Maxing Out 401(k) Contributions

[Tortoise]

I have a question for those of you who max out your pre-tax 401(k) contributions each year: Are you usually able to hit the contribution limit exactly (e.g., $17,500 for 2014), and if not, do you try to go slightly under it or slightly over it? If you happen to exceed it, do the excess contributions just get automatically classified as after-tax and get tracked separately, or are they still considered "pre-tax" and the IRS charges you tax or penalties on them when you file your taxes?

Going forward, I'm just trying to figure out if I should be trying to hit the 401(k) contribution limit as closely as possible, or if exceeding the limit even slightly is enough of a tax/bookkeeping headache that I should go slightly under the limit to be on the safe side.

[flyingpylon]

Our payroll processor automatically stops 401(k) contributions once you've hit the limit (we use ADP for payroll).  You might want to check with the person at your company that handles payroll to verify how it's done and whether there are any "gotchas" that might affect the company match (if you have one), etc.

[WildAboutHarry]

Same here.  Automatic stop at contribution limit.

[moda0306]

(Annoyed that you all talk about maxing your 401(k) like you've been doing it for years).

[dualstow]

I only have a solo 401(k). I used to put in as much as I could. Now I contribute a bit less than what my accountant tells me I can.

[Tyler]

In my experience every company is a little different.  I've always been irritated by the ones that only let you specify a percentage of a paycheck instead of a fixed monthly amount, as you have to remember to change it if you get a raise.  I generally calculate it to get within a few hundred dollars without going over. 

[Libertarian666]

When I was contributing to a 401k, they stopped taking the money out as soon as I hit the contribution limit. I believe there was a separate place to specify if you wanted non-deductible contributions.

[dualstow]

I only have a solo 401(k). I used to put in as much as I could. Now I contribute a bit less than what my accountant tells me I can.

Because.....?

Just to be on the safe side. He overdid it last time and I had to remove the excess when he revised his calculation. (I know, it sounds like he's not a very good accountant, but he is. I had a change in income). I didn't have any penalties.

Next year, when the renovation & rent costs are behind me, I will consider going full steam ahead with the 401(k) contributions. I always max out my Roth IRA, for what it's worth.

[WildAboutHarry]

[quote=moda0306](Annoyed that you all talk about maxing your 401(k) like you've been doing it for years). [/quote]

I have been maxing out 401(k) for a few years, but that is to make up for all those years of 4-figure Social Security reported income.

[Jay-UMN]

My 401k setup automatically rolls over to post tax 401k after the limit, but I adjust it so that is is right around the limit.  A little under or a little over; doesn't really matter.

[hljockey]

My employer plan automatically stops at the cutoff (plus an extra 5k for those of us old enough) but my wife's plan allows contributions beyond the max. I have no clue what that is all about. Why would anybody want to contribute extra to a plan where they might be double taxed, i.e., on the way in and on the way out? Maybe the extra money on my wife's plan goes into some kind of separate account with different tax rules but I haven't heard of such a thing so I watch it closely with the intention of cutting it off when it gets near the max.

[Pointedstick]

My employer plan automatically stops at the cutoff (plus an extra 5k for those of us old enough) but my wife's plan allows contributions beyond the max. I have no clue what that is all about. Why would anybody want to contribute extra to a plan where they might be double taxed, i.e., on the way in and on the way out?

Perhaps if your 401k was fortunate enough to have better options available than a conventional taxable account where you would be otherwise putting that money. Some 401ks offer funds' institutional share classes with extremely low expense ratios, for example. Otherwise, I dunno either.

[rickb]

My employer plan automatically stops at the cutoff (plus an extra 5k for those of us old enough) but my wife's plan allows contributions beyond the max. I have no clue what that is all about. Why would anybody want to contribute extra to a plan where they might be double taxed, i.e., on the way in and on the way out?

Perhaps if your 401k was fortunate enough to have better options available than a conventional taxable account where you would be otherwise putting that money. Some 401ks offer funds' institutional share classes with extremely low expense ratios, for example. Otherwise, I dunno either.

Plans that allow extra contributions beyond the max at least should treat the "extra" as post-tax contributions, which are treated differently from pre-tax contributions.  Post-tax contributions can be withdrawn without penalty, and without being taxed, whenever you want.  The basic advantage is that the gains accrue tax-deferred, which over time can be a significant difference. 

[TripleB]

I only have a solo 401(k). I used to put in as much as I could. Now I contribute a bit less than what my accountant tells me I can.

Because.....?

Just to be on the safe side. He overdid it last time and I had to remove the excess when he revised his calculation. (I know, it sounds like he's not a very good accountant, but he is. I had a change in income). I didn't have any penalties.

Next year, when the renovation & rent costs are behind me, I will consider going full steam ahead with the 401(k) contributions. I always max out my Roth IRA, for what it's worth.

You can contribute Solo 401k contributions until October of the following year, if you file for a tax extension. So you can be 100% sure what your income will be, and make the full contribution. Your accountant is a terrible person for not telling you this.

