There’s a tax increase in the new SECURE Act 2.0 legislation. Unfortunately, it falls largely on those least equipped to shoulder it.
Catch-Up Contributions
Since enacted in 2001, “catch-up” contributions have been a great feature of 401(k) plans. Currently, they allow those age 50 or older to contribute an additional $6,500 annually to their 401(k) or similar plan. Those contributions can be traditional deductible contributions, Roth contributions, or a combination of both.
The idea is that by age 50, workers have much less time to make up for deficiencies in retirement savings. Thus, the law allows those workers to make catch-up contributions to have a better chance of financial success in retirement.
Other than age (must be at least 50 years old), there are no limits on the ability to make catch-up contributions. That could be viewed as a give-away to the rich. However, it is logical to keep retirement savings rules simple, especially those designed to help older workers behind in retirement savings.
Catch-Up Contributions for Those Behind in Retirement Savings
For those behind in retirement savings, deducting catch-up contributions usually makes the most sense. First, many in their 50s are in their highest earning years, and thus tax deductions are their most valuable. Second, those behind in retirement savings are not likely to be in a high tax bracket in retirement. With modest or low retirement income, they are likely to pay, at most, a 10% or 12% top federal income tax rate in retirement.
Here is an example of how that works:
Sarah, single and age 55, is behind in her retirement savings, so she maxes out her annual 401(k) contribution at $27,000 ($20,500 regular employee contribution and $6,500 catch-up contribution). Sarah currently earns $130,000 a year and lives in California. Since she deducts her catch-up contributions, she saves $2,165 a year in taxes ($6,500 times 24% federal marginal tax rate and 9.3% California marginal tax rate). That $2,165 in income tax savings makes catching up on her retirement savings much more affordable for Sarah.
Sarah’s approach is quite logical. If things work out, Sarah can make up the deficit in her retirement savings. Doing so might push her up to the 12% marginal federal tax bracket and the 8% marginal California tax bracket in retirement.
For someone like Sarah who is behind in their retirement savings, the Roth option on catch-up contributions is a very bad deal!
SECURE 2.0 and Catch-Up Contributions
SECURE 2.0 disallows the tax deduction that people like Sarah rely on. It requires all catch-up contributions to be Roth contributions. For the affluent, this makes some sense. Why should someone with very substantial assets get a tax deduction when they already have a well-funded retirement?
Sadly, many Americans in their 50s and 60s do not have well-funded retirements. Removing the tax deduction for catch-up contributions increases their taxes. These are people who can least afford to shoulder a new tax. The goal should be to make it easier for those behind in retirement savings to catch-up. Taking away this tax deduction makes it more difficult to build up sufficient savings for retirement.
Fortunately, as of this writing SECURE 2.0 has only passed the House. It has not passed the Senate. Hopefully this provision will be reconsidered and will not ultimately become law.
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