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Easier To Max Out On 401(k)s – Lifting Of Salary Percentage Limit Expands Options

by Tim Haran

CBS.MarketWatch.com, May 1, 2002

SAN FRANCISCO (CBS.MW) – Participants in 401(k) plans gained a powerful and largely overlooked benefit in the 2001 tax act with an end to limits on the percentage of salary they can set aside. Employees can now shelter up to 100 percent of their pre-tax pay, up to this year’s $11,000 annual limit, if their employer elects to modify 401(k) plan guidelines. The law previously restricted contributions to 25 percent of pay, and most employers capped the amount at 15 percent under their plans.

That common cap meant most workers had to earn $73,300 to contribute the maximum. The change is especially beneficial for two-income households where one partner works part-time, lacks a 401(k) or whose plan is less desirable because of limited mutual fund choices or other restrictions.

“If both get a company match (on contributions), they each should contribute to the maximum match level and put the excess in whatever plan is the better of the two,” said Lynn Ballou, a certified financial planner in Lafayette, Calif. “You don’t want to walk away from free money.”

Many plans have yet to eliminate their old ceilings, and most that have allow for something less than 100 percent because employees need to cover Social Security, health insurance and other payroll deductions, said David Wray, president of the Profitsharing/401(k) Council of America. The idea is to get people investing as close to $11,000 a year as possible, he said.

For instance, it now may make sense for a spouse to return to work part-time. Before, if one person made $60,000 and the other made $10,000 part-time, almost $4,000 of the added income might get eaten up by federal, state and local taxes. With the ability to put the extra income into a 401(k), it may be worthwhile to return to work. “We’re obviously excited about the fact that people can contribute as much as they want” up to the annual limit, Wray said.

Empty-nesters

The rule change also benefits empty-nesters who are no longer supporting children and may now be able to set aside more in the 401(k), said Stephen Butler, president of Pension Dynamics. Workers over 50 are allowed to contribute $12,000 in 2002 to a 401(k) plan under so-called catch-up provisions. While the general limit rises to $15,000 by 2006, the over-50 limit rises to $20,000. “That group of people has a greater need to be contributing to their retirement nest egg,” Butler said. “And they’ve got more discretionary income.”

Think long term

One drawback to the eliminated salary cap is that people may get so caught up in saving the maximum for retirement they might not be able to meet living expenses.

Participants shouldn’t contribute so much that they must take loans or max out credit cards to pay monthly bills, said Joyce Franklin, president of Franklin Financial Advisors.

Said Franklin: “The worst thing people can do is put money in a plan and have to take it out early. Think about current year expenses as well as expenses a few years down the road.” Tim Haran is a reporter for CBS.MarketWatch.com in San Francisco.