This is a tough time to be a retiree. Many investors getting close to retirement age are living in a "sandwich" generation. They may have elderly parents who they want or need, to support. And in some cases, they are subsequently trying to ensure their own children are successfully launched into the world. As retirement has gone from being a concept that will happen "someday" to a looming reality, the idea of a comfortable retirement may be moving to the front burner. The problem for many retirees is they simply don’t have enough money set aside for their retirement savings.
One of the ways that investors over the age of 50 can help set aside more money for their retirement is through catch-up contributions. This article will define catch-up contributions and review the benefits that go beyond just setting aside additional retirement funds, and provide examples of how catch-up contributions can add to a nest egg depending on the type of plan being used. The article will also look at some of the limitations that keep investor participation levels in catch-up contributions very small and review the role that a financial planner can play in determining an investor’s need for catch-up contributions.
What are catch-up contributions?
Catch-up contributions are deposits that are made above and beyond what is allowed in an employer-sponsored retirement plan. They are designated as catch-up contributions because they allow someone to “catch up” on an underfunded retirement account.
The catch-up contribution provision was created in 2001 through the Economic Growth and Tax Relief Reconciliation Act (EGTRRA). This was done as a way to help ensure that as the baby boomer generation was preparing for retirement they would have the ability to set ample money aside. The provision for catch-up contributions was originally set to expire in 2011, but the Pension Protection Act signed in 2006 made these contributions permanent.
How much can an individual set aside as a catch-up contribution?
The amount varies depending on the type of retirement plan. For 2019, the IRS has set the following limits:
- Individual Retirement Account (IRA) – An investor can make an additional $1,000 in catch-up contributions. This amount is unchanged from 2018. However, the limit for their standard contribution has been raised to $6,000 (a $500 increase from 2018). This includes savings in a Roth IRA. One note, Roth IRA contributions are not tax-deferred. However, the money that investors put into a Roth IRA can be withdrawn without penalty at a later date.
- 401(k), 403(b), most 457 plans and the U.S. Government’s Thrift Savings Plan – An investor can add up to $6,000 per year. This amount is unchanged from 2018. The limit for their standard contribution has been raised to $19,000 (this is also a $500 increase from 2018).
- SIMPLE 401(k) plans – An investor can make up to $3,000 in catch-up contributions. This amount remains unchanged.
Catch-up contributions provide additional benefits.
Although the most common benefit of catch-up contributions for investors is the ability to set aside more money for their retirement, there are additional benefits. A few of them are:
It can prompt an honest analysis of retirement savings– There is the old saying “You don’t plan to fail; you fail to plan.” When it comes to retirement, someone may think they are on track because they are following their plan. The problem is that these investors seldom think about how conditions in the broader economy may be affecting their long-term goals. What was a sufficient amount 15 or 20 years ago may not be sufficient today. Knowing they are eligible for a catch-up contribution can prompt many of these employees to take a close look at their retirement plan. Maybe they will find they are still on track. However, if they’re not, catch-up contributions are a good way to re-evaluate and contribute more if needed.
Employers may still match catch-up contributions– One of the most appealing parts of a 401(k) plan is the matching employer contribution. The ability to generate compounding interest off of what amounts to free money is a true no-brainer for investors. Although many employers will not match catch-up contributions, there are some that will and that can be a significant reason for investors to make catch-up contributions if they qualify.
There are tax advantages– Investors already know that the money they set aside in their 401(k) is tax-deferred. However, their catch-up contributions are also tax-deferred. This means they can defer up to $24,000 per year. Lower taxes can be particularly important for investors in a higher tax bracket.
Automatic savings is part of a disciplined investing strategy– The money that goes into a 401(k) plan is deducted from a paycheck. This means investors don’t have to take any additional steps to ensure that money is set aside for their retirement and that can be the difference between success or failure in meeting investment goals.
Do catch-up contributions really work?
One of the benefits of retirement plans is that they work on the principle of compounded interest. Over time, this can have a significant impact on your retirement savings. For example, if an individual were to begin contributing the maximum of $1,000 in their qualified IRA starting at age 50, here is a table that shows (to the nearest $1,000) how much their savings can grow assuming a 5%, 7%, or 10% annual return.
