the Employer Match
For all ages, a 401(k) plan can be a valuable tool for saving towards retirement. When it comes to retirement savings, there can be confusion around what it means to “max out” your 401(k) contributions. Are you contributing the maximum amount allowed by the IRS or are you simply contributing the minimum amount to receive your employer’s match?
A Refresher: How 401(k) Plans Work
Before looking at the contribution limits for 2023, let’s review the basics of a 401(k) plan. As established by subsection 401(k) of the Internal Revenue Code, a 401(k) plan is a profit-sharing plan that allows employees to contribute a percentage of their earnings towards retirement[1]. Many employers will offer a “match”, which is an additional contribution made by the employer to the employees’ retirement savings. Commonly, employers will match 3% of gross salary, as an example.
Aside from creating a pool of assets to withdraw from during retirement, 401(k) plans offer tax advantages for the current year. When making a contribution to a 401(k) plan, taxable income will be reduced dollar-for-dollar for every contribution made. Additionally, capital gains, dividends, and interest payments related to investments within a 401(k) plan are tax-deferred. Taxpayers will normally only incur a tax liability related to a 401(k) plan when they are retired and begin withdrawing money. At this time, the withdrawals will be taxed as ordinary income (the same way that salary and wages are taxed).
What About Roth 401(k) Plans?
For many employees, Roth 401(k) plans are an increasingly popular alternative to the aforementioned “traditional” 401(k) plan. It is important to understand the difference between the two.
Mainly, contributions to a Roth 401(k) are made with “after-tax” dollars. This means that there is not a dollar-for-dollar decrease to current year taxable income for contributions. So, if there are not current year tax deductions, what’s the point? Roth 401(k)s are unique in that all withdrawals made during retirement from a Roth account are completely tax-free.
Furthermore, like the “traditional” 401(k), capital gains, dividends, and interest income related to investments within a Roth 401(k) are also tax-free.
The final noteworthy feature of a Roth 401(k) comes from how the employer match works. As mentioned, all employee contributions are made with after-tax dollars. However, usually, the employer matching contribution is made with “pre-tax” dollars and therefore goes into a traditional 401(k). An easy way to visualize this is as two buckets that are created upon opening a Roth 401(k): one Roth bucket and one traditional bucket. All employee contributions accumulate in the Roth bucket while employer matching contributions accumulate in the traditional bucket. Withdrawals from the Roth bucket during retirement are tax-free whereas withdrawals from the traditional bucket are taxed as ordinary income.
Please note that Section 604 of the Secure Act 2.0 (passed by Congress on 12/23/2022) now allows employer contributions to be made on an after-tax basis going forward[2].
How the IRS Defines Maxing Out a Retirement Plan
Most people are not currently maximizing their 401(k) personal contributions. In fact, at the end of 2021, only 9.7% of employees with their 401(k)s held at Fidelity Investments reached the IRS limits[3].
For 2023, the IRS limits for employee contributions to 401(k), 403(b), most 457 plans, and Thrift Savings Plans is $22,500. In other words, an employee enrolled in any of the above plans cannot contribute more than $22,500 in 2023 to their plan[4]. The main exception to this rule is for anyone age 50 or older by the end of the calendar year. These individuals qualify for an additional “catch-up contribution” of $7,500 each year.
To get a better understanding of the difference between maxing out a 401(k) and maxing out an employer match, let’s look at an example.
Scenario A
Imagine you are currently under age 50 in 2023 and your salary is $100,000 per year. Your employer offers a 401(k) with a “50% match, up to 6% of salary”. If you were to contribute 6% of your salary to the 401(k) per year ($6,000 total), then the employer match would be 50% of your contribution, or 3% of your salary ($3,000). In this example, you are maxing out your employer match, but not the personal contributions to the 401(k) ($16,500 remaining). Total contributions to the 401(k) for the year are $9,000, or 9% of your gross income.
Scenario B
Now imagine the same scenario, except you contribute $22,500 to the 401(k). Even though you contributed 22.5% of your income, the employer match is still 3% of your salary ($3,000). However, in this example, your 401(k) savings as a percentage of income is 25.5% ($25,500). Compare this to the 9% total savings from Scenario A and there is a large difference between maxing out the 401(k) to IRS limits and maxing out the employer match.
What is the Right Amount to Contribute?
In deciding the right percentage of income to contribute towards retirement savings, it is important to consider monthly cash flow. Many of us have heard the standard rule of thumb in budgeting known as the 50/30/20 rule. Simply, the rule asserts that 50% of gross income should be allocated towards needs, 30% towards wants, and 20% towards savings. While this serves as a decent guide, it fails to consider the idiosyncrasies of different financial situations.
