devastation of workers' 401K plans.

Retirement savers may find it more challenging to rebuild diminished 401(k) accounts next year--the result of a possible reduction by the IRS of the maximum allowable contribution.

The issue here is the low inflation rates we've been experiencing as a result of the recession. By law, the Internal Revenue Service sets the 401(k) annual maximum contribution using a formula tied to inflation rates in the third quarter of each year, with adjustments up or down in $500 increments. The ceiling has been rising steadily in recent years; for 2009, it's $16,500--up from $15,000 as recently as 2006. Workers over age 50 can kick in an additional $5,000 in catch-up contributions.

The IRS will compare third quarter inflation to the same period a year ago--a time when consumer prices temporarily spiked just before the economy crashed. So, the formula almost certainly will indicate a lower contribution ceiling for 2010--probably $16,000 and $5,000 for catch-ups.

The IRS will announce the 2010 contribution limits in October. However, this year marks the first time that the limits have been set using the inflation formula when the year-to-year inflation formula produces a downward adjustment--and it's not entirely clear what the IRS actually will do. "The IRS code is a bit unclear about whether the limit can go down one year to next," said Bill McClain, a senior consultant at Mercer, the employee benefits consulting firm.

To be sure, it's not a problem that affects all retirement investors. With a weak economy, high jobless rate and struggling consumers, many people won't be able to come close to the maximum contribution next year. But the ceiling is an issue of some importance to older investors close to retirement who are trying to rebuild portfolios in the wake of the market crash. Mercer data shows that 13 percent of investors over age 50 made maximum 401(k) contributions in 2008, as did 10 percent of investors age 40-49. Those figures are much higher than the 9 percent average of all investors.

Recovering from the market crash will take some time. The Employee Benefits Research Institute (EBRI) ran simulations earlier this year aimed at quantifying the time it will take for the average retirement investor to get back to where they were in early 2008, before the big market declines began. Assuming a modest 5 percent rate of stock market return over the next few years, recovery would take five years for 90 percent of investors. If the market return is zero for the next few years, it would take nine or 10 years for 90 percent of investors to recoup their losses.

A lower contribution ceiling also is an issue for anyone working at a company that has reduced or eliminated its 401(k) matches; investors may want to make up the difference through higher contributions. One-third of U.S. employers have reduced or eliminated their matching contributions to retirement accounts since the start of 2008, according to Spectrum Group, a retirement benefits consulting firm. Another 29 percent said they planned to do so this year.

McClain thinks a lower contribution ceiling could lead more employers to offer their employees a Roth 401(k) option. The same contribution ceiling applies to both traditional pre-tax 401(k) and Roth 401(k) accounts, but a Roth is more efficient from a tax perspective. "If you are up against your contribution limit, a Roth is better because the contribution doesn't include any future tax liability," he said. About half of large employers currently offer a Roth 401(k) option to employees.

The potential change in 401(k) contributions comes on the heels of another inflation-related blow to older Americans. It's likely that Social Security recipients won't see a cost-of-living adjustment (COLA) in their checks next year, since that's also tied to inflation. The 2010 COLA won't be announced formally until this fall, government forecasts have made it clear that Social Security recipients shouldn't expect an increase next year -- and probably not for at least two years beyond that.

 

Inflation May Squeeze 401(k) Contribution Limits In 2010

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