How Can You Catch Up on Retirement Savings?

MARK RIEPE: One of the greatest comebacks in sports history happened in 2004. The New York Yankees were up three games to zero on the Boston Red Sox in the American League Championship Series. The Yankees’ path to a record 40th World Series appearance seemed to be locked up. No Major League Baseball team had ever lost a playoff series after holding a –three- -nothing advantage.¹

But guess what? There’s a first time for everything, and that year the Red Sox stunned everyone. They won the next four games in a row and went on to win their first World Series championship in 86 years.²

Now compare that unlikely achievement with what the Houston Astros did over a period of four years. From 2011 to 2013, they lost over a hundred games per season​​​​​​​³ and finished last, or near the bottom, of their division every year.

But in 2017, they won 101 games in the regular season and went on to claim their first World Series title. From last place to champions—how did they turn it around? The Astros’ management spent years rebuilding the team and patiently waiting for the results to pay off.⁴

When you think about “coming from behind,” do you imagine the Red Sox’s surprise victory in one series or the Astros’ slow transformation over time?

Most of us get caught up in the drama of the unexpected triumph. The long slog is far less romantic, but it’s a model you can actually emulate in your own life, specifically in the area of retirement preparation.

If you are behind on saving for retirement, it may seem like you can never catch up without taking drastic, life-altering steps. But today we are going to discuss some biases and heuristics that might actually help you add to your retirement savings, whatever your portfolio balance.

I’m Mark Riepe, and this is Financial Decoder, an original podcast from Charles Schwab.

It’s a show where we study the cognitive and emotional biases that can influence your financial decisions, both large and small. And we offer strategies designed to help you mitigate those biases and improve your financial life.

Sixty-seven percent of Americans report​​​​​​​⁵ that they are very or somewhat confident that they are doing a good job when it comes to saving for retirement.

For this episode we’ll assume those 67% are accurate in their assessment and focus on the remaining 33% who aren’t confident. Some fraction of that 33% are people who find themselves in their peak earning years but off track with their retirement savings.

What’s the path for them to catch up and get where they want to be? And what are the cognitive and emotional decision-making biases that could help them?

Most of the time we focus on heuristics and biases that cause people to make decision-making errors. In this episode we’re going to mix it up and instead feature biases and heuristics that may actually help rather than hurt, thus making the catching-up process easier.

The other piece of good news is that, as we’ll see later, the federal government has stepped up to the plate and created some incentives to help with this process.

Let’s start with the biases.

Salience is one that we’ve talked about before. When making decisions, it’s the tendency to give too much weight to risks or factors that are salient, or vivid. Saliency can be a problem for the younger person because there are so many ways to spend money that are more salient, and thus seemingly a higher priority, than saving for retirement. However, as one ages and retirement appears ever closer, it becomes far more salient—which makes sense because competing priorities are often dropping by the wayside at the same time.

Another bias stems from the goal gradient hypothesis. This term was coined by Clark Hull in 1932 in a paper​​​​​​​⁶ he wrote about how rats learn to run through mazes. He concluded that “animals traversing a maze will move at a progressively more rapid pace as the goal is approached.”

Some might consider it a bit of stretch to connect lab rats with people saving for retirement, but there are all kinds of examples of people who, when their goal is in sight, receive a burst of motivation.

Runners in a competitive race are one example. For many people, the thought of crossing the finish line, and maybe posting that accomplishment on Instagram, is their primary motivator for signing up for the race.

We also see this phenomenon with weight loss.​​​​​​​⁷ Once someone gets within a few pounds of their goal weight, the motivation to stick with the program increases.

Or how many times have you been in a meeting about a project and someone says “Let’s just power through this and get it done”?

The finish line can be an excellent motivator, and it seems to me this describes people who are entering their 50s. A new phase of life is within sight, and people, when they see that goal, get more motivated to get to that goal in the best shape possible.

Today, I’m joined by Hayden Adams. Hayden is a CPA and CERTIFIED FINANCIAL PLANNER,™ and he’s the director of tax and financial planning for the Schwab Center for Financial Research. He’s here today to talk about the different provisions of the U.S. Tax Code that are designed to make it easier to catch up on your retirement savings. Hayden, thanks for being on the show.

