Should You Max Out Your 401(k) Early in the Year?
To get the most out of your tax-efficient 401(k) retirement savings plans, try to contribute as much as you can. The Internal Revenue Service (IRS) sets annual limits for how much you can contribute, but that doesn’t always mean contributing up to that limit is in your best financial interest, or even possible. You will need to weigh several factors regarding your financial situation to help you determine the ideal contribution amount.
For 2022, the maximum amount you can contribute to a 401(k) plan is $20,500, or $27,000 if you’re 50 or older through the $6,500 catch-up contribution. You will need to weigh several factors about your financial situation to help you determine if you should contribute up to the limit.
Let’s take a closer look at the pros and cons of maximizing your 401(k) contribution at the start of the year, as well as strategies for saving the maximum amount.
Key points to remember
- Review your budget and financial goals to help you determine whether to max out your 401(k) at the start of the year.
- Prioritize contributions at least up to your company’s matching contribution limit so you don’t leave “free money on the table”.
- If you have a lower income, you may not have the extra funds needed to maximize your 401(k) at the start of the year after paying for necessities.
- People with higher income levels may find it easier to maximize their annual 401(k) contribution.
How 401(k) plans work
The 401(k) plan is a popular way to save for retirement due to its tax advantages. With traditional 401(k), your contributions are made with pre-tax money, so your tax bill is lower. With Roth 401(k)s, you make contributions after paying income tax, but you can then make tax-free withdrawals in retirement, including earnings.
Not all employees contribute up to the maximum each year. The amount of your contribution will depend on your budget and financial priorities.
In 2020, there were approximately 600,000 workplace-sponsored 401(k) plans, with approximately 60 million active participants, as well as millions of former employees and retirees. The plans held approximately $7.3 trillion in total assets as of June 2021.
How to maximize a 401(k)?
The IRS sets annual contribution limits on the amount you can contribute. For 2022, the maximum amount you can contribute to a 401(k) plan is $20,500, or $27,000 if you’re 50 or older through the $6,500 catch-up contribution.
If you can hit these maximums, you’ll be able to reap the power of compound interest sooner and enjoy more tax benefits. One way to maximize a 401(k) at the start of the year is to take regular contributions from your paychecks for amounts greater than you would need to reach the maximum in 12 months.
For example, if you were under 50 and paid weekly, you would want to contribute more than $394.23 per pay period to maximize your 401(k) early. If you contributed $789 a week, you would max out your 401(k), contributing $20,500 before the first half of the year.
How many people max out their 401(k)?
Maximizing a 401(k) at the start of the year is difficult for most workers. In 2021, only 14% of 401(k) participants contributed the maximum amount of $19,500, according to research conducted by Vanguard.
According to the Vanguard study, those who contributed the annual maximum tended to “have higher incomes, were older, had longer tenures with their current employers, and had accumulated significantly higher account balances.”
Your income level, necessary expenses and financial priorities all play a part in deciding whether to save up to the maximum. For example, it’s important that you pay off your mortgage before aggressively saving for your retirement, otherwise you could lose your home to foreclosure.
Consider debt before maxing out a 401(k) early
When deciding whether to max out your 401(k) at the start of the year, consider how your debt affects your finances. Interest on your debt can significantly increase your long-term expenses. Debts such as credit cards, car loans, student loans, and personal loans can also negatively affect your credit score, which in turn can affect your ability to get other loans.
U.S. consumer debt, which includes mortgages, reached $15.31 trillion in the third quarter of 2021, with the total average balance at $96,371, compared to $92,727 in the same period a year earlier. early, according to Experian.
It often makes more sense to pay off high-interest revolving debt before aggressively saving for retirement. But you may find that it can also be a good idea to max out your 401(k) early before you pay off your mortgage. Evaluate your expected rate of return on a 401(k) portfolio against the interest you’ll pay on your debt to help you decide where to allocate your additional funds.
Prepare for emergencies
Another financial factor to consider before deciding to max out your 401(k) early is whether you have an adequate emergency fund. An emergency fund can help you stay financially healthy when you face an unexpected cost like a major auto repair or medical bill.
Many financial advisers recommend setting aside three to six months of expenses, but the right size of emergency fund for you depends on other factors like your lifestyle and debts.
More than two-thirds of American adults (68%) in a 2021 Federal Reserve survey said they would be able to afford a sudden emergency expense of $400 in cash or the equivalent. And 11% said they would not be able to cover expenses by any method.
Once you’ve contributed to a 401(k), you generally can’t access that money without penalties until you’re 59½. So building an emergency fund that you can easily access may be a higher priority for many people than maxing out a 401(k) early.
How to get the full match 401(k)
Many 401(k) account holders aim to contribute at least up to the company’s match in order to maximize their benefits. Employers usually match their own limit, not the IRS maximum. For example, they can match up to 3% of your salary.
If you cannot contribute up to the maximum IRS limit in one year, consider trying to make at least up to the corresponding contribution limit each year.
Can you have multiple 401(k) accounts?
You can have multiple 401(k) accounts, but you can only make payroll contributions to an active 401(k) account. Many people have 401(k) accounts from former employers, but you cannot contribute to an inactive account. If you have two jobs, each offering a 401(k) plan, you can contribute to both accounts. But the Internal Revenue Service (IRS) maximum contribution limit ($20,500 for 2022 for people up to age 50, or $27,000 if age 50 or older) applies to your total contributions.
What happens if you overcontribute to your 401(k)?
If you contribute more than the maximum allowable contribution in a year, you will need to report the excess contributions to the IRS using a Form 1099-R. Excess funds will be withdrawn from the account and you will face a 10% penalty if you are under 59.5 since you will effectively be withdrawing those funds earlier. If the funds are not returned by April 15, you could be taxed again on those excess funds.
What is the maximum employer contribution to an employee’s 401(k) account?
For 2022, the total employer and employee contributions cannot exceed the lesser of 100% of the employee’s total compensation or $61,000 (or $67,500 if age 50 or more).
The essential
Whether you should max out your 401(k) depends on your finances and personal circumstances. There is no one-size-fits-all solution, as your salary, expenses, and financial priorities determine whether you can and should contribute the full amount before the end of the year.
If you can’t afford to contribute up to the limit set by the IRS, try to contribute at least the amount necessary to qualify for your employer’s match, if your plan offers one. Matching contributions are essentially free money.