What does it mean to “max out” your retirement account?

Summary:

• Each plan has different contribution and matching rules that need to be considered when crafting a savings approach.
• There are three “buckets” of contributions allowed in the plan (Pre-tax/Roth, employer match, and Roth after-tax) with up to $66k/year of total funding, plus catch-up contributions when applicable.
• Roth after-tax can strategically be used for super-savers to force significant amounts of money into Roth when they may not otherwise be eligible for those contributions.
• Maxing out is not right for everyone, and it is important to balance funding current vs future goals.  Make sure that you are working with a professional who understands and addresses the various benefits provided to you by your company.

If you were asked if you “max out” your companies retirement plan, how would you answer?  The idea of maxing out your retirement account may seem like an obvious answer at first glance, but the truth is that “maxing out” can vary depending on several factors.  Furthermore, should you be maxing out in the first place?  Whether you are paycheck to paycheck balancing financial priorities or have more than you need and want to maximize generational wealth, these accounts have a strategic place in the conversation.

So, let’s try to break this down to understand what it really means to max out a 401k or 403b plan…

To get started, let’s establish some of the basics.  Companies offer retirement plans as a competitive benefit to attract and retain employees.  Generally, there is some type of matching contribution from the employer, employees can contribute some mix of tax advantaged (Pre-tax, Roth, and Roth after-tax) money towards retirement.  The employer match portion is subject to a “vesting” schedule, which lays out what portion of the match would be forfeited by the employee if they leave before predetermined timeframes (typically 3-5 years).  The money is invested at the employee’s direction into a fund lineup determined by the company and their advisors.

Since the focus of this writing is contributions, let’s unpack those limits a bit.  As referenced before, the “maximum” is different, depending on the plan and situation.  Here’s a look at each bucket and the respective applicable limits…

First (bucket 1), Pre-tax or Roth employee contributions… Virtually all plans allow a pre-tax savings option, and many also allow a Roth contribution.  Pre-tax contributions go in before taxes, with the funds being taxed at the time of withdrawal.  Roth, on the other hand, goes in after-tax and can be withdrawn tax-free.  So, if your tax rate today is relatively high, then you can contribute pre-tax, defer tax on the income now, to be recognized later at a (hopefully) lower rate.  If your tax rate today is relatively low, then Roth allows you to go ahead and “lock in” that rate by paying the tax now and tax-free withdrawals later.  The limit for this contribution type changes year to year, but for 2023 is $22,500.

The next contribution type (bucket 2) is the employer match contribution. This match is made on behalf of the employee and is subject to a vesting schedule determined by the employer.  The match is made in pre-tax dollars based on the employee’s gross compensation, subject to a compensation cap of $330k in 2023.  So, if a plan were to offer a 5% match, the maximum allowable matching contribution would be $16,500 (5% of $330k).  Some matching contributions can have their own unique rules as well.  For example, some plans only provide a match if a contribution is made on a given paycheck.  In that scenario, you must strategize to make a contribution each pay period throughout the year, rather than front-loading contributions in the first few checks.

The last contribution (bucket 3) is known as “non-Roth after-tax” money.  The difference between this contribution and a Roth contribution is that the non-Roth after-tax contributions do not grow tax-free.  Instead, these contributions grow tax-deferred, meaning that the earnings on the after-tax money will be taxed upon distribution.  Between a combination of pre-tax and Roth contributions, employer matching contributions, and these non-Roth after-tax contributions, there is a maximum allowance of up to $66,000/year combined. Furthermore, if the plan allows for either an in-plan Roth conversion, or an after-tax distribution, these contributions can be converted into a Roth account, where they can grow tax-free for life.

Thinking about a true-to-life scenario… let’s consider an employee with compensation of $300k, a plan with a 5% match, that allows for Roth after-tax contributions and conversions.  Theoretically, this person could contribute $22,500 of pre-tax or Roth, receive an employer contribution of 15k (5% of $300k), and still contribute an additional $28,500 that could be added to non-Roth after-tax ($66k – $25k – $22.5k) which to then be converted into a Roth account. This would result in over 50k of tax advantaged annual savings from the employee, with almost 30k into Roth accounts growing tax-free! Furthermore, if you have access to catch-up contributions, these are allowed in addition to the limits above, and are set to be expanded in 2024 with the recently passed “Secure Act 2.0”

But should you even be maxing out your plan in the first place?  Depending on your situation, it may or may not make sense…  When we perform a 401k analysis, it’s important not only to consider what the plan rules and capabilities are, but the need to save, ability to save, and other financial goals as well…  For example, someone who has high-interest debt might consider only saving to the plans matched percentage, whereas a family with all their current needs met with income to spare may want to take full advantage of their limits.

So, the next time that you get asked if you “max-out” your retirement plan, how are you going to answer?

Disclosure: This material is for general information only and is not intended to provide specific advice or recommendations for any individual. Advisory services offered through National Wealth Management Group, LLC, a Registered Investment Advisor