How Do 401(k) Catch-Up Contributions Work?

If your employer offers you a 401(k) planthis can be a very effective way to save for retirement. The money you put into your plan is deferred tax, so you won’t pay income tax for the year you earn it. Instead, you will be taxed on exit from your 401(k) account during your retirement. Since most people are in an inferior situation tax bracket retired than when working, it can save you a lot of money.

There are annual limits on how much you can contribute to your 401(k) account. In 2022, the limit was $20,500. However, people aged 50 and over can bring catch-up contributions. Making those catch-up contributions can make all the difference when it comes to retiring comfortably. In this article, we’ll tell you how you can make them and why you should.

Understanding catch-up contributions

There are annual limits to the amount you can contribute to your 401(k). In 2022, for people under age 50, this limit is $20,500. This limit applies to all 401(k) plans you have, including any Roth 401(k) accounts. It includes all optional employee salary deferrals and all after-tax contributions made to a designated Roth account under your 401(k) plan or a special Roth 401(k) plan.

The same contribution limits apply to 403(b) plans and more 457 packagesas well as the federal government Savings Scheme (TSP). However, contributions you make to any other type of pension plan, such as a traditional Where Roth Individual Retirement Account (IRA)), does not count towards the limit.

The only exception to this is once you reach 50. At this stage, to encourage workers close to retirement to accelerate their savings, the Tax Service (IRS) allows 401(k) participants age 50 and older to make additional contributions beyond the standard contribution limit. If you’re 50 or older, you can make an additional 401(k) contribution of $6,500 per year.

This is called a catch-up contribution, and it applies from the beginning of the year to those who reach the age of 50 at any time of the year. So even if you turn 50 on New Year’s Eve, you can still make that extra contribution for it. taxation year.

Why you should make catch-up contributions

There are a number of benefits to making catch-up contributions, and these are largely similar to the more general benefits of a 401(k) plan. By choosing to contribute more to your 401(k), you further reduce your tax bill. If you are in a relatively high tax bracket, these savings can be significant: if a worker age 50 or older who is in the 35% tax bracket contributes the full $27,000 to a 401( k), he will reduce his current tax bill by $9,450, an additional tax saving of $2,275 compared to no catch-up contributions.

Also, if you start putting extra money into your 401(k) at age 50 and don’t retire until age 65 or even older, it can increase the value of your retirement. wallet significantly. You’ll have saved nearly $100,000 more over those 15 years, and that amount could grow even more in retirement, depending on how the economy performs and how your money is invested.

That said, contributing $27,000 a year to a 401(k) is overkill for many people. Even a worker earning a relatively generous salary of $100,000 a year should set aside a quarter of their income, and someone earning $50,000 a year probably won’t be able to set aside half their income for retirement. .

This is confirmed by the data. Almost all 401(k) plans (97%) allow catch-up contributions, but only 15% of participants take advantage of them when offered, according to an analysis of Vanguard 401(k) plans. It is primarily workers with high incomes and large account balances who are able to make catch-up contributions, Vanguard found.

In other words, if you’re already earning a good salary, are on track with your other financial goals, and are hitting the 401(k) contribution limit, catch-up contributions may be worthwhile. However, the majority of workers simply do not earn enough to take advantage of the increased cap.

The essential

Workers age 50 and older have a higher annual 401(k) contribution limit than their younger peers. In 2022, this catch-up contribution is $6,500, which means people age 50 and older can contribute a maximum of $27,000 to their 401(k) for that year.

If you’re already making the maximum contribution to your 401(k) and can afford to increase it, making catch-up contributions can save you a lot of tax money. However, the majority of workers simply don’t earn enough to contribute $27,000 a year to their retirement portfolio, and only 15% of 401(k) participants take advantage of catch-up contributions.