I currently contribute 13 percent of my salary to my 401(k), which is the maximum percentage allowed by my company. But this maximum percentage doesn't get me close to the maximum dollar amount the government has set for 401(k) accounts. Is it possible to make extra contributions to reach this limit?
-- Annette, Parsippany, New Jersey
I admire your determination to sock away more money in your 401(k). But unless you convince your employer to jack up your salary or increase the maximum percentage of pay that you can kick into your plan, you're not going to be able to reach the government-imposed dollar limit for pre-tax contributions of $12,000. (That ceiling rises to $15,000 by 2006, after which it's indexed for inflation.)
The reason is that all 401(k) participants are bound by the percentage-of-salary maximums the company sets for its plan. Thus, if your company sets a 13 percent maximum contribution percentage -- which is actually quite generous given that most companies fall in the 6 to 10 percent range -- you can't contribute anything beyond that percentage, even if you end up falling short of this year's $12,000 ceiling. So with a 13 percent of salary contribution limit, you would need a salary of $92,308 to get you to this year's $12,000 dollar max.
If your company allowed you to sock away up to 13 percent of salary and you made more than $92,308, however, then the government dollar maximum would come into play, stopping your contributions at $12,000. This is a drag, of course, for people like yourself who would like to get closer to the $12,000 dollar maximum. But the dollar limit wasn't set as a target for avid savers like you to shoot at. It's there to limit how much higher wage earners can sock away.
One can argue about whether this dollar ceiling is a good idea, but for now at least this is the arrangement you've got to live with. That said, though you may be able to take advantage of other options to save.
There are other options
If you're 50 or older, for example, you may be eligible to make "catch up" contributions to your 401(k). This year, people 50 and older can contribute an extra $2,000 to their 401(k), although that amount rises to $5,000 in 2006 and is then indexed to inflation.
Your employer's plan must allow for catch-up contributions, however, so you should check with your human resources department to see if they're available.
Another option is to open a traditional or Roth IRA account, which would allow you to sock away another $3,000 this year and more in subsequent years since the maximum contribution for IRAs is scheduled to climb to $5,000 by 2008.
There are some income eligibility rules that apply to both traditional and Roth IRAs, so you'll want to be sure you meet them before you fund such an account.
You may really be able to ramp up your retirement savings, however, if the president's new tax-free savings proposals become law. As you may recall, the president has proposed adding two new accounts: a Lifetime Savings Account (LSA) that would allow you to save up to $7,500 a year and a Retirement Savings Account (RSA) that would also allow you to salt away up to $7,500.
By funding both accounts, you could put away as much as $15,000 a year. You wouldn't get a tax deduction on your contribution. But the earnings would be tax free. For details on how they would work if they are approved as proposed, click here.
Don't forget after-tax saving
One final note: many 401(k) plans also allow participants to make after-tax contributions to the plan. That means you wouldn't be getting the same immediate tax break you do with your pre-tax contributions. But those contributions would earn a tax-deferred return, just like the earnings on your regular contributions.
If I were you, though, I would do the traditional or Roth IRA before making any after-tax contributions to my 401(k), since the combination of a tax deduction (in the case of the traditional IRA) or tax-free returns (Roth IRA) is better than the mere tax deferral benefit you get with after-tax 401(k) contributions.
If you do an IRA and still have money left over, I'd still probably hold off making after-tax contributions until I saw what happens to the LSA and RSA proposals.
The reason is that if the president's plan passes, you'll be much better off putting any extra savings into an LSA or RSA that generates a totally tax-free return than you would merely postponing the tax bite on earnings generated by after-tax contributions to a 401(k). If the proposal seems to be going nowhere, you could then consider nondeductible contributions to your 401(k), assuming the plan allows them.
Walter Updegrave is a senior editor at MONEY Magazine and is the author of "Investing for the Financially Challenged." He can be seen regularly Monday mornings at 7:40 am on CNNfn.