High-earning individuals will need to adjust their approach to 401(k) catch-up contributions, as there will be a change in how they work starting in 2024. Currently, 401(k) plans offer attractive benefits for retirement savings due to their employer-sponsored nature, hands-off management, and potential to lower taxable income. Additionally, their relatively high annual contribution limits make them an effective tool for building retirement income.
For tax year 2024, the maximum contribution limit for a 401(k) is $22,500. Individuals aged 50 or older are allowed a catch-up contribution, increasing the limit by $7,500 to $30,000. This is significantly higher than the contribution limits for IRAs, which stand at $6,500, with a $1,000 catch-up contribution.
Starting in 2024, individuals who earned more than $145,000 in the previous year will need to make changes to how they handle their catch-up contributions. They will no longer be able to add these contributions to their pre-tax 401(k) account; instead, they will need to direct them into an after-tax Roth account.
Roth accounts work differently from traditional retirement accounts like 401(k)s and IRAs. In Roth accounts, contributions are made with after-tax money, but the money grows tax-free, and withdrawals in retirement are also tax-free. The new rule change will not apply to Roth IRA catch-up contributions, so individuals eligible to contribute to a Roth IRA can still make their $1,000 catch-up contribution.
While traditional 401(k) catch-up contributions currently offer a tax deduction, paying taxes on Roth catch-up, contributions may seem less favorable at first glance. Although there is an initial tax payment, the benefits of tax-free withdrawals during retirement can ultimately outweigh this cost. The growth potential of Roth contributions, coupled with tax-free withdrawals, can lead to significant savings in the long run.
To qualify for tax-free withdrawals from a Roth 401(k), the account holder must have reached 59 1/2 years of age and maintained the account for at least five years. The five-year period starts at the beginning of the tax year in which the account was first created.
Investors should consider their circumstances and preferences when deciding between a regular 401(k) and a Roth 401(k). While some people choose a regular account, expecting their tax bracket to be lower in retirement, high earners with substantial retirement balances might find tax-free growth more advantageous in the long term.
Companies have raised concerns about implementing these changes’ logistical challenges and requested a two-year delay. However, as of now, the change is scheduled to take effect on January 1, 2024.
Investors must stay informed and prepared, even if there are possibilities of delays. While the change may not require a complete overhaul of their retirement saving and investing strategy, individuals should consider how they want to approach their catch-up contributions. Being proactive and informed about these changes will help investors make the best decisions for their financial future. For instance, they could decide to allocate catch-up contributions to a particular index fund option within their retirement plan.