Content of the material
- What is the 401(k) maximum?
- 7. Rein in spending
- Your contribution rate: A little extra can help make a big difference
- Saving for healthcare costs
- Don’t miss out on the Roth IRA
- When Should You Avoid Maxing Out Your 401(k)?
- Next Steps: Strategic Investments
- 4. Open an IRA
- Choosing retirement accounts
- 1. Traditional 401(k)
- 2. Roth 401(k)
- 3. Traditional Individual Retirement Account (IRA)
- 4. Roth Individual Retirement Account (IRA)
- 5. Health Savings Account (HSA)
- 1. Individual Retirement Account (IRA)
- Benefits of Maxing Out Your 401k
- Invest Smarter with The Motley Fool
- How to Grow a Retirement Fortune When You Cant Max out Accounts
- The next year, I made my retirement savings top priority
What is the 401(k) maximum?
The maximum anyone can contribute to a 401(k) account for 2020 is $19,500 for most savers. This limit applies to 401(k) plans and similar 403(b) and 457 plans. Those 50 and older can save an additional $6,500 per year, which is called a “catch up” contribution.
For investors under 30, the $19,500 maximum means you can save an average of $1,625 per month. If you are able to save and invest that much, you’re well ahead of the typical American in saving for retirement.
401(k) accounts are great for pre-tax contributions. This means you don’t pay any income taxes the year of your contribution. Instead, you pay taxes on withdrawals in the future, presumably at a lower tax rate than you pay today.
However, 401(k) plan accounts are notorious for high fees and few investment options. If you have old 401(k) accounts with past employers, it’s often a wise idea to roll over your balance to a Rollover IRA. But as long as you have the job, contributing to a 401(k) is still usually a good idea even with the typical fees.
7. Rein in spendingExamine your budget. You might negotiate a lower rate on your car insurance or save by bringing your lunch to work instead of buying it. Merrill has a cash flow calculator that can help you determine where your money is going — and find places to reduce spending so you have more to save or invest.
Your contribution rate: A little extra can help make a big differenceHow much you contribute to your retirement plan account today can make a big difference in how much you have when you’re ready to retire. Just increasing your contribution rate from 4% to 6% could add more than $101,000 to your nest egg over 30 years, assuming a $50,000 salary. Investing in securities involves risks, and there is always the potential of losing money when you invest in securities.
Source: Bankrate, 401k Retirement Calculator. Example is based on a 7.2% rate of return. This example is hypothetical and does not represent the performance of a particular investment. Your results will vary. Actual investing includes fees and other expenses that may result in lower returns than this hypothetical example.
Saving for healthcare costs
Let’s talk doctors and dentists: Americans spend more than $10,000 per person per year on healthcare.6
If you qualify, consider opening a health savings account (HSA). HSAs are available if you have a high-deductible health plan—with at least a $1,400 annual deductible ($1,350 in 2019) for an individual or $2,800 for a family in 2020 ($2,700 in 2019), according to the IRS. HSAs let you save $3,550 ($3,500 in 2019) pretax as an individual and $7,100 ($7,000 in 2019) pretax if you have a family plan. And if you are 55 or older, you can contribute an additional $1,000 to an HSA.7
You can use funds in the account to pay for current qualified healthcare costs (think contact lenses, office co-pays, prescriptions), or you can leave the money in the account and use it later—even in retirement. After you turn 65, it’ll be tax-free if you use it for your qualified healthcare costs, and taxed as income with no penalty if you spend it other ways.
Don’t miss out on the Roth IRA
The Roth IRA is one of the most coveted retirement accounts in existence, and there are tons of reasons why people flock to this golden goodie. After you contribute post-tax dollars, you’re in the driver’s seat of your money and can buy investments that grow tax-free. The most captivating perk may be the ability to withdraw all the funds in your account 100% tax-free during retirement.
Many people rely solely on their employer-sponsored retirement plans to cover their retirement lifestyles. However, that may not be enough to build a sizable nest egg that aligns with your goals. As long as you meet the income requirements, contributing to a Roth IRA can get you one step closer to your retirement goals.
In 2022, those with incomes under the limits can contribute up to $6,000 to a Roth IRA if they’re under 50. The contribution limit goes up to $7,000 after you turn 50. If you contribute around $500 a month or $125 a week to a Roth IRA, you can max out your account within 12 months.
Develop a “set it and forget it” strategy to help you achieve your goal. For example, you can set up automatic transfers from a checking account to a Roth IRA to put your contributions on autopilot.
You’ll have until April 15, 2023 to contribute to a Roth IRA for 2022. If you need to take care of other financial obligations now, you’ll have time to work toward your Roth IRA goals later in the year.
When Should You Avoid Maxing Out Your 401(k)?
