The Secure Act 2.0 of 2022 provided changes to retirement savings, some good, some bad. Starting in 2024, older, high-income earners are losing a tax-advantage.
To help older workers catch up on their retirement, as some are empty nesters and more focused on retirement, an additional contribution is permitted for people ages 50 and over. In 2023, an eligible employee can put $22,500 from their salary into a 401k. However, if you are age 50 or older, you can contribute another $7,500 for a total of $30,000 into a 401k.
Many in this age range are in their highest earning years and want to save taxes now. The traditional employee salary deferral is like a traditional IRA, where a contribution is made and taken off your income for tax purposes. That means an employee making $100,000 who puts $10,000 into their 401k account pre-tax will only be taxed on $90,000. The tax benefit is upfront in this instance and taxes are paid when the money is withdrawn from the retirement account, typically in retirement.
In 2006, the tax code was changed to permit Roth contributions (after-tax) to a 401k by an employee. In this scenario, the employee makes $100,000 and puts $10,000 into their 401k after tax so he or she will still be taxed on $100,000 of income that year. The tax benefit comes in retirement. A qualified distribution from a Roth account is not taxed, so all growth from the Roth contributions is never taxed.
Given the tax benefits, generally, Roth contributions are more advantageous when the more time you have to grow the account, the more returns you get in the account and the higher your tax rate in retirement. In other words, a young, lower wage earning employee will typically benefit more from a Roth account than an older, high earning individual, all things being equal.
Starting in January 2024, Secure Act 2.0 limits the tax deduction for high earners who are age 50 or older. The catchup contribution for those making over $145,000 cannot be done pretax. Going back to the first paragraph, an employee can put $30,000 into their 401k as a salary deferral once they are age 50 but $7,500 of that amount must be done after-tax.
The downside of this restriction is that the very people who are trying to “catch up” on their retirement contributions and might be able to afford to put the extra $7,500 away aren’t able to deduct it from their taxes when they are highly paid.
Plan providers may be caught in the crossfire. Some providers with 401k plans don’t offer Roth contributions, thus causing issues with the new rule. Fidelity estimates 30% of their 401k clients don’t have a Roth option. Payroll providers and 401k record-keepers (TPAs) have sent a letter to Congress requesting a two-year delay for the rule to kick-in (moving it to January 2025). This would give providers, payroll systems and record-keepers time to put Roth options in place and restrict catch-up to Roth contributions for employees affected by the limitation.
For small employers, SIMPLE IRA accounts are exempt from the rule so only ‘qualified’ plans, 401k, 403b and 457 would be required to track their employees and have Roth contribution options.
We will see if the rule is delayed. If not, employees who are high earners and contributing the catchup contribution should check with their 401k providers to see if a plan is in place to restrict their catchup to the Roth option.
All investing is subject to risk, including possible loss of the money you invest. Nothing in this article should be construed as investment or retirement advice. Always consult with a professional advisor and consider your risk tolerance and time to invest when making investment decisions. Review your personal situation with a professional before planning any gifting or estate planning.
