New 401(k) Rule Impacts Tax-Deferred Contributions Discover Who Is Affected

Effective Next Year: Key Tax Changes for High Earners’ Retirement Contributions

Understanding the New Rule for Retirement Plan Contributions

Starting next year, a new regulation stemming from the Secure 2.0 retirement law will impact high-income earners making “catch-up contributions” to their 401(k)s or other tax-deferred workplace retirement plans. This rule effectively removes the immediate tax break typically offered on these contributions, aligning them with Roth 401(k) contributions where applicable.

Who Is Affected by the Rule Change?

The rule particularly affects employees over 50 years of age who earn more than $145,000 in FICA wages, which are the earnings subject to Social Security and Medicare taxes, from the prior year. Previously, they could defer taxes on contributions up to federal limits and also make additional “catch-up” contributions that were similarly tax-deferred. With the new mandate, these contributions will now be taxed as Roth contributions.

What Are the Current Contribution Limits?

Presently, individuals over 50 can maximize their 401(k) contributions up to a federally set cap, currently $23,500, and make additional “catch-up” contributions of up to $7,500. Those between the ages of 60 and 63 may contribute up to $11,250, inflation-adjusted annually. Next year, high earners will see these catch-up contributions subject to immediate taxation.

Implications for Affected Retirement Plan Holders

• Higher Tax Costs: Paying today’s tax rates on catch-up contributions could result in higher taxes during peak earning years.
• Reduced Take-Home Pay: Losing the pre-tax benefits translates to a decrease in take-home pay.
• Tax-Free Growth: Forced Roth conversion means the contributions will grow tax-free and can be withdrawn tax-free under certain conditions.

Potential Advantages of the New Regulation

Despite the immediate tax liabilities, the regulation offers potential benefits. The Roth portion of a 401(k) allows for tax-free growth and withdrawals, provided the funds remain invested for at least five years and the account holder is over 59-1/2. Moreover, the rule waives required minimum distributions from Roth 401(k)s at age 73.

Plan Alternatives for Affected Earners

It’s important to note that 93% of workplace retirement schemes offer an option to establish a Roth 401(k). However, if this is unavailable in your plan, you might be barred from making catch-up contributions under the new rule. This change compels high-income earners to reassess their retirement strategies, considering effective tax rates now versus prospective rates in retirement.

While the new rule primarily impacts those earning above $145,000 annually, it does not affect individuals who earn less. This threshold will likely be adjusted in response to cost-of-living variations. As financial landscapes evolve, understanding these regulatory shifts is key to optimizing retirement planning and financial security.