5% annual return - $26,000
7% annual return - $31,000
10% annual return - $41,000
If you are contributing the maximum to an employer-sponsored plan, the numbers are even larger:
5% annual return - $155,000
7% annual return - $185,000
10% annual return - $243,000
Remember, this is solely the growth from their catch-up contribution. It does not take into account the compound interest they can be achieved through their standard contribution. And by putting this money into their retirement plans, investors are potentially reducing their tax liability.
What are the limitations to catch-up contributions?
Catch-up contributions have so far remained more theoretical than practical. There are a few reasons for this. One reason is that a catch-up contribution is one that is made above and beyond the current limit to an eligible retirement account. This means that to be eligible for catch-up contributions, an investor must first be maximizing their standard contribution. In practice, few employees do. In fact, a study by the Center for Retirement Research put the percentage of employees who maximize their 401(k) contribution at 9%.
One of the reasons for this is that it's generally only the higher income employees who can afford to maximize their contributions (and want to reap the tax benefits). This means that lower-income employees who might benefit the most from catch-up contributions are generally not taking the maximum standard deduction and therefore are not eligible for catch-up contributions. A related issue is that, since the IRS increases the standard contribution limit, the max-out level can become a moving target for even well-intentioned investors.
A second reason that catch-up contributions are failing to gain traction is that the tax advantages to catch-up contributions make the most sense to upper-income investors. Lower income investors do not have as many tax incentives particularly since they may already eliminate their tax liability after their standard deductions. Also, lower income investor may find it to be more important to keep as much of their paycheck as they can. So even though they know they should be investing, they frequently are keeping their deductions to a more comfortable amount.
A third reason why catch-up contributions are not being used as extensively as first believed is that they are limited to investors over 50 years of age. Since this demographic tends to be more inclined to save, they may face less of a need to utilize catch-up contributions. Younger workers, however, who have more disposable income, might be more willing to make larger contributions earlier – before a family and other responsibilities – but the option is not available for them.
Are catch-up contributions for everyone?
The simple answer is hopefully not. But to be sure, investors should consult a qualified financial advisor to get a retirement checkup. In some cases, if investors start early enough, they will be well on track to meet their retirement goals without needing catch-up contributions. However, in some cases, even if an investor does not max out their catch-up contributions just adding a little bit can help offset potential unforeseen events that may put their carefully laid out retirement plan in jeopardy.
The bottom line on catch-up contributions
If every investor were maximizing the amount they could save for retirement, there would be no need for catch-up contributions. However, the reality for most investors is that they are not where they want to be and are looking to save more. Advances in health care mean that retirees are living longer and with a better quality of life. They may also be living longer with a variety of medical conditions that require them to have funds beyond the limitations of their fixed income. Other investors who are at, or nearing, retirement age are finding themselves being squeezed by the needs of aging parents and their desire to support kids who are launching their own lives.
Catch-up contributions are one way that the IRS is allowing investors over the age of 50 to make additional contributions to qualified retirement plans above and beyond their normal plan limits. The amount of these contributions varies depending on the type of plan with investors who participate in an employer-sponsored 401(k) plan having the ability to put in the largest catch-up contribution of $6,000 per year. This is in addition to their standard contribution which has been increased to $19,000 in 2019.
Because of the power of compounding interest, even a small catch-up contribution can have a large impact on an investor’s retirement savings. Still, there are other reasons why investors may want to make catch-up contributions. One reason is that they may be able to reduce their taxable income. This is important for high-income investors who can reduce their tax bill. Another reason is that some employers will match catch-up contribution dollars as well as their standard contribution and another is that even by simply looking into catch-up contributions investors may be able to determine whether their retirement plan is on track.
Catch-up contributions are made above and beyond a standard deduction. This is seen as one potential limitation since it favors higher-income investors who may have the means, and the tax incentive, to save more. Another potential limitation is that by being available exclusively to investors over the age of 50, catch-up contributions cater to a generation that is already saving more. Younger investors who may have the means to put away more, particularly single investors or married couples without children, do not have this option.