Boost Your Savings as Retirement Approaches
The purpose of catch-up contributions is to provide older workers with one last opportunity to increase their savings in the years leading up to retirement.
The IRS limits the amount individuals can contribute to 401(k)s, 403(b)s and other tax-deferred retirement savings accounts. In 2022, that limit is $20,500. Workers who have reached age 50 or older are permitted to contribute an additional $6,500, for a total of $27,000. IRAs have a maximum 2022 contribution amount of $6,000, with a $1,000 catch-up contribution (in 2023, those limits increase to $22,500 plus a $7,500 catch-up for 401(k)s and $6,500 plus a $1,000 catch-up for IRAs1).
Does it make sense to max out retirement plan contributions, including the catch-up? In many cases, the answer is yes. Even if you need to forego certain luxuries in the short term to make it happen, the benefits of catch-up contributions may be worth it for the following reasons.
#1 – Compound interest
Remember that your retirement savings have the benefit of compounding interest while growing for your retirement. As you add money to the account, that money should eventually grow, thanks to investment gains. As gains hit the account, they increase the balance and begin earning their own interest. Over time, this can add up to a significant amount. And compounding interest is even more impactful within a tax-deferred or tax-exempt retirement account, such as an IRA or Roth IRA. Not having to pay tax on dividends and capital gains allows more money to stay within the account to grow/compound.
By maxing out your retirement contributions, you’re increasing your savings by more than just your contribution amount. You’re also allowing for maximum compounding interest potential within your account.
#2 – Tax savings
Pre-tax contributions to a retirement account lower your taxable income in the current year, which can have a big impact on both your savings and your tax bill. Consider the following example.
Joe Worker is 50 years old and falls into the 35% tax bracket. He decides to contribute the maximum of $20,500 plus an additional $6,500 catch-up contribution to max out his 401(k). As a result, he saves $9,450 on his current year’s taxes ($27,000 x 35%). Not only is Joe better prepared for retirement but he has also significantly reduced his tax liability. That’s a win/win!
#3 – Roth catch-ups
Catch up contributions also apply to Roth IRAs and 401(k)s ($20,500 plus $6,000 for Roth 401(k)s and $6,000 plus $1,000 for Roth IRAs). Because contributions to these accounts are made after taxes, they don’t reduce your income in the current year. However, the benefits of contributing after-tax funds to a Roth account include tax-exempt growth of those assets within the account as well as tax- and penalty-free withdrawals after age 59 ½. Plus, unlike pre-tax savings accounts, Roth accounts aren’t subject to required minimum distributions (RMDs).
#4 – Employer match
Hopefully, you’re already contributing enough to your 401(k) to receive the maximum employer match. If not, now is definitely the time to increase your contributions. If you’re not taking full advantage of your company’s match, you’re leaving free money on the table. Even if you don’t reach the maximum contribution amount, make sure you’re receiving your full employer match.
#5 – Focused savings
Many people age 50 and older find they have fewer immediate expenses, such as children in the home, mortgage payments, etc. While it may have been difficult to max out your retirement plan contributions in your younger years, now may be a great time to redirect any extra funds toward your retirement savings. Once you retire, you’ll be glad you did.
Need some help saving in the years leading up to retirement? Creative Planning is here for you. Our teams specialize in helping clients make smart financial decisions. We take time to get to know you and understand your needs before implementing custom retirement planning strategies to help maximize your savings. To get started, schedule a call with a member of our team.