When you’re 50+, you can contribute more to an IRA than younger folks can. That extra $1,000 added to the limit can make a big difference. (The 401(k) also has a catch up limit, but we’re just focusing on the IRA catch up here.)
Recently, Maria Bruno of Vanguard (whom I interviewed for a podcast) wrote an article that caught my attention. It included a graph showing the percentage of Vanguard investors who max out their IRA each year.
It starts out with folks around age 20, where about 25% of investors max out their contributions each year. By their mid-20s, though, that number quickly jumps to 50%, and it more or less stays at 50% through age 70.
What’s interesting about this graph is that dip you see in maxed-out contributions at age 50. Then it jumps back to about 50% a few years later.
So why do maxed-out contributions dip at age 50? Well, when you hit 50, the amount you can contribute goes up because of this catch-up contribution. And, probably, many folks who turn 50 don’t know about catch up contributions, or maybe they just forget to ratchet up their contributions.
And you might be asking, “Yeah, but does an extra $1,000 make that big a difference? Is it really a big deal?”
Yes, it is a big deal. If you’ve been following my podcasts, you know I’m a big fan of Excel. I think it’s better than online calculators because it forces you to understand the math behind the calculations. We actually get our hands dirty with the numbers (exciting, I know). And it’s really easy to use Excel to determine just how much difference that extra $1,000 from age 50 to 65 makes when you retire.
Here’s how to figure it out:
1. Open Excel (or a Google docs spreadsheet, which is what we’re using in the screenshots), and find the function (fx) line.
2. Type =fv (for future value) in the function section. Google/Excel will tell you what information you need to put into the formula, like this:
As you can see, the information you need to enter for a future value equation is the rate of return, number of payment periods, payment amount, and starting/present value. You can also add in a 0 or 1 to tell the spreadsheet if the payment is due at the end or beginning of the period, but we’ll skip this function.
3. So for this calculation, we’re going to assume the rate of return is 7% (.07). We’ll assume that you’ll pay the extra $1,000 into your IRA from age 50 to 65 – so 15 years. The contribution is obviously $1,000. And we’ll assume that the starting value is $1,000 because at age 50, we put in $1,000 to begin with, and then we put in another $1,000 every year for the next 15 years.
Here’s what you get:
That’s $27,888.05. Not bad for an extra $1,000 a year once you turn 50.
That’s assuming a 7% rate of return. We can all debate what returns are going to be. If you could hit 10% (and I’m not saying you can), but that would be just under $36,000. And you’d just have to be making the $1,000 catch up contribution. That’s not including your base contribution to your IRA.
You can even go a step further. Imagine if you kept making those contributions. What if you didn’t stop at 65, but kept going until age 70? Change the number of periods to 20 instead of 15 in your spreadsheet, and now you’re looking at $64,000.
So there you go. That’s how you calculate the future value of a stream of payments. More importantly, this calculation underscores the value of the $1,000 catch-up contribution. If you’re 50 or older, make sure you take advantage of this opportunity if at all possible.