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The New 401(k) Changes and Their Impact on Higher Earners
Changes to Catch-Up Contributions
Although higher earners have been maximizing their retirement savings through catch-up contributions, changes to the 401(k) system enacted in 2022 may soon erode this tax break. Currently, workers aged 50 and older can contribute an additional $7,500 to their 401(k) after reaching the maximum of $22,500 in employee deferrals. However, starting in 2024, higher earners will only be able to make catch-up contributions to after-tax Roth accounts, which do not provide an upfront tax break but allow for tax-free growth of funds.
Impact on Higher Earners
Individuals who earn more than $145,000 in 2023 from a single employer will be affected by the 2024 shift to after-tax Roth accounts. This change has already caused administrative challenges for employers and may lead high-earning employees to reconsider making catch-up contributions after 2023. According to a Vanguard report, only 16% of eligible employees took advantage of catch-up contributions in 2022.
Considerations for Higher Earners
Certified financial planner Jim Guarino advises higher earners to fund pre-tax catch-up contributions in 2023 while they still can, as it provides a larger tax break. For example, making a $6,000 catch-up contribution while in the 35% tax bracket could save $1,200 in taxes if withdrawn in retirement while in the 15% bracket. On the other hand, making a $6,000 Roth contribution would mean paying upfront taxes in the 35% bracket, resulting in a 20% higher tax rate.
Diversification and Individual Goals
While the changes to catch-up contributions may lead to some loss of tax breaks for higher earners, financial experts believe it can provide tax diversification. The best option between pretax and Roth 401(k) contributions depends on individual goals, expected income tax brackets in retirement, and other factors. Some advisors recommend diversifying and hedging by setting up Roth individual retirement accounts before the change.
Benefits of Roth IRAs
Investors with Roth 401(k) funds may want to transfer the money to a Roth IRA in retirement to avoid the pro-rata rule, which requires taking both pre-tax and after-tax money with 401(k) withdrawals. By keeping pre-tax and after-tax money in separate IRAs, retired clients can have better control of their money based on its tax character.
Implementation Challenges
With less than six months until 2024, many companies are struggling to update their retirement plans to accommodate the changes. Approximately 200 organizations have written a letter to Congress requesting more time to implement the new rules. However, the number of retirement plans offering Roth contributions has been increasing, with 80% of plans offering Roth contributions in 2022 compared to 71% in 2018, according to Vanguard.
Conclusion: The Impact of New 401(k) Changes on New Businesses
The recent changes to 401(k) catch-up contributions and the shift to after-tax Roth accounts may have significant implications for new businesses and higher earners. While the focus has primarily been on the impact on individuals, it's essential to consider how these changes may affect new businesses and startup ventures.
One possible impact is the potential decrease in participation and contributions from high-earning employees. With the elimination of upfront tax breaks for catch-up contributions in 2024, higher earners may be less inclined to contribute additional funds to their retirement accounts. This could lead to a decline in overall retirement savings by key employees, potentially affecting the long-term financial security of both individuals and the business itself.
Moreover, the administrative challenges faced by employers in implementing these changes may pose additional burdens on new businesses. With the need to update retirement plans and ensure compliance, resource-strapped startups may struggle to navigate these requirements effectively. This could result in additional costs, potential errors, or delays in adapting to the new rules.
On the flip side, the shift to after-tax Roth accounts provides an opportunity for tax diversification and potential benefits for certain individuals and businesses. Startups may want to consider advising their high-earning employees on the advantages of Roth contributions and encourage them to explore this option. By educating employees on the potential long-term advantages and discussing individual financial goals, new businesses can help their employees make informed decisions about their retirement savings.
Ultimately, the impact of these 401(k) changes on new businesses will depend on how well businesses adapt, communicate with employees, and navigate the administrative complexities. It will be crucial for startup employers to stay informed, seek guidance from financial experts, and proactively address the implications to ensure the financial well-being of their employees and the success of their businesses.
Article First Published at: https://www.cnbc.com/2023/07/21/what-higher-earners-need-to-know-about-401k-catch-up-contributions.html.svg)
