Every year as December approaches, people start thinking about ways to cut their taxes. One of the best ways to reduce your taxable income is to contribute to a 401(k). But to know how much you can hide under the IRS' radar, knowing the 401(k) contribution limits is absolutely essential to avoiding big problems. Here are the most important facts about how much you can contribute to your retirement plan at work as well as some strategies to make the most of it.
The limits and how to use them
For 2012, two different limits apply for 401(k)s. If you haven't reached your 50th birthday by the end of this year, then you can contribute up to $17,000 of any wages you earn to your 401(k) plan account. But if you're 50 or older by the end of the year, then you can add what's called a catch-up contribution of $5,500, boosting your total to $22,500. Your contribution is always limited by the total amount you earn at that job, however, so if your earnings are less than those figures, you can't contribute more than you earned.
It's important to understand, though, that the limits above govern how much employees can contribute toward their 401(k) account. A higher limit applies to total contributions to a 401(k) on your behalf, including employer matching and profit-sharing contributions. In 2012, as much as $50,000 can be added to accounts, combining both your savings and what your employer pitches in. Again, you can add $5,500 to that total if you're 50 or older.
Special note for the self-employed
Those higher limits may sound great, but most employers won't add $30,000 or more to your 401(k) account for you. If you're self-employed, though, setting up your own 401(k) plan -- often known as a self-employed or solo 401(k) -- can give you access to those higher limits.
Many financial institutions will allow you to set up a solo 401(k). If you operate as a sole proprietor, partnership, or limited liability company, then you can typically contribute up to 20% of the net income of your business to a solo 401(k) -- subject to the $50,000 limit above. Those who incorporate their businesses get a higher 25% contribution limit.
A warning for the highly compensated
On the other hand, if you're part of a business that has multiple employees and your earnings are near the top end of the spectrum at your company, then you may face lower limits. The rules for what the IRS calls highly compensated employees -- defined as those earning more than $115,000 or who own 5% or more of the business -- include a test. The exact provisions are complicated, but the gist is that if employees who aren't considered highly compensated don't save enough in their 401(k) accounts, then lower contribution limits may apply to those who are highly compensated.
Should you max out your 401(k)?
Unless you pull down at least a six-figure salary, it can be really tough to set aside $17,000 or $22,500 from your pay for a 401(k) contribution. Moreover, with some plans charging high fees for limited investment options, you may not want to max out your contribution, preferring instead to use other savings vehicles like IRAs for your retirement planning.
Usually, though, it's a good idea to save at least enough to get the full benefit of any matching contributions that your employer makes. Those matches are free money to you, and with many matching programs, contributing just 6% or so of your total salary is enough to get all the matching money that's coming to you.
The sky's the limit
Your 401(k) gives you the most potential to save for retirement of any savings vehicle out there. Make the most of it, and you'll set the stage for a much more prosperous retirement.
Fool contributor Dan Caplinger appreciates your comments. You can follow him on Twitter @DanCaplinger. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.