High earners will need to change how they approach their 401(k) catch-up contributions.
401(k) plans lead the way when it comes to saving and investing for retirement. This is partly because they’re employer-sponsored, so many companies auto-enroll their employees; partly because they’re hands-off and operate behind the scenes; and partly because they can lower your taxable income.
One overlooked reason a 401(k) can effectively be someone’s primary retirement income is its relatively high annual contribution limits. For tax year 2023, the maximum you can contribute to a 401(k) is $22,500. Investors age 50 or older are allowed a catch-up contribution, increasing the limit by $7,500 to $30,000. These limits far exceed IRAs, which have a $6,500 limit and a $1,000 catch-up contribution.
Although catch-up contributions will remain, high earners will see a change in how they work starting in 2024. People earning over $145,000 in the previous year will no longer be able to add their catch-up contributions to their pre-tax 401(k) account. They’ll have to go into an after-tax Roth account instead.
How Roth accounts work
Retirement accounts like 401(k)s and traditional IRAs give you a tax break upfront, allowing you to lower your taxable income. In Roth accounts, you contribute after-tax money; in return, your money grows tax-free with tax-free withdrawals in retirement.
Roth IRAs and Roth 401(k)s work the same tax-wise, but they have some key differences. First, the new rule change does not apply to Roth IRA catch-up contributions. If you’re eligible to contribute to a Roth IRA (it has income limits), you can make your $1,000 catch-up contribution.
Like regular 401(k)s, Roth 401(k)s are employer-sponsored, and contributions are automatically taken from your paycheck. In a regular 401(k), your contributions don’t have a 1:1 effect on your take-home pay because your tax bracket is calculated after you make contributions.
With a Roth 401(k), the amount of your contributions will decrease your take-home pay by that exact amount. For example, if you currently take home $150,000 annually after taxes and decide to contribute the max $7,500 catch-up contribution, your new take-home pay would be $142,500.
Can the new change actually benefit you?
As it stands, pre-tax 401(k) catch-up contributions benefit people in higher tax brackets more. With a $7,500 catch-up contribution, someone in the 35% tax bracket would essentially receive a $2,625 tax deduction, while someone in the 24% bracket would get a $1,800 deduction. The goal isn’t to “fix” this, but the new change could be more beneficial than it appears.
On the surface, paying taxes on catch-up contributions seems unfavorable, but the potential backend benefits of tax-free withdrawals often cancel it out. For example, a one-time $7,500 investment could grow to around $19,400 in 10 years averaging 10% annual returns. The savings from the roughly $12,000 in capital gains you’d typically owe taxes on will outweigh the taxes you paid to contribute the initial $7,500.
To be eligible for tax-free withdrawals from a Roth 401(k), you must be 59 1/2 years old and have had your account for at least five years. Your five-year clock begins at the beginning of the tax year when you first open your account. For instance, if you open an account in July 2023, your five years will be up on Jan. 1, 2028.
People often choose a regular account over a Roth because they expect their tax bracket to be lower in retirement, so they’d rather pay taxes on the backend. However, this isn’t always the case — especially for high earners who’ve racked up large 401(k) and traditional IRA balances. When required minimum distributions begin at age 73, it could be the case that you’re in the same tax bracket. The alternative of tax-free growth will serve a lot of people better.
What should investors do next?
There is pushback on the changes from companies because of the logistical challenges involved. Companies like Delta and Anheuser-Busch have requested a two-year delay, but that doesn’t mean Congress will change its mind before the Jan. 1, 2024 start date.
Regardless of how that plays out, it’s best to control what you can control and prepare accordingly. The change won’t require an overhaul of your retirement saving and investing strategy, but it would be good to think about how you want to approach your catch-up contributions. For instance, if your contributions go into a target-date fund, you could decide you want to dedicate your catch-up contributions to a particular index fund option.
More than anything, it’s about being informed and knowing how changes affect you directly.
