One of the advantages of a 401(k) plan is the high contribution limit. Compared to other retirement plans like IRA accounts, the 401(k) has a very generous contribution limit. Understanding those limits allows you to make the most of your plan and your long-term retirement savings as well.
Basic 401k Limits
As of the 2011 tax year, the basic 401(k) contribution limit is $16,500. All of the money you contribute to the 401(k) plan is deducted from your taxable income and can yield significant tax savings. This $16,500 limit applies to your contributions only, and does not impact your employer's ability to make additional contributions on your behalf.
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If you are at least 50 years of age, you can contribute extra money to your 401(k.) The IRS instituted these catch-up contributions to help older workers make up for lost time in their retirement plans. Like basic 401(k) contributions, these catch-up contributions are reviewed on an annual basis. It is important to check those limits when planning your yearly retirement savings. For 2011, the catch-up contribution for workers 50 and older stands at $5,500 per year. That brings the total allowable contribution for older workers to a generous $22,000.
Your ability to make the full basic and catch-up contribution to your 401(k) could be affected by the rules set forth by your employer. Some firms limit employee contributions to a set percentage of income, sometimes as low as 15 percent. Depending on how much you earn, that could mean you cannot contribute even enough to reach the basic 401(k) contribution, much less any catch-up contributions permitted by the IRS. In some cases employers limit 401(k) contributions to keep the plan from becoming too heavily skewed toward the top earners in the company. Other firms may not realize that placing too low a limit on contributions creates a hardship for their workers.
While maxing out your basic and catch-up contributions makes a lot of sense, it is important to look at all of your retirement savings when deciding how best to allocate your resources. If contributing the maximum amount to your 401(k) means you cannot contribute to a Roth IRA, for instance, you could be giving up the potential of tax-free income in retirement. You need to weigh the up front tax benefit of the 401(k) against the long-term benefits of building a tax-free retirement fund with a Roth IRA.