HAYDEN ADAMS: Happy to be here.

MARK: As I said, this episode is about how to catch up on your retirement savings. And within the financial industry, we refer to a set of tax rules as the so-called catch-up provisions. Why don’t we start right at the beginning: What are the catch-up provisions?

HAYDEN: So generally, the Tax Code allows people who are 50 or older to make additional contributions to their retirement account.

MARK: Now, do you have to be behind on your retirement savings, in some sense, to be eligible to participate in this?

HAYDEN: No, you don’t. This is just an opportunity for people to make additional contributions, whether or not they’re behind, and something people should definitely take advantage of.

MARK: So let’s talk about the term “retirement account.” There are lots of different retirement accounts, right? What do you mean by that?

HAYDEN: Congress created numerous types of tax-advantaged accounts. Basically, they’re grouped into two categories: employer-sponsored plans—that would be like your 401(k) and SEP IRA—and plans for individuals, such as your traditional IRA or Roth IRA. The idea behind these accounts is that it gives people incentive to save, because there are tax advantages to it. So you can either defer taxes early on, or, if you go for a Roth, you don’t have to pay taxes later on.

MARK: Let’s go through those accounts starting with the employer sponsored plans; the 401(k) is probably the biggest and the most well-known. What’s the basic rule with respect to a catch-up provision?

HAYDEN:  For 401(k)s, the basic rule is, is that if you’re 50 or older, you can contribute an additional $6,000 per year. Now, luckily, that’s also inflation-adjusted, so as we go into the future, that number will change and grow over time.

MARK: So if you’re under 50, there’s a contribution limit? And then you get to contribute an extra $6,000 on top of that, if you’re over 50. Is that the basic idea?

HAYDEN: Exactly. So anybody can contribute up to $19,000 a year, for 2019. But people who are over 50 can add $6,000 to that, so you can have a total of $25,000 in 2019.

MARK: Usually, there’s some fine print associated with these government programs. So give us some more details about how these work.

HAYDEN: Well, obviously first you have to be 50 by the end of the year to make that catch up contribution. But in addition to that you also have to be eligible for the plan. So a lot of plans have rules about, you know, you have to work here for a year before you can actually do any contributions. So if you haven’t met the eligibility requirements for your employer then you wouldn’t be able to do a catchup contribution. Also, that contribution has to be an elected deferral. So you can’t take $6,000 out of your bank account and throw that into your 401(k). You actually have to reduce your paycheck with the elected deferral and contribute that to the retirement plan. And then finally, we’ve talked about the dollar limits, but there’s an additional limit that applies here, and that is that you can’t contribute more to the plan than 100% of your income. So you may be eligible to contribute $25,000 this year. However, if you only made $22,000, you’re going to be falling under that 100% limitation rule, which means you can only contribute that $22,000

MARK: Well, despite having to look out for the limitations you mentioned, the actual retirement savings opportunities seem like a great deal. Is there any reason not to take advantage of them?

HAYDEN: No, not if you have the money. I think, though, the one concern that a lot of people bring up is once you make these elective contributions, you can’t necessarily get to the money until you’re 59-and-a-half. There are some situations the rules can be exempted but, in general, you have to be 59-and-a-half to get the money. So some people are concerned that, “If I make these contributions, what if I have an emergency?” Well, the option that I give those people is consider using a traditional taxable brokerage account or something like that, make the contributions there, or you could also consider a Roth IRA, because either one of those accounts will allow you to withdraw your contributions, and there won’t be a significant tax impact.

MARK: So if you’re making that contribution of an extra $6,000, you got to leave that money in there until you’re 59-and-a-half.

HAYDEN: Right. So if there’s any concern on your part that you may need that money, you may want to talk to a financial advisor or somebody like that, and they can help you plan around those situations.

MARK: The 401(k) is one type of employer-sponsored program. There are lots of others, so what are those and to what extent do the catch-up provisions apply to those types of accounts, as well?

