What to Do If You’ve Maxed Out Your 401(k)

Only about 1 out of 15 of people contribute the maximum allowed amount to their 401(k) retirement plans, according to a report from the Center for Retirement Research at Boston College.

The report’s authors defined the maximum as the IRS-set limit for tax-free contributions — recently increased to $17,500 for 2013 — or 25 percent of the contributors’ annual salary.

No matter how you define it, that’s a sizable sum. It’s no wonder that so few manage to plow that much into their retirement savings. Still, as incomes rise, so does the percentage of 401(k) maxers — 28 percent of those earning over $100,000 contribute the maximum limit.

401(k) Contributions on the Rise

Recently, the overall amount people contribute to their 401(k) accounts has been rising.

Fidelity Investments, which oversees 11.9 million 401(k) accounts, said in August 2012 the average 401(k) contribution rose to $1,660 during the second quarter, up $30, or nearly 2 percent, from the same period in 2011.

When compared to the depths of the recession in 2009, it’s up $150, or nearly 10 percent, Fidelity said.

Tax Advantages and Matching

It’s generally smart to contribute as much as possible to 401(k) plans because, for one thing, contributions are made on a pre-tax basis. A 401(k) contribution comes out of an employee’s paycheck before income taxes are deducted.

As a result, take-home pay is reduced by a smaller amount. At an income tax rate of 20 percent, for example, putting $100 in a 401(k) reduces take-home pay by only $80 or so, with the exact amount depending on income and tax rate.

Taxes on contributions do have to be paid, but not until money is withdrawn. Taxes on investment gains in a 401(k) also are deferred until withdrawal. Finally, one of the greatest attractions of 401(k) plans is that most employers make matching contributions that are equal, or close, to an employee’s contributions.

Most people who don’t max out their 401(k) plans simply don’t have enough left over after paying the bills. Those whose earnings are high enough, or whose living costs are low enough, to max out a 401(k) may wonder whether there is another investment with similar advantages. Unfortunately, there isn’t.

Still, it’s probably smart to keep saving and investing — even if you max out a 401(k). If you have maxed out your 401(k), here are some options:

Emergency Fund

The first thing to do after maxing out your 401(k) is to pad your emergency fund. At least six months worth of expenses is a good goal for a rainy day fund. This will usually be kept in a bank or credit union savings account, despite the low yields, to keep it safe and accessible.

Roth IRA

Next, consider a Roth IRA. This plan requires you to pay taxes on contributions now, but lets you withdraw funds from the account later tax-free. Thus, any investment gains are also tax-free.

Roth IRAs are only available, however, to single people whose modified adjusted gross income is less than about $117,000, and married couples with joint income less than about $178,000. The exact income cap depends on situation.

Taxable Investments

Finally, there are taxable investments. You’ll pay taxes on contributions and, in most cases, earnings. However, earnings from some investments, such as municipal bonds, are free of federal and, in most cases, state and local taxes.

You can also invest in tax-efficient funds that reduce taxes by employing depreciation write-offs and reducing the number of taxable events, such as buying and selling securities.

With all its benefits, the 401(k) plan remains the most appealing retirement savings vehicle for almost everyone — a fact that may be appreciated most by the fortunate few who are able to max out their 401(k) plans.

“What to Do If You’ve Maxed Out Your 401(k)” was written by Mark Henricks.