Starting this year, high-income Americans age 50 and older face a change in how they can make additional contributions to their retirement plans, with new rules requiring some to pay taxes on those funds early.
New Donation Rules
Under the new law, introduced under the SECURE 2.0 Act of 2022, workers age 50 or older who earn $150,000 or more in FICA taxable income will no longer be able to make pre-tax 401(k) contributions. Instead, those additional contributions must go into a Roth 401(k), meaning they are made with income that has already been taxed.
Late contributions allow older workers to increase their retirement income beyond the average annual rate. Colleen Carcone, director of wealth planning strategies at retirement financial services firm TIAA, explained in Newsweek: “Taxpayers participating in an employer-sponsored retirement plan can contribute up to $24,500 to their plan. All taxpayers over age 50 can make an additional $8,000 ‘catch-up’ contribution each year, and for taxpayers age 60 to 63, that contribution amount is $11,250.”
In the past, savers could choose whether those additional contributions were subject to tax or postal tax. Now, the flexibility is removed for high earners.
Carcone said the revised law, which went into effect Jan. 1, means “those with earnings over $150,000 on a W-2 from an employer sponsoring the plan (for the previous year) will be allowed to make back-to-back contributions with back-to-back tax dollars.”
Importantly, this rule only applies to income, not regular contributions, and is intended to apply to the previous year’s W-2 earnings. Employees making less than $150,000 are not affected and can continue to choose between traditional and Roth contributions, depending on what their employer offers.
Impact on Income
For those covered by the new law, the change could affect their wages.
Because traditional 401(k) contributions reduce the amount paid up front, they reduce the amount of money used to calculate income taxes. Roth contributions do not provide the same immediate tax break.
Carcone said: “The calculation of federal and state income tax is calculated after all pre-tax deductions have been deducted from the employee’s salary. If the employee makes post-tax contributions to the employer’s plan, the tax base from which the withholding is calculated and the employee’s salary will be higher.”
As a result, employees who make contributions to a Roth account may see a reduction in their take-home pay compared to previous years when those contributions were made before taxes.
Paying Taxes Up Front
While the law may feel like a tax hike, Carcone says it changes mainly when the tax is paid, rather than how much is ultimately owed.
“This changes the time that the tax is paid by the employee,” said Carcone. “Having a small salary may hurt today, but it’s not all bad news.”
Traditional retirement contributions are taxed when funds are withdrawn during retirement, including any investment growth. However, Roth contributions are taxed first – but qualified withdrawals, including earnings, are tax-free.
“Although there may be an increase in current tax liabilities, Roth retirement plans provide people with significant tax benefits once they retire and begin contributing,” Carcone said.
Among those benefits, Roth accounts are not subject to minimum withdrawal requirements, giving retirees the opportunity to draw down their savings. He said that because withdrawals are tax-free, “the growth in those accounts will effectively escape tax.”
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