Leaving Your Job? What Should You Do With Your 401(k)?

When you separate from an employer, there are important decisions to make regarding your 401(k) plan. It’s crucial to understand the pros and cons of each option, as the optimal solution often varies depending on individual financial situations and objectives. The four primary options are:

1. Leave it in the existing 401(k) plan

2. Rollover to an IRA

3. Rollover to your new employer’s 401(k) plan

4. Cash Distribution

Option 1:Leave It In The Existing 401(k) Plan

If your 401(k) balance exceeds $7,000, your employer is legally prohibited from forcing you to take a distribution or roll over the funds. You can keep your balance invested in the plan. While no new contributions are allowed since you’re no longer employed, you can still change your investment options, receive statements, and maintain online access to the account.

PROS to Leaving Your Money In The Existing 401(k) Plan

#1:  No Urgent Deadline to Move

Leaving a job often coincides with major life changes—whether retiring, job hunting, or starting a new position. It’s reassuring to know that you don't need to make an immediate decision regarding your 401(k), allowing time to evaluate options and choose the best one.

#2:  You May Not Be Eligible Yet For Your New Employer’s 401(k) Plan 

One of the distribution options that we will address later in this article is rolling over your balance from your former employer's 401(k) plan into your new employer’s 401(k) plan.  However, it's not uncommon for companies to have a waiting period for new employees before they're eligible to participate and the new company’s 401(k) plan.  If you must wait a year before you have the option to roll over your balance into your new employer's plan, the prudent solution may be just to leave the balance in your former employer’s 401(k) plan, and just roll it over once you become eligible for the new 401(k) plan. 

#3:  Fees May Be Lower

It's also prudent to do a fee assessment before you move your balance out of your former employer’s 401(k) plan.  If you work for a large employer, it's not uncommon for there to be significant assets within that company’s 401(k) plan, which can result in lower overall fees to any plan participants that maintain a balance within that plan.  For example, if you work for Company ABC, which is a big publicly traded company, they may have $500 million in their 401(k) plan when you total up all the employee's balances.  That may result in total annual fees of under 0.50% depending on the platform.  If your balance in the plan is $100,000, and you roll over your balance to either an IRA or a smaller employer’s 401(k) plan, the total fees could be higher because you are no longer part of a $500 million pool of assets.  You may end up paying 1% or more in fees each year, depending on where you roll over your balance.

#4: Age 55 Rule

401(k) plans have a special distribution option that if you separate from service with the employer after reaching age 55, you are allowed to request cash distributions directly from that 401(k) plan, but you avoid the 10% early withdrawal penalty that normally exists in IRA accounts for taking distributions under the age of 59 ½.  For individuals that retire after age 55, not before age 59 ½, this is one of the primary reasons why we advise some clients to maintain their balance in the former employer’s 401(k) plan and take distributions from that account to avoid the 10% penalty.  If they were to inadvertently roll over the entire balance to an IRA, that 10% early withdrawal penalty exception would be lost.

CONS to Leaving Your Money In The Existing 401(k) Plan

#1:  Scattered 401(k) Balance

I have met with individuals who have three 401(k) plans, all with former employers.  When I start asking questions about the balance in each account, how each 401(k) account is invested, and who the providers are, most individuals with more than one 401(k) account have trouble answering those questions. From both a planning and investment strategy standpoint, it's often more efficient to have all your retirement dollars in one place so you can very easily assess your total retirement nest egg, how that nest egg is invested, and you can easily make investment changes or updates to your personal information.

#2:  Forgetting to Update Addresses

It's not uncommon for individuals to move after they've left employment with a company, and over the course of the next 10 years, it's not uncommon for someone to move multiple times.  Oftentimes, plan participants forget to go back to all their scattered 401K plans and update their mailing addresses, so they are no longer receiving statements on many of those accounts which makes it very difficult to keep track of what they have and what it's invested in.

#3:  Limited Investment Options

401(k) plans typically limit plan participants to a set menu of investments which the plan participant has no control over. Rolling your balance into a new employer’s plan or an IRA could provide a broader range of investment options.

OPTION 2: Rollover to an IRA

The second option for plan participants is to roll over their 401(k) balance to an IRA(s).  The primary advantage of the IRA rollover is that it allows employees to remove their balance from their former employers' 401(k) plan, but it does not generate tax liability.  The pre-tax dollars within the 401(k) plan can be rolled directly to a Traditional IRA, and any Roth dollars in the 401(k) plan can be rolled over into a Roth IRA. 

PROS of 401K Rollover to IRAs

#1:  Full Control of Investment Options

As I just mentioned in the previous section, 401(k)’s typically have a set menu of investments available to plan participants by rolling over their balance to an IRA. The plan participant can choose to invest their IRA balance in whatever they would like - individual stocks, bonds, mutual funds, CD, etc. 

#2:  Consolidating Retirement Accounts

Since it's not uncommon for employees to have multiple employers over their career, as they leave employment with each company, if the employee has an IRA in their own name, they can keep rolling over the balances into that central IRA account to consolidate all their retirement accounts into a single account. 

#3:  Ease of Distributions in Retirement

It is sometimes easier to take distributions from an IRA than it is from a 401(k) plan.  When you request a distribution from a 401(k) plan, you typically have to work through the plan’s administrator. The plan trustee may need to approve each distribution, and some plans are “lump-sum only,” which means you can’t take partial distributions from the 401(k) account. With those lump-sum-only plans, when you request your first distribution from the account, you have to remove your entire balance.  When you roll over the balance to an IRA, you can often set up monthly reoccurring distributions, or you can request one-time distributions at your discretion.

#4: Avoid the 401(k) 20% Mandatory Fed Tax Withholding

When you request Distributions from a 401(k) plan, by law, they are required to withhold 20% for Federal Taxes from each distribution (unless it’s an RMD or hardship).   But what if you don’t want them to withhold 20% for Fed taxes? With 401(k) plans, you don’t have a choice.  By rolling over your balance to an IRA, you have the option to not withhold any taxes or electing a Fed amount less than 20% - it’s completely up to you.

#5: Discretionary Management

Most 401(k) investment platforms are set up as participant-directed platforms which means the plan participant has to make investment decisions with regard to their accounts without an investment advisor overseeing the account and trading it actively on their behalf.  Some individuals like the idea of having an investment professional involved to actively manage their retirement accounts on their behalf, and rolling over the balance from 401(k) to an IRA can open up that option after the employee has separated from service.

CONS of 401(k) Rollover to IRAs

Here is a consolidated list based on some of the pros and cons already mentioned:

1. Fees could be higher in an IRA compared to the existing 401(k)

2. The Age 55 10% early withdrawal exception could be lost

3. No point in rolling to an IRA if the plan is just to roll over to the new employer’s plan once you have met the plan’s eligibility requirements

OPTION 3: Rollover to New Employer’s 401(k) Plan

To avoid repeating many of the pros and cons already mentioned here is a quick hit list of the pros and cons

PROS:

1. Keep retirement accounts consolidated in new employer plan

2. No tax liability incurred for rollover

3. Potentially lower fees compared to rolling over to an IRA

4. If the new plan allows 401(k) loans, rollover balances are typically eligible toward the max loan amount

5. Full balance eligible for age 55 10% early withdrawal penalty exception

A new advantage that I would add to this list is for employees over the age of 73 who are still working; if you keep your pre-tax retirement account balance within your current employer’s 401(k) plan, you can avoid the annual RMD requirement. When you turn certain ages, currently 73 but soon to be 75, the IRS forces you to start taking taxable distributions out of your pre-tax retirement accounts. However, there is an exception to that rule for any pretax balances maintained in a 401(k) plan with your current employer.  The balance in your 401(k) plan with your CURRENT employer is not subject to annual RMDs so you avoid the tax hit associated with taking distributions from a pre-tax retirement account.

