For some reason in the US we have retirement planning backwards. As we get closer and closer to retirement we try to squirrel away a few more dollars, but by the time we’re near retirement, it’s too late. Government policies exacerbate this problem with the concept of catch-up contributions.
Once you turn 50, the IRS allows you to contribute $6,000 more to certain retirement accounts; a 401(k), 403(b), SARSEP, and 457(b). You can also contribute an extra $1,000 to a traditional or Roth IRA. While you should take advantage of every savings opportunity available to you, if you’re serious about investing for retirement, catch-up contributions won’t save you.
What the IRS should allow is those in their 20s to make extra contributions tax-free. Since this group is potentially in the worst financial situation to contribute money towards retirement, it should have every incentive to do so. Here are a few scenarios.
Imagine a 27-year-old maximizes 401(k) contributions every year from age 27 to 65. We’ll assume the contribution limit never goes up, and she maxes out her contributions at $18,000 a year. Assuming a 7% return, this person would have $3,341,525.25 at retirement.
Now suppose starting at age 50 this person made catch up contributions of $6,000 a year. At age 65 the ending balance would be $3,508,853.57, a difference of $167,328.32.
Envision though at ages 27, 28, and 29 this person was allowed to make $6,000 “catch-up” contributions, instead of from age 50 to 65. This person would have $3,561,886.24 at age 65. They’d have more money despite investing $6,000 for 12 fewer years, $72,000 less invested in total.
The takeaway here is that a secure retirement is a young person’s game. It’s unlikely the government will ever change policies to encourage young people to stop spending and start investing, but you should understand that the more you save today, the less you have to worry about tomorrow.
To drive this point home, imagine a person that puts $6,000 a year ($500 a month) into a 401(k) starting at age 23. At age 67 they would have $1,714,495.87. If this same person started at age 50 and contributed the maximum of $18,000 a year, plus the $6,000 catch-up contribution, at age 67 they would have $815,976.78. The first person would have contributed a total of $264,000, while the second contributed a total of $360,000.
Think about that for a second. The first person has $898,519.09 more saved for retirement, despite saving $96,000 less.
For the 50-year-old investor late to the game, they’d have to invest over $50,000 a year, or $750,000 total, to have the same account balance as the 23-year-old who steadily invested $6,000 a year. That’s almost half a million dollars less spending money by delaying.
It doesn’t matter what your age is, it’s important that you start investing today. The investment decisions you make today will impact your life greater than the decisions you make tomorrow.