Playing 401(k) Catch-Up Might Cost You $1 Million or More

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By Vanessa Richardson

Imagine yourself at your retirement party. You're happy. You've saved enough -- you think. But what if someone said you could've saved at least $1 million more in your 401(k) alone, had you managed to make larger contributions in your 20s and 30s?

Granted, that isn't easy -- or even possible when you're starting a career. The paychecks are thinner and plenty of financial goals take priority to retirement in your 20s and 30s: student loans, wedding, mortgage, diapers.

But let's look at the numbers regardless. And you'll see why it might just be worth it to try to contribute as much as you possibly can to that 401(k) plan of yours, as early on as you can.

The chart above shows two scenarios. The first, illustrated in a blue line, is the current median annual 401(k) contribution path of investors in a data set analyzed by SigFig. (SigFig, an investment advisory firm in San Francisco, tracks nearly $300 billion invested by more than 750,000 individual investors.)

For investors in their 20s, this data shows, the median 401(k) contribution is $9,000 a year. It jumps to $15,000 a year for investors in their 30s, $19,000 a year for those in their 40s, and tops out at $20,000 for investors in their 50s. (Those contributions include the company match, which it goes without saying should be maximized -- or you're leaving free money on the table.) Based on this path and assuming an 8 percent average annualized return, investors who started saving at age 25 would have $4 million when they turn 65. Not bad!

The second line (in green) shows the same numbers, but flipped around. What if people started socking away every last penny in their 401(k)s when they were young and scaled those contributions down as they approach retirement? Sure, to put $19,000 in your 401(k) when you're 25 -- or $20,000 when you're in your 30s -- seems outlandish. Who makes that sort of money? But let's assume that you do. The difference? You will retire with $5.3 million.

Boomer Reality

Because retirement looms closest for boomers, the good news for 50-plus workers is they're able to stash more into their 401(k)s with so-called catch-up contributions. While in 2014 the maximum contribution limit is $17,500, those who are 50 or older can save an additional $5,500, for a total of $23,000. Those limits go up to $18,000 and $24,000, respectively, in 2015.

But while most employers point out the opportunity to their older employees, the take-up rate isn't that high. Last year, Fidelity Investments took a look at the 401(k) plans it administers and found that the percentage of employees 50-plus who were making catch-up contributions was a lowly 12.9 percent.

In SigFig's data, investors in their 60s are doing a little better than that: 37 percent have contributed $20,000 or more to their 401(k)s so far this year, including employer matching contributions. But 20 percent of those investors have contributed less than $5,000. That's not good -- unless they are already sitting on solid retirement savings accounts piled up in their earlier years (see our "outlandish" scenario above).

Are Younger Generations Doing Better?

Maybe. A small subset -- 7 percent of investors in their 20s -- have contributed $20,000 or more (including the company match) so far this year, which is impressive. Sure, they may seem like overachievers now, but if they keep it up -- let's assume they started stashing away $20,000 a year at 25 -- by the time they're 65, they could be retiring with a cool $5.6 million.

Then again, such diligent (and likely high-income) savers are the minority. So far this year, 36 percent of 20-somethings in the SigFig analysis have put in less than $5,000.

The Magic of Compounding

It all boils down to one elementary mathematical principle: compound growth. Interest that accrues to an amount will accrue interest itself. That's the deceivingly simple force that causes wealth to rapidly accumulate.

All of the investment returns earned in your 20s and 30s are snowballing – to the point that someone who saved far less than you early on may not be able to catch up, even with larger catch-up contributions as they get older.

Say you got your first full-time job at age 25 and started maxing out your 401(k), at this year's maximum of $17,500, every year. If you decided to retire at age 65, you'd have a whopping $4.9 million. However, if you only saved $7,000 a year from age 25 to 65, you'd only have $1.9 million in retirement.

Catch-up 401(k) contributions are a great way to put away money in the late stages of your career, but the longer you wait to start saving for retirement, or save minimal amounts, the more you'll miss out on the benefits of compound interest. Don't let those catch-up contributions try to do the hard lifting for your nest egg too little, too late.

Vanessa Richardson is a contributing writer at SigFig. Nearly a million people use SigFig to track, improve and manage over $300 billion in investments.