I put CURRENT in all caps because this 401(k) RMD exception does not apply to balances in former employer 401(k) plans. You must be employed by that company for the entire year to avoid the RMD requirement.  Balances in former employer 401(k) plans are still subject to the RMD requirement. 

CONS:

1. Potentially limited to investment options offered via the 401(k) investment menu

2. You may not be allowed to take distribution at any time from your 401(k) account after the rollover, whereas a rollover IRA would allow you to keep that option open.

3. Your personal investment advisor cannot manage those assets within the 401(k) plan

4. Possible distribution and tax withholding restrictions depend on the plan design

OPTION 4: Cash Distributions

I purposely saved cash distributions for last because it is rarely the optimal distribution option.  When you request a cash distribution from a 401(k) plan and you are under the age of 59 ½, you will incur fed taxes, potentially state taxes depending on what state you reside in, and a 10% early withdrawal penalty.  When you begin to total up the taxes and penalties, sometimes you’re losing 30% - 50% of your balance in the plan to taxes and penalties. 

When you lose 30 to 50% of your retirement account balance in one shot, it can set you back years in the future when it comes to trying to figure out what date you can retire. While, it's not uncommon for a 25-year-old to not be overly concerned with their retirement date; making the decision to withdraw their entire account balance can end up being a huge regret when they are 75 and still working while all their friends retired 10 years before them. 

However, as financial planners, we do acknowledge that someone losing their job can create financial disruption, and sometimes a balance needs to be reached between a cash distribution to help them bridge the financial gap to their next career while maintaining as much of their retirement account as possible.  The good news is it's not an all-or-nothing decision.  For clients that have a high degree of uncertainty, it can sometimes be prudent to roll over the balance from the 401(k) to an IRA which gives them maximum flexibility as to how much they can take from that IRA account for distributions, but usually reserves the right to allow them to roll over that IRA balance into a future employer’s 401(k) plan at their discretion. 

Example: Samantha Was just laid off by Company XYZ; she has a $50,000 balance in their 401(k) plan and she is worried that she's not going to be able to pay her bills for the next few months while she's looking for her next job. She may want to roll over that $50,000 balance to an IRA so she can distribute $10,000 from the IRA, pay the taxes and the penalties, but continue to maintain the remaining $40,000 in the IRA untaxed.  But if she struggles to continue to find her next career, she can always go back to the IRA and take additional distributions.  Samantha then gets hired by Company ABC and is eligible to participate in that company's 401(k) plan after three months. At that time, she can make the decision to either roll over the IRA balance to her new 401(k) plan or just keep the IRA where it is.

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

Focusing On Buying Dividend Paying Stocks Is A Mistake

Picking the right stocks to invest in is not an easy process, but all too often I see retail investors make the mistake of narrowing their investment research to just stocks that pay dividends. This is a common mistake that investors make, and in this article, we are going to cover the total return approach versus the dividend payor approach to investing.  

Myth: Stocks That Pay Dividends Are Safer

Retail investors sometimes view dividend paying stocks as a “safer” investment because if the price of the stock does not appreciate, at least they receive the dividend. There are several flaws to this strategy. First, when times get tough in the economy, dividends can be cut, and they are often cut by companies to preserve cash.  For example, prior to the 2008/2009 Great Recession, General Electric stock was paying a solid dividend, and some retirees were using those dividends to supplement their income. When the recession hit, GE dramatically cut it dividends, forcing some shareholders to sell the stock at lower levels just to create enough cash to supplement their income. Forcing a buy high, sell low scenario.

The Magnificent 7 Stocks Do Not Pay Dividends

In more recent years, when you look at the performance of the “Magnificent 7” tech stocks which have crushed the performance of the S&P 500 Index over the past 1 year, 5 years, and 10 years,  there is one thing most of those Magnificent 7 stocks have in common. As I write this article today, Nvidia, Microsoft, Google, Amazon, and Meta either don’t pay a dividend or their dividend yield is under 1%.  So, if you were an investor that had a bias toward dividend paying stocks, you may have missed out on the “Mag 7 rally” that has happened over the past 10 years.

Growth Companies = No Dividends

When a company issues a dividend, they are returning capital to the shareholders as opposed to reinvesting that capital into the company.  Depending on the company and the economic environment, a company paying a dividend could be viewed as a negative action because maybe the company does not have a solid growth plan, so instead of reinvesting the money into the company, they default to just returning that excess capital to their investors.  It’s may feel good to have some investment income coming back to you, but if you are trying to maximize investment returns over the long term, will that dividend paying stock be able to outperform a growth company that is plowing all of their cash back into more growth?

Companies Taking Loans to Pay Their Dividend

For companies that pay a solid dividend, they are probably very aware that there are subsets of shareholders that are holding their stock for the dividend payments, and if they were to significantly cut their dividend or stop it all together, it may cause investors to sell their stock. When these companies are faced with tough financial conditions, they may resist cutting the dividends long after they really should have, putting the company in a potentially worse financial position knowing that shareholders may sell their stock as soon as the dividend cut is announced.

Some companies may even go to the extreme that since they don’t have the cash on hand to pay the dividend, they will issue bonds (go into debt) to raise enough cash for the sole purpose of being able to continue to pay their dividends, which goes completely against the reason why most companies issue dividends.

If a company generates a profit, they can decide to reinvest that profit back into the company, return that capital to investors by paying a dividend, or some combination of two. However, if a company goes into debt just to avoid having to cut the dividend payments to investors, I would be very worried about the growth prospects for that company.

Focus on Total Return

I’m a huge fan on focusing on total return.  The total return of a stock equals both how much the value of the stock has appreciated AND any dividends that the stock pays while the investor holds the stock.   If I gave someone the option of owning Stock ABC that does not pay a dividend and Stock XYZ that pays a 5% dividend, a lot of individuals will automatically start to build a strong bias toward buying XYZ over ABC without digging much deeper into the analysis.  However, if Stock ABC does not pay a dividend due to its significant growth prospects and rises 30% in a year, while Stock XYZ pays a 5% dividend but only appreciates 8%, the total return for Stock XYZ is just 13%. This means the investor missed out on an additional 17% return by choosing the lower-performing stock.

Diversification Is Still Prudent

The purpose of this article is not to encourage investors to completely abandon dividend paying stocks for growth stocks that don’t pay dividends.  Having a diversified portfolio is still a prudent approach, especially since growth stocks tend to be more volatile over time. Instead, the purpose of this article is to help investors understand that just because a stock pays a dividend does not mean it’s a “safer investment” or that it’s a “better” long-term investment from a total return standpoint. 

Accumulation Phase vs Distribution Phase

We categorize investors into two phases: the Accumulation Phase and the Distribution Phase. The Accumulation Phase involves building your nest egg, during which you either make contributions to your investment accounts or refrain from taking distributions. In contrast, the Distribution Phase refers to individuals who are drawing down from their investment accounts to supplement their income.

During the Accumulation Phase, a total return approach can be prudent, as most investors have a longer time horizon and can better weather market volatility without needing to sell investments to supplement their income. These investors are typically less concerned about whether their returns come primarily from appreciation or dividends.

As you enter the Distribution Phase, often in retirement, the strategy shifts. Reducing portfolio volatility becomes crucial because you are making regular withdrawals. For instance, if you need to withdraw $50,000 annually from your Traditional IRA and the market drops, you may be forced to liquidate investments at an inopportune time, negatively impacting long-term performance. In the Accumulation Phase, you can ride out market declines since you are not making withdrawals.

