Contributing as much as possible to a 401(k) plan can go a long way toward helping to build wealth and being adequately prepared for retirement. But there are also limits on the amount that can be set aside in this type of retirement plan each year by both the individual employee and the employer via matching contributions. And those limits are adjusted each year by the Internal Revenue Service (IRS).
Individuals who are 50 or older are also allowed to make what’s known as catch-up contributions—and the limit for these contributions also changes annually.
Here’s what to know about 401(k) contribution limits and the benefits of these valuable retirement accounts.
What is a 401(k) Plan?
For those who may be just beginning their retirement savings journey, it’s important to understand what a 401(k) plan is and why it can be an important tool to help prepare for retirement.
A 401(k) plan is a savings account offered by employers that allow employees to set aside money from each paycheck for retirement. They are the most common type of retirement account used in the United States. According to the Census Bureau, 34.6 percent of retirement savings accounts among working individuals aged 15 to 64 were 401(k) accounts as of 2020.
When enrolling in a 401(k) plan, the employee decides what percentage of their pay they’d like deducted each pay period and allocated to retirement savings. And in some cases, employers may provide matching contributions to each employee’s 401(k) retirement fund up to a certain percentage—such as 4 or 5 percent. The 401(k) contributions taken from each paycheck are deducted pre-tax, thus reducing the employee’s taxable income.
Funds set aside in a 401(k) plan are deposited into an investment account that typically includes a variety of investment options such as mutual funds or exchange-traded funds (ETFs.) This allows the money to grow and typically, 401(k) plans earn average returns of between 5 percent to 8 percent each year, depending on the asset mix and market performance.
401(k) contribution limits for 2023
Each year the IRS establishes limits on the amount individuals can set aside in these tax-advantaged accounts. The limits are adjusted annually to account for the cost of living increases and inflation.
For 2023, the 401(k) contribution limit set by the IRS is $22,500 for individuals. However, as mentioned at the beginning of this article, those who are 50 or older are allowed to make what’s known as catch-up contributions. The 2023 catch-up contribution limit is $7,500. That means individuals in this age group can contribute up to $30,000 to a 401(k) in 2023.
The combined employee and employer contribution limit for 2023, meanwhile, is $66,000. This limit applies in cases where employers make matching contributions to 401(k) accounts. About 98 percent of employers make contributions to employees’ 401(k) accounts, according to the Plan Sponsor Council of America.
What is a good percentage to contribute to a 401(k)?
While everyone’s financial situation and needs are unique, it’s a good idea to contribute enough to a 401(k) to earn the full matching amount provided by an employer (if matching contributions are offered.) In other words, individuals working for a company that matches 5 percent of 401(k) contributions, for instance, should contribute at least 5 percent of each paycheck to retirement savings.
Matching contributions made to a retirement savings account by an employer are an important benefit and one that can significantly accelerate retirement savings efforts. Those who chose not to contribute enough to earn the full employee match are essentially leaving free money on the table.
Overall, it’s a good idea to set aside as much as 10 percent to 15 percent of your income each year in retirement accounts in order to be adequately prepared for retirement. Depending on your spending needs in retirement and how soon you plan to retire, it may make sense to set aside the maximum contribution amount.
Benefits of 401(k) plan contributions
Beyond the importance of simply being prepared for retirement, there are many benefits to making contributions to 401(k) plans.
Pre-tax deductions
Because deductions are made pre-tax, they reduce the annual taxable income for the individual making contributions. That means you’re paying taxes on a smaller portion of your annual salary, and 401(k) contributions may also lower your overall tax rate.
Compounding interest
It’s hard to overstate the importance of compounding interest. The sooner you get started contributing to a 401(k), the more time your money has to grow and earn interest. And then, you earn interest on your accumulated interest, which is a powerful way to grow wealth.
Automated retirement contributions
401(k) deductions are automatically taken from each paycheck, eliminating the opportunity and temptation to spend the money elsewhere. This approach is a highly effective way to keep retirement savings efforts on track and successfully reach retirement goals. Having enough money set aside in your retirement nest egg is critical to ensuring that you’re able to cover living expenses—such as food, housing, and medical care— once you leave the workforce behind.
As a retirement savings vehicle, 401(k) plans can be incredibly valuable. The aggregate rate of return for all 401(k) plans in the United States was about 20 percent in 2019, before the market volatility triggered by the COVID-19 pandemic. On an individual level, 401(k) plans typically return from 5 to 8 percent annually.
Starting a 401(k) plan is simple
Starting and managing a 401(k) plan can seem daunting—particularly for small business owners. But it doesn’t have to be. Penelope has designed 401(k) accounts for small businesses that are simple, transparent, and straightforward. We’ve streamlined the process to make it affordable and easy to manage for businesses of any size. And plans can be created in as little as 15 minutes.
Interested in retirement plans for your employees?
Get started today with a free, no-obligation consultation with a 401(k) retirement specialist.
Penelope Team
Mia Taylor