It's a paradox of the retirement system: the government encourages people to save money for retirement, and yet puts limits on how much you can contribute to retirement plans in any given year. To save for a comfortable retirement, you have to push those limits to their maximum.
Making up for lost time
For 2015, the IRS has imposed a limit of $18,000 on most 401(k) plan contributions. On the surface, this seems generous enough. If you started saving at age 25 and contributed $18,000 a year every year until retirement 40 years later - with an average annual investment return of 6 percent a year - you would build a retirement nest egg of $2,869,287.
That sounds pretty nice until you consider that adjusted for inflation, that would probably work out to be the equivalent of about $879,600 in today's dollars. Stretched over 20 or 30 years, that should be enough to fund a comfortable but not lavish retirement.
Unfortunately, the reality is that few people hit the ground running by making the maximum 401(k) contribution as early as age 25. Usually they start slowly, and then ramp up their contributions as their salaries rise - and as the reality of eventual retirement starts to come into focus. So, consider a more realistic scenario, where a person contributes nothing in his 20s, $9,000 a year in his 30s, and then $18,000 a year for the remaining 25 years.
Those sub-par contributions in the early years would be enough to cut the accumulated nest egg nearly in half, to an inflation-adjusted $472,586. This starts to look a little thin when you think about stretching it out over 20 or 30 years.
In a perfect world, one would avoid getting off to a slow start in saving for retirement, but the reality is that early-career incomes often make this a necessity. In any case, if you did get off to a slow start, there's nothing you can do about the past. The real solution is figuring out how to make large enough contributions later on to make up for lost time. To do that, you need to push the retirement saving limits every way you legally can.
Here are four tips for getting the most out of retirement savings limits:
1. Move with annual contribution limits
In the examples given above, an employee was shown to max out his 401(k) plan contributions at today's limit of $18,000. However, that limit has been adjusted for inflation over time, and is likely to continue to be raised in the future. The problem is that too many people set their contribution levels and forget them. If you want to make the most of 401(k) plan contributions, check the limit every year and reset your contributions when the limit is raised.
2. Save with a traditional IRA
If you do not have a 401(k) retirement plan at work, you can contribute up to $5,500 to a traditional individual retirement account and deduct this contribution. This is better than nothing, but obviously your saving potential is greater if you can participate in a 401(k) compared to an IRA. Again, IRA contribution limits change over time, so check each year that you are getting the most you can out of that year's limit.
3. Look into catch-up contributions
Recognizing that people nearing retirement often need to make up for lost ground in retirement savings, the IRS allows people aged 50 and over to contribute an extra $6,000 a year to a 401(k), so when you reach that age, you can actually put a total of $24,000 a year into your 401(k) plan. For traditional IRAs, there is an extra $1,000 allowed, bringing the total contribution for people aged 50 and over to $6,500.
4. Take advantage of Health Savings Accounts (HSAs)
Contributions to an HSA are free from taxes as long as you ultimately spend the money on legitimate health care expenses. People often look at HSAs as a way of funding near-term health care expenses, but you can also build up savings for future health care expenses. Given that health care is often a major expense in retirement, building your HSA balance can be a good way to augment your retirement nest egg. To participate, you must be enrolled in a high-deductible health care plan, and the annual contribution limit for an individual is $3,350.
Saving for retirement is like any other situation where you have a lot to do in a limited amount of time - you may have to push the pace a little bit to make it work. By pushing retirement savings limits to the max, you can help build the nest egg you need.
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