401(k) Change Not So Awful for the Wealthy After All

You might hear a little extra grumbling from your well-heeled neighbors during future tax seasons.

The federal Secure Act 2.0 of 2022, signed into law last December, contains a provision that left some high-earning folks shaking their fists at Congress.

Under the provision, which takes effect in January 2024, savers age 50 and older who earned $145,000 or more in wages in the prior year no longer will be eligible to make “catch-up” contributions to traditional 401(k)s or other similar retirement plans.

Essentially, this means workers in this income group will lose a potential tax deduction of up to $7,500 in 2024. (That’s because $7,500 is the current maximum catch-up contribution amount for 401(k)s, and such contributions are tax-deductible.) And that lost tax deduction likely will grow larger in future years as the federal government raises the catch-up contribution limit to keep pace with inflation.

However, the news might not be as bad as those affluent taxpayers think. Those who earn $145,000 or more can still make 401(k) catch-up contributions as long as they make them to Roth 401(k) accounts.

While contributing to a Roth account deprives taxpayers of a tax deduction for the year of the contribution, the money that goes into these accounts will grow tax-free forever. (With traditional retirement accounts, on the other hand, the principal and growth are taxable once the account holder starts withdrawing funds.)

In simple terms, these wealthier workers are giving up a tax break now in exchange for a permanent tax break on the money for the rest of their lives.

The change to the catch-up contribution is part of a recent trend in which Congress appears to be pushing people toward investing in Roth individual retirement accounts (Roth IRAs) and Roth 401(k)s.

The reason for this shift is pretty obvious to those who understand the difference between Roth and traditional accounts: The government is drowning in debt and seemingly cannot stop spending itself further into the red. That means the feds need as much revenue as they can get, and they need it now.

As The Wall Street Journal explains:

“For lawmakers, a key lure of Roth accounts is that they provide tax revenue upfront within a 10-year budget window, while tax-deductible IRAs and 401(k)s lose it. This is one reason recent law changes have favored Roth accounts …”

It’s easy to understand why high-earning folks are unhappy about the recent change to their options for catch-up contributions to workplace retirement accounts. There are many advantages — especially for wealthy folks — to contributing to traditional retirement plans.

However, there are also advantages to choosing the Roth option, even for those with higher income tax rates.

Perhaps the biggest plus of a Roth account is that you never have to take required minimum distributions (RMDs) from your account. That can help the account holder in many ways, ranging from a lower annual tax bill to reduced taxes on Social Security income and cheaper Medicare premiums.

Roth accounts also can offer significant advantages if you plan to pass your money on to heirs.

In recent years, rules have changed such that many people who inherit IRAs and 401(k)s must withdraw all income from the accounts within 10 years of the original account holder’s death, potentially creating a large tax bill and robbing the accounts of continued growth.

The rule change states that heirs of traditional retirement accounts must make taxable withdrawals for each year during that post-death decade. By contrast, heirs of Roth accounts can wait until the last year to withdraw, giving those heirs another decade of tax-free growth.

If all of these changes on the part of the federal government leave you flummoxed, you have our sympathy. Perhaps it’s time to visit Money Talks News’ Solutions Center and find a great financial adviser who can help you chart the best path forward.