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Flex Your 401(k): Maximize Your Contributions

Congress made permanent higher limits that were set to be rolled back in 2010.

Editor's note: As a special feature for Feburary,

offers a four-part series on 401(k) plans designed to help you maximize your retirement savings. Today is Part 1. Here's Part 2. Here's Part 3.

Do you have a 401(k) plan? That is one of the questions most frequently posed by prospective employees at job interviews. Increasingly, the answer is yes.

Traditional pension plans have become virtually extinct, at least for new hires. But 401(k) plans, which allow employees to have a portion of their wages paid directly, or "deferred," into tax-advantaged investment accounts, are booming. Employers love them because they shift most of the cost of saving for retirement to employees themselves. Companies can even pass along some of the administrative costs.

The good news is that Congress has preserved higher annual contribution limits that were set to expire in 2010. In 2007, employees can contribute $15,500, and those aged 50 or older can contribute an additional $5,000 for a total of $20,500. Going forward, the limits will be indexed in $500 increments to inflation.

It goes without saying that the most important way you can maximize your retirement income through a 401(k) is to contribute as much as possible. Putting aside just a few thousand more dollars each year can translate into hundreds of thousands of dollars in additional funds by the time you're ready to retire.

"Now, more than ever, people's financial future is in their own hands," says Gary Schatsky, an attorney, CPA and former chairman of the National Association of Personal Financial Advisors. "A 401(k) plan allows a worker to save for retirement while deferring taxes on the saved money and earnings until withdrawal. In addition, it can act as forced savings and be the basis for your retirement future."

These retirement plans may not be for everyone; some people don't need to save for retirement, and others may feel they can't spare the funds. But Schatsky says most should contribute to their 401(k) but don't. "You need to look at your tax bracket, your cash situation and whether or not there is a company match," he says.

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The planner notes that for people in a 35% tax bracket, contributing $1,000 to a 401(k) plan will only remove $650 from your paycheck.

At a minimum, he says, you should aim to contribute as much to your plan as your employer will match, since these matching funds are essentially "a pay raise."

But contributing the maximum amount can have a powerful impact on your income in retirement. Adam Meyers, vice president and director of the benefits practice in the New York marketplace for Hay Group, provides the following example: If a 30-year old hired on Jan. 1 at a salary of $100,000 were to contribute 2% of his salary a year, he would have $406,663 in his 401(k) plan by age 65, assuring him a monthly income in retirement of $3,183.

But by raising his contribution to the maximum, the same person could increase the assets in his plan at age 65 to $3.15 million, resulting in a monthly income of $24,663. This assumes he earns 7% a year on his portfolio.

The Pension Protection Act of 2006 also made it easier for companies to automatically enroll employees in their 401(k) plans, increase their savings over time and put their assets in suitable long-term investments. That means more workers are likely to participate in their plans, and those who do are likely to grow their retirement savings faster than they would in a low-yielding money market fund, the typical default option.

A recent survey of 146 large U.S. companies by Hewitt Associates, a human resources consulting firm, indicates that more than half of them plan to automatically enroll employees in 401(k) plans by the end of the year. And almost one-fifth of companies that already offer automatic enrollment plan to increase the default contribution rate, while more than two-fifths plan to change the default option to either balanced funds, which combine stocks and bonds; life-cycle funds based on a worker's target retirement date; or managed accounts.

Still, you're unlikely to maximize your retirement savings by relying on your employer to enroll you.

Watch for three more steps to fixing your 401(k) in the next few days.

Steve Viuker is a Brooklyn, N.Y.-based business and finance writer. He has been published in The New York Post, The New York Times and other national publications.