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Should I Invest Part of My Bonus in My 401(k)?

Q: Should I elect to put my bonus into my 401(k)? I've heard conflicting advice, but I don't understand the downside.

A: You're thinking along the right lines here--the goal in retirement savings is to sock away as much as you can reasonably afford to.  

But one potential issue with investing a percentage of your bonus, especially if you are a higher-income employee maxing out your 401(k), is that it might cause you to hit your annual contribution limit--currently $19,500 ($26,000 if you are 50 or older)--before the calendar year is up. And if you hit the $19,500 cap too early in the year, you could miss out on company matches in the later months. 

To illustrate, let's say you earn $200,000 and you are under age 50 (not eligible for catch-up contributions). By contributing 10% of your annual salary, you can stretch your contributions all the way into December. If you contribute any amount less than 10% you will not have contributed up to the $19,500 maximum by December. If you contribute more--let's say 15%--you will have already maxed out your $19,500 maximum contribution somewhere around the beginning of August, so you would miss out on collecting more than four months' worth of employer match. 

In the example above, 10% is the sweet spot in terms of 401(k) contribution percentage, where (depending on your salary) you are not exceeding the annual IRS contribution limit before the end of the calendar year, which will also allow you to also nab the full employee match. If your plan provider doesn't provide one, you can try one of many online calculators to help figure out your own sweet spot.

But also be aware that not all plans work this way--some plans match aftertax contributions or include provisions that "true up" or reconcile the employer contribution to make sure employees get the maximum potential match. If you're not sure how your plan works, ask your benefits department or consult the plan document.

Q: Can you be phased out of contributing to a 401(k) if you make too much money?

A: No, and yes (sort of). It's not quite the same as an income limit, such as what a Roth IRA imposes, but it is possible that a high income will limit your contribution flexibility. 

As discussed above, the maximum amount of pretax salary contributions an employee can make in 2020 is $19,500 ($26,000 if over age 50). Total contribution, which means the contributions from the employee plus contributions from the employer (such as a 401(k) match), cannot exceed $57,000 ($63,500 for savers over 50). 

How this all comes together depends on the terms of your plan. Some 401(k) plans allow you to contribute to your 401(k) until you've contributed a total of $19,500, even if you've already made more than $285,000 in compensation for the year. (If you make $480,000, or $40,000 per month, you will have earned $285,000 in year-to-date compensation sometime in August).

In other cases, you cannot contribute when you've earned more than the $285,000 limit, which means you would have to stop contributing in August. If this is the case with your plan, you will want to make sure you right-size your contribution so you can take full advantage of your 401(k).

The rules pertaining to matches are more straightforward, however. Any amount over $285,000 cannot factor in to the bonus calculation. 

Here's how the IRS explains this: Say you earn $400,000 and your plan matches 50% of the first 5% you contribute to your 401(k). Plugging in the numbers, you would expect to get a match of $10,000 ($400,000 x 5% / 2). However, you can only factor in up to $285,000 of compensation when applying the matching formula for 2020, so the maximum employer match you can get is $7,125 ($285,000 x 5% / 2).