[Libertarian666]

My employer plan automatically stops at the cutoff (plus an extra 5k for those of us old enough) but my wife's plan allows contributions beyond the max. I have no clue what that is all about. Why would anybody want to contribute extra to a plan where they might be double taxed, i.e., on the way in and on the way out? Maybe the extra money on my wife's plan goes into some kind of separate account with different tax rules but I haven't heard of such a thing so I watch it closely with the intention of cutting it off when it gets near the max.

Yes, such "after-tax" contributions do in fact go into a separate account with different tax rules.

[dualstow]

You can contribute Solo 401k contributions until October of the following year, if you file for a tax extension. So you can be 100% sure what your income will be, and make the full contribution. Your accountant is a terrible person for not telling you this.

I don't have a lot of income. Thankfully, I have a lot of savings for my age, but I don't make enough to put a ton into a 401(k). You could say my portfolio is "taxable-heavy" (but not tax-heavy).

I've never elected to get an extension. I just get it over with. However, he did give me options. He's good.

Off topic but important: I had previous accountants who didn't know my 15% bracket allowed me to pay zero tax on my capital gains and qualified dividends. My current accountant knew better, but of course I did my own research after a disappointing one.

[sophie]

Interesting, dualstow.  I have the opposite problem:  too much in tax-deferred and not enough in taxable outside of home equity.  This is in part because I've been pretty aggressive about paying down the mortgage.

I maxed my 403b contributions religiously until about 2 years ago (yes contributions would stop when I reached the limit).  Now I'm contributing about 3/4 of max so that I can build up taxable savings to a more comfortable level.

Not sure how to define that but it would be nice to have enough savings to get me to age 59.5 in case of job loss or drastic income reduction, without having to risk early withdrawal penalties.

[dualstow]

Not sure how to define that

"Overdeferred?" I don't know; made it up. But, A few years ago I started wondering if I could run into overdeferrence territory. I think there has been a thread or two about it.

[sophie]

Yes I remember that thread.  Deferring too much means that you end up paying close to the same level of tax on withdrawal that you would have paid initially, and even worse the gains get taxed not at the preferred dividend & capital gains rate, but at the regular income rates.  Plus extra if tax rates go up in the meantime.  Supposedly the ability to compound gains tax free in the meantime helps but I'm not sure it's enough.

"Too much" for most of us - well me anyway - is probably an amount large enough that you can't get it all out by, say, age 80 without venturing above the 15% bracket.  That's an annual income of no more than $36,900 after deductions.  Assuming you need to reserve half that space for Social security and other income, and you withdraw every year from ages 60-80, that comes to about $400,000.

Hmmm, need to think about this some more.  It's possible to make a case for cutting tax-deferred contributions once a certain milestone is reached.  Thoughts???

[williswine]

DualStow, Sophie: which thread was it that discussed overdeferrence? Thank you!

[sophie]

It was mostly a debate about bird in the hand vs future tax rate increases.

I've been thinking some more about thus, thus the desire to resurrect this thread.  There are definitely downsides to deferring:

- Essentially no access to your money until age 59.5 (a few exceptions + the 10% early withdrawal tax)
- The tax savings may turn out to be minimal or nonexistent even if tax rates don't increase.  If your marginal federal tax rate is 28%, you may drop your marginal tax rate only to 25% on retirement.  In exchange for that 3% benefit, you have agreed to have all earnings taxed as ordinary income, not at the dividend or capital gains rates.
- If tax rates increase you may come out worse on the deal.

The main benefit is allowing the gains to compound tax free, which wins out over the higher tax obligation at the other end.  This however requires that the money be left in the account for many years - probably 15-20 years at least - before you come out ahead.  (Requires some spreadsheet fiddling...can't do that right now, so let's call this X years.)

The other clear win is if you can take advantage of the 0-15% tax bracket space to move the money out.  After you start receiving Social Security, you will have very little space in that bracket, if anything.  So your only opportunity is after retirement and before age 67 or whenever you plan on taking SS, and you are limited to $36,900 per year after deductions and minus all other income.

So I would say that if you are confident you can let the money sit in the account for at least X years (see above) then by all means contribute the maximum.  However, if you anticipate wanting to access the money in less time than that, then you will want to figure how much "space" you have in that 0-15% tax bracket and limit your tax-deferred retirement accounts to that amount.    You may find that given your number for X, your maximum tax-deferred # might be pretty low!

I realize I've signed myself up for another excel session but have limited time right now, so I am hoping someone (Tyler??) can jump on it.

[Libertarian666]

It was mostly a debate about bird in the hand vs future tax rate increases.

I've been thinking some more about thus, thus the desire to resurrect this thread.  There are definitely downsides to deferring:

- Essentially no access to your money until age 59.5 (a few exceptions + the 10% early withdrawal tax)
- The tax savings may turn out to be minimal or nonexistent even if tax rates don't increase.  If your marginal federal tax rate is 28%, you may drop your marginal tax rate only to 25% on retirement.  In exchange for that 3% benefit, you have agreed to have all earnings taxed as ordinary income, not at the dividend or capital gains rates.
- If tax rates increase you may come out worse on the deal.