HAYDEN: Oh, yeah, there’s definitely a confusing array of different retirement plans available to people. For example, there’s a 403(b), which is a retirement plan for not-for-profits. There’s government retirement plans and all kinds of other plans for small businesses.

The catch-up contributions for these plans are very different for each of the plans, so you have to be careful and know exactly which plan you’re part of. Don’t just assume that the rules that we’re talking about for 401(k)s apply to each of these other plans. So definitely take the time to do some research so that you don’t make too large of a contribution, or miss out on additional contributions that you may be eligible for.

MARK: Let’s switch gears a little bit and talk about the so-called individual retirement accounts, IRAs—traditional IRAs, Roth IRAs. How do the catch-up provisions work for these types of accounts?

HAYDEN: IRAs have many differences as compared to a 401(k). One of the main differences is the actual contribution limits are quite a bit lower, so your traditional contributions are $6,000, and then you have an additional catch-up contribution of $1,000. The nice thing about them, though, is that you can contribute to both your 401(k) and to an IRA. There’s limitations in there when it comes to how much you can contribute to the IRA based on your income, but, potentially, you could contribute to both of them, and you have until April 15 of the year after you’ve made that income. So basically, you can go through 2019, decide if you want to contribute to an IRA in 2020, and make that contribution before you file your tax return.

MARK: OK, so this is all well and good for those of us who are earning a paycheck, but earlier you mentioned that some of the contribution levels are limited by earned income. And that makes me wonder—what about spouses who don’t work outside the home? Are there ways for a spouse to save in a retirement account even if they don’t have earned income?

HAYDEN: Oh, definitely. One of the nice provisions that the IRS put in there is that you can contribute for your spouse, even if they don’t have earned income, within a traditional IRA. Now, again, those limits that we were talking about do apply. So if your household income goes over a certain level, you may be limited as to what you can contribute for your spouse, but it’s a great opportunity to beef up that savings again.

MARK: Hayden, we talk all the time about different cognitive biases that people have; one of those is the tendency to take current conditions and just extrapolate those way into the future. People really underestimate the degree to which conditions will change. So my question is, couldn’t all these rules relating to tax-deferred accounts change in the future, and how can people plan for that?

HAYDEN: Oh, definitely. The Tax Code can change at any moment. Congress has the right to change the tax laws anytime they basically please. However, in general, whenever they change the tax laws, they don’t make them retroactive. They tend to only make the changes for this date and going forward. So any contributions you’ve previously made to a Roth, or a traditional IRA, or any of those kinds of accounts, they’re probably not going to be affected by these changes. It will affect your planning changes going forward. So you have to be careful, and anytime Congress changes the rules, you need to meet with a tax advisor to make sure you understand how those changes are going to affect your overall financial plan.

MARK: Hayden, our next episode is talking about the decision of when to retire. But since you’re here, there’s some interesting tax-related questions that, I think, influence that decision. If I have, let’s say, a balance of $100,000 in my traditional IRA account, do I really have $100,000 in there, or is some money going to be taken out of that account?

HAYDEN: That’s a great point. And I think a lot of people forget about this, that when they look at their account balance they say, “Well, I’m on track for my savings because, well, my goal is X number of dollars, and I’m really close to that number of dollars in my account.” But the reality is you have to also factor in that you’re going to have to pay taxes on those withdrawals, specifically, from like a 401(k), some tax-deferred account. So you need to make a little bit more contributions than you may think. You got to plan for those taxes, and you got to plan for those unexpected expenses that you may face during the hopefully long, 30-year retirement

MARK: Yeah, because all these accounts we’ve been talking about, they’re tax-deferred accounts, not tax-free accounts, right?

HAYDEN: Exactly, because the vast majority of people are making contributions to tax-deferred accounts. Roth accounts, which, again, you can pull out the money during retirement with no tax implications,​​​​​​​⁸ those are not the majority of accounts that are out there right now.

MARK: Let’s talk a little bit about health savings accounts. Is it appropriate for people to look at those as a vehicle for retirement savings?

HAYDEN: In many ways, I see them as a supplement to retirement savings. In general, you should use your health savings account (your HSA) specifically for medical expenses. This account’s a great account because it’s kind of a triple tax threat. You can get a tax deduction for contributing to the HSA, it grows tax-free, and then, finally, when you’re in retirement, you can pull the money out tax-free if you’re using it to pay for medical expenses.

