Maxed Out 401(k) and Roth IRA

What Does It Mean to “Max Out” Your 401(K) And Roth IRA?

The IRS restricts how much you can contribute to 401(k) plans each year because they provide such significant tax benefits. However, the potential for earning a 401(k) is still very substantial due to the fact that it allows for investment, compounding interest, and tax deferrals.

In 2021, 401(k) plan participants can contribute up to $19,500 to their accounts. If you’re at least 50 years old, the IRS will allow you to contribute more money. These are called “catch-up” contributions.

In 2021, a $6,500-catch-up-contribution is allowed by the IRS. This is an addition to the $19,500 base which is equal to the total limit of $26,000 for 50-years-olds and up.

For Roth IRAs, younger people can only contribute a maximum of $6,000 to their IRAs. American citizens age 50 and up can contribute up to $7,000 in an IRA.

Why Should I Max Out My 401(k) and Roth IRA?

You should max out your 401(k) and Roth IRA because they provide a great way to save money.

401(k) plans aren’t taxed until you withdraw the funds, which means those dollars grow faster than they would if those dollars were close to what you actually earned

Benefits of Maxing Out Your 401(k) and Roth IRA:

Benefits_of_Maxing_Out_Your_401(k)_and_Roth_IRA

  1. 401(k) plans don’t withhold taxes until you withdraw the funds, meaning that your tax bracket is likely to be lower when you retire than it is now.
  2. You have more money saved for retirement, which means that you have a better chance of being able to retire comfortably.
  3. Maxing out your plan offers an immediate pay raise because you’re able to save more.

Places to Save After Maxing Out Your 401(k) and Roth IRA

1. Establishing Your Emergency Funds

An emergency fund is a sum of money that you keep saved in cash. It’s what you’ll use if something unexpected were to happen, such as getting into an accident and having your car damaged or stolen.

It doesn’t matter what your income is: everyone should have some money put aside for emergencies. If you’re just starting out and don’t have a lot of money, commit to saving what you can. In fact, what would really be ideal is if you could save up half of what an emergency will cost and then pay the rest with your credit card.

2. Open a Health Savings Account (HSA)

An HSA is a type of savings account that works with your health insurance. It allows you to save money for medical, dental, and vision expenses tax-free.

You can open an HSA if you have what’s called a high deductible health plan (HDHP). An HDHP has a deductible of what’s called a minimum annual value (MAV).

The MAV is what you have to pay out-of-pocket for your health care each year before your insurance kicks in. In other words, it’s what you have to pay before the HDHP coverage comes into play.

You can save money tax-free. You don’t have to worry about the IRS taking what you’ve saved if something happens; what’s in your account is yours for good.

3.Invest in a Brokerage Account

If you’re over what’s called the age of 59.5, then what goes in your brokerage is yours to keep for good. If you are under the age of 59.5, what you invest in your brokerage is what’s called a “constructive receipt”.  This means what’s in your account is what the IRS considers income.

A brokerage account allows people to invest after-tax money in the stock market, just like a typical 401k, except that it happens after tax. Any capital gains levied at withdrawal.

Each trade made by the investor incurs a brokerage fee.

The Bottom Line

Don’t believe that you must quit saving once you’ve used up all of your company’s 401(k) contributions for the year. This might be a mistake that prevents you from achieving your retirement objectives. There are other long-term possibilities for accumulating assets.

If you’re young, what you should do first is save what you can. Put aside what you have to in order to reach the minimums of your company’s 401(k). If what’s left over is too much for a traditional catch-up contribution, then open a Roth IRA.

If what’s left over after maxing out your 401(k) and Roth IRA is what you’ll use to pay off debt or invest in general, what you should do first if what’s left over is what you’ll use for retirement because those dollars grow tax-free.

Review what's your company policy regarding what you'll need to do to be able to invest what's left over that hasn't been used. If what's left over is less than what that the IRS allows, then put what you can into a Traditional IRA and what remains in a Roth IRA.
Employer or not, you can still invest in a traditional IRA. It's possible to open a Traditional IRA at a brokerage even though you do have an employer offering a plan. If what your annual income is too high to qualify for the tax benefits offered by an IRA, then consider the Roth IRA. It doesn't offer any tax breaks, but what you do get is that your investments are yours for good once they're inside the account.
If there's a match from your employer, then contribute as much as you can up to the maximum. If what's left over can't be contributed to a Roth IRA, then consider contributing it to a brokerage account. Just take note of what you'll need to pay in order for the capital gains to be considered tax-free earnings.
If your income is too high to contribute money to an IRA and what you want to do with the contributions is invest in stocks, then consider investing in a dividend reinvestment plan (DRIP). Income from this type of investment isn't taxed until it's withdrawn.
A Roth IRA is a particularly useful savings tool for younger savers because it allows them to save more than what's allowed in a traditional, tax-advantaged account like a 401(k), 403b or 457.

401(k) Plan | A Complete Beginner's Guide

401(k) Meaning

The 401(k) retirement savings account got its name from the Revenue Act of 1978, where an addition to the Internal Revenue Services (IRS) code was added in section 401(k). Consequently, 401(k) does not stand for anything except for the section of IRS tax code it was created in.

