A 401k can be a pretty powerful investment tool for retirement if you make full use of it. Basically, through a 401k offered by your employer, you can contribute a certain amount of pre-tax dollars from your gross salary to your account. This money may be matched dollar for dollar (to a certain amount) by your employer and invested into stocks, bonds, mutual funds, money market accounts, and other asset classes.
How much, exactly, can you contribute to a 401k every year? And what is the best way to take advantage of a 401k for maximum return? These are two questions with answers that aren’t always readily available – which is why I’ll address them here and cover the ins and outs of 401k contributions.
401k Contributions Explained
Before we get into dollar amounts, I’ll cover how contributions for a 401k work.
A 401k is a retirement savings plan. It’s not really an investment plan, even though sometimes it’s advertised like one; the investment part of a 401k is there to grow your savings over time. At its core, it is a plan that encourages savings, primarily because it was invented in the 1970’s and implemented in the 1980’s when Americans weren’t saving nearly enough for retirement.
The idea is that a plan participant contributes a certain percentage of his or her monthly pre-tax income – in other words, gross pay before taxes are deducted – to a plan. This money is invested and the gains are kept in the plan and compounded annually while contributes continue to flow in. This results in a pretty substantial growth in (pre-tax) value while you are working. When you reach the age of 59 ½ you are allowed to withdraw the money from your account, minus state and federal income taxes on the full amount.
Why put in pre-tax contributions? Well, by putting in more money at the beginning, you will have a larger capital base, or, a larger amount of money that you can invest and receive a return on. Earning 5% for the first year on $5,000 is a lot better than earning 5% for the first year on $3,978 – and it just snowballs from there.
If you are fortunate enough to work for an employer that provides matching employee contributions, you can reap even more benefits because that is essentially free money. Most employees will contribute 50% of your contribution up to 6% of your gross annual salary. Some contribute a dollar for a dollar of contributions up to 5% of your gross salary. There are other methods; you’ll have to check with your employer for details.
Each year, employer contributions are capped. The limit for 2012 is $50,000 minus whatever you can contribute. This can change annually; for 2012, an employer can contribute up to $33,000 if they so desired (but most don’t and won’t). An employer may also require you to be vested in your plan. This means you have to be with a company for a certain period of time before that money is considered yours.
Employer matching is an incredibly powerful way to make the most of your 401k. Most will not contribute a dollar unless you do, though, so right away, the best way to optimize your 401k is to contribute.
How much can you put in each year?
Your Annual Contribution Limits
The level of contributions you can personally put in each year changes annually and sometimes goes up or down. For 2012, you can put in $17,000 of your own money to your 401k plan. That is actually an increase from 2011 and is the first increase since 2008; in 2011, the maximum was $16,500.
The total amount that can be contributed to your plan per year, as of now, is $50,000 – which, as mentioned above, includes your contributions and your employer’s contribution.
There is, though, one way to go above the annual limit – using something called a catch-up contribution. A catch-up contribution is an additional contribution you can make each year once you hit the age of 50. For 2012, this is $5,500 a year. The purpose is to help you cover some of the shortfall that may exist between how much you need and how much you actually have.
Your employer may not allow these, and may not match them if they do, but if you can, take advantage of them. Even a few years of interest can add to your nest egg at retirement – and in today’s economy, that’s always a plus.