Times Are Changing

Traditionally, investors would buy and hold 10 to 30 individual dividend-paying stocks indefinitely. This is why inherited stock accounts often include companies like GE, AT&T, and Procter & Gamble, known for their consistent dividends.

However, the S&P 500 now features seven tech companies that make up over 30% of the index's total market cap, driving a significant portion of stock market returns over the past decade, with very few paying meaningful dividends. This article highlights the need for investors to adapt their stock selection methodologies as the economy evolves. It’s essential to understand the criteria used when selecting investments to maximize long-term returns.

Special Disclosure: This article does not constitute a recommendation to buy or sell any of the securities mentioned and is for educational purposes only.

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

What Is an ETF & Why Have They Surpassed Mutual Funds in Popularity?

There is a sea change happening in the investment industry where the inflows into ETF’s are rapidly outpacing the inflows into mutual funds.  See the chart below, showing the total asset investments in ETFs vs Mutual Funds going back to 2000, as well as the Investment Company Institute’s projected trends going out to 2030.   

Why is this happening?  While mutual funds and ETFs may look similar on the surface, there are several dramatic differences that are driving this new trend.

What is an ETF?

ETF stands for Exchange Traded Fund.  On the surface, an ETF looks very similar to an index mutual fund.   It’s a basket of securities often used to track an index or an investment theme.  For example, Vanguard has the Vanguard S&P 500 Index EFT (Ticker: VOO), but they also have the Vanguard S&P 500 Index Fund (Ticker: VFIAX); both aim to track the performance of the S&P 500 Index, but there are a few differences. 

ETFs Trade Intraday

Unlike a mutual fund that only trades at 4pm each day, an ETF can be traded like a stock intraday, so if you want to see $10,000 of the Vanguard S&P 500 ETF at 10am, you can do that, versus if you are invested in the Vanguard S&P 500 Index Fund, it will only trade at 4pm which may be at a better or worse price depending where the S&P 500 index finished the trading day compared to the price at 10am. 

How ETFs Are Traded

When it comes to comparing ETFs to Mutual Funds, a big difference is not only WHEN they trade, but also HOW they trade.  When you sell a mutual fund, your shares are sold back to the mutual fund company at 4pm and settled in cash.  An exchange traded fund trades like a stock where shares are “exchanged” between a buyer and a seller in the open market, which is where ETF’s get their name from. They are “exchanged”, not redeemed like mutual fund shares. 

ETF Tax Advantage Over Mutual Funds

One of the biggest advantages of ETFs over mutual funds is their tax efficiency, which relates back to what we just covered about how ETFs are traded.  When you redeem mutual fund shares, if the fund company does not have enough in its cash reserve within the mutual fund itself, it has to go on the open market and sell securities to raise cash to meet the redemptions. Like any other type of investment account, if the security that they sell has an unrealized gain, selling the security to raise cash creates a taxable realized gain, and then the mutual fund distributes those gains to the existing shareholders, typically at the end of the calendar year as “capital gains distributions” which are then taxed to the current holders of the mutual funds.

If the current shareholders are holding that mutual fund in a taxable account when the capital gains distribution is issued, the shareholder needs to report that capital gains distribution as taxable income. This never seemed fair because that shareholder didn't redeem any shares, however since the mutual fund had to redeem securities to meet redemptions, the shareholders that remain unfortunately bear the tax burden.

Example:  Jim and Sarah both own ABC Growth Fund in their brokerage accounts.  ABC has performed well for the past few years, so Sarah decides to sell her shares. The mutual fund company then has to sell shares of stock within its portfolio to meet the redemption request, generating a taxable gain within the mutual fund portfolio. At the end of the year, ABC Growth Fund issues a capital gain distribution to Jim, which he must pay tax on, even though Jim did not sell his shares, Sarah did.

ETFs do not trigger capital gains distributions to shareholders because the shares are exchanged between a buyer and a seller, an ETF company does not have to redeem securities within its portfolio to meet redemptions.  So, you could technically have an ABC Growth Mutual Fund and an ABC Growth ETF, same holdings, but the investor that owns the mutual fund could be getting hit with taxed on capital gains distribution each year while the holder of the ETF has no tax impact until they sell their shares.

Holding ETFs In A Taxable Account vs Retirement Account

Tax efficiency matters the most in taxable accounts, like brokerage accounts. If you are holding an ETF or mutual fund within an IRA or 401(k) account, since retirement accounts by nature are tax deferred, the capital gains distributions being issued by the mutual fund companies do not have an immediate tax impact on the shareholders because of the tax deferred nature of retirement accounts.   For this reason, there has been less urgency to transition from mutual funds to ETFs in retirement accounts.  

Many ETFs Don’t Trade In Fractional Shares

The second reason why ETFs have been slower to be adopted into employer sponsored retirement plans, like 401(k) plans, is most ETFs, like stocks, only trade in whole shares. Example:  If you want to buy 1 share of Google, and Google is trading for $163 per share, you have to have $163 in cash to buy one whole share. You can’t buy $53 of Google because it’s not enough to purchase a whole share.  Most ETF’s work the same way. They have a share price like a stock, and you have to purchase them in whole shares. Mutual funds by comparison trade in fractional shares, meaning while the “share price” or “NAV” of a mutual fund may be $80, you can buy $25.30 of that mutual fund because they can be bought and sold in fractional shares.

This is why from an operational standpoint, mutual funds can work better in 401(k) accounts because you have employees making all different levels of contributions each pay period to their 401(K) accounts - Jim is contributing $250 per pay period, Sharon $423 per pay period, Scott $30 per pay period. Since mutual funds can trade in fractional shares, the full amount of those contributions can be invested each pay period, whereas if it was a menu of ETFs that only traded in full shares, there would most likely be uninvested cash left over each pay period because only whole shares can be purchased.

ETF’s Do Not Have Minimum Initial Investments

Another advantage that ETF’s have over mutual funds is they do not have “minimum initial investments” like many mutual funds do. For example, if you look up the Vanguard S&P 500 Index Mutual Fund (Ticker VFIAX), there is a minimum initial investment of $3,000, meaning you must have at least $3,000 to buy a position in that mutual fund.  Whereas the Vanguard S&P 500 Index ETF (Ticker: VOO) does not have a minimum initial investment, the current share price is $525.17, so you just need $525,17 to purchase 1 share.

NOTE: I’m not picking on Vanguard, they are in a lot of my example because we use Vanguard in our client portfolios, so we are very familiar with how their mutual funds and ETFs operate. 

ETFs Do Not CLOSE To New Investors

Every now and then a mutual fund will declare either a “soft close” or “hard close”.  A soft close means the mutual fund is closed to “new investors” meaning if you currently have a position in the mutual fund, you are allowed to continue to make deposits, but if you don’t already own the mutual fund, you can no longer buy it.   A “hard close” is when both current and new investors are no longer allowed to purchase shares of the mutual fund, existing shareholders are only allowed to sell their holdings.

Mutual Funds will sometimes do this to protect performance or their investment strategy. If you are managing a Small Cap Value Mutual Fund and you receive buy orders for $100 billion, it may be difficult, if not impossible to buy enough of the publicly traded small cap stock to put that cash to work. Then, the fund manager might have to expand the stock holding to “B team” selections, or begin buying mid-cap stock which creates style drift out of the core small cap value strategy.  To prevent this, the mutual fund will announce either a soft or hard close to prevent these big drifts from happening.

Arguably a good thing, but if you love the fund, and they tell you that you can’t put any more money into it, it can be a headache for current shareholders.

Since ETFs trade in the open market between buyers and sellers, they cannot implement hard or soft closes, it just becomes, ‘how much are the current holders of the ETF willing to sell their shares for in the open market to the buyers’.