Of course, not all people are in a position to add $20,500 a year to a retirement plan. If you earn $50,000 a year, that $20,500 represents 41% of your total income—some of which you may need to meet your living expenses. It’s okay that you may not have the excess cash flow needed to make this happen. Each year brings a new enrollment period, so you can always choose to increase your contribution over time if your financial situation improves.
There are other reasons to think about maxing out 401(k) contributions. Employer-sponsored plans come in many forms, but most are managed by outside investment firms with their own rate and package options. Your retirement plan at work may have a great track record with a history of steady growth, or it may be more modest. You may be able to have some say in whether your money is invested aggressively or cautiously, or you may have only one option.
It's possible that your plan charges high fees. You can usually find these details in your summary plan description and annual report. You should think about all these factors when you sign up and decide how much of your earnings will be put toward your plan each pay period.
Lastly, your 401(k) is only one of many potential retirement vehicles. You can always opt out of your company plan and save for retirement in an independent fund, like an IRA through your bank or credit union.
Other tax-advantaged retirement accounts, such as traditional or Roth IRAs, allow you to contribute up to $6,000 a year and give you more control over your options.
Next Steps: Strategic Investments
Let's say you have also maxed out your IRA options—or have decided you'd rather invest your extra savings in a different way.
Although there is no magic formula that is guaranteed to achieve both goals, careful planning can come close. “Look at the options in terms of investment products and investment strategies,” says Keith Klein, CFP and principal at Turning Pointe Wealth Management in Tempe, Arizona. Here are some non-IRA options to consider as well.
4. Open an IRAConsider establishing an individual retirement account (IRA) to help build your nest egg. You have two options: a traditional IRA or a Roth IRA. A traditional IRA may be right for you depending on your income and whether you or your spouse are eligible to participate in a workplace retirement plan. Contributions to a traditional IRA may be tax-deductible and the potential investment earnings have the opportunity to grow tax-deferred until you make withdrawals during retirement. If you meet the phased-out modified adjusted gross income limits, which are based on your federal tax filing status, a Roth IRA may be a good choice for you.Footnote 2 A Roth IRA is funded with after-tax contributions, so once you have turned age 59½, qualified distributions, including any potential earnings, are federal income tax-free (and may be state income tax-free) if certain holding period requirements are satisfied. To determine what type of IRA could work best for you, go to Find out which IRA may be right for you and view the most current 401(k) and IRA contribution limits.
Choosing retirement accounts
Once you know how much you need to save, it’s time to think about where that money will go. Earning interest and taking advantage of tax benefits can help you reach your goal faster, and that’s why choosing the right investment accounts is a key part of retirement planning. While there are many kinds of investment accounts, people usually use five main types to save for retirement.
1. Traditional 401(k)
A Traditional 401(k) is an employer-sponsored retirement plan. These have two valuable advantages:
- Your employer may match a percentage of your contributions
- Your contributions are tax deductible
You can only invest in a 401(k) if your employer offers one. If they do, and they match a percentage of your contributions, this is almost always an account you’ll want to take advantage of. The contribution match is free money. You don’t want to leave that on the table. And since your contributions are tax deductible, you’ll pay less income tax while you’re saving for retirement.
2. Roth 401(k)
A Roth 401(k) works just like a Traditional one, but with one key difference: the tax advantages come later. You make contributions, your employer (sometimes) matches a percentage of them, and you pay taxes like normal. But when you withdraw your funds during retirement, you don’t pay taxes. This means any interest you earned on your account is tax-free.
With both Roth and Traditional 401(k)s, you can contribute a maximum of $20,500 in 2022, or $27,000 if you’re age 50 or over.
3. Traditional Individual Retirement Account (IRA)
As with a 401(k), an IRA gives you tax advantages. Depending on your income, contributions may lower your pre-tax income, so you pay less income tax leading up to retirement. The biggest difference? Your employer doesn’t match your contributions. The annual contribution limits are also significantly lower: just $6,000 for 2022, or $7,000 if you’re age 50 or over.
4. Roth Individual Retirement Account (IRA)
A Roth IRA works similarly, but as with a Roth 401(k), the tax benefits come when you retire. Your contributions still count toward your taxable income right now, but when you withdraw in retirement, all your interest is tax-free.
So, should you use a Roth or Traditional account? One option is to use both Traditional and Roth accounts for tax diversification during retirement. Another strategy is to compare your current tax bracket to your expected tax bracket during retirement, and try to optimize around that. Also keep in mind that your income may fluctuate throughout your career. So you may choose to do Roth now, but after a significant promotion you might switch to Traditional.
5. Health Savings Account (HSA)
An HSA is another solid choice. Contributions to an HSA are tax deductible, and if you use the funds on medical expenses, your distributions are tax-free. After age 65, you can withdraw your funds just like a traditional 401(k) or IRA, even for non-medical expenses.
You can only contribute to a Health Savings Accounts if you’re enrolled in a high-deductible health plan (HDHP). In 2022, you can contribute up to $3,650 to an HSA if your HDHP covers only you, and up to $7,200if your HDHP covers your family.
