The 401(k) plan offers people an opportunity to invest employment earnings for retirement on a pretax basis. "Pretax" has a catch, though: You can only set aside pretax funds up to certain limits. What limits apply to your situation depend on your age and, to some extent, your marital status.
As of publication, the Internal Revenue Service permits individual taxpayers to set aside up to $17,000 per year on a pretax basis. If you are older than 50, you can save $22,500 per year, pretax. If you are married, you and your spouse can set aside retirement money into a 401(k) account up to your individual limits, thus doubling your tax benefit. Limits sometimes change from year to year, so consult a licensed accountant or the IRS for updated rules.
Many employers encourage employees to save for retirement by offering a matching program that helps increase pretax savings beyond the stated IRS limits. These matching programs typically offer 50 cents on the dollar up to 6 percent, according to CNN Money. That means if you earn $100,000 per year and you save 6 percent of your pretax income toward retirement, your employer would kick in an additional 3 percent. This totals 9 percent, or $9,000 pretax, pre-investment savings dollars. Your employer's contribution doesn't count toward your annual IRS limit.
How Contributions Work
Calculating your maximum contribution is simple. For example, if you earn $80,000 per year, you are 38 years old and you want to save $17,000 per year toward retirement, divide 17,000 by 80,000 for your percentage contribution. In this case, you'd need to put aside 21 percent of every paycheck on a pretax basis. If $10,000 sounds like a more manageable sum, divide 10,000 by 80,000 and ask your employer to take out 12.5 percent of every paycheck. If you are able, increase your annual contribution when you turn 50.
Your Employer's Role
Check with your employer after you turn 50 so you can maximize your pretax savings, as limits change frequently. Your employer will automatically deduct your new contribution from your paycheck before taxes, and it will invest the funds in an available investment option of your choosing. Don't assume your employer will automatically increase your pretax contribution once you turn 50. It will automatically make its contribution to your retirement account without your prompting, though. To maximize your pretax savings benefits, make regular contributions a habit.
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