ETFs Can Offer A Wider Selection of Investment Strategies

With ETFs, there are also a wider variety of investment strategies to choose from and the number of ETFs available in the open market are growing rapidly.   

For example, if you want to replicate the performance of Brazil’s stock market within your portfolio, iShares has an ETF called MSCI Brazil (Ticker: EWZ) which seeks to track the investment results of an index composed of Brazilian equities.   While traditional indexes exist within the ETF world like tracking the total bond market or S&P 500 Index, EFTs can provide access to more limited scope investment strategies.

ETF Liquidity Risk

But this brings me to one of the risks that shareholders need to be aware of when buying thinly traded ETFs.  Since they are exchange traded funds, if you want to sell your position, you need a buyer that wants to buy your shares, otherwise there is no way to sell your position. One of the metrics we advise individuals to look at before buying an ETF is the daily trade volume of that security to determine how easily or difficult it would be to find a buyer for your shares if you wanted to sell them.

For example, VOO, the Vanguard S&P 500 Index ETF has an average trading volume right now about 5 million shares and as the current share price is about $2.6 Billion in activity each day, there is a high probability that if you wanted to sell $500,000 of your VOO, that order could be easily filled.  If instead, you are holding a very thinly traded ETF that only has an average trading volume of 100,000 share per day and you are holding 300,000 shares, it may take you a few days or weeks to sell your position and your activity could negatively impact the price as you try to sell because it could move the market with your trade given the light trading volume. Or worse, there is no one interested in buying your shares, so you are stuck with them.  You just have to do your homework when investing the more thinly traded ETFs.

Passive & Active ETFs

Similar to mutual funds, there are both passive and active ETF’s. Passive ETFs aim to replicate the performance of an existing index like the S&P 500 Index or a bond index, while active strategy ETFs are trying to outperform a specific index through the implementation of their investment strategy within the ETF. 

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

When Should High-Income Earners Max Out Their Roth 401(k) Instead of Pre-tax 401(k)?

While pre-tax contributions are typically the 401(k) contribution of choice for most high-income earners, there are a few situations where individuals with big incomes should make their deferral contributions all in Roth dollars and forgo the immediate tax deduction.

No Income Limits for Roth 401(k)

It’s common for high income earners to think they are not eligible to make Roth deferrals to their 401(k) because their income is too high.  However, unlike Roth IRAs that have income limitations for making contributions, Roth 401(k) contributions have no income limitation.   

401(k) Deferral Aggregation Limits  

In 2024, the employee deferral limits are $23,000 for individuals under the age of 50, and $30,500 for individuals aged 50 or older.  If your 401(k) plan allows Roth deferrals, the annual limit is the aggregate between both pre-tax and Roth deferrals, meaning you are not allowed to contribute $23,000 pre-tax and then turn around and contribute $23,000 Roth in the same year.  It’s a combined limit between the pre-tax and Roth employee deferral sources in the plan.  

Scenario 1:  Business Owner Has Abnormally Low-Income Year 

Business owners from time to time will have a tough year for their business.  They may have been making $300,000 or more per year for the past year but then something unexpected happens or they make a big investment in their business that dramatically reduces their income from the business for the year.  We counsel these clients to “never waste a bad year for the business”.    

Normally, a business owner making over $300,000 per year would be trying to max out their pre-tax deferral to their 401(K) plans in an effort to reduce their tax liability.  But, if they are only showing $80,000 this year, placing a married filing joint tax filer in the 12% federal tax bracket, I’ll ask, “When are you ever going to be in a tax bracket below 12%?”. If the answer is “probably never”, then it an opportunity to change the tax plan, max out their Roth deferrals to the 401(k) plan, and realize that income at their abnormally lower rate.  Plus, as the Roth source grows, after age 59 ½ they will be able to withdrawal the Roth source ALL tax free including the earnings.  

Scenario 2:  Change In Employment Status 

Whenever there is a change in employment status such as: 

1. Retirement

2. High income spouse loses a job

3. Reduction from full-time to part-time employment

4. Leaving a high paying W2 job to start a business which shows very little income

All these events may present an abnormally low tax year, similar to the business owner that experienced a bad year for the business, that could justify the switch from pre-tax deferrals to Roth deferrals.

The Value of Roth Compounding

I’ll pause for a second to remind readers of the big value of Roth.  With pre-tax deferrals, you realize a tax benefit now by avoiding paying federal or state income taxes on those employee deferrals made to your 401(k) plan. However, you must pay tax on those contributions AND the earnings when you take distributions from that account in retirement. The tax liability is not eliminated, just deferred.

For example, if you are 40 years old, and you defer $23,000 into your 401K plan, if you get an 8% annual rate of return on that $23,000, it will grow to $157,515 when you turn age 65.  As you withdraw that $157,515 in retirement, you’ll pay income tax on all of it.

Now instead let’s assume you made the $23,000 employee deferral all Roth, with the same 8% rate of return per year, reaching the same $157,515 balance at age 65, now you can withdrawal the full $157,515 all tax free.

Scenario 3:  Too Much In Pre-Tax Retirement Accounts Already  

When high income earners have been diligently saving in their 401(k) plan for 30 plus years, sometimes they amass huge pre-tax balances in their retirement plans.  While that sounds like a good thing, sometimes it can come back to haunt high-income earnings in retirement when they hit their RMD start date.  RMD stands for required minimum distribution, and when you reach a specific age, the IRS forces you to begin taking distributions from your pre-tax retirement account whether you need to our not. The IRS wants their income tax on that deferred tax asset.

The RMD start age varies depending on your date of birth but right now the RMD start age ranges from age 73 to age 75.   If for example, you have $3,000,000 in a Traditional IRA or pre-tax 401(k) and you turn age 73 in 2024, your RMD for the 2024 would be $113,207.  That is the amount that you would be forced to withdrawal out of your pre-tax retirement account and pay tax on.  In addition to that income, you may also be showing income from social security, investment income, pension, or rental income depending on your financial picture at age 73. 

If you are making pre-tax contributions to your retirement now, normally the goal is to take that income off that table now and push it into retirement when you will hopefully be in a lower tax bracket. However, if your pre-tax balances become too large, you may not be in a lower tax bracket in retirement, and if you’re not going to be in a lower tax bracket in retirement, why not switch your contributions to Roth, pay tax on the contributions now, and then you will receive all of the earning tax free since you will now have money in a Roth source.

Scenario 4:  Multi-generational Wealth

It’s not uncommon for individuals to engage a financial planner as they approach retirement to map out their distribution plan and verify that they do in fact have enough to retire.  Sometimes when we conduct these meetings, the clients find out that not only do they have enough to retire, but they will not need a large portion of their retirement plan assets to live off and will most likely pass it to their kids as inheritance.

Due to the change in the inheritance rules for non-spouse beneficiaries that inherit a pre-tax retirement account, the non-spouse beneficiary now is forced to deplete the entire account balance 10 years after the decedent has passed AND potentially take RMDs during the 10- year period. Not a favorable tax situation for a child or grandchild inheriting a large pre-tax retirement account.

If instead of continuing to amass a larger pre-tax balanced in the 401(k) plan, say that high income earner forgoes the tax deduction and begins maxing out their 401K contributions at $31,500 per year to the Roth source.  If they retire at age 65, and their life expectancy is age 90, that Roth contribution could experience 25 years of compounding investment returns and when their child or grandchild inherits the account, because it’s a Roth IRA, they are still subject to the 10 year rule, but they can continue to accumulate returns in that Roth IRA for another 10 years after the decedent passes away and then distribute the full account balance ALL TAX FREE. That is super powerful from a tax free accumulate standpoint.

