IRS Extends 401(k) Tax Breaks for High Earners

The Internal Revenue Service on Friday put temporary brakes on implementing a new law that eliminates a major tax deduction enjoyed by higher-income Americans, allowing them to enjoy those tax breaks for two more years.

The nation’s tax collector said it would delay until 2026 a requirement that earners make catch-up contributions only to their after-tax Roth plans, and not to their 401(k)s. The requirement was originally set to begin in 2024. The two-year delay will mean an additional 24 months of millions of dollars of tax deductions on 401(k) contributions.

Contributions to Roths are made with dollars on which taxes have already paid, so there’s no deduction for them. By contrast, contributions to employer-sponsored plans are made with pre-tax dollars, which makes them deductible.

The requirement that catch up money be put into Roths came last December in a sweeping federal law that shook up how Americans save for retirement.

“It’s good news for high-income earners, because they have two more years where they have the choice of where they want their catch up contributions to go, and can take the deduction if they want,” said Ed Slott, a retirement expert in Rockville Centre, New York.

Individual retirement accounts and 401k(s), both traditional and Roth, allow savers age 50 and over to make catch-up contributions.

This year, contributions to all 401(k)s are capped at $22,500. That includes employer matches. But savers ages 50 and older can make catch-up contributions beyond that limit  — an extra $7,500, for a total of $30,000. Savers who put an extra $1,000 into their plan at the beginning of each year for the next 20 years would have nearly $44,000 more in their account, assuming an annual return of 7%, Fidelity Investments says.

The sweeping retirement law last December said people making $145,000 or more have to put their catch-up dollars in a Roth 401(k), not a traditional plan.

Anyone can contribute to a Roth 401(k), regardless of how much they make. Because withdrawals from Roths are tax-free, they’re a favorite of higher-earning people. By contrast, contributions to Roth IRAs are restricted by income levels. This year, a single person has to earn less than than $153,000 (less than $228,000 if they’re married and filing jointly).

Roths are best for people who expect to have high taxable income in retirement — hence their appeal to wealthier earners.

Americans are saving for retirement like mad, the Plan Sponsor Council of America said last December. In 2021, at the height of the COVID-19 pandemic, 401(k) participant and employer contribution rates reached an all-time average high of 13.9% of pay. Roth plans are increasingly available, with nearly nine in 10 companies offering one.

Still, only 14.1% of those eligible currently contribute to a Roth 401(k), Fidelity says. The plans are most popular for people aged 20 to 34, and for those with income of $75,000-$199,000.