Diligent savers will have the opportunity to tuck away extra money in their retirement plan next year. Investors will be able to contribute up to $17,000 to their 401(k) plan in 2012, up $500 from 2011. Retirement savers age 50 and older can defer taxes on as much as $22,500 because the IRS will allow older workers to make catch-up contributions worth as much as $5,500 next year. Here's how to make the most of the higher 401(k) contribution limit in 2012.
Break it into smaller increments. To completely max out your 401(k) and get the best possible tax benefits, you will need to save about $1,417 per month, which comes out to $327 per week. Workers age 50 and older who want to capture the entire tax break will need to tuck away $1,875 each month, or about $433 weekly.
Remember to reset your direct deposits. If you have direct deposit set up from your paycheck to your 401(k) and already contribute the maximum amount allowed, remember to boost the amount by $500 next year if you can. The extra savings comes out to about $42 per month. "Tell your employer's payroll department to take out the maximum amount," says Don Martin, a certified financial planner for Mayflower Capital in Los Altos, Calif. "You might have to go on their website to authorize the increase to the maximum amount."
Watch out for lower limits. The Internal Revenue Service may set the 401(k) contribution limit at $17,000, but some individual employers might set lower limits for their employees. "Your plan might not allow that much of a contribution," says Mike Branch, a certified financial planner for Focus Financial in Roseville, Minn. "Some plans might cap you at a 10 percent contribution."
Consider a Roth 401(k). The $17,000 contribution limit applies to both traditional and Roth 401(k)s, or a combination of the two. Traditional 401(k)s give you a tax break in the year you make the deposit, but taxes are due upon withdrawal. Roth 401(k) contributions are made with after-tax dollars, and withdrawals from accounts that are at least five years old are tax-free in retirement. "If you are in a high tax bracket, like 25 percent or more, it could make better sense to take the 401(k) deduction now," says Linda Stratton, a certified financial planner for Stratton Advisors in Oro Valley, Ariz. "If you are in the 15 percent bracket or below, it might make more sense to do the Roth."
Don't be discouraged if you can't save the max. While it's a worthy goal to max out your 401(k) contributions, most people don't save anywhere near the tax-deductible limit. Only 9 percent of Vanguard 401(k) participants hit the 401(k) limit of $16,500 in 2010. And just 13 percent of older workers used catch-up contributions when they were offered in 2010, Vanguard found. A Government Accountability Office report found that only about 5 percent of more than 40 million 401(k) participants contribute the maximum tax-deductible amount. Most of the people who are able to completely max out their 401(k)—72 percent—earn $126,000 or more per year, GAO found. If you're not able to take advantage of the entire tax break, at least strive to contribute enough to capture any 401(k) match offered by your employer. "The fact that the IRS increased the contribution limit doesn't really mean anything if you are not saving the maximum amount right now," says Branch. "If you are saving the maximum amount, it is an opportunity to put more away."