Maximizing the Savings Power of your 401(k)

If you contribute to a 401(k), it is likely that you are familiar with the benefits of saving to a workplace savings plan and are at least somewhat aware of your salary deferral limit. What most do not realize is that you may be able to sock away more, and even more strategically, than you think in your plan.

When it comes to 401(k) rules, there are actually two types of annual limits. The first and most widely known is the maximum amount you can contribute as a salary deferral. The other limit refers to the amount of total contributions for Defined Contribution Plans, which includes contributions made by both you and your employer.

The total salary deferral limit for 401(k) elective pre-tax and designated Roth contributions for 2022 is $20,500, plus an additional $6,500 in catch-up contributions if you are 50 or older.

The total contribution limit in 2022 is $61,000, plus the additional $6,500 in catch-up if you are 50 or older- or 100% of your compensation, whichever is less.

The total contribution limit is different than the salary deferral limit. This overarching limit includes the total sum of your salary deferrals (pretax contributions and designated Roth contributions), plus your employer contributions (also known as the company match) and any after-tax contributions. The salary deferral limit may allow enough savings room for some, but for those who still have the means and desire to contribute beyond this limit, then after-tax contributions may be for you.

Do not confuse “designated Roth contributions” with “after-tax contributions.” They are two separate and distinct types of contributions. The terms can be misleading. If your plan allows designated Roth contributions, consider yourself lucky. There is no income cap on your designated Roth contributions in a 401(k), unlike an IRA. Once you have maxed out on your designated Roth contributions, you may want to consider making after-tax contributions.

Example:

If you are 53 years old this year (2022) and you max out your pre-tax and Roth contributions ($20,500 + $6,500= $27,000) and you also receive $5,000 in employer contributions, you could potentially contribute up to $35,500 in after-tax contributions to a 401(k) plan that allows these contributions.

Taking advantage of after-tax contributions can allow you to invest more dollars with the potential of tax-deferred and tax-free growth. Furthermore, you could then convert your after-tax contributions into a Roth account. This can be accomplished by either doing an in-plan Roth conversion (again, your plan must allow this) or by rolling over your balances to a Roth IRA. After conversion, no taxes are due on the contributions because you have already paid tax on these dollars. However, any earnings associated with those contributions would be taxed as ordinary income.

Making additional after-tax contributions now can help you to maximize your contributions and allow you to lower your overall tax burden in the future. Careful and proactive financial planning should be used to determine which types of 401(k) contributions would be most beneficial for your financial situation in the long run.