Now, the question I always get is, “Well, what if I’m really healthy in retirement? What if I don’t need the money for medical expenses, what do I do with that money then?” Well, luckily, there’s an extra provision in the Tax Code that says, “If you’re over 65, you can pull that money out of the HSA and treat it, basically, like an IRA.” So there won’t be any money that gets penalized for pulling the money out to use for your personal living expenses; however, like any IRA, you’re going to have to pay taxes on those funds. But, in general, what I tell people is to view that account, mainly, for saving for those inevitable expenses that you’re going to face when it comes to medical expenses in retirement.

MARK: Earlier we talked about catch-up provisions. Are there any catch-up provisions that apply to the HSA?

HAYDEN: Yeah, luckily that account also benefits from the catch-up provisions. So you can contribute an additional $1,000 after age 55 to those accounts. And the idea here is again, if you’re a little bit behind in your savings for medical expenses, this gives you that opportunity to beef that up.

MARK: We’ve got a lot of small-business owners who are clients. What are some strategies that small-business owners can use to catch-up on their retirement savings?

HAYDEN: When it comes to business owners, there’s some very interesting strategies that they can implement. Now, like any business, they can create the traditional retirement plans like a 401(k) and make the normal contributions and the tax-deferred contributions via their paychecks. However, there’s other benefits to being self-employed. There’s a lot of different plans designed specifically for them. So a business owner, for example, could open a SEP IRA. Now, these plans only allow employer contributions; you can’t defer from your paycheck. But if you’re self-employed and you’re the boss and make all the decisions, and you’re the only employee, you can contribute up to $56,000 per year to a SEP IRA, or the other limitation is that it can’t be more than 25% of the earnings of the business. So that’s a great opportunity to make some pretty big contributions as a self-employed person.

MARK: Yeah, much larger than some of the limits we were talking about with traditional IRAs or 401(k) plans, right?

HAYDEN: Exactly.

MARK: Tell me a little bit about defined-benefit plans. I’ve heard those are also an option for some people.

HAYDEN: Defined-benefit plans are a form of pension plan, which guarantees specific benefits and payouts when you’re in retirement. Defined-benefit plans are a bit more complex. They require actuarial projections, higher administration costs and some strict contribution rules. However, the benefit to them is that the actual contribution can be rather large, and it’s a tax-deferred contribution.

MARK: So give me an example of what type of profession or what type of small business would be amenable to a defined-benefit plan like this?

HAYDEN: I think one of the best examples would be a doctor. The reason I choose doctors as a good example is because they tend to incur a lot of debt early on, and they spend a lot of years educating themselves, so they don’t tend to start making income until their late 20s/early 30s. That puts them behind. So when you look at a doctor, some of them in their 40s and 50s will be pretty behind on their actual retirement savings.

Now, the reason I recommend this, a lot of times, for doctors is that they have a fairly stable income that rises as their careers go on, which means they can handle the required contributions that you have to make to a defined-benefits plan.

MARK: Hayden, give me a sense as to how large these required contributions might be.

HAYDEN: Well it varies, like I said, it varies based on your age, what you want your benefit to be in retirement, and then they do a calculation to say, “Here’s how much you’re going to have to contribute.” So, for example, a person in their late 50s who opens a plan and says, “I want to retire at 65.” They might be told they have to make $100,000, $200,000 of payments per year to these plans, and those are all tax-deferred payments.

MARK: Hayden, a lot of great information here. Thanks for dropping by.

HAYDEN: Thanks for having me.

MARK: The catch-up savings provisions are great—because for many people it’s now or never when it comes to retirement savings. The good news is that according to our analysis of data from the Bureau of Labor Statistics, people in the 45-54 age group are typically at the peak of their earnings power. And that means it easier for people to take advantage of these provisions.

But we have to be realistic and recognize that doing so requires real change to savings behaviors, and not everyone can afford it.

The good news is that we can take some of the biases we all have and make them work for us instead of against us when making decisions.

