Catch-up Contributions Will Help Baby Boomers Build Nest Eggs

By Clifton Linton Senior Writer, mPower

What if you were given the chance to make up for lost time in your 401(k)? You know, those years when you were paying off a mortgage and raising kids (with all the associated expenses) and you couldn't scrape together a very big contribution.

One of the provisions of the tax law passed earlier this year should allow workers over 50 to do just that, starting in 2002, by making pre-tax "catch-up" contributions. The catch-up rules were included in a section of the law targeted at "intermittent" workers, such as parents, especially women, who choose to stay home to raise their children.

But, they aren't a magic bullet to boost low balances that result from years of neglecting retirement accounts. "The catch-up is a limited way to put aside extra money when you didn't save or took money out" prematurely, said Diane Oakley, vice president with TIAA-CREF.

At best, a worker will be able to add a few thousand pre-tax dollars extra a year, and those contributions won't benefit from the same long-term interest compounding that earlier contributions would have enjoyed.

Also, this benefit may be available for a limited time. Unless extended or made permanent by Congress, catch-up contributions will expire at the end of 2010 along with the rest of the tax bill's provisions. And you'll only be able to start making them once your employer amends its 401(k) document, which could take some time.

Yet, these rules are worth taking advantage of while they're in force, financial planners say.

Catch-up Rules

The maximum catch-up contribution amount will start at $1,000 in 2002 and increase $1,000 a year until reaching $5,000 in 2006. Further increases, in $500 increments, will be indexed to inflation.

Increases to catch-up and 401(k) contributions from 2007 to 2010 will be indexed to inflation.

The new law says that catch-up contributions will be made as a salary deferral on top of your plan's limit. That means in 2002 you may be able to contribute a total of $12,000 for the year — the new federal 401(k) maximum limit of $11,000 plus the $1,000 catch-up limit.

If your 401(k) plan restricts your annual contributions so that your maximum is less than the federal limit, you should still be able to make the full catch-up contribution if your plan permits these contributions. Suppose your plan limited your regular contributions to $8,000 in 2002. With a catch-up contribution of $1,000, your maximum allowable total contribution limit would be $9,000.

The catch-up contributions aren't included in the discrimination test your employer is required to carry out for your plan. This means highly compensated employees (those earning more than $85,000 in 2001 or owning 5 percent or more of the business) will not be prohibited from making a catch-up contribution even if their regular contributions are limited because their plan fails its discrimination test.

If you have a generous employer that decides to match your catch-up contribution, the amount of the match could be reduced if you are a HCE and your plan fails its discrimination test.

Catch-up contributions will likely benefit middle-income baby boomers who haven't been able to afford substantial contributions to their retirement accounts until now, said David Wray, president of the Profit Sharing/401(k) Council of America. The new rules give boomers a structure for catching up at a time when they are realizing that they need to think about retirement, he said. "Now they are faced with a situation where they need to do a savings sprint to get the nest egg they need."

Details Needing Clarification

The U.S. Department of the Treasury will need to clarify some issues before a majority of employers feel comfortable adopting the new rules in 2002, benefits industry trade groups have said. Here are some of the issues:

• Do you have to already be 50 at the beginning of the calendar year or plan year in order to make a catch-up contribution for that year, or can you turn 50 during the year? "The understanding we have of the legislative intent is if you turn 50 in a calendar year, you can make the contribution in that year," said James Delaplane, vice president of retirement policy with the American Benefits Council. "That has to be clarified by the Department of the Treasury."
• Will workers be able to make a single contribution at any time of the year, or will it have to be spread across several paychecks or delayed until the end of the year? If you wanted to make it early in the year, for example, how would you make sure it was counted as a catch-up contribution and not as part of your regular contributions? This is important because if it is counted as a regular contribution you'll reach your limit on those contributions faster than you want to.
• What happens if a plan changes its maximum contribution limit in the middle of the year?
• If an employee has taken a hardship withdrawal from a 401(k), will he be restricted from making a catch-up contribution?
• If a highly compensated employee receives a refund because the plan fails the discrimination test, could the refund be recharacterized as a catch-up contribution?
• How will catch-up contributions be affected if you die or if you change employers within a year?
• How will catch-up rules affect union employees with a 401(k) plan covered by a collective bargaining agreement and employees at separate line of business firms?

	"The catch-up is a limited way to put aside extra money when you didn't save or took money out prematurely." — Diane Oakley, vice president with TIAA-CREF.

William F. Sweetnam, Jr., benefits tax counsel at the Department of the Treasury, said officials are working on answers to those questions and sample plan document amendments should be ready by the end of August.

Employers will be able to decide whether to use those sample amendments to amend their plans. The Treasury Department will issue final regulations later. Some companies might wait to amend their plans until the final regulations are issued, so it's possible that your plan won't be amended by Jan. 1, 2002.

These potential roadblocks shouldn't be a major obstacle, though, said Martha Priddy Patterson, an analyst with the human capital advisory services group of Deloitte & Touche. "Congress made it as simple as it could. They knew employers wouldn't do it if there was a huge cost of administering," she said.

Catch-up's Future

The reason the catch-up rules and many other provisions of the tax bill will expire at the end of 2010 is that Congress used special rules to get the bill passed quickly. It was labeled a "reconciliation bill," meaning debate was limited and it was on a fast track for passage.

In order for these changes to be made permanent, they must be included in a stand-alone tax bill that is subject to full debate by both the Senate and House.

The prospects that retirement provisions will pass in that kind of bill are slimmer, Patterson said. She pointed out that either the House or Senate passed the retirement provisions contained in the tax bill seven times in previous years but they were never enacted. "I have severe reservations about what will happen" with retirement legislation in the future, she said.

Despite Patterson's pessimistic outlook, several House Republicans have already proposed legislation to make the changes permanent. The most likely way this legislation will be passed is if it is included in "larger package," Delaplane said.

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The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.
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