Very few strategies can come close to replicating the value of this multigenerational wealth accumulation strategy.

One more note about this strategy, Roth sources are not subject to RMDs.  Unlike pre-tax retirement plans which force the account owner to begin taking distributions at a specific age, Roth accounts do not have an RMD requirement, so the money can stay in the Roth source and continue to compound investment returns.   

Scenario 5:  Tax Diversification Strategy

The pre-tax vs Roth deferrals strategy is not an all or nothing decision.  You are allowed to allocate any combination of pre-tax and Roth deferrals up to the annual contribution limits each year. For example, a high-income earner under the age of 50 could contribute $13,000 pre-tax and $10,000 Roth in 2024 to reach the $23,000 deferral limit.

Remember, the pre-tax strategy assumes that you will be in lower tax bracket in retirement than you are now, but some individuals have the point of view that with the total U.S. government breaking new debt records every year, at some point they are probably going to have to raise the tax rates to begin to pay back our massive government deficit.  If someone is making $300,000 and paying a top Fed tax rate of 24%, even if they expect their income to drop in retirement to $180,000, who’s to say the tax rate on $180,000 income in 20 years won’t be above the current 24% rate if the US government needs to generate more tax return to pay back our national debt?

To hedge against this risk, some high-income earnings will elect to make some Roth deferrals now and pay tax at the current tax rate, and if tax rates go up in the future, anything in that Roth source (unless the government changes the rules) will be all tax free.

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

How Much Should I Contribute to Retirement?

A question I’m sure to address during employee retirement presentations is, “How Much Should I be Contributing?”.  Quick internet search led me to two popular answers.

1. Whatever you need to contribute to get the match from the employer,

2. 10-15% of your compensation.

As with most questions around financial planning, the answer should really be, “it depends”.  We all know it is important to save for retirement, but knowing how much is enough is the real issue and typically there is more work involved than saying 10-15% of your pay.

In this article, I will address some of the variables at play when coming up with your number and provide detail as to why the two answers previously mentioned are so common.

Expenses and Income Replacement

Creating a budget and tracking expenses is usually the best way to estimate what your spending needs will be in retirement.  Unfortunately, this is time-consuming and is becoming more difficult considering how easy it is to spend money these days.  Automatic payments, subscriptions, payment apps, and credit cards make it easy to purchase but also more difficult to track how much is leaving your bank accounts. 

Most financial plans we create start with the client putting together an itemized list of what they believe they spend on certain items like clothes, groceries, vacations, etc.  A copy of our expense planner template can be found here.  These are usually estimates as most people don’t track expenses in that much detail.  Since these are estimates, we will use household income, taxes, and bank/investment accounts as a check to see if expenses appear reasonable.

What do expenses have to do with contributions to your retirement account now?  Throughout your career, you receive a paycheck and use those funds to pay for the expenses you have.  At some point, you no longer have the paycheck but still have the expenses.  Most retirees will have access to social security and others may have a pension, but rarely does that income cover all your expenses.  This means that the shortfall often comes from retirement accounts and other savings.

Not taking taxes, inflation, or investment gains into account, if your expenses are $50,000 per year and Social Security income is $25,000 a year, that is a $25,000 shortfall.  20 years of retirement times a $25,000 shortfall means $500,000 you’d need saved to fund retirement.  Once we have an estimate of the coveted “What’s My Number?” question, we can create a savings plan to try and achieve that goal.

Cash Flow

As we age, some of the larger expenses we have in life go away.  Student loan debt, mortgages, and children are among those expenses that stop at some point in most people’s lives.  At the same time, your income is usually higher due to experience and raises throughout your career.  As expenses potentially go down and income is higher, there may be cash flow that frees up allowing people to save more for retirement.  The ability to save more as we get older means the contribution target amount may also change over time.

Timing of Contributions

Over time, the interest that compounds in retirement accounts often makes up most of the overall balance. 

For example, if you contribute $2,000 a year for 30 years into a retirement account, you will end up saving $60,000.  If you were able to earn an annual return of 6%, the ending balance after 30 years would be approximately $158,000.  $60,000 of contributions and $98,000 of earnings.

The sooner the contributions are in an account, the sooner interest can start compounding.  This means, that even though retirement saving is more cash flow friendly as we age, it is still important to start saving early.

Contribute Enough to Receive the Full Employer Match

Knowing the details of your company’s retirement plan is important.  Most employers that sponsor a retirement plan make contributions to eligible employees on their behalf.  These contributions often come in the form of “Non-Elective” or “Matching”.

Non-Elective – Contributions that will be made to eligible employees whether employees are contributing to the plan or not.  These types of contributions are beneficial because if a participant is not able to save for retirement from their own paycheck, the company will still contribute.  That being said, the contribution amount made by the employer, on its own, is usually not enough to achieve the level of savings needed for retirement.  Adding some personal savings in addition to the employer contribution is recommended.

Matching – Employers will contribute on behalf of the employee if the employee is contributing to the plan as well.  This means if the employee is contributing $0 to the retirement plan, the company will not contribute.  The amount of matching varies by company, so knowing “Match Formula” is important to determine how much to contribute.  For example, if the matching formula is “100% of compensation up to 4% of pay”, that means the employer will contribute a dollar-for-dollar match until they contribute 4% of your compensation.  Below is an example of an employee making $50,000 with the 4% matching contribution at different contribution rates.

As you can see, this employee could be eligible for a $2,000 contribution from the employer, if they were to save at least 4% of their pay.  That is a 100% return on your money that the company is providing.

Any contribution less than 4%, the employee would not be taking advantage of the employer contribution available to them.  I’m not a fan of the term “free money”, but that is often the reasoning behind the “Contribute Enough to Receive the Full Employer Match” response.

10%-15% of Your Compensation

As said previously, how much you should be contributing to your retirement depends on several factors and can be different for everyone.  10%-15% over a long-term period is often a contribution rate that can provide sufficient retirement savings.  Math below…

Assumptions

Age: 25

Retirement Age: 65

Current Income: $30,000

Annual Raises: 2%

Social Security @ 65: $25,000

Annualized Return: 6%

Step 1: Estimate the Target Balance to Accumulate by 65

On average, people will need an estimated 90% of their income for early retirement spending.  As we age, spending typically decreases because people are unable to do a lot of the activities we typically spend money on (i.e. travel).  For this exercise, we will assume a 65-year-old will need 80% of their income throughout retirement.

Present Salary - $30,000

Future Value After 40 Years of 2% Raises - $65,000

80% of Future Compensation - $52,000

$52,000 – income needed to replace

$25,000 – social security @ 65

$27,000 – amount needed from savings

X       20 – years of retirement (Age 85 - life expectancy)

$540,000 – target balance for retirement account

Step 2: Savings Rate Needed to Achieve $540,000 Target Balance

40 years of a 10% annual savings rate earning 6% interest per year, this person could have an estimated balance of $605,000.  $181,000 of contributions and $424,000 of compounded interest.

I hope this has helped provide a basic understanding of how you can determine an appropriate savings rate for yourself.  We recommend reaching out to an advisor who can customize your plan based on your personal needs and goals.

Rob Mangold

About Rob……...

Hi, I’m Rob Mangold, Partner at Greenbush Financial Group and a contributor to the Money Smart Board blog. We created the blog to provide strategies that will help our readers personally, professionally, and financially. Our blog is meant to be a resource. If there are questions that you need answered, please feel free to join in on the discussion or contact me directly.

