Educating yourself about the nuances of a 401(k) retirement account will require understanding the terminology associated with such an instrument. Understanding the difference between a 401(k) account and a 401(k) catch-up contribution is an excellent example of this.
A 401(k) refers to a tax-advantaged retirement fund, while a 401(k) catch-up contribution refers to a specific type of supplemental contribution that you can make to that fund. Catch-up contributions must meet rules established by the IRS, such as the interested party being 50 years of age or older.
To help you navigate the world of 401(k)s, in this article, I will elaborate on the critical differences between the 401(k) plan itself and the catch-up contribution that is a part of it.
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You Need 401(k) To Have 401(k) Catch-Up
To properly differentiate between a 401(k) and a 401(k) catch-up contribution, you must first understand that they are not independent of one another. You are not comparing two different retirement plans. As such, conducting a point-by-point comparison of the two is not possible.
A 401(k) catch-up contribution is a component of all 401(k) retirement plans. Think of the 401(k) retirement plan as an automobile, with the 401(k) catch-up contribution as a feature of that car. For this analogy, imagine the catch-up contribution being the air-conditioner.
Just as in a car, you could decide to use the air-conditioner for the added benefit of comfort, so too can you exercise your option of making a 401(k) catch-up contribution for your financial advantage.
A 401(k) catch-up contribution would have no meaning or purpose if you did not already have a 401(k) retirement plan. Similarly, an automotive air-conditioning unit sitting in your garage would have no functional benefit to you if it were not attached to a car.
401(k) and 401(k) Catch-Up Key Differences
As explained earlier, the 401(k) plan and the catch-up contribution are integrated. The latter augments the former. Therefore, comparing both as if the base plan and the supplemental contribution were competing retirement instruments is not ideal.
However, suppose you look at the catch-up contribution as a conditional option to exercise when you meet certain conditions within the base 401(k). In that case, the differences that govern eligibility between the parent plan and the optional contribution can be placed into a proper context.
Established by Different Legislations
One of the key differences in the 401(k) and the catch-up contribution is that different pieces of legislation were responsible for establishing both at different times. The result of this was the catch-up contribution was implemented as an update to the 401(k) system instead of a congruent part of it.
What is commonly known as the 401(k) plan came into being as part of the Revenue Act of 1978. The provision for their existence appears in section 401(k) of that legislation, hence their colloquial name. These plans’ original purpose was to defer the tax burden of employees who received bonuses from employers.
By 1981, the IRS wrote rules which clarified how these tax deferments could be applied to employee contributions made through deductions in their salary by their employers. The 401(k) system marched along in that fashion for roughly two decades.
Twenty years later, another Federal law established the option of making 401(k) catch-up contributions available in all 401(k) retirement plans. It was part of the Economic Growth And Tax Relief Reconciliation Act of 2001 (EGTRRA).
While this fact may seem trivial, it is fundamental to understand the other differences between the base 401(k) and the catch-up contribution regarding eligibility, definition, and duration.
Different in Scope
As explained at the beginning of the article, the catch-up contribution is a method to fund your 401(k) plan. It allows an employee to contribute additional funds to their 401(k) on top of what the base 401(k) rules allow. Therefore, you can define it as a supplemental income deferment mechanism.
However, the base 401(k) is an instrument that takes the employees’ contributions and any employer contributions and invests them in 401(k) providers. These can take the form of mutual funds, company stock, insurance company investment contracts, etc.
Different Eligibility Criteria
Base 401(k) plans and the rules governing employee contributions were written without any conditions regarding age. In other words, anyone could have and contribute to a 401(k) regardless of age provided their employer offered one.
When the 401(k) catch-up contribution came into being, it was conditioned to the employee’s age. Only individuals 50 years and older were entitled to make these additional catch-up contributions.
Different Amounts of Allowed Deferments
As of 2021, the IRS limits the total amount that an employee can contribute to a traditional 401(k) at $19,500 per year. This figure is capped at $13,500 per year when the deferral is sent to a SIMPLE 401(k). The latter is a traditional 401(k) variation designed for companies with fewer than 100 employees. Each year, these figures can be adjusted by the IRS.
For those who qualify by being 50 years of age or older, the 401(k) catch-up contribution limit for the year is set to $6,500 over the deferment limit mentioned above for traditional 401(k) plans and $3,000 above the limit for SIMPLE 401(k) plans.
Employer Contributions
Employers can match up to 100 percent of an employee’s salary, provided the combined amount of employee and employer contributions do not exceed $58,000 in the year. For those over 50 using the catch-up contribution, the combined total limit goes up to $64,500. These figures are for 2021 and may be adjusted by the IRS in subsequent years.
Risks of Not Knowing These Differences
Even though your employer will most likely have an administrator dedicated to managing 401(k)s, it is still important that you are personally aware of the differences described above.
First, it will allow you to take advantage of the added deferment contributions of the catch-up contribution once you reach 50 years of age.
Additionally, by being aware of the differences in deferment limits based on whether or not you are using catch-up contributions, you can avoid the unnecessary risk of contributing more than the IRS allows for a calendar year.
While the most common consequence of over-contributing is withdrawing the amount of contributions above the established IRS limits, this usually adversely affects your tax liability for the tax year in which the over-contribution took place.
The reason for this is that the amount of the forced withdrawal—and the portion of interest or capital gains assessed on it based on the overall growth of the fund for that year—will be added to that tax year’s gross income. As a result, your tax liability would be adjusted upward.
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Conclusion
A 401(k) plan being the whole and a 401(k) catch-up contribution as a part of that whole, you cannot compare them as you would two cars in the same class.
However, noting differences in how eligibility requirements and contribution limits differ when catch-up contributions are involved instead of the stand-alone 401(k) will help you make more informed decisions regarding your overall 401(k). It can also help you avoid over-contributing and having to take a forced withdrawal that would affect your gross income for tax determination purposes that year.
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