Are You Really Maxing Your 401(k)?

Prospective clients would regularly tell me they are “maxing” their 401(k)s. Upon closer inspection, I’d discover that they were not maxing their 401(k)s. What were they doing? They were maxing their employer match. This happens often enough that I think it bears explaining. When financial planners say you should “max your contribution to your 401(k),” I don’t think it means what you think it means. (See The Princess Bride.) Let me explain:

The Max Match

In a perfect world, your employer offers a generous matching contribution in your 401(k). Most likely, it ranges from 3% to 6%. And it’s best practice to encourage everyone to get all the free money they can get. Financial planners want everyone to save for retirement in tax-preferred vehicles (duh.) That means that the minimum you should be contributing to your 401(k) is the amount that will get you the full match.

Let’s say the match is 6%. Sweet. That means that you contribute 6% of your salary and the employer contributes 6%, right? Not so fast. While that’s certainly possible, getting the Max Match may involve a formula. For example, the 6% match may be 100% of every dollar for the first 4% and 50% of every dollar for the next 4%. In other words, you get 6% when you contribute 8%. Read the fine print.

The Max Contribution

What we normally mean when we ask if you’re maxing your contribution to your employer plan is, are you committing the highest amount you can contribute, which in 2024 is $23,000. It’s worth it to try to get to that number and stay there as early as possible in your career. Tax-free growth and compounding are super important for building wealth. If you can contribute on a Roth basis, that’s even better.  That means you’re paying the tax on the seed and NOT on the crop.

Sometimes planners may recommend, if you’re within the annual income limit, that you contribute the employer match max, then fund a Roth IRA, then return and contribute the maximum amount to the plan. They may suggest this because there are a few early distribution benefits to IRAs that are not available to 401(k)s (education, first home purchase, medical expenses above 7.5% of adjusted gross income, or AGI).

So, it’s beneficial to have one of every different type of retirement savings account.

If you are over age 50, you can max the catch-up as well. In 2024, the catch-up contribution is still $7,500. And if you can, you should think about contributing all the way to $30,500 ($23,000 + $7,500). By the way, in 2026, catch-up contributions will be made on a Roth basis only.

The After-tax Max

Here’s where it gets fun. Let’s say you’re in sales, and you have a commissions windfall. Or you make a lot of money, and you want to follow your planner’s recommendation that you save at least 20% of everything you earn. Did you know that your 401(k) plan may have a provision to contribute after-tax dollars all the way up to $69,000 in 2024? That’s worth checking on. It’s called a Mega Roth.  Here’s how it might work:

• You earn something fabulous—like $300,000—and you contribute the maximum amount: $23,000.

• You maximize your catch-up and contribute another $7,500.

• Your employer matches 5% of your salary and contributes $15,000.

• Your total contributions now equal $45,500.

• If the total contribution maximum is $69,000 in 2024, plus a $7,500 catch-up, that’s $76,500.

• You could continue to contribute up to $31,000 more on an after-tax basis!

That’s truly Mega.

Now there’s a big caveat here. Not all plans support after-tax dollar contributions. If they do, they must pass more ERISA (Dept. of Labor) non-discrimination testing, and they probably don’t want to subject themselves to that. But there are plenty of companies that do support after-tax contributions. If you’re employed by one of those firms and looking for a place to park more money for retirement, this might be for you.  

Why do I keep writing “after-tax” and not Roth? Nothing is simple. (Sigh.) After-tax money in a retirement plan is not the same as your contribution, even if your contribution is made on a Roth basis. Think of after-tax dollars as “zombie” Roth money. Financial planners don’t normally recommend that you keep it in that zombie state forever. Either within the plan, or via a rollout/rollover, you will be better served by converting after-tax dollars to Roth dollars. Why? Because technically, while the principal grows tax free (like Roth dollars), the earnings on after-tax dollars will be taxed as income when you distribute the funds directly from your 401(k). Yikes! Don’t do that! Instead, either convert the after-tax dollars to Roth within the plan, or roll the after-tax dollars out to a Roth IRA to avoid paying taxes on earnings

Whew! That’s a lot of savings and a lot of rules.

I want to make one note on two-income households, in the spirit of saving the most you can in retirement vehicles. If one spouse earns more than enough to maximize the contribution to the 401(k) ($23,000) but has run out of places to save, the other spouse should try to maximize their contribution too, even if they earn less and it means they contribute less to the household. Nobody can promise forever. But it breaks my heart to see couples break up and discover that the husband has all the retirement savings, while the wife has been using her income to fund the household and the children.  

Yes, she will receive her share of the retirement funds in the long run. But overall, she has lost a lot of tax-free growth if she hasn’t been saving enough while raising the family. If the money is there, try to maximize two contributions—or $46,000—for retirement per year.  (That $46,000 is 20% of a $230,000 income household.)

Did you learn something you didn’t know prior to today? The beauty of maxing your employer plan is that it comes out of your paycheck before you see it. And you rarely miss what you don’t see. Newer plans also may automatically increase your annual contribution. That’s a great way to sneak in more Roth and after-tax savings. 

Last item from me today: There are no longer age limits for IRA contributions. If you make part-time money in retirement, go ahead and put that money into a Roth IRA.

If this information is no longer useful to you because you are already retired, you know the drill: Please make sure it gets to your daughters. #WeRescueOurselves #MathNotMagic

Copyright Madrina Molly, LLC 2024

The information contained herein and shared by Madrina Molly™ constitutes financial education and not investment or financial advice

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