Catch-up contributions are about to change. Beginning in 2024, some workers who make compensatory contributions to employer-sponsored retirement plans, such as 401(k), will have to put that money into Roth account. This means that they cannot deduct these contributions from their income taxes, but they will be able to withdraw the account gains later without the life tax. This change will apply to anyone earning $145,000 or more. Here’s what happens.
It is considered Work with a financial advisor As you evaluate your options for building your nest egg.
What are instant contributions?
Every tax advantage the retirement The account has a maximum contribution limit. This is the maximum amount of money you can put into the account each year without paying taxes. For example, in 2023, an individual can contribute up to $22,500 just to their 401(k) account. For an IRA, you can contribute up to $6,500.
In order to motivate retirement savings, the IRS allows “compensation contributions” for those 50 and older. So if you’re over 50, you can contribute an additional $7,500 to your 401(k) or an additional $1,000 to an IRA in 2023. That’s in addition to the contribution cap mentioned above.
Historically, the rules regarding compensatory contributions were based on basic arithmetic. If you make compensation contributions to 401(k)For example, you receive the standard tax deduction for this account. If you make compensation contributions to a Roth IRA, you pay taxes up front and pay no taxes on withdrawals.
For higher-income families, this is about to change.
Section 603 changes how catch-up contributions work
In 2022, Congress passed the law known as SECURE 2.0, a comprehensive set of changes in retirement in the United States. Although it has a few signature elements, most notably the transition of 401(k) programs from opt-in to opt-out, most of the law makes detailed changes to far too many programs.
But detailed changes aren’t the same as small changes, a fact made abundantly clear in the now infamous Section 603.
In Section 603 of the SECURE Act 2.0, Congress changed the method Catch-up contributions Work for high-income families. Specifically, with employer-sponsored plans like a 401(k), if you earned more than $145,000 in the prior tax year, you must make all compensation contributions on a Roth basis. This means that you can’t deduct the income they use for compensation contributions, but you won’t have to pay taxes on the money or its earnings when you withdraw it later in life.
This rule does not affect IRA plans.
Contribution limits will not change, because individuals will still contribute that money to an employer-sponsored plan. Instead, employers that allow compensation contributions will need to start offering Roth plans in addition to standard pretax retirement plans. This has led to some push backas retirement industry groups pointed out the time and costs involved in creating new Roth plans.
These changes are set to become effective January 1, 2024.
What does this mean for taxes?
The first thing to note is that Section 603 does not come into force. Individuals who earn $144,999 or less are exempt. They may fully deduct the income they contribute to an employer-sponsored retirement account, including any compensation contributions.
This section applies entirely to individuals who earn $145,000 or more. They may deduct the income you contribute to your 401(k) account in full up to the standard annual limit. They cannot deduct any income they use for compensation contributions and must pay taxes on that money. They should put that money into a Roth account, which will grow it back tax-free.
The specific tax effect depends entirely on the individual’s income. Take, for example, someone who earns $150,000 and makes maximum compensation contributions. Without addressing other deductions or other tax implications, the impact On their income tax it will look like this:
Currently they would be able to deduct this contribution, allowing them next opponent:
Income – $150,000
Highest tax bracket: 24% for income between $89,076 – $150,000
Tax deduction – $7,500
Residual taxable income – $142,500
Tax deduction – 24% x $7,500 = $1,800
Final income taxes – $24,928
Income tax deductions always come from the highest income bracket first. In this case, the highest tax bracket for an individual is 24%. They can deduct $7,500 from the money that is currently taxable at 24%, giving them a deduction of $1,800 in total tax savings.
Starting in 2024, that same person will no longer be able to deduct compensation contributions. Assuming the same compensatory contribution limit (which will increase each year), the new taxes for that person would look like this:
Income – $150,000
Tax deduction – $0
Residual taxable income – $150,000
Final income taxes – $26,728
The individual functionally has $1,800 less to invest. However, while it will make saving for retirement more expensive upfront, it will also incentivize employers to build more Roth options into their retirement plans. These plans have much greater tax benefits in the long run, as the investor ultimately pays no taxes on the larger amount withdrawn in retirement, rather than the smaller amount invested up front.
For individuals looking to avoid this tax issue, a good option would be this To unlock the IRA. These are pretax accounts, and you can have a 401(k) (or equivalent) and an IRA at the same time. While IRAs have much lower maximum contribution limits, you can generally invest in an IRA almost as much as you can invest with catch-up contributions, making this a good equivalent investment strategy.
This number has been mistaken for an error
The new tax cap is not wrong. The original script of SECURE 2.0 contained a syntax error related to catch-up contributions. In short, among the changes, Section 603 deleted a small clause in the Internal Revenue Code. A deleted section of the Internal Revenue Code (IRS) states that if the IRS allows a plan participant to make compensatory contributions to a 401(k) plan or other employer-sponsored plan, those contributions qualify for pre-tax status.
The idea was to prevent contradictory wording in the tax code. But in deleting this section, rather than specifying that it applies only to certain taxpayers, Congress would likely make pretax compensation contributions illegal for everyone. members of Congress since then advertiser that this was a syntax error and that they intend to correct it, although it has not been fixed at the time of writing.
Some reports have mixed this error up with the new tax cap, suggesting that Congress may undo the $145,000 cut. This is not accurate. The new cap on catch-up contributions was intentional.
If you earn more than $145,000 a year, starting in 2024 you won’t be able to deduct compensation contributions you make to an employer-sponsored plan. Instead, all of these contributions must go into a Roth plan, where you’ll pay taxes upfront but not when you withdraw the gains.
Retirement planning tips
a financial consultant It can help you build a comprehensive retirement plan, including how to handle catch-up contribution opportunities. Finding a financial advisor doesn’t have to be difficult. Free SmartAsset tool It matches you with up to three vetted financial advisors who serve your area, and you can place a free introductory call with your advisor matches to select the one you feel is a good fit for you. If you are ready to find a counselor who can help you achieve your financial goals, let’s start.
Catch-up contributions can be a great way to add extra liquidity to your retirement account, especially considering that most people will work and save for about another 20 years. So it is worth making the most of it.
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