The Internal Revenue Service recently announced that it was not raising the deduction limit for 401(k) contributions in 2017. Given that the IRS isn't going to make retirement saving any easier, it is especially important that you make the most of the opportunities the tax code does allow.
Current 401(k) contribution limits
401(k) plan contributions are tax-deductible, but only up to certain limits. For most taxpayers, that limit was $18,000 in 2016, an amount that has been raised over time to account for the rising cost of living. However, the IRS just announced that there would be no boost in this limit for the coming year.
On the surface, the reasoning is easy to understand. With inflation having been dormant over the past 12 months, the normal cost-of-living adjustment to the 401(k) deferral limit would not come into play this year. On closer examination though, there are reasons to wonder whether a short-term snapshot of inflation is really a sufficient basis for adjusting retirement saving policy.
A more encouraging approach might help improve the somewhat woeful level of retirement saving in this country, but in the absence of more help from the IRS, it is vital for each taxpayer to make the most of the retirement savings chances that already exist.
Bad policy to limit tax benefits for retirement savings?
To understand where the IRS is coming from, you have to think about its mandate: its role is not to encourage retirement saving, but to collect tax revenue. More broadly though, the government is faced with a conflict between trying to collect as much as it can in tax revenues on the one hand and trying to improve retirement saving on the other. Given that impoverished retirees would just end up depending on government resources anyway, it might be short-sighted of the government to so tightly limit tax deductions on retirement savings.
It's also questionable whether adjusting 401(k) contribution limits to year-to-year changes in inflation is appropriate. Retirement funding is affected by the long-term rate of future inflation, not a single year of inflation in the recent past. Using a long-term inflation rate assumption would be a more forward-looking way of adjusting 401(k) contribution limits for the rising costs retirees are likely to face.
3 ways to maximize 401(k) contribution limits in 2017
Bad policy or not, the 401(k) contribution limits are set, and the only thing you can do about it is make the most of your opportunities to save for retirement.
Here are three ways to do that:
1. Max out your contributions during peak earnings years
The fact that 401(k) plan contributions are limited means that you can't afford to waste them. You get to deduct up to $18,000 a year, and for every year you don't max out that limit you are paying extra money in taxes, and leaving your retirement savings wanting.
You also are missing a shot at an extra year of compounded investment returns. When you are just starting your career, it might be hard to find room in your budget to come close to contributing $18,000 a year to your 401(k), but as you enter your peak earning years in your 30s and 40s, you should start working towards that goal. You only have so many years to save for retirement, so treat each one of them as something precious.
2. Use IRAs and HSAs to augment your 401(k)
If you find yourself bumping up against the 401(k) contribution limit, avail yourself of tax-advantaged savings opportunities in an individual retirement account (IRA) and a health savings account (HSA) to augment your 401(k) savings. People tend to look at health savings accounts as merely a way to fund short-term healthcare costs. However, they can also be used to build long-term savings to meet future medical expenses. You can also consider an IRA money market account to add to your retirement portfolio.
3. Take advantage of catch-up contributions
If you are aged 50 or over, you can contribute more to your 401(k) plan than the $18,000 limit. So-called catch-up contributions (the name reflects an assumption that most people have fallen behind on their retirement savings) are available to older workers. For 2017, the limit on catch-up contributions is $6,000, meaning that people aged 50 and over can actually deduct up to a total of $24,000 a year in 401(k) contributions.
People tend to resent paying taxes, so it's easy to grumble about the IRS not raising the deductible limit on 401(k) contributions. The truth is, though, that most people don't make the most of those contributions as it is.
Rather than looking for an extra break from the IRS, make 2017 the year that you make the most of the breaks that are already available.
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