Online Extra: Playing Catch-Up Can Be Good for You

With the tax law allowing folks nearing retirement to sock away extra money finally in place, here's what you need to consider

Don't be surprised if your employer starts encouraging you to contribute more to your 401(k). Congress' 2001 tax cut increased the amount of money that people nearing retirement can contribute to their retirement accounts. The "catch-up" provision allows people 50 and older to contribute an additional $2,000 beyond the regular maximum of $12,000 to a 401(k) or to a nonprofit or government employer's retirement plan. It also provides for an additional $500 beyond the regular limit of $3,000 to an IRA.

Why might you now be hearing about a tax-law change that's two years old? Final regulations -- which affect companies with the plans, not the individuals who invest in them -- were issued only on July 8, 2003. David Wray, president of the Profit-Sharing Council of America, which represents employers with 401(k) plans, says 88% of the companies surveyed by the Council had set up a mechanism for the catch-up contributions by the end of 2002. But in many cases, employers may have postponed full implementation until the regulations were set. Now that they are, Wray expects companies will start promoting the catch-up option more aggressively.

Indeed, many companies haven't been promoting them at all. Mari Adam, a financial planner in Boca Raton, Fla., says although the catch-up provision has been around for a couple of years, "roughly half" of her clients who have asked their human-resources department about it "couldn't get a clear answer, meaning they were not aware of the provision...or had not put anything in place" to allow employees to make the catch-up contributions.

WEIGHING OPTIONS.

  Who's eligible to play catch-up? If your employer's retirement plan operates on a calendar year, you'll qualify if you turn 50 anytime that year. If the plan operates on a noncalendar year, you'll be eligible to make a catch-up contribution on Jan. 1 of the year you turn 50. Though the law was passed two years ago, it's possible your employer didn't put such a plan in place, because it's not mandated.

Even with half the year over, you can still take full advantage of the opportunity for extra savings. But before rushing to put additional money into your retirement accounts, you need to figure out if it could be put to better long-term use.

Adam has a client she says "would be crazy not to take advantage" of the catch-up rules. "She's in her late 60s, working in a sales job where her income is variable," earning $80,000 to $90,000 in a good year, and paying about a third of it in taxes. This client needs both immediate tax deductions and retirement savings, so Adam strongly recommended that she use the catch-up option. Anyone who makes a catch-up contribution to an employer plan or traditional IRA receives a tax deduction for it that year. (The money you put in a Roth IRA is taxed as income when it goes in, but not when you withdraw it.)

DOSE OF DISCIPLINE.

  In the past, it has been a no-brainer to save for retirement in a tax-deferred account if you had the opportunity. However, with the capital-gains tax rate down to 15% under the tax law passed this year, Adam says you should carefully consider whether to save that extra $2,000 or $500 in a taxable account instead of your 401(k) or IRA.

Here's why: The money you save in a 401(k) or traditional IRA will be taxed at your income-tax rate when you take it out, usually after you retire. If your tax bracket turns out to be higher than 15% at that time, saving in a taxable account and paying capital-gains tax instead could turn out to have been a better financial decision.

On the other hand, Adam points out, the key to saving is discipline, and "most people need the discipline of periodic savings to meet their goals," so she thinks most people should use the tax-deferred accounts.

WHAT COMES OUT.

  Another catch-up consideration: Do you have an emergency fund? Retirement accounts aren't the most liquid, regardless of what kind of investments you have. If you lose your job or have another emergency, you could end up paying a penalty of 10% plus income tax on funds you withdraw early.

If you decide that making a catch-up contribution this year makes sense for you, start by asking if your employer has a plan. If not, you and your colleagues may want to lobby for one. Then, to save the additional $2,000 in 2003, you'll need to arrange to have an extra $400 per month withheld from your paychecks to get the maximum. The process is simpler for people with an IRA: Just deposit up to $500 in catch-up money by April 15, 2004, or whenever you pay your 2003 taxes.

What's the payoff for these extra savings? Adams calculates that if you save $2,000 above your regular 401(k) contribution annually from age 50 through 65, with a 9% annual return, you'll end up with an extra $66,006. For the extra IRA contribution of $500 for each year, you'll reap $16,502. (These figures do not reflect taxes on withdrawals, nor the higher contributions that you would be able to make after 2003.)

While this amount of additional savings may sound modest in comparison with the proceeds of the contributions you've made over a 30-year career, they still represent a doubling of the actual amounts you put in the account -- $32,000 for the 401(k) and $8,000 for the IRA. And the comfort that extra stash will give you during retirement will probably exceed the pleasure you would've gotten frittering it in spending during your working years.

By Ellen Hoffman, who writes Your Retirement for BusinessWeek Online and is the author of The Retirement Catch-Up Guide and Bankroll Your Future Retirement with Help from Uncle Sam. You can contact her through her Web site, www.retirementcatchup.com

Edited by Patricia O'Connell

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