Federal Disaster Area Penalty-Free IRA & 401(k) Distribution and Loan Options

Individuals who experience a hurricane, flood, wildfire, earthquake, or other type of natural disaster may be eligible to request a Qualified Disaster Recovery Distribution or loan from their 401(k) or IRA to assist financially with the recovery process.  The passing of the Secure Act 2.0 opened up new distribution and loan options for individuals whose primary residence is in an area that has been officially declared a “Federal Disaster” area.

Qualified Disaster Recovery Distributions (QDRD)

In December 2022, the passing of the Secure Act 2.0 made permanent, a distribution option within both 401(K) plans and IRAs, that allows individuals to distribute up to $22,000 from either a 401(k) or IRA, and that distribution is exempt from the 10% early withdrawal penalty.  Typically, when an individual is under the age of 59½ and takes a distribution from a 401(K) or IRA, the distribution is subject to both taxes and a 10% early withdrawal penalty. 

For an individual, it’s an aggregate of $22,000 between both their 401(k) and IRA accounts, meaning, they can’t distribute $22,000 from their IRA and then another $22,000 from their 401(k), and avoid the 10% penalty on the full $44,000.  

If you are married, if each spouse has an IRA and/or 401(k) plan, each spouse would be eligible to process a qualified disaster recovery distribution for the full $22,000 and avoid the 10% penalty on the combined $44,000.    

Taxation of Federal Disaster Distributions 

Even though these distributions are exempt from the 10% early withdrawal penalty, they are still subject to federal and state income taxes, but the taxpayer has two options:

1. The taxpayer can elect to include the full amount of the distribution as taxable income in the year that the QDRD takes place; OR

2. The taxpayer can elect to spread the taxable amount evenly over a 3-year period that begins the year that distribution occurred. 

Here is an example of the tax options. Tim is age 40, he lives in Florida, and his area experiences a hurricane.  Shortly after the hurricane, the area where Tim’s house is located was officially declared a Federal Disaster Area by FEMA. To help pay for the damage to his primary residence, Tim processes a $12,000 qualified disaster recovery distribution from his Traditional IRA.  Tim would not have to pay the 10% early withdrawal penalty due to the QDRD exception, but he would be required to pay federal income tax on the full $12,000. He has the option to either report the full $12,000 on his tax return in the year the distribution took place, or he could elect to spread the $12,000 tax liability over the next 3 years, reporting $4,000 in additional taxable income each year beginning the year that the QDRD took place.  

Repayment Option

If an individual completes a disaster recovery distribution from their 401(k) or IRA, they have the option to repay the money to the account within 3 years of the date of the distribution.  This allows them to recoup the taxes paid on the distribution by filing an amended tax return(s) for the year or years that the tax liability was reported from the QDRD. 

180 Day & Financial Loss Requirement

To make an individual eligible to request a QDRD, not only does their primary residence have to be located within a Federal Disaster area, but they also need to request the QDRD within 180 days of the disaster, and they must have sustained an economic loss on account of the disaster.

QDRD Are Optional Provisions Within 401(k) Plans

If you have a 401(k) plan, a Qualified Disaster Recovery Distribution is an OPTIONAL provision that must be adopted by the plan sponsor of a 401(k) to provide their employees with this distribution option. In other words, your employer is not required to allow these disaster recovery distributions, they have to adopt them. If you live in an area that is declared a federal disaster area and your 401(k) plan does not allow this type of distribution option, you can contact your employer and request that it be added to the plan.  Many companies may not be aware that this is a voluntary distribution option that can be added to their plan.

If you have an IRA, as long as you meet the criteria for a QDRD, you are eligible to request this type of distribution. 

If you have a 401(k) plan with a former employer and their plan does not allow QDRD, you may be able to rollover the balance in the 401(k) to an IRA, and then request the QDRD from the IRA. 

What Changed?

Prior to the passing of Secure Act 2.0, Congress had to authorize these Qualified Disaster Recovery Distributions for each disaster.  Section 331 of the Secure Act 2.0 made these QDRDs permanent. 

However, one drawback is in the past, these qualified disaster recovery distributions were historically allowed up to $100,000, but the new tax law lowered the maximum QDRD amount to only $22,000. 

$100,000 401(k) Loan for Disaster Relief

In addition to the qualified disaster recovery distributions, Secure Act 2.0, also allows plan participants in 401(K) plans to request loans up to the LESSER of $100,000 or 100% of their vested balance in the plan. 

Typically, when plan participants request loans from a 401(K) plan, the maximum amount is the LESSER of $50,000 or 50% of their vested balance in the plan.  Secure Act 2.0, doubled that amount.  The eligibility requirements to receive a disaster recovery 401(k) loan are the same as the eligibility requirements for a Qualified Disaster Recovery Distribution. 

In addition to the higher loan limit, plan participants eligible for a 401(K) qualified disaster recovery loan, are also allowed to delay the start date of their loan payments for up to 1 year from the loan processing date.  Normally when a 401(K) loan is requested, loan payments begin immediately.

These loans are still subject to the 5-year duration limit, but with the optional 12-month delay in the loan payment start date, the maximum duration of these qualified disaster loans is technically 6 years.

401(K) Loans Are an Optional Provision

Similar to Qualified Disaster Recovery Distributions, 401(k) loans are an optional provision that must be adopted by the plan sponsor of a 401(k) plan. Some plans allow plan participants to take loans while others do not, so the ability to take these disaster recovery loans will vary from plan to plan.

Loans Are Only Available In Qualified Retirement Plans

The $100,000 loan option is only available for Qualified Retirement Plans such as 401(k) and 403(b) plans.  IRAs do not provide a loan option. The $22,000 Qualified Disaster Recovery Distribution is the only option for IRAs unless Congress specifically authorizes a higher maximum distribution amount for a specific Federal Disaster, which is within their power to do.

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

Starting in 2024, 401(k) Plan Will Be Required to Cover Part-time Employees

In the past, companies have been allowed to limit access to their 401(k) plan to just full-time employees but that is about to change starting in 2024.  With the passing of the Secure Act, beginning in 2024, companies that sponsor 401(K) plans will be required to allow part-time employees to participate in their qualified retirement plans.

It’s very important for companies to make note of this now because many companies will need to start going through their employee census data to identify the part-time employees that will become eligible for the 401(K) plan on January 1, 2024. Failure to properly notify these part-time employees of their eligibility to participate in the plan could result in plan compliance failures, DOL penalties, and it could require the company to make a mandatory employer contribution to those employees for the missed deferral opportunity.

Full-time Employee Restriction

Prior to the passing of the Secure Act 1.0 in December 2019, 401(K) plans were allowed to limit participation in plans to employees that had completed 1 year of service which is commonly defined as 12 months of employment AND 1,000 hours worked within that 12-month period. The 1 year wait with the 1,000 hours requirement allowed companies to keep part-time employees who work less than 1,000 hours from participating in the company’s 401(k) plan.   

Secure Act 1.0

When Congress passed Secure Act 1.0 in December 2019, it included a new provision that requires 401(K) plans to cover part-time employees who have completed three consecutive years of service and worked 500 or more hours during each of those years to participate in the plan starting in 2024. For purposes of the 3 consecutive years and 500 hours requirement, companies are only required to track employee service back to January 1, 2021, any services prior to that date, can be disregarded for purposes of this new part-time employee coverage requirement. 

Example: John works for Company ABC which sponsors a 401(k) plan. The plan restricts eligibility to 1 year and 1,000 hours.  John has been working part-time for Company ABC since March 2020 and he worked the following hours in 2021, 2022, and 2023:

• 2021 Hours Worked:  560

• 2022 Hours Worked: 791

• 2023 Hours Worked: 625

Since John had never worked more than 1,000 hours in a 12-month period, he was never eligible to participate in the ABC 401(k) plan.  However, under the new Secure Act 1.0 rules, ABC would be required to allow John to participate in the plan starting January 1, 2024, because he works for three consecutive years with more than 500 hours.

