For many Americans, financial security in old age will ultimately depend on whether or not enough money has been set aside to last throughout the duration of retirement. The best way to accomplish this is to begin saving as early in one’s professional life as possible but many individuals do not, or for a variety of reasons cannot, seriously start saving for retirement until much later on in their careers. For these people, the best option is to significantly increase their rate of saving in order to try to make up for the lost time (compound growth). This strategy can be effective but it can also run into a few obstacles when using popular tax-advantaged plans.
Indeed, the tax code encourages individuals to save using a 401(k) plan but there are limits to what can be contributed each year ($18,000 per annum under current law). Once a person reaches the age of 50, though, an additional $6,000 per year can be contributed to his or her 401(k) plan (along with an extra $1,000 per year for Individual Retirement Accounts (IRAs)). The annual ceilings for both regular and catch-up contributions are occasionally raised in order to keep up with changes in the cost of living, i.e. inflation, but many people in Congress and the financial services industry have argued that these limits should be increased at a faster pace. The general argument against this is that a higher ceiling is not particularly needed since few Americans actually contribute anything near the annual limit. For example, one study from the Center for Retirement Research at Boston College found that just 9 percent of the individuals they examined who participated in a 401(k) plan made annual contributions that came within 10 percent of the limit.
However, this same study also found that raising the contribution ceiling can in fact have an outsized effect on at least one cohort of savers, i.e. those over age 50 and near the maximum contribution level. For this group, every 1-percentage-point increase in the tax-deferred limit was found to result in a nearly one-half of a percentage point increase in contributions. As the researchers explained: “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.” Most other groups were not found to be nearly as sensitive to increases in the deferral ceiling but it seems unlikely that higher contribution limits would hurt these Americans either. Perhaps another takeaway from this study is that plan sponsors should explore ways to boost workers’ savings rates, e.g. auto-escalation, since the majority of participants are likely not contributing as much as possible.
Sources: Center for Retirement Research at Boston CollegePost author: Charles Couch