One of those biases is present bias. By that I mean the tendency we have to disproportionately focus on immediate gratification at the expense of achieving important long-term goals that only pay off years down the road.

Here’s a tip to make the present bias work for you. : Reward yourself as you set aside dollars to take advantage of the expanded opportunities for savings available to you once you reach age 50.

The boost in savings would seem to be its own reward, just like exercising now rewards you down the road with better long-term health.

The grim reality for many, however, is that the delayed nature of those rewards doesn’t outweigh the immediate cost.

One way around this classic self-control problem​​​​​​​⁹ is that reward I mentioned. Find a way to reward yourself now for each step you take. For example, hold off on going to that movie you’ve been dying to see until you’ve completed the paperwork to boost your 401(k) contribution.

Another idea is to give yourself permission to watch 100 minutes of additional TV for each $100 in additional savings you subtract out of your paycheck.

These examples may not work with you, but it’s worth taking the time to figure out what little rewards will be enough to spur action.

Another tip is driven by an odd fact I recently uncovered. The tip is that both partners in a dual-earning household need to do some lifting when it comes to savings. It seems obvious, right? But, a study​​​​​​​¹⁰ that examined 7,800 married couples shows that the average 401(k) contribution rate as a percentage of household earnings for a single earner couple is 8.6%. That’s a mouthful, but the idea is that if you take the one earner’s 401(k) contributions and divide by the household earnings, you get 8.6%.

However, there were many couples where both people worked, but only one was participating in their employer-sponsored retirement plan. The oddity is that the savings rate for the “both working, one saving” households was only 4.9%.

It’s okay for one person to save and the other not, but you would think that the saving rate would be more like the 8.6% we heard earlier, but it isn’t. What’s even stranger is that the number of couples studied who fell into the “both working, one saving” group was 31% of the sample, so this isn’t a rare occurrence.

We started out this episode talking about great comebacks in baseball, but high-pressure professional sports are a win-or-nothing sort of deal. You win a championship or you don’t. Retirement preparation isn’t like that. There’s no magic number where if you make it everything is great and if you miss you feel lousy for the entire offseason. Use these tips to just put yourself into a better place than you were before.

If you’re behind on retirement savings, there are a lot of options to help you get back on track. But with all these options it might be confusing to know which option is right for you.

If you’re a do-it-yourselfer, schwab.com/insights as well as irs.gov can provide you with lots of great information on the various retirement accounts and rules. To learn more about small business retirement plans, check out schwab.com/smallbusiness.

Of course with any major financial decision, you should probably consult with a financial planner or a CPA to help guide you through the process. You can find a Schwab consultant at schwab.com/consultant.

Thanks for listening. If you’ve enjoyed this episode, consider leaving us a review on Apple podcast or your favorite listening app. It helps others discover the show.

For important disclosures and a transcript, see the show notes and schwab.com/financialdecoder.

¹ https://bleacherreport.com/articles/723993-baseballs-greatest-miracle-the-2004-red-sox-comeback-against-the-new-york-yank

² https://en.wikipedia.org/wiki/2004_American_League_Championship_Series

³ http://houston.astros.mlb.com/hou/history/year_by_year_results.jsp

⁴ http://static7.businessinsider.com/how-the-astros-built-a-world-series-contender-2017-10

⁵ Dan Martin, “Use These Behavioral Tips to ‘Science’ Your Clients on Saving,” Journal of Financial Planning, February 2018, p. 20.

⁶ Clark L. Hull, “The Goal Gradient Hypothesis and Maze Learning,” Psychological Review, 1932.

⁷ http://www.lifetime-weightloss.com/blog/2013/1/30/the-finishing-line-effect.html

⁸ Roth account must be established for 5 years and investor must be over the age of 59 ½ for tax-free withdrawals.

⁹ Kaitlin Woolley and Ayelet Fishbach, “Immediate Rewards Predict Adherence to Long-Term Goals,” Personality and Social Psychology Bulletin, 2016.

¹⁰ Geoffrey T. Sanzenbacher and Wenliang Hou, “Do Individuals Know When The Should be Saving for a Spouse?” Center for Retirement Research, March 2019