Excluded Employees

The new part-time employee coverage requirement does not apply to employees covered by a collective bargaining agreement or nonresident aliens.  401(K) plans are still allowed to exclude those employees regardless of hours worked.

Employee Deferrals Only

For the part-time employees that meet the 3 consecutive years and 500+ hours of service each year, while the new rules require them to be offered the opportunity to participate in the 401(k) plan, it only requires plans to make them eligible to participate in the employee deferral portion of the plan.  It does not require them to be eligible for EMPLOYER contributions.  For part-time employees who become eligible to participate under these new rules, they are allowed to put their own money into the plan, but the company is not required to provide them with an employer matching, employer non-elective, profit sharing, or safe harbor contributions until that employee has met the plan’s full eligibility requirements.

In the example we looked at previously with John, John would be allowed to voluntarily make employee contributions from his paycheck but if the company sponsors an employer matching contribution that requires employees to work 1 year and 1,000 hours to be eligible, John would not be eligible to receive the employer matching contribution even though he is eligible to make employee contributions to the plan.

Secure Act 2.0

Up until now, we have covered the new part-time employee coverage requirements under Secure Act 1.0.  However, in December 2022, Congress passed Secure Act 2.0, which changed the part-time employee coverage requirements beginning January 1, 2025.  The main change that Secure Act 2.0 made is it reduced the 3 Consecutive Years down to 2 Consecutive Years starting in 2025.   Both still require 500 or more hours each year but now a part-time employee will only need to complete 2 consecutive years of 500 or more hours instead of 3 beginning in 2025.

Also in 2025, under Secure Act 2.0, for purposes of assessing the 2 consecutive years with 500 or more hours, companies only have to look at service dating back to January 1, 2023, employment before that date is excluded from this part-time employee coverage exception. 

2024 & 2025 Summary

Starting in 2024, employers will need to look back as far as January 1, 2021, and identify part-time employees who worked at least 3 consecutive years with 500 or more hours worked in each of those three years.

Starting in 2025, employers will need to look at both definitions of part-time employees.  The Secure Act 1.0, three consecutive years of 500 hours or more going back to January 1, 2021, and separately, the Secure Act 2.0, 2 consecutive years of 500 hours or more going back to January 1, 2023.  An employee could technically become eligible under either definition. 

Penalties For Not Notifying Part-time Employees of Eligibility

Companies should take this new part-time employee eligibility rule very seriously.  Failure to properly notify part-time employees of their eligibility to make employee deferrals to the 401(K) plan could result in a plan compliance failure and the assessment of Department of Labor penalties. The DOL conducts random audits of 401(K) plans and one of the primary pieces of information that they typically request during an audit is for the employer to provide a full employee census file and be able to prove that they properly notified each eligible employee of their ability to participate in the company’s 401(K) plan. 

In addition to fines for not properly notifying these new part-time employees of their ability to participate in the plan, the DOL could require the company to make a “QNEC”  (Qualified Non-Elective Contribution) on behalf of those part-time employees which is a pure EMPLOYER contribution.   Even though these part-time employees might not be eligible for other employer contributions in the plan, this QNEC funded by the employer is to make up for the missed employee deferral opportunity.  The DOL is basically saying that since the company did not properly notify the employee of their ability to make contributions out of their paycheck, now the company has to fund those contributions on their behalf.  They could assign the QNEC amount equal to the average percentage of compensation amount deferred by the rest of the employees covered by the plan which could be a very costly mistake for an employer.

Why The Rule Change?

There are two primary drivers that led to the adoption of this new 401(k) part-time employee coverage requirement.  First, acknowledging a change in the U.S. labor force, where instead of employees working one full-time job, more employees are working multiple part-time jobs.  By working multiple part-time jobs with different employers, while that employee may work more than 1000 hours a year, they may never become eligible to participate in any of their employer’s 401(K) plans because they were not considered full-time with any single employer.

This brings us to the second driver of this new rule, which is increasing access for more employees to an employer-based retirement-saving solution.   Given the increase in life expectancy, there is a retirement savings shortfall issue within the U.S., and giving employees easier access to employer-based solutions may encourage more employees to save more for retirement.  

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

Fewer 401(k) Plans Will Require A 5500 Audit Starting in 2023

401(K) plans with over 100 eligible plan participants are considered “large plans” in the eyes of DOL and require an audit to be completed each year with the filing of their 5500.  These audits can be costly, often ranging from $8,000 - $30,000 per year. 

Starting in 2023, there is very good news for an estimated 20,000 401(k) plans that were previously subject to the 5500 audit requirement.   Due to a recent change in the way that the DOL counts the number of plan participants for purposes of assessing a large plan filer status, many plans that were previously subject to a 401(k) audit, will no longer require a 5500 audit for plan year 2023 and beyond.

401(K) 5500 Audit Requirement

A little background first on the audit rule: if a company sponsors a 401K plan and they have 100 or more participants at the beginning of the year, that plan is now considered a “large plan”, and the plan is required to submit an audit report with their annual 5500 filings.  

For plans that are just above the 100 plan participant threshold, the DOL provides some relief in the “80 – 120 rule”, which basically states that if the plan was a “small plan” filer in the previous year, the plan can remain a small plan filer until the plan participant count reaches 121.

Old Plan Participant Count Method

Not all employees count toward the 100 or 121 audit threshold. Under the old rules, the company only had to count employees who were:

1. Eligible to participate in the plan; and

2. Terminated employees with a balance still in the plan

But under the older rules, ALL plan-eligible employees had to be counted whether or not they had a balance in the plan.   For example, if a landscaping company had:

• 150 employees

• 95 employees are eligible to participate in the plan

• Of the 95 eligible employees, 27 employees have balances in the 401(K) plan

• 35 terminated employees with a balance still in the plan

Under the 2022 audit rules, this plan would be subject to the 5500 audit requirement because they had 95 eligible plan participants PLUS 35 terminated employees with balances, bringing the plan participant audit count to 130, making them a “large plan” filer.  A local accounting firm might charge $10,000 for the plan audit each year.

New Plan Participant Count Method

Starting in 2023, the way that the DOL counts plan participants to determine “large plan” filer status changed.  Now, instead of counting all eligible plan participants whether or not they have a balance in the plan, starting in 2023, the DOL will only count:

1. Eligible employees that HAVE A BALANCE in the plan

2. Terminated employees with balances still in the plan

Looking at the same landscaping company in the previous example:

• 150 employees

• 95 employees are eligible to participate in the plan

• Of the 95 eligible employees, 27 employees have balances in the 401(K) plan

• 35 terminated employees still have balances in the plan

Under the new DOL rules, this 401(K) plan would no longer require a 5500 audit because they only have to count the 27 eligible employees WITH BALANCES in the plan and the 35 terminated employees with balances, bringing the total employee audit count to 62.  The plan would be allowed to file as a “small plan” starting in 2023 and would no longer have to incur the $10,000 cost for the 5500 audit each year.

20,000 Fewer 401(k) Plans Requiring An Audit

The DOL expects this change to eliminate the 5500 audit required for approximately 20,000 401(k) plans.   The primary purpose of this change is to encourage more companies that do not already offer a 401(k) plan to their employees to adopt one and to lower the annual cost for many companies that would otherwise be subject to a 5500 audit requirement. 