1. Individual Retirement Account (IRA)
IRAs can be a great tool to supplement your 401(k) contributions and you can enjoy some tax benefits in the process. With a traditional IRA, you get the benefit of a tax deduction on the contributions you make and you don’t pay any taxes on the money until you start making qualified withdrawals in retirement.
A Roth IRA isn’t deductible, but that can work to your advantage if you expect your income to go up over time. Withdrawals of Roth IRA contributions are always tax-free along with any earnings you take out beginning at age 59.5. Since you’ll be paying taxes on your 401(k) withdrawals, a Roth IRA can supplement your income in retirement without increasing what you owe to Uncle Sam.
Whether or not you can open a Roth IRA or deduct your traditional IRA contributions depends on your income and filing status. For 2021, the full IRA deduction is available to single filers who also have a 401(k) as long as they earn $66,000 or less per year. (For 2022 it’s $68,000.) The income cap increases to $105,000 for married couples filing jointly. In addition, if you’re single and earn $140,000 or more, or you’re married and together you make $208,000 or more, you can’t contribute to a Roth IRA for 2021.
Benefits of Maxing Out Your 401k
- A 401k is a tax-advantaged account. If you choose a traditional 401k, you won’t pay taxes until retirement. If you opt for a Roth 401k, you’ll pay taxes now but not on withdrawals in retirement.
- 401ks offer opportunities for automated savings. Often, 401k contributions are automatically withheld from your paycheck and deposited in a retirement account. This means you never miss the money in your paycheck.
- The 401k sometimes comes with an employer match. This means that in addition to your contributions, your employer contributes a certain amount to your retirement savings. If you’re not able to max out your 401k, consider at least contributing enough to get your employer match. This money represent a risk-free return on investment — it’s the closest thing there is to a “free lunch.”
Invest Smarter with The Motley Fool
- New Stock Picks Each Month
- Detailed Analysis of Companies
- Model Portfolios
- Live Streaming During Market Hours
- And Much More
How to Grow a Retirement Fortune When You Cant Max out Accounts
Now let’s mix in a bit of reality. Many people in their 20s or even 30s either can’t max out retirement accounts or have other financial priorities, like paying down debt, buying a home or saving for a child’s education. To acknowledge that, let’s assume that one doesn’t start saving for retirement until age 35. That reduces our time to retirement to 35 years.
The first thing to recognize is that a 10-year delay in retirement savings has a significant effect on the outcome of our portfolio, assuming the same contribution rate and returns:
• IRA: $571,000, down from $1 million
• 401(k): $1.85 million, down from $3.31 million
• IRA and 401(k): $2.42 million, down from $4.33 million
In other words, a 10-year delay cut the portfolio almost in half. While you still end up with much more than you originally contributed, it’s clear the early years matter.
If you can’t max out your retirement accounts early in your life, strive to save as much as you can for retirement as early as possible. Saving even smaller amounts can go a long way to establishing a financially secure retirement. If your employer offers a retirement match, you should aim to contribute at least enough to qualify for the full employer contribution.
Now, let’s see what happens if you start saving a smaller amount, like $3,000 a year, at 25. Then, once you’re more established and financially secure, you begin maxing out your IRA, 401(k) or both at the age of 35:
• IRA: $795,000, up from $571,000 if you waited to start contributing anything until 35
• 401(k): $2.08 million, up from $1.85 million
• IRA and 401(k): $2.65 million, up from $2.42 million
In other words, the extra $30,000 saved over the initial 10 years translated into $200,000 or more at retirement.
The next year, I made my retirement savings top priority
With the money out of sight and out of mind, I didn’t find myself missing it much. But with my savings account leveled, I knew I wouldn’t be able to pull the same stunt the next year — especially because the contribution cap was increasing from $5,000 to $5,500.
So I sat down at the beginning of the year to figure out just how much I’d need to set aside every month to max out my account again and be ready for tax season. The answer was $458, which felt incredibly intimidating. So I divided again, to come up with a biweekly amount of $229.
Every payday, as soon as the money hit my Bank of America checking account, I’d zip $230 out of it and over to a high-yield savings account at Ally. Since I was so low on cash, I was afraid to put it directly into the retirement account, so I kept it in easily accessible savings until the last minute.
As much as I possibly could, I tried not to look at my savings balance, putting that energy toward getting used to my “new” salary instead. To help myself along, I did all the un-fun things that experts recommend: cutting out lattes in favor of the office coffee machine, bringing lunch to work, starting a money diary where I recorded every single purchase. Plus, I started picking up the odd bartending shift to supplement my income — falling back on my old strategies, but not on my old spending habits.
No matter what happened, I was determined to keep my promise to myself. Week after week, I’d move the money over to my savings account, and force myself to forget about it once it was there. It was all just a matter of turning my situation into the new normal.