September, 2023
A special note to my clients who are approaching retirement, including my own father (who might come across this message, 🤫): We’ll use my father as an example to illustrate some points. His passion is sailing, and his dream is 6-month journey along the Mexican coast next year, his first year of retirement. At 65, he’s in good financial standing, enjoys a respectable income, and after years of planning, he’s finally set to retire later this year.
Like many Americans, my father has taken advantage of a feature in his 401(k) known as catch-up contributions to help him reach this stage. Beginning at the age of 50, catch-up contributions are what allow you to add an extra $7,500 to your retirement 401(k) accounts, totaling a cool $30,000 for 2023(1). Well, here is a new twist – catch-up contributions will in the future only be allowed after-tax Roth retirement accounts if you earned more than $145,000 in the previous year (2).
Let’s break this down. This change means savers might face more upfront taxes during high-earning years instead of waiting until retirement, when tax burdens might be lighter. This change is shaking-up how we approach retirement tax-savings planning. For instance, with today’s current law, if you’re in the 35% tax bracket, you’d enjoy a sizable $2,625 tax deduction for a $7,500 catch-up contribution. Slide down to the 22% bracket, and you’re looking at a $1,650 deduction (3). With the new law change those upfront tax savings for catch-up contributions will vanish in exchange for lower taxes during retirement years, but to a lesser extent assuming a lower marginal tax rate during retirement.
Congress gave the green light to the catch-up contribution rule change, back in December 2022 (4). However, the Internal Revenue Service (IRS) has hit the brakes on this new rule, which was initially set to kick in next year. Concerns have been raised by employer groups that sponsor retirement plans, to implement the changes in timely fashion will be nearly impossible. The good news is the timeline has been postponed to 2026.
Admittedly, the new rules might mean some of us have to allocate more funds for taxes. But here’s the bright side – there is an advantage in encouraging savers nearing retirement to stash more money in a Roth account. Why? Because in a Roth, your money grows and can be withdrawn tax-free. The benefit is you have what we “financial planners” call “tax diversification” options in your investment accounts. Meaning in years of retirement you can decide where to pull money from to avoid being place in a higher tax bracket or worse yet trigger Medicare premium increases known as income-related monthly adjusted amount (IRMAA). This adjustment occurs when you exceed certain levels of income. Another prized benefit is for your heirs, as Roth accounts are inherited tax-free, however they are generally subject to the 10-year liquidation rule for most beneficiaries who are not spouses. Unfortunately, this prevents non-spouse beneficiaries to retain the Roth status beyond the 10 years.
It’s important to stay abreast of changes in tax laws that could potentially have an impact on your financial strategy. I want to emphasize the importance and value of working with a financial planner, who can help bring confidence in your financial decision making. If you’re scratching your head about how this may impact you or need clarification, just shoot me an email, or schedule a chat with me!
Happy Planning! 🚀
(1) https://www.irs.gov/newsroom/401k-limit-increases-to-22500-for-2023-ira-limit-rises-to-6500
(3) https://www.irs.gov/newsroom/irs-provides-tax-inflation-adjustments-for-tax-year-2023
(4) https://www.wsj.com/personal-finance/retirement/high-earners-50-and-up-get-two-year-reprieve-from-irs-on-401-k-rule-3a6d4727