401(k) Tax Changes: Who’s Affected?

A new rule is going into effect next year that will affect high earners who make “catch-up contributions” in their 401(k)s or other tax-deferred workplace retirement plans.

The rule, which was created under the Secure 2.0 retirement law, will essentially eliminate the immediate tax break for catch-up contributions that you get for the bulk of your other contributions to a 401(k) — or 403(b), 457(b), Simplified Employee Pension Plan (SEP) or SIMPLE IRA.

Here’s a breakdown of what will change and who, specifically, will be affected.

Currently, if you’re over 50 and max out your 401(k) contributions up to the federal cap (which is $23,500 this year), you are eligible to make additional “catch-up” contributions above that amount if you choose.

The limit on catch-up savings this year is $7,500 (or if your employer allows it, up to $11,250 for participants between the ages of 60 and 63). Those limits are adjusted for inflation annually.

Until now, you could choose for all of your 401(k) contributions to be made tax-deferred. That means the amount gets taken out of your paycheck before tax – thereby lowering your income tax bill today – and the contributions are allowed to grow tax-deferred until you start taking distributions in retirement.

But, starting next year, if you’re over 50 and made more than $145,000 in FICA wages — which is the income subject to Social Security and Medicare taxes — in the prior year, any so-called “catch-up contributions” you make will automatically be subject to income tax. In other words, they will be treated as Roth 401(k) contributions.

Once invested, your after-tax money will be allowed to grow tax free and be withdrawn tax free assuming certain conditions are met.

The vast majority of workplace retirement plans (93%) do offer employees the option of creating a Roth 401(k), according to the 2024 annual survey of the Plan Sponsor Council of America. But if your plan doesn’t, as a result of the rule change you will no longer be permitted to make catch-up contributions at all even though you’re 50 or older, according to Angela Capek, a senior vice president at Fidelity Investments, one of the largest workplace retirement plan providers.

Keep in mind, the new rule will have no effect on the taxation of anyone who is eligible to make catch-up contributions and makes below $145,000 (a number that may be adjusted upward for cost of living changes).

But for those high earners who are affected by the rule change, there are potential upsides and downsides.

On the one hand, being forced to pay taxes on part of your retirement savings now when you’re likely in your peak earning years means you may pay a higher tax rate on those savings than you would if you withdrew them in retirement. (We say “may” because no one can predict where tax rates will be in the coming years.)

And for every year that you opt to make catch-up savings, “you’ll owe more taxes to the federal government now because you lose pre-tax treatment (on those contributions),” said Brigen Winters, a principal at Groom Law Group, an employee benefits law firm that represents retirement plan sponsors, among others.

Put another way, “your take-home pay could be reduced,” Capek said.

But the rule change does offer you some potential advantages. First, the money you invest in the Roth portion of your 401(k) will grow tax free and can be withdrawn tax free assuming you let it stay invested for at least five years and are at least 59-1/2. Plus, thanks to Secure 2.0, unlike with your traditional, tax-deferred 401(k) contributions, you will not be required to make minimum withdrawals from your Roth 401(k) when you turn 73.

And when you do retire, having an amount of money that is free and clear of any tax obligation gives you a lot more flexibility when deciding how to manage your finances since your other retirement income sources — including potentially part of your Social Security benefits — are likely to be taxable.

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