If You Can Make Catch-Up 401k/IRA Contributions, Should You?

For 401k and IRA accounts, there are annual contribution limits of $19,500 and $6,000 respectively. However, if you
are 50 years old or older, you have the option to make "catch-up" contributions of an additional $6,500 to a 401k (for a total of $26,000), and an additional $1,000 to an IRA (for a total of $7,000). Many people will be fortunate just to save the initial contribution amounts, but the question is, if you have the financial ability to also make the catch-up contributions, should you? Or is there a better use of that money?

The advantage of contributing as much as possible to 401k/IRA accounts is well known - contributions to Traditional 401k's/IRA's are tax deductible in the year they are made, and no tax is owed on the principle or any capital gains until the money is withdrawn. Contributions to Roth accounts are made with after-tax money, but any capital gains are not taxed even when the funds are withdrawn. This is a huge opportunity, especially when you consider the effect of compound interest over many years of having those funds invested. So why wouldn't you also try to make catch-up contributions? The biggest consideration is whether or not the rest of your financial house is in order, and if you have other important financial goals to achieve:

• Do you have at least 6 months (a year is even better) of living expenses easily available in a liquid account? Being adequately prepared for an emergency will help prevent the need to harm your retirement savings by taking premature withdrawals that will incurr penalties and additional taxes when you can least afford them.

• Have you eliminated high-interest debt from credit cards, personal loans, auto/boat loans, etc.? If you have any debt that is costing you more than you would earn from investments in a 401k/IRA you may be better off eliminating that debt before making catch-up contributions, saving you from losing money on interest and giving you the ability to save more going forward.

• Are you prepared to meet shorter term goals such as: saving for a house, paying for a significant home repair (e.g. a new roof, exterior painting, etc.), having a child, paying for a child's education, paying for a new(er) car when needed?

• Do you have the personal legal documents you need (e.g. a will, power of attorney for finances and health care, a healthcare directive in case you are incapacitated, possible trusts to help protect your assets. etc.)? Having these types of documents prepared by an attorney can cost thousands, but are essential.

• Are you contributing to a Healthcare Savings Account (HSA), if eligible? Contributions are tax deductible and withdrawals may be used tax-free for health expenses at any time, forever. You can contribute up to $3,550/year ($7,100 if married) and an extra $1,000 if over age 55. Balances may also be investable, helping these accounts to act as a "health care IRA". You can see all HSA rules at the I.R.S. web site www.irs.gov.

• How familiar are you with the details of your 401k plan at work? If it has excessively high fees, or a poor selection of investment choices, you may be better served by contributing only enough to qualify for the company match and then contributing to other tax-deferred options (like an IRA or HSA), or even using after-tax money to contribute to a Roth account, if eligible.

A common premise for contributing to a 401k/IRA is the tax deduction that you receive when you make the contributions, the possibility that you will be in a lower tax bracket when you withdraw those funds in retirement, and qualifying for matching funds from your employer. Those are certainly valid points, with receiving "free" money from your employer being the most important, but they may not always be quite as advantageous as they seem. If any of the considerations listed above apply to you, they are just as important to resolve, even if you miss out on an initial tax deduction. Here's why - having your entire financial house in order will benefit you in a variety of ways over the long term far more than a tax deduction.

Also, remember that if you invest after-tax money (outside of a Roth account), long term capital gains are usually taxed at a rate of 0%, 15%, or 20% (short term gains are taxed at ordinary income rates). When you withdraw funds from a 401k/IRA (after age 59 1/2) you will be taxed at your current tax rate. If you are retired, those rates are likely to be in the 0% or 15% range as long as you don't have a large amount of other income. This means that whether you withdraw 401k/IRA funds, or sell long-term investments that are not in tax-deferred accounts, they will likely be taxed at a similar rate. This mitigates one advantage of contributing to a 401k/IRA, and adds the advantage of investing the funds however you like (not just having to choose from a limited selection of choices). Before age 59 1/2, there would also be no early withdrawal penalties, although withdrawals before this age should only be done as a last resort.

This is not to suggest that you are better off contributing less to a 401k/IRA, or only up to the amount needed for a company match, only that other financial priorities can be just as important as catch-up contributions, and the "loss" of some tax deductions can be offset in the future by being better financially prepared and/or by investing in non tax-deferred accounts when it makes more sense. Withdrawals in retirement, either way, will likely be taxed at a similar rate, and the flexibility of having more investment options may allow you to generate a greater gain, or at least make you feel more comfortable with your investments. The most important benefit is ensuring that you have all your financial bases covered as well as possible, rather than focusing only on contributing as much as possible to one type of account. The more options you have, and the less restrictions, the better.

So, if you are able to make catch-up contributions to a 401k/IRA, should you? Maybe. First, make sure that you have a solid financial foundation in place. Then assess the quality and flexibility of your employer's retirement plan. If you still have other essential financial goals to address (not a vacation, new car, or bigger house!), or your 401k plan is not top notch, you probably have better options than making catch-up contributions.


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