The main benefit is allowing the gains to compound tax free, which wins out over the higher tax obligation at the other end.  This however requires that the money be left in the account for many years - probably 15-20 years at least - before you come out ahead.  (Requires some spreadsheet fiddling...can't do that right now, so let's call this X years.)

The other clear win is if you can take advantage of the 0-15% tax bracket space to move the money out.  After you start receiving Social Security, you will have very little space in that bracket, if anything.  So your only opportunity is after retirement and before age 67 or whenever you plan on taking SS, and you are limited to $36,900 per year after deductions and minus all other income.

So I would say that if you are confident you can let the money sit in the account for at least X years (see above) then by all means contribute the maximum.  However, if you anticipate wanting to access the money in less time than that, then you will want to figure how much "space" you have in that 0-15% tax bracket and limit your tax-deferred retirement accounts to that amount.    You may find that given your number for X, your maximum tax-deferred # might be pretty low!

I realize I've signed myself up for another excel session but have limited time right now, so I am hoping someone (Tyler??) can jump on it.

If you want to increase your 0-15% bracket space, you could always get married. 

[Xan]

Sophie, I think you're understating the advantages of tax-deferral.  The concept of "over-deferring" is a fascinating one, and I do believe that it's possible, but deferring isn't as bad as you're making it seem.

First, the list of exceptions to the early withdrawal penalty is fairly substantial, and covers many of the scenarios where you might need the money, like disability and medical expenses, and even first-time home buying (not sure why that one's there...)
http://www.irs.gov/publications/p590/ch ... 1000230905

More importantly, I don't think that having all earnings taxed as ordinary income instead of capital gains is a bad thing.  Let's say you're 50, in the 28% bracket, and you retire at 70, still in the 28% bracket.  Let's say the PP (or whatever you're investing in) doubles in that time.

If you don't defer the taxes, then you pay $280,000 in taxes up front.  You're investing $720K.  You have $1.44M when you retire, at which point you pay $108K (15% of the $720K gain) in taxes.  You're left with $1.332M.

If you defer the money, then you're investing the whole $1M, you have $2M at age 70, and you pay 28% on it at that time.  You have $1.44M after taxes.  That's $108K more than the non-deferral scenario.  The difference is the capital gains taxes which you NEVER had to pay.

Apart from the issue of the rules changing, tax deferral can only make you better off.  It's not a matter of losing the sweet capital gains rate in exchange for a hopefully lower tax bracket; it's never having to pay capital gains taxes at all.

Also, the non-deferred scenario was a best-case presentation of no buying or selling (rebalancing) during the 20-year period.  You might have to pay capital gains taxes multiple times.

[moda0306]

Sophie, I think you're understating the advantages of tax-deferral.  The concept of "over-deferring" is a fascinating one, and I do believe that it's possible, but deferring isn't as bad as you're making it seem.

First, the list of exceptions to the early withdrawal penalty is fairly substantial, and covers many of the scenarios where you might need the money, like disability and medical expenses, and even first-time home buying (not sure why that one's there...)
http://www.irs.gov/publications/p590/ch ... 1000230905

More importantly, I don't think that having all earnings taxed as ordinary income instead of capital gains is a bad thing.  Let's say you're 50, in the 28% bracket, and you retire at 70, still in the 28% bracket.  Let's say the PP (or whatever you're investing in) doubles in that time.

If you don't defer the taxes, then you pay $280,000 in taxes up front.  You're investing $720K.  You have $1.44M when you retire, at which point you pay $108K (15% of the $720K gain) in taxes.  You're left with $1.332M.

If you defer the money, then you're investing the whole $1M, you have $2M at age 70, and you pay 28% on it at that time.  You have $1.44M after taxes.  That's $108K more than the non-deferral scenario.  The difference is the capital gains taxes which you NEVER had to pay.

Apart from the issue of the rules changing, tax deferral can only make you better off.  It's not a matter of losing the sweet capital gains rate in exchange for a hopefully lower tax bracket; it's never having to pay capital gains taxes at all.

Also, the non-deferred scenario was a best-case presentation of no buying or selling (rebalancing) during the 20-year period.  You might have to pay capital gains taxes multiple times.

This.

Definitely build in some after-tax options such as Roth, but the combo of roth and traditional tax accounts are better than taxable accounts.

[WildAboutHarry]

Tax deferral is a wonderful gift.  I think it is a given that funding tax-deferred accounts to the maximum of your ability is the way to go, especially since you lose "deferral dollars" each year that you do not use them (i.e. there is no carry over).

One caveat is with a Roth or Roth 401(k).  If you live in a high state-tax state (like I do) and you intend to retire in a no-state-tax state (like I will) Roths do not make as much sense.