What higher earners need to know about 401(k) catch-up contributions

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Higher earners maximizing savings ahead of retirement may soon lose a tax break, thanks to 401(k) changes enacted last year.

If you’re 50 or older, you can funnel extra money into your 401(k), known as “catch-up contributions.” For 2023, eligible workers can save another $7,500 after maxing out employee deferrals at $22,500.

But starting in 2024, higher earners can only make 401(k) catch-up contributions to after-tax Roth accounts, which don’t provide an upfront tax break but the funds can grow levy-free.

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The 2024 shift applies to individual accounts, meaning workers who earn more than $145,000 in 2023 from a single employer can expect to see the change, experts say.

“This change has already started to create administrative turbulence for employers as they plan for the January 1, 2024 implementation date,” said certified financial planner Jim Guarino, managing director at Baker Newman Noyes in Woburn, Massachusetts. 

“In addition, it may also cause high‐earning employees to rethink their decision to make catch‐up contributions after 2023,” said Guarino, who is also a certified public accountant.

Some 16% of eligible employees took advantage of catch-up contributions in 2022, according to a recent Vanguard report based on roughly 1,700 retirement plans. 

A separate Secure 2.0 change starting in 2025 boosts catch-up contributions by 50% for employees aged 60 to 63.  

Fund pre-tax catch-up contributions for 2023

Guarino urges higher earners to fund pre-tax catch-up contributions in 2023 while they still can because it provides a bigger tax break.

For example, let’s say an employee makes a $6,000 catch-up contribution while in the 35% tax bracket. If they withdraw the $6,000 in retirement while in the 15% bracket, they’ve saved $1,200 in taxes, he said.

Alternatively, if the same employee makes a $6,000 Roth contribution, they’re paying upfront taxes in the 35% bracket, which means paying taxes at a 20% higher rate upfront, Guarino said.

“There are many advantages to Roth retirement accounts,” Guarino said. “However, being in a lower tax bracket during retirement is not necessarily one of them.” But there may be other reasons for boosting Roth contributions — like avoiding required minimum distributions. 

Change provides tax diversification

While some higher earners will lose a tax break, the catch-up contribution change is “not necessarily a bad thing,” according to Dan Galli, a CFP and owner at Daniel J. Galli & Associates in Norwell, Massachusetts. “There’s some diversification from a tax point of view.”

Of course, when comparing pretax and Roth 401(k) contributions, the best option depends on your individual goals, expected income tax brackets in retirement and other factors. “I’m a big fan of hedging and diversifying,” said CFP John Loyd, an enrolled agent and owner at The Wealth Planner in Fort Worth, Texas.

Preparing for the catch-up contribution change

Galli is pushing higher-earning clients to set up Roth individual retirement accounts ahead of the change. The reason: Investors with Roth 401(k) funds may want to transfer the money to a Roth IRA in retirement.

Otherwise, they’ll have to deal with the so-called “pro-rata rule,” which requires you to take both pre-tax and after-tax money with 401(k) withdrawals, Galli said.

Instead, he prefers retired clients to keep pre-tax and after-tax money in different IRAs. “You get more control in retirement if you can segregate your money by its tax character,” he said.

However, with fewer than six months until 2024, many companies are struggling to update retirement plans by the deadline. Roughly 200 organizations wrote a letter to Congress asking for more time to implement the changes.

Some 80% of retirement plans offered Roth contributions in 2022, according to Vanguard, compared with 71% in 2018.

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