Now that the glittery crystal balls around the world have been lowered, and the holidays passed, it’s time to get back to work regarding our finances. Back in October of last year, the IRS released its updated retirement contribution limits, and being the prudent investors that we are, we took a look, but likely dismissed it until next year. Well, that “next year” is here, and it’s time to take a look at those benefit plan elections once again.
For the first time in nearly three years, the IRS has increased the amount that employees can contribute to 401(k), 403(b), and similar plans from $18,000 in 2017 to $18,500 in 2018. The periodic increases, while seemingly random, are actually made to allow savers the ability to save at a rate that is in line with inflation, and while the additional $500 per year may not seem like much, with the effect of compounding, this will undoubtedly lead to tens of thousands of dollars when withdrawn at retirement if allowed to grow over the course of a 20 to 30 year (or longer) career. Unfortunately, for those 50 years of age or older, the annual “catch-up” bonus remains unchanged at an additional $6,000 for a total of $24,500 in allowed tax-deferred savings.
While investors should rejoice at the 401(k) contribution limit increase, IRA contributions (both Traditional and Roth) remain limited to just $5,500 per year. The IRA can be particularly challenging to grasp due to its many complexities, so we’ll do our best to simplify. You’ll recall from an earlier article, that the difference between Traditional IRAs and Roth IRAs is that Traditional IRA contributions are made on a pre-tax basis while Roth contributions are made post-tax. Well, to make things more complicated, the amount of your IRA contribution that is entitled to receive the full tax benefit varies based not only on your earned income for the year but also on whether you make Traditional or Roth contributions. For instance, a single man earning $60,000 per year and whose employer offers a 401(k) or similar plan should receive full credit for the tax deduction, but if that same individual earned $70,000 he would only be entitled to a partial benefit. Due to the nature of the tax law, the benefits begin to “phase out” within certain ranges, until they eventually disappear completely. You can see a summary of the limits for both Traditional and Roth IRAs in the table below:
Note that while the maximum IRA contribution for most investors remains at $5,500, investors over 50 years of age are eligible for an additional $1,000 “catch-up” bonus for a total of $6,500. Also, keep in mind that if your income in 2018 exceeds the high end of the Roth phase-out range for your filing scenario, you will not be eligible to contribute to a Roth IRA, and doing so may result in fines from the IRS. This is different than the Traditional IRA, which allows you to make contributions even if your income exceeds the phase-out range, however, you will not see any immediate the tax benefits.
Entrepreneurs will also find that they’ll benefit from certain changes as well, and potentially more than others due to their ability to use a SEP IRA account. The advantage stems from the fact that the overall defined contribution limit for everyone (so-called “wage slaves” and business owners, alike) has increased to $55,000 in 2018, up from $54,000 in 2017 and $53,000 the year before. So what is a SEP IRA? It’s a retirement savings account option that is available to self-employed individuals and small businesses, that may provide more benefits for these two groups, than traditional accounts. The drawbacks, however, tend to make this account type only advantageous for sole proprietors. The SEP IRA’s main advantage is that business owners can put aside up to 25% of their income (so long as the 25% doesn’t exceed $55,000) in a tax favorable manner as long as their compensation doesn’t exceed $275,000 in 2018 (up from $270,000 in 2016). If so, only $275,000 may be used in the calculation. It would be significantly harder for regular wage earners to save $55,000 given the 401(k) limit of $18,500, and IRA limit of $5,500. Even if we include the “catch-up” bonuses, it would still be difficult to reach $55,000 and we would likely some help from a generous employer match and profit sharing plan. The downside of the SEP IRA is that employees cannot make their own contributions, rather the company must establish the account and contribute to it, and the percentage of salary contributed to the plan must be consistent across all employees in most cases. This means that the owner cannot decide to contribute 25% of her income and only 5% of the income of her employees. The combined effect of these two negatives typically prevents small business from using this account type. They instead opt for Solo 401(k) plans, which are a hybrid of the typical 401(k) and SEP IRA accounts. Keep in mind that if you are eligible for an SEP IRA, you can still contribute to a 401(k) plan as long as you only have control over the company offering the SEP IRA. Contributions to a 401(k) should not limit the amount that you can contribute to an SEP IRA, so long as the combined amount does not exceed $55,000.
Regular Yield Goals readers should be familiar with my stance on retirement saving contributions: maximize, maximize, maximize! But right now you’re likely questioning whether it’s actually worth it to contribute the extra $500 each year. Socking away $18,000 each year is already tough enough, and you’ll likely need to spend half an hour on the phone with your plan administrator to reset your password if you haven’t accessed your account in a while, but the simple answer is absolutely! As mentioned above, the additional $500 you save each year should be worth significantly more when you finally withdraw it, and if you’re currently on a bi-weekly pay schedule, you’ll only be missing out on about $20 per pay period. Take a look at the illustration below to get a sense of just how much those additional dollars could be worth in the long run:
Those with 401(k) and similar plans should definitely take advantage of the $500 increase in the contribution limit: The limit increased from $18,000 in 2017 to $18,500 in 2018, and while the $500 per year may not seem like much now, over the course of your career it may provide an additional $100,000 or more for you and your family in retirement.
IRA (both Traditional and Roth) contribution limits have not changed: IRA limits remain at $5,500, the same as they were in 2017. However, the income ranges at which the tax benefits begin to phase out (and determine eligibility – in the case of the Roth option) have been increased. Everyone should re-visit these changes to see if they have become eligible for more benefits, and to make sure they aren’t still contributing to a Roth IRA that they are no longer eligible for – this may result in fines that can derail your savings plans for 2019.
The total defined contribution limit has increased to $55,000 in 2018: This is an increase of $1,000 over last year’s limit. While most of us can only dream of being able to put away $55,000 in any given year, those in business for themselves and working with family members or close friends should consider leveraging an SEP IRA to take advantage of the contribution limit increase.
Regardless of what you decide to do, be sure to refresh your memory on your employer’s matching program and be sure to at least put away that much. It’s a great way to get started if you’re new to investing, and it provides an almost risk-free, 100% return every year*.
The IRS’s contribution limits can definitely be tricky. If you have a question about any of the scenarios mentioned above, or another scenario that wasn’t mentioned, be sure to leave a comment below and we’ll do our best to simplify this convoluted topic.
*Assumes your employer and plan administrator do not lose solvency.