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

3 New Startup 401(k) Tax Credits

When Congress passed the Secure Act 2.0 in December 2022, they introduced new tax credits and enhanced old tax credits for startup 401(k) plans. There are now 3 different tax credits that are available for startup 401(k) plans that were put into place to help companies to subsidize the cost of sponsoring a retirement plan and also to subsidize employer contributions made to the employees to enhance the company’s overall benefits package. Here are the 3 startup 401(k) credits that are now available to employers:

• Startup Tax Credit (Plan Cost Credit)

• Employer Contribution Tax Credit

• Automatic Enrollment Tax Credit

Startup Tax Credit

To incentivize companies to adopt an employer-sponsored retirement plan for their employees, Secure Act 2.0 enhanced the startup tax credits available to employers starting in 2023.  This tax credit was put into place to help businesses offset the cost of establishing and maintaining a retirement plan for their employees for the first 3 years of the plan’s existence.  Under the new Secure 2.0 credit, certain businesses will be eligible to receive a tax credit for up to 100% of the annual plan costs.

A company must meet the following requirement to be eligible to capture this startup tax credit:

1. The company may have no more than 100 employees who received compensation of $5,000 or more in the PRECEDING year; and

2. The company did not offer a retirement plan covering substantially the same employees during the PREVIOUS 3 YEARS.

3. The plan covers at least one non-HCE (non-Highly Compensated Employee or NHCE)  

To identify if you have a NHCE, you have to look at LAST YEAR’s compensation and both this year’s and last year’s ownership percentage.  For the 2023 plan year, a NHCE is any employee that:

• Does NOT own more than 5% of the company; and

• Had less than $135,000 in compensation in 2022.  For the compensation test, you look back at the previous year’s compensation to determine who is a HCE or NHCE in the current plan year.    For 2023, you look at 2022 compensation.  The IRS typically increases the compensation threshold each year for inflation.

A note here about “attribution rules”.  The IRS is aware that small business owners have the ability to maneuver around ownership and compensation thresholds, so there are special attribution rules that are put into place to limit the “creativity” of small business owners.   For example, ownership is shared or “attributed” between spouses, which means if you own 100% of the business, your spouse that works for the business, even though they are not an owner and only earn $30,000 in W2, they are considered a HCE because they are attributed your 100% ownership in the business.   

Besides just attribution rules, employer-sponsored retirement plans also has control group rules, affiliated service group rules, and other fun rules that further limit creativity.  Especially for individuals that are owners of multiple businesses, these special 401(k) rules can create obstacles when attempting to qualify for these tax credits. Bottom line, before blindly putting a retirement plan in place to qualify for these tax credits, make sure you talk to a professional within the 401(k) industry that understands all of these rules.

401(k) Startup Tax Credit Amount

Let’s assume your business qualifies for the 401(k) startup tax credit, what is the amount of the tax credit?  Here are the details:

• For companies with 50 employees or less: The credit covers 100% of the company’s plan costs up to an annual limit of the GREATER of $500 or $250 multiplied by the number of plan-eligible NHCE, up to a maximum credit of $5,000.

• For companies with 51 to 100 employees: The credit covers 50% of the company’s plan costs up to an annual limit of the GREATER of $500 or $250 multiplied by the number of plan-eligible NHCE, up to a maximum credit of $5,000.

This is a federal tax credit that is available to eligible employers for the first 3 years that the new plan is in existence.  If you have enough NHCE’s, you could technically qualify for $5,000 each year for the first 3 years that the retirement plan is in place.

A note on the definition of “plan-eligible NHCEs”.  These are NHCEs that are also eligible to participate in your plan in the current plan year.  NHCEs that are not eligible to participate because they have yet to meet the eligibility requirement, do not count toward the max credit calculation.   

What Type of Plan Costs Qualify For The Credit?

Qualified costs include costs paid by the employer to:

• Setup the Plan

• Administer the Plan (TPA Fees)

• Recordkeeping Fees

• Investment Advisory Fees

• Employee Education Fees

To be eligible for the credit, the costs must be paid by the employer directly to the service provider. Fees charged against the plan assets or included in the mutual fund expense ratios do not qualify for the credit.  Since historically many startup plans use 401(k) platforms that utilize higher expense ratio mutual funds to help subsidize some of the out-of-pocket cost to the employer, these higher tax credits may change the platform approach for start-up plans because the employer and the employee may both be better off by utilizing a platform with low expense ratio mutual funds, and the employer pays the TPA, recordkeeping, and investment advisor fees directly in order to qualify for the credit.

Note: It’s not uncommon for the owners of the company to have larger balances in the plan compared to the employees, so they also benefit by not having the plan fee paid out of plan assets.

Startup Tax Credit Example

A company has 20 employees, 2 HCEs and 18 NHCEs, and all 20 employees are currently eligible to participate in the new 401(k) plan that the company just started in 2023.  During 2023, the company paid $3,000 in total plan fees directly to the TPA firm, investment advisor, and recordkeeper of the plan.  Here is the credit calculation:

18 Eligible NHCEs x $250 = $4,500

Total 401(k) Startup Credit for 2023 = $3,000

Even though this company would have been eligible for a $4,500 tax credit, the credit cannot exceed the total fees paid by the employer to the 401(k) service providers, and the total plan fees in this example were $3,000. 

No Carry Forward

If the company incurs plan costs over and above the credit amount, the new tax law does not allow plan costs that exceed the maximum credit to be carried forward into future tax years.

Solo(k) Plans Are Not Eligible for Startup Tax Credit

Due to the owner-only nature of a Solo(K) plan, there would not be any NHCEs in a Solo(K) plan, so they would not be eligible for the startup tax credit.

401(k) Employer Contribution Tax Credit

This is a new tax credit starting in 2023 that will provide companies with a tax credit for all or a portion of the employer contribution that is made to the 401(k) plan for employees earning no more than $100,000 in compensation. 

The eligible requirement for this employer contribution credit is similar to that of the startup tax credit with one difference:

1. The company may have no more than 100 employees who received compensation of $5,000 or more in the PRECEDING year; and

2. The company did not offer a retirement plan covering substantially the same employees during the PREVIOUS 5 YEARS.

3. The plan makes an employer contribution for at least one employee whose annual compensation is not above $100,000.   

Employer Contribution Tax Credit Calculation

The maximum credit is assessed on a per-employee basis and for each employee is the LESSER of:

• Actual employer contribution amount; or

• $1,000 for each employee making $100,000 or less in FICA wages

$1,000 Per Employee Limit

The $1,000 limit is applied to each INDIVIDUAL employee’s employer contribution.  It is NOT a blindfolded calculation of $1,000 multiped by each of your employees under $100,000 in comp regardless of the amount of their actual employer contribution.

For example, Company RTE has two employees making under $100,000 per year, Sue and Rick.  Sue receives an employer contribution of $3,000 and Rick received an employer contribution of $400.  The max employer contribution credit would be $1,400,  $400 for Rick’s employer contribution, and $1,000 for Sue’s contribution since she would be subject to the $1,000 per employee cap. 

S-Corp Owners

As mentioned above, the credit only applies to employees with less than $100,000 in annual compensation but what about S-corp owners? The only compensation that is taken into account for S-corp owners for purposes of retirement plan contributions is their W2 income.  So what happens when an S-corp owner has W2 income of $80K but takes a $500,000 dividend from the S-corp?  Good news for S-corp owners, the $100,000 comp threshold only looks at the plan compensation which for S-corp owners is just their W2 income, so an employer contribution for an S-corp would be eligible for this credit as long as their W2 is below $100,000 but they would still be subject to the $1,000 per employee cap. 

5-Year Decreasing Scale

Unlike the startup tax credit that stays the same for the first 3 years of the plan’s existence, the Employer Contribution Tax Credit decreases after year 2 but lasts for 5 years instead of just 3 years.   Similar to the startup tax credit, there is a deviation in the calculation depending on whether the company has more or less than 50 employees.