Individuals who recently graduated from college may have more than 50% of their income going towards nondiscretionary expenses such as rent/mortgage, student loans, car payments, etc. Conversely, individuals who are close to retirement may have much less than 50% of income going towards those expenses. Nonetheless, targeting a savings rate of 20% is not appropriate for everyone.
In general, it is advisable to at least maximize the employer match. The employer match is “free money” to you that would otherwise be missed, and therefore costly. Next, it is often helpful to understand your contributions as a percentage of your compensation. Looking back to Scenario A above, assume you earn $100,000 annually and are contributing 6% to maximize your employer match. Maximizing contributions at $22,500 may not be immediately possible due to cash flow needs. However, it may be advisable to increase the percentage contributed by 0.5% to 1.0% annually. Over time between cost-of-living adjustments and raises and/or promotions, the contribution levels will become closer to that ultimate goal of $22,500 annually.
Contributions for Married Couples
Families are increasingly consisting of dual income households. One benefit of earning money is the feeling of autonomy and independence. However, it can be detrimental to fail to consider the financial picture of an entire household when determining the appropriate amount to contribute. If Spouse A earns $750,000 annually and Spouse B earns $80,000 annually. Spouse B may feel like $22,500 is significant to take from the paycheck if Spouse B considers $80,000 “my money” and the remaining income “my spouse’s money.” However, at a 37% marginal tax rate, contributions of $22,500 from Spouse B to a traditional 401(k) saves the household $8,325 in annual taxes. Use all the members of your family team to optimize your tax situation.
Savings Outside of the 401(k)
Though the 401(k) is a relatable, accessible, and relatively easy investment vessel, it is not the only way to save nor should it be the only way that an individual is saving. One of the downfalls with 401(k) savings is that they are essentially locked up until retirement. Generally, the amount an individual withdraws from a retirement plan before reaching age 59.5 is subject to a 10% penalty. There are a few exceptions to this rule[5]. For individuals that are many years away from this age, it is important to have savings accounts that are not for retirement.
One example of a non-retirement savings account is an emergency fund. It is often recommended that individuals have 3-6 months’ worth of nondiscretionary expenses saved to account for unexpected financial situations such as large, one-time expenses or the loss of employment. Emergency funds are usually established in highly liquid investments like traditional savings accounts, high-yield savings accounts, CDs, or even in money market mutual funds.
Another appropriate way to create non-retirement savings is by opening a taxable brokerage account. This can be a great way to invest in the market while still enjoying liquidity before and during retirement. It is important to note that taxable brokerage accounts, unlike traditional and Roth 401(k)s, create taxable dividends, interest, and capital gains. Like salary and wages, income stemming from dividends and interest received is taxed as ordinary income (with the exception of qualified dividends) while capital gains are taxed at the more preferential capital gains tax rate.
Outside of enjoying pre-retirement liquidity, taxable brokerage accounts can offer tax diversification to an individual’s portfolio. For example, imagine you just retired at age 65 and decided to reward yourself by taking a vacation. If you used your traditional 401(k) as the source of funds for the trip, the income received from your 401(k) would be taxable as ordinary income. At the highest rate, this could be as much as a 37% tax. Now imagine if, conversely, you funded the vacation by selling a few positions in your taxable brokerage account that increased in value over the years. This would result in long-term capital gains tax which, at its highest rate, is a 20% tax. The tax savings created by using capital gains instead of ordinary income could be significant for higher earners.
Finding the Solution That Works for You
Admittedly, the various strategies discussed are not one-size-fits-all solutions. While there are healthy financial practices and good rules of thumb, each client’s financial position is unique and should be handled accordingly. If you have any questions regarding retirement savings, financial planning, or anything else stemming from these topics, please feel free to contact us for assistance in implementing change to your long-term wealth management plan.
[1]https://www.irs.gov/retirement-plans/401k-plans
[2]https://www.finance.senate.gov/imo/media/doc/Secure%202.0_Section%20by%20Section%20Summary%2012-19-22%20FINAL.pdf
[3]https://www.washingtonpost.com/business/2022/10/26/irs-401k-limit-increasing-to-22500/
[4]https://www.irs.gov/newsroom/taxpayers-should-review-the-401k-and-ira-limit-increases-for-2023#:~:text=The%20amount%20individuals%20can%20contribute,up%20from%20%2420%2C500%20for%202022
[5]https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-tax-on-early-distributions#:~:text=Generally%2C%20the%20amounts%20an%20individual,tax%20unless%20an%20exception%20applies.