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With 2015 coming to a close, now is a great time to start making financial plans for the coming year. The Internal Revenue Service has already released its changes for retirement accounts such as IRAs and 401(k)s, and very little is changing this year. And while no change is good because it means living costs didn't rise much this year, it's not good in the long term since it means retirement contribution limits didn't increase.
Let's take a closer look at 401(k) benefits and contribution limits for the year ahead. Even with no major changes in course, it's a good idea to be sure you're up to speed.
The 401(k) summarized
A 401(k) is a kind of retirement savings arrangement sponsored by your employer. The idea with the 401(k) is that you can contribute a portion of your pay and have it directed right to your retirement account automatically. There are two benefits to this arrangement:
- Studies show you save significantly more when it's automatically deducted from payroll.
- The federal government lets you deduct your contributions to a 401(k) from your taxable income, meaning you pay less taxes.
There are several other benefits as well:
- Your employer will often also contribute, matching (in whole or in part) your contributions, up to a certain percentage of your pay.
- Your contributions grow tax-free until you retire and start taking distributions.
In other words, you save taxes each year you contribute money, you get to grow the money tax-free, and you'll probably get free money in matching employer contributions.
Limits on contributions
In 2015, employee contributions -- i.e., the amount of your pay you could put in your 401(k) each year -- were limited to $18,000. This amount will stay the same in 2016. This is where the "good and bad" news come in.
Typically, the IRS will increase the amount you can contribute to your 401(k) (and also IRAs -- read here for more on IRA changes for 2016) every year or two, based on changes in the cost of living, primarily due to inflation. But since inflation has been relatively low over the past several years, the cost-of-living index the IRS uses didn't rise enough to meet the statutory thresholds that would have triggered a bump in contribution limits.
That's good because it means living costs haven't gone up significantly over the past year, meaning many people may have more disposable money at hand. It's bad, because, well, if you're in a position to max out your 401(k) contributions in 2016, you won't be able to increase them from 2015.
Other 401(K) facts you need to know
- The $18,000 contribution limit is specifically employee contributions. When including employer contributions, the maximum 2015 and 2016 is $53,000 (or total employee compensation if less than that).
- Those 50 and over can make an additional $6,000 in "catch-up" contributions. This adds to both the maximum employee contributions, and the maximum total contribution limits.
- Many companies now offer a Roth option for their 401(k) plans. If this is your situation and you make designated Roth employee contributions, they would not reduce your taxable income the year of contribution. However, your distributions in retirement would be completely tax-free, unlike traditional 401(k) distributions, which would be considered taxable income in retirement.
Putting it all together
Whether you'll contribute to the maximum limit or not, taking advantage of your employer-sponsored 401(k) is an important step toward a financially independent retirement. But don't count on your employer to make the decisions you need to be making yourself.
Take the time to make sure you're contributing enough in 2016 and beyond in order to reach your retirement goals. Even if your company automatically enrolled you in the 401(k) doesn't mean you're contributing enough. Take a look at the dollars you are contributing as well as the percentages. At the end of the day, it's the total dollars you save and how long that will largely determine how much you have when you retire.
