Consider this edition of TGIF 2 Minutes an “automatic Part 1” in a 2-part series on changes to the taxation of 401k contributions.
Calling these tax changes “under the radar” may be underestimating the level of attention paid by the average TGIF 2 Minutes reader to tax news. But fear not! Missing these tax changes is common and mostly due to
- the IRS typically making substantial tax law changes overnight in the last two weeks of December (see: 2015, 2017, 2020, 2021, 2022 and prior) thus easily missed by the most attentive of savers amidst year-end and holiday activity,
- the complicated language used in the changes, confusing both savers and employers and their HR departments.
One of the latest tax law changes was made in mid-December 2022 (quite possibly forgotten about) and which goes into effect in 2024. The change is related to the taxation of 401k catch-up contributions.
As a reminder, savers (mostly employed savers with access to a 401k plan) age 50 and older can make additional annual contributions to a 401k. The reason for the term, “catch-up” is related to a couple of factors, namely that an alarmingly low number of Americans contribute to a 401k and the average balance in a 401k at retirement being only $129,000.* Therefore, at age 50 there can be enough time to try to catch up on saving. The emphasis on “try to” is because savings behavior does not automatically kick in at age 50. But with proper advice (and a bit of fear) saving more after age 50 can become more of a habit.
Back to the tax law change on catch-up contributions starting in 2024. As opposed to current IRS policy which allows 401k catch-up contributions to be made either before OR after-tax, the new rule says that catch-up contributions must be made only after-tax – into Roth 401k accounts – for those who earned more than $145,000 in the prior year.
It may sound simple, but there are a host of reasons why the situation could get really complicated really quickly. A few reasons:
- a huge number of employers currently offering a 401k plan do not offer the Roth 401k option (if yours does, you are lucky!)
- there will be complications for employers, payroll processors and 401k administrators in the ability to track who earned more than $145,000 in the prior year.
- there is literally confusion in Congress about whether or not the catch-up will or can (by law) be offered in 2024 — which would be mildly devastating for both diligent and not-so-diligent 401k savers.
- Education on the concepts and taxation of catch-up contributions already cannot happen fast enough.
The next edition of TGIF 2 Minutes can delve into the positives and negatives of pre-tax and after-tax contributions to a 401k (for hints, please click on the image of mine and my colleague’s** whitepaper below, “The 401K TRAP”).
*According to Vanguard’s How America Saves report published in 2021 for 2020.
**The 401K TRAP, by Brian Doe®, CFP and Kerrie Debbs, CFP®. 2020.