Beware Playing 401(k) Catch-Up Close to Retirement

Understanding the rules for ramping up 401(k) contributions is crucial for older workers.

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Severe economic recessions generally mean rising unemployment, but the recent downturn has been worse than most in one crucial way: the surge in long-term unemployment. According to the Bureau of Labor Statistics, the average period of joblessness has reached about 40 weeks, roughly three times the duration during the 2001 recession. As bad as that sounds, it's worse for people 55 and older. Their average unemployment duration has reached 56 weeks—19 weeks more than for people under 55.

Among other things, that means a nasty hit to an older person's retirement plan at a point when he or she can least afford it. According to Fidelity, the combined employee/employer 401(k) contribution averaged about $9,020 last year, or about $9,700 over 56 weeks. If you're a 55-year-old of average means who's aiming to retire at 65, forfeiting that much in contributions could cost you nearly $21,000 upon retirement (assuming 8 percent compounded growth, not adjusted for inflation).

[See Learn How to Spot 401(k) Fees.]

As everyone knows, time is a nonrenewable resource, and yet it's a critical factor in determining retirement-portfolio outcomes. (All else being equal, you're far better off investing $10,000 at age 25 than investing $50,000 at age 55).

Luckily, IRS rules provide older workers a way to make up for lost time. Unfortunately, to take advantage of it, you'll need to be either a very high earner or an unusually diligent saver.

The "catch-up" provision, introduced as part of the sweeping 2001 tax reform, allows workers age 50 and older to make 401(k) contributions in excess of the limit imposed on younger workers. (The 2001 tax cuts are to expire at year's end, but the catch-up provision became permanent in 2006.) This year, that means anyone who turns 50 by December 31 may contribute an additional $5,500 in pretax income beyond the annual contribution limit for younger people ($17,000 by law, although some plans have lower caps).

But catch-up contributions come with conditions attached. First, your plan has to permit them. That shouldn't be a problem for most workers: According to the Plan Sponsor Council of America (PSCA), 98 percent of all 401(k) plans do so, and a quarter of eligible workers participate. And while employers are not obliged to match catch-up contributions, 36 percent do, says the PSCA.

Most important, however: You must meet at least one of the standard contribution limits—either the employee maximum or the combined employee/employer maximum ($50,000 for 2012)—before you can start making catch-up contributions. That puts the catch-up option beyond the means of most 401(k) participants, only 5 percent of whom maximize their contributions, according to a 2011 report by the Government Accountability Office.

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Indeed, the GAO noted, the benefits of tax-favored retirement plans tend to go overwhelmingly to high earners. About half of the private-sector work force—the half where most low-income workers toil—have no retirement benefit at all. Among workers who had employer-sponsored plans in 2007 and maximized contributions, 72 percent were in the top 10 percent of earners.

IRS rules do constrain high earners in one way: Thanks to the principle of "nondiscrimination"—meaning plans must benefit rank-and-file workers, not just executives and owners—their contributions mustn't stray too far from those of the plan's average contributor. In practice, that can restrict high earners to contributions of less than $17,000. PSCA Vice President Ed Ferrigno says more than 30 percent of plans do this.

For most workers, though—particularly those just recovering from a stretch of unemployment—the catch-up provision is likely to provide little benefit. Analyst Jean Young of the Vanguard Group's Center for Retirement Research says 16 percent of Vanguard clients eligible for catch-ups are using them, up from 12 percent five years ago. There's "no way to know" how much of that increase stems from older folks re-entering the work force, she says, but likely not much. The maximum personal contribution—$22,500, including the catch-up increment—would represent a 45 percent deferral rate for someone making $50,000, which is about the median household income.