Saving enough money for retirement is incredibly difficult. Many questions simply remain unanswerable – how long will you live for, what health problems will you have, and how will the markets behave?
That’s why it is essential to fully utilize the available tools and programs, such as tax-advantaged retirement accounts, optimized Social Security benefits, and Medicare.
Enter catch-up contributions—another powerful tool designed to supercharge your retirement savings once you reach the age of 50. By fully maxing out your retirement accounts, you’ll likely have a significant cushion that can make a considerable difference in your overall retirement readiness.
If you often read our articles and newsletters, you’re likely well aware of catch-up contributions. But for those who aren’t, we’ll break them down.
A catch-up contribution is the extra money those aged 50 and above can contribute to their retirement accounts beyond the standard annual contribution limits. While useful for everyone, they’re particularly relevant to those who got a late start saving for retirement.
The Internal Revenue Service (IRS) sets a maximum limit on the amount that you can contribute to various retirement accounts such as 401(k)s, 403(b)s, and Individual Retirement Accounts (IRAs). These are what we refer to as regular contributions. For example, in 2023, the limit for regular 401(k) contributions is $22,500.
Catch-up contributions, however, come into play once you reach 50. In 2023 you can contribute an additional $7,500 to your 401(k) as a catch-up contribution, bringing the total maximum contribution to $30,000.
The concept of catch-up contributions is relatively modern, tracing its origins back to the turn of the 21st century as part of a broader effort to encourage retirement savings among older Americans.
Unfortunately, many individuals might be behind on their retirement savings as they approach their 50s and 60s for various reasons- financial challenges, life events, or simply a lack of foresight in earlier years.
The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) first introduced catch-up contributions. The aim was clear: to provide individuals aged 50 and above an opportunity to make additional contributions to their retirement accounts, enabling them to ‘catch up’ and boost their retirement savings. Before EGTRRA, once you hit the contribution limit for your retirement account in a given year, you had to wait until the following year to contribute again.
Meet Susan and John, both 50 years old, who have been diligent savers throughout their working lives.
By the time they reach the age of 50, Susan and John have accumulated $600,000 in their retirement savings. They’ve been contributing to their 401(k) plans at work and have also been making regular contributions to their Individual Retirement Accounts (IRAs).
As they enter their 50s, Susan and John decide to take advantage of the catch-up contributions provision in both the 401(k) and IRA rules.
Assuming they both continue to max out their contributions, including catch-up contributions, for the next 15 years and that their investments grow at an average annual rate of 6%, here’s how their savings would grow:
At age 50, their combined retirement savings is $600,000. Each year, they contribute an additional $30,000 (each) to their 401(k)s and $7,500 (each) to their IRAs, for a total annual contribution of $75,000.
Now let’s take a look at Jim and Shelly, good friends of Susan and John. Jim and Shelly have also grown their nest egg through diligent saving and investing. However, at 50, they opt out of catch-up contributions, figuring they’re already on a great path to retirement.
They also start with $600,000 at age 50 and contribute the regular maximum allowed to their 401(k) and IRA, which comes out to $58,000 a year, for the next 15 years, with an annual return rate of 6%.
Their retirement savings would grow to approximately $2,787,848 by the time they turn 65.
The difference is an astounding $395,785.
Ok, you may be thinking that $395,785 isn’t that much of a difference.
Let’s put it this way: your nest egg doesn’t suddenly stop growing once you retire. Yes, you’ll likely be getting a lower rate of return as you put more of your funds into more conservative assets, but most of your funds will still be invested in some way or another.
And having an extra $395,000 to grow at a compound rate will provide an excellent cushion against things like down markets and inflation. You’re giving your savings the potential push they need to endure challenging times.
Let’s hit the point home with inflation and the later years of life.
With a 3% inflation rate, a post-retirement growth rate of 4%, a monthly retirement income of $6,500 (or about 61% of pre-retirement income), and a life expectancy of 95, catch-up contributions will lead Susan and John to the ripe old age of 95 without running out of money – though it will be close. They can expect to pass on a humble legacy of about $40,000 in assets (not including material possessions).
Let’s look at Jim and Shelly, though. If they would also like a retirement income of $6,500 like their friends, they’ll run out of money at 91. In fact, they’ll be about… $357,000 short. Where will they get the funds to live another four years?
Basically, the older you get, the more critical those catch-up contributions become. So, Jim and Shelly have a few options – reduce their retirement lifestyle or continue working. Too bad they hadn’t taken advantage of those catch-up contributions!
Our opinion is that we should take advantage of tax-advantaged accounts to the fullest. The benefits they give you are just too much to ignore.
Catch-up contributions have been a lifesaver for millions of Americans, and there is no guarantee that they will always be available. It may be difficult at an emotional level to ‘sacrifice’ those funds in your fifties and early sixties, but your older self will definitely thank you!
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