Avoid This Mistake or Miss Out on Free Money
If you are fortunate enough to have an employer-matching 401(k) program at your workplace, you should take advantage of it to the full extent possible. Whether it is a dollar-for-dollar match or a lesser percentage, this is free money from your perspective – and tax-deferred free money on top of that.
However, you do have to be careful in one aspect. There are limits on 401(k) contributions and matching contributions to consider, and if you surpass a limit, you may end up costing yourself potential matching money from your employer.
- Salary Deferral – You can put aside a maximum of $18,000 in salary for 2016 toward your 401(k), and you can add another $6,000 in catch-up contributions if you are aged 50 years or older.
With greater monthly contributions, you have to be careful as you approach the $18,000 contribution limit. If you reach your employee contribution limit early in the year, you miss the opportunity for matching funds later in the year.
For example, let’s assume you make $200,000 and have a dollar-for-dollar match up to 5% of income. If you contributed $3,000 each month, you would hit the $18,000 limit in six months. Instead of receiving $10,000 in employer-matching contributions, you would only receive the match for six months’ worth of contributions, or $5,000. Your 401(k) would be up $23,000 for the year.
If you instead contributed $1,500 per month to your 401(k), you would have $18,000 in employee contributions and $10,000 in matching contributions for a yearly total of $28,000 – and you would also have an extra $1,500 in taxable take-home pay each month.
For the same reason, bonuses applied toward your 401(k) can be problematic if they are paid early in the year. You have to rebalance your remaining contributions throughout the year to stay below the $18,000 limit.
Some 401(k) plans have a “true-up” provision, which allows the employer to take into account your salary throughout the year (not just in your contributing months) and add back the employer match. Check your plan to see if this provision is included.
- Total Compensation Limits – Matching compensation plans are set up to reach within some percentage limit of compensation (5% is not uncommon). However, the limit on total annual compensation to be included in the matching calculations is $265,000 in 2016.
If your compensation is $400,000 and you have a dollar-for-dollar matching plan up to 5% of compensation, the maximum employer contribution would be $13,250 (5% of $265,000) instead of $20,000 (5% of $400,000).
Check the language of your 401(k) plan carefully. If salary deferrals are based on the first $265,000 in compensation (“first” being the key word), once you reach the $265,000 mark you cannot contribute any more to the plan for the year – even if you have not reached the $18,000 employee contribution limit yet. This is not common in plans, but it is a clause of which you should be aware.
- Total Contributions – The overall limit for contributions from employers and employees combined is $53,000 for 2016. If your salary is below that mark, the limit is 100% of your total salary. Catch-up contributions are not included in this total.
Most people will have no trouble staying below this limit, but for jobs with large 401(k) bonuses, this can be an issue.
Keep an eye on those matching limits, spread your contributions throughout the year, and make the most of your pot of “free” money.