No, we aren’t talking about maxing out credit cards. We’ll save that for next month (hint hint). This post is focused on maxing out your employer sponsored retirement plan and how to mathematically accomplish that savings goal.
In the spirit of tax season and my most recent posts on 401(k)s and other tax efficient retirement saving accounts, I thought it was appropriate to spend a minute on the term “maxing out” a 401(k).
Put simply, maxing out a 401(k) means contributing the maximum allowable amount into a 401(k) each year. In 2020, the maximum contribution is $19,500 for employees under 50 and $26,000 for employees over age 50 (they are allowed a $6,500 “catch-up” contribution). Seems simple but can become more complicated when asked to make 401(k) deferral (read contribution) election. How do you tell your plan administrator that you want to max out your contributions each year?
I’ve recently had to make my elections for my company’s new 401(k) plan and sadly there is no box that reads “max out”. What you will find is an option to select a % deferral or flat dollar amount deferral for each paycheck. Which one do you pick and what number should you fill into each space?
Let’s do the math.
% Deferral Formula
$ Deferral Formula
There are some articles out there that say a % deferral program is better than a flat dollar deferral program but in the case of maxing out an employer program they achieve the same goal. I do agree with those articles and recommend percentage deferrals to my clients who are still working towards maxing out their plan. When using the % method, contributions will automatically go up with income increases where a flat dollar amount election will remain the same despite income increases. The % deferral method will accelerate progress towards maxing out the plan.
How Does it Work?
The benefit to using the formulas above to specify a % deferral amount or flat dollar contribution is creating automated savings patterns throughout the year that will result in maxing out your 401(k). This method ensure equal contributions are spread out equally across the whole year which results in steady take home income during the year.
If you don’t take the time to calculate the specific amount needed to max out a 401(k) you will find your tax home pay to be lumpy as a result. In this example, your plan is to max out your 401(k) and decide to defer 20% of your income into the plan. Later, after reading this great post, you decided to run the numbers and identify the correct deferral amount, which turns to to be 15%, in this example.
In this scenario, withholding at 20% would put you in a situation where the maximum funding limit is reached before the end of the year. Subsequent paychecks, after the max is hit, would have “bonus” take home pay because what was previously being used for 401(k) contributions is now showing up in your bank account. That’s exciting, right!? Yes… but consider what you could have been doing with those extra funds in your paycheck during the first part of the year. Those dollars could have been going towards near term goals like a home or car purchase.
If nothing else, I hope this post prompts you to identify how much you should be deferring to max out your 401(k) and compare it to your current elections and make changes as needed.