How To Increase Your Tax-Free Savings

How To Increase Your Tax-Free Savings

Probably most everyone is familiar with a company 401(k) retirement savings plan. Employees age 50 or older can defer up to $26,000 of their salary in 2021. The employer can additionally add contributions based on a matching formula or some percentage of company profits. In the majority of plans today employees can even choose to split their salary deferrals between tax-deductible contributions and non-deductible Roth contributions, with the latter growing tax-free for life. Compare all that to the relatively paltry $7,000 limit the same individual faces when contributing to an individual retirement account (IRA) and you can see why for flexibility and generosity the 401(k) is hard to beat. But did you know that if you work for the right company you can save significantly more in your 401(k)?

It helps to understand how much savings headroom a 401(k) actually has. Although a fifty-year old employee is limited to $26,000 of contributions (this year), the maximum annual amount that the IRS allows in any 401(k) is $64,500. That includes all employee salary deferrals plus company contributions. If the company does not offer any match, that leaves $64,500 minus $26,000 which equals $38,500 potentially available for additional savings. Companies that do provide a match generally follow what are called safe-harbor rules designed to keep them compliant with ERISA requirements. That’s either 3% of total compensation or 100% of the first 4% of salary deferrals. For an employee making $200K per year that adds up to either $6,000 or $8,000. The most generous plans I’ve seen match 50% of all salary deferrals, or $13,000. Even in the latter case, after maximizing salary deferrals plus company contributions there’s still room for another $25,500 before hitting the $64,500 maximum limit.

If you’re one of the lucky few that work for a company whose 401(k) plan allows it, you can fully save up to the IRS $64,500 limit. The additional savings “bucket” is technically a non-deductible salary deferral above the employee contribution limit, sometimes more concisely referred to as a “mega-Roth.” As the name implies, your savings into that portion of your 401(k) will not be tax deductible, but earnings will grow tax free and can be rolled over to a Roth IRA account when you leave the company or – if the plan allows it – anytime you want. So in effect it’s just like being able to save an additional $25K to $38K into a Roth every year. That’s a lot more than the maximum amount – which could be $0 depending on your income – that you’re allowed to contribute to a personal Roth IRA.

If you haven’t looked into whether or not your 401(k) allows this capability, I recommend doing so. Especially if you have extra salary income not needed for expenses that is currently being saved in a bank or brokerage account. By shifting those same savings to a mega-Roth you will avoid having to pay taxes on future returns throughout your entire lifetime. There aren’t many good deals available from the IRS, but this is definitely one of them!

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