Traditional 401(k) vs Roth 401(k)

There are two types of 401(k) plans: Traditional and Roth 401(k)s. The traditional 401(k), named after the relevant section of the IRS code, has been around since 1978. With this plan, any contributions you make to the 401(k) account will reduce your income taxes for that year and will be taxed when they are withdrawn. Roth 401(k)s, named after former senator William Roth of Delaware, were introduced in 2006. Unlike a traditional 401(k), all contributions are made with after-tax dollars and the funds in the Roth 401(k) account accrue tax free. Typically, employees can take advantage of both plans at the same time, which is recommended among financial advisors to maximize retirement savings. Because of the way the contribution limits work, it is possible to invest different amounts into each account, even year-to-year, so long as the total contribution does not exceed the set limit.

Contributing to Your 401(k) Retirement Plan

Contributing to a 401(k) plan is traditionally done through one’s employer. Typically, the employer will automatically enroll you in a 401(k) that you may contribute to at your discretion. If you are self-employed, you may enroll in a 401(k) plan through an online broker, such as TD Ameritrade. If your employer offers both types of 401(k) accounts, then you will most likely be able to contribute to either or both at your discretion. To reiterate, with a traditional 401(k), making a contribution reduces your income taxes for that year, saving you money in the short term, but the funds will be taxed when they are withdrawn. With a Roth 401(k), your contributions can be made only after taxation, which costs more in the short term, but the funds will be tax free when you withdraw them. Because of this, deciding which plan will benefit you more involves figuring out in what tax bracket you will be when you retire. If you expect to be in a lower tax bracket upon retirement, then a traditional 401(k) may help you more in the long term. You will be able to take advantage of the immediate tax break while your taxes are higher, while minimizing the portion taken out of your withdrawal once you move to a lower tax bracket. On the other hand, a Roth 401(k) may be more advantageous if you expect the opposite to be true. In that case, you can opt to bite the bullet on heavy taxation today, but avoid a higher tax burden if your tax bracket moves up. Check out this article from Forbes to see the IRS tax rate tables for 2020, but remember that they are subject to change. A smart move may be to hedge your bets and divide your contributions between the two types of IRAs. If your employer allows you to add funds to both a traditional and Roth 401(k), then doing so reduces the potential risks of each. In this case, you will also have the ability to decide what proportion of your income goes into each account, meaning that as you near retirement and have a clearer idea of what position you will be in, you can put more into one or the other. When you do decide which avenue to take, make sure to thoroughly evaluate your decision. Moving funds from one account to another, such as from a traditional to a Roth 401(k), is time consuming and expensive, if even possible. Likewise, transferring a 401(k) from one employer to another in the event of a job change is also tricky. You want to make sure that when you put money into your plan, it will be able to sit undisturbed for a very long time.

Pension vs 401(k)

Pensions are similar to a 401(k), but are a liability to a company. If an employer offers an employee a pension, it means that they are promising to pay out a set amount of money to the employee at the time of their retirement. There is typically no option to grow this amount, but it also does not require any financial investment from the employee. Pensions, also referred to as defined-benefit plans, are becoming increasingly rare because it puts the financial burden of offering a retirement fund for employees entirely on the employer. 401(k)s, which are also called defined-contribution plans, take some of the financial pressure off of an employer, while also allowing employees to potentially earn a larger retirement package than they would have with a pension.

How Much Should I Contribute to My 401(k)?

Most financial experts say you should contribute around 10%-15% of your monthly gross income to a retirement savings account, including but not limited to a 401(k). There are limits on how much you can contribute to it that are outlined in detail below. There are two methods of contributing funds to your 401(k). The main way of adding new funds to your account is to contribute a portion of your own income directly. This is usually done through automatic payroll withholding (i.e. the amount that you wish to contribute, counting all adjustments for taxation, is simply withheld when receiving payment and automatically put into a 401(k)). The system mandates that the majority of direct financial contributions will come from your own pocket. It is essential that, when making contributions, you consider the trajectory of the specific investments you are making to increase the likelihood of a positive return. The second method comes from deposits that an employer matches. Usually employers will match a deposit based on a set formula, such as 50 cents per dollar contributed by the employee. However, employers are only able to contribute to a traditional 401(k), not a Roth 401(k) plan. This is especially important to keep in mind if you want to utilize both types of plans. A key variable to keep in mind is that there are set limits for how much you can add to a 401(k) in a single year. For employees under 50 years of age, this amount is $19,500, as of 2020. For employees over 50 years of age, the amount is $25,000. If you have a traditional 401(k), you can also elect to make non-deductible after-tax contributions. The absolute limit, counting this choice and all employer contributions, is $57,000 for employees under 50, and $63,000 for those over 50 as of 2019.

Plan in Advance

Allow us to help you prepare and plan for your retirement ahead. Contact a financial advisor in St Helena, CA or visit our financial advisor page for other details.

401(k) Plan FAQs

True Tamplin, BSc, CEPF®

About the Author
True Tamplin, BSc, CEPF®

True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.

True is a Certified Educator in Personal Finance (CEPF®), a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website, view his author profile on Amazon, or check out his speaker profile on the CFA Institute website.

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