When you turn age 50, you become eligible to contribute more money to your 401(k) plan. The tax deduction you can claim on these catch-up contributions could save you over $1,000 on your annual tax bill.
Taxpayers can defer paying income tax on as much as $18,000 that they contribute to a 401(k), 403(b) and the federal government’s Thrift Savings Plan in 2015. Once you turn age 50 you become eligible to make additional catch-up contributions of up to $6,000 to your 401(k) plan, for a total of $24,000 you can temporarily shield from income tax.
The tax benefit of taking advantage of catch-up contributions can be huge. If a worker over 50 who is in the 35 percent tax bracket contributes the full $24,000 to a 401(k), he will reduce his current tax bill by $8,400, an extra $2,100 in tax savings. A worker in the 25 percent tax bracket who contributes the same amount would save $6,000 in taxes, $1,500 more than younger workers. Income tax won’t be due on the money in your 401(k) plan until it is withdrawn from the account. And if you drop into a lower tax bracket in retirement, you will pay that lower rate on the distributions.
But few people are able to save this much money in a 401(k) plan. A worker earning $100,000 would have to save about a quarter of his pay to take full advantage of catch-up contributions. And someone earning $50,000 would need to tuck nearly half of his income into a 401(k) to get the maximum possible tax break. Almost all 401(k) plans (97 percent) permit catch-up contributions, but only 16 percent of participants take advantage of them when they are offered, according to an analysis of Vanguard 401(k) plans. A 2014 Government Accountability Office report found that only 3 percent of 401(k) participants ages 50 and older contributed the maximum possible amount to their 401(k) plan.
It’s primarily people who are already relatively wealthy who get a tax break for making catch-up contributions to 401(k) plans. A Center for Retirement Research at Boston College analysis of Census Bureau data found that older workers who max out their 401(k) plan earn about $163,000 and have a net worth of $439,000, compared to earnings of $57,000 and a net worth of $200,000 among all older 401(k) participants.
The CRR analyzed how workers changed their savings habits when catch-up contributions were added to 401(k) plans beginning at $1,000 in 2002 and climbing to $4,000 by 2005. When workers age 50 and older were permitted to contribute an additional 6.8 percent starting in 2002, they increased their 401(k) saving by 3.5 percent.
The older workers who were bumping up against their 401(k) plan’s contribution limits were the primary beneficiaries of this change. Between 2001 and 2005, older workers who were already maxing out their 401(k) contributions boosted their savings by another 14 percent when they became eligible for catch-up contributions, CRR found. Their contributions increased by $1,697 in the years after catch-up contributions were added to 401(k) plans.
“Only those near the maximum respond to increased tax incentives to save in 401(k)s,” according to the CRR report. “While this group does not increase their contributions all the way up to the new limit, they appear to be quite sensitive to tax incentives to increase their 401(k) saving.”
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How to Take Advantage of 401(k) Catch-Up Contributions originally appeared on usnews.com