Looking for a bigger tax break in 2020?
If you participate in a 401(k) plan, you are in luck. Contribution limits for 401(k) plans have been raised for 2020, giving you the opportunity to shelter more of your income from taxes.
Even if you can't afford to take full advantage of the higher 2020 401(k) contribution limits, this is a good time to revisit your retirement-saving strategy to take as much advantage of your 401(k) plan as you can.
2020 401(k) Contribution Limits
Tax deductible contributions to 401(k) plans and other retirement accounts are subject to IRS limits. These limits are given cost-of-living adjustments from time to time, and the IRS has just announced how those adjustments will affect contribution limits for 2020.
The 401(k) contribution limit for 2020 has been set at $19,500. (This is up from the 2019 401(k) contribution limit of $19,000.)
Contribution limits for 403(b) and 457 plans have also been raised from $19,000 to $19,500. 403(b) and 457 plans operate in similar fashion to 401(k) plans but cover employees of non-profits and the government rather than corporations.
Catch-up Contributions in 2020
Employees in 401(k), 403(b) or 457 plans who are age 50 or over are able to contribute an extra amount to their plans annually. The limit for these extra contributions, known as catch-up contributions, has also been given a cost-of-living increase for 2020.
The limit on catch-up contributions in 2020 is $6,500, which is up $500 from $6,000.
This $500 difference represents an 8.3% increase, which is well above the recent inflation rate. This gives people who are approaching retirement without adequate retirement savings an extra chance to try to catch up.
Along with the raise to the general contribution limit for 401(k), 403(b) and 457 plans, this higher contribution limit allows people age 50 or over to contribute a total of $26,000 to these plans in 2020. That level of savings would represent significant progress toward meeting your retirement goals.
How to Reach Retirement-Savings Targets
While saving up to the maximum level would be ideal, realistically it is beyond the means of many workers.
If saving $26,000 or even $19,500 per year in your retirement account is more than you can afford, there are other benchmarks you can use to set your retirement-savings targets.
As described below, two possible ways to set your 2020 retirement-savings target are to maximize your employer match or to calculate how much you need to contribute each year to meet your retirement-savings goals.
Maximizing your employer match
While 401(k) and similar plans are fueled primarily by employee contributions, in many cases the employer will kick in something as well.
Some employers contribute an amount to the plan regardless of what the employee contributes. Often though, employer contributions are based on what the employee contributes.
These are known as matching contributions, because the employer matches some or all of what the employee contributes. Employer matches have two key elements to them:
- Employer matching contributions are based on some percentage of what the employee contributes, and 50% is a common formula. That means that, for every dollar you put into the plan, the employer will put in 50 cents.
- The other key element of employer matching contributions is that they may apply only up to a certain level. For example, an employer may match up to 50% of each employee's contributions, up to a maximum of 6% of salary.
In that case, an employee can maximize the employer match by contributing at least 6% of salary to the retirement plan each year. Anything less will be leaving money on the table.
So, even if you can't contribute up to the full amount of IRS contribution limits, you should aim to contribute at least enough to get the maximum matching contribution out of your employer.
>> To learn more about matching contributions, read: Does your employer's 401(k) measure up?
Benefits of Making Contributions to your 401(k) Plan
Your 401(k) contributions offer a double tax advantage. You can direct pre-tax dollars from your paycheck into your 401(k), thus reducing the amount of your income that will be subject to income tax next year.
Also, any investment earnings on your 401(k) contributions will also be exempt from taxes.
You will have to pay income taxes on the money when you take it out of the 401(k) in retirement; but you may find that your income is lower in retirement than in your working years, in which case you would be in a lower tax bracket then as well.
In addition, to some extent, you can manage the timing of your 401(k) withdrawals to increase tax efficiency.
Planning 401(k) Contributions to Meet Retirement Goals
Another approach to deciding how much to contribute to your 401(k) plan or other retirement account is to figure out how much money you want at retirement and work backward from there to determine how much you'll need to contribute each year to meet that goal.
A retirement calculator can help you figure this out.
While many employees just contribute what they feel they can afford, using a retirement calculator can help you understand what it will take to afford a comfortable retirement.
How to plan if you just started your career
If you are just starting your career, you may have to make smaller contributions now and then pick up the pace as your wages grow. That's fine, but don't leave too much of your retirement saving for the later part of your career.
For one thing, as wages grow, spending tends to grow as well. Ten years from now you might have a higher income; but by then, saving for retirement might mean competing with other priorities like having buying a house, having children, or paying off student loans.
Investment growth is a big factor in turning your retirement contributions into a big enough nest egg to fund your retirement. The earlier in your career you get money into your retirement plan, the more years of potential investment growth you'll have working for you.
Setting year-to-year retirement-account contributions based on your long-term goals is a good way to weigh your future needs alongside near-term spending temptations. If nothing else, it will give you a clearer idea of what to expect from the future.
Other Retirement-Account Limits for 2020
In addition to the cost-of-living increase to contributions for 401(k), 403(b) and 457 plans, the IRS announced some other notable updates to retirement-account rules for 2020:
- The contribution limit for SIMPLE plans was raised by $500 to $13,500.
- Contribution limits for both traditional and Roth IRAs remain unchanged at $6,000, and IRA catch-up contribution limits remain unchanged at $1,000.
- Your ability to deduct traditional IRA contributions may be limited by your income. The deduction limits are phased in over certain income ranges, and those income ranges depend on your marital status and whether you are covered by a workplace-retirement plan.
There are several variables involved, so you or your tax advisor should check the IRS guidelines for details on how they apply to you because most of the income ranges have been raised for 2020.
- Eligibility to contribute to a Roth IRA is also subject to income limits. Here, again, there are a range of phased-in limits depending on your situation, so you should check the IRS guidelines. The good news is that you should find the income ranges at which the limits apply have been increased.
Whichever of these retirement-account changes affect you, the way your savings habits respond should follow the same general approach. Even if you can't make full use of the IRS limits, use your employer's match or long-term savings goals as the basis for a contribution target to strive for this year.
If nothing else, at least higher IRS contribution limits should give you a little more room for setting your target.
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