Here's a hard truth: you should max out your retirement accounts as early and often as you can. Having money in tax-protected accounts gives you piece of mind now, and a cushion in case of unplanned issues and bumps in the future.
The Failure to Contribute Is Costly
We once read a piece in Bloomberg claiming the 401(k) "crisis" is getting worse. To wit:
Tim Egan has been working since he was 14. He’s now 56 and has spent most of his career as a restaurant manager. He has virtually nothing saved for retirement and, until last month, never had a 401(k) account.
In the article, we learn Mr. Egan also did not open an IRA until his 40s, only to chase stock returns in 2008 and (apparently) leave his investment in cash in the subsequent recovery, missing the gains.
As his IRA was then worth around $20,000, we know he'd been investing since at least 2008. That means he hadn't been maximizing his IRA contributions.
Even if only in cash, he would have had a higher balance.
Mr. Egan's story looks to have a happy ending - he landed a job with a 6% 401(k) match. At this point, he's probably doing much better on the retirement front.
But, as always, let's find the takeaways:
- You should max out your retirement accounts as early and as often as you can
- Even if you don't have access to a 401(k) (or 403(b)/similar), you should take advantage of IRAs
Of course, after that you should save outside your tax-advantaged accounts. But even if you don't you will be in fine shape.
Can you make up for missed contributions later?
We once wrote that You Need to Have Savings In Your 20s. While that is undoubtedly true, the importance of savings in these tax-advantaged accounts is exponentially more important in your 20s!
Here's the thing (for our American readers):
Once you miss a year, you will never be able to go back and catch up.
That's right - if you suddenly find yourself with a windfall, you will be unable to go back and make the contributions you 'missed'. That window is broken, and you've got no way to fix it... there's no way to max out your retirement accounts for past years.
As it stands today, our tax code in the United States works under the principal of use it or lose it. If you only made a $500 IRA contribution in 2013, you don't have the chance to go back today and max it out - it's over.
For this reason alone, you should max your accounts today – or come as reasonably close as you can.
Of course, there is another way that you may be blocked from contributing: you may eventually make too much money to qualify!
What about catch up contributions?
Catch-up contributions are a provision in the tax code that allows folks 50 years old and older to make larger than normal contributions to their 401(k)s and IRAs and other similar accounts. (See the history of 401(k) contribution maximums)
For 2019, this meant a 50 year old worker can make a $19,000 contribution to their 401(k) or 403(b), and an additional $6,000 in catch up contributions. For IRAs, it worked out to a $6,000 contribution plus an additional $1,000 catch-up.
Although catch-up might sound like you can contribute to past year accounts, it doesn't work that way. As it is based on age, everyone that age qualifies for all of the cap space (you know, assuming eligibility).
Although the catch-up provision is an excellent feature of retirement accounts, it doesn't substitute for earlier years of compound growth and cap space. Since you will likely make more money in your 50s than your 20s-40s, you'll have more money to contribute (usually). However, you won't be able to make up old cap space or gains.
What if I Save Too Much? (And What If I Need Money?)
This shouldn't be your largest concern. There is a way to tap money from your IRA known as the 72(t) Substantially Equal Periodic Payment Distribution. By crafting your withdrawals in this way, you can get money out even before "full retirement age".
That isn't the only thing: first, Roth IRAs allow withdrawal of the contributions (but not any appreciation!) at any time.
Of course, you won't be able to put that money back (after a year), but in a hardship it is an option. There are also explicitly called out hardship withdrawal options which have no associated penalty. From the non-hardship side, some accounts (such as IRAs) allow withdrawals for specific categories like first-time home-buying and education.
401(k)s, depending on the setup, may also allow loans. It's not a suggested method of tapping your funds in most situations, but 26% of all 401(k) holders have one outstanding.
Finally, you can (of course) tap your accounts with penalties. But with the number of exceptions above odds are you don't have to.
So, please, just max out your retirement accounts instead of dealing with theoreticals that have workarounds.
Max Out Your Retirement Accounts Early and Often.
Even if you can't max your contribution every year, you should put as much into the account as you can. Do this every year you qualify.
There are always ways to get money out if you need it - whether using an exception or taking a penalty. There is zero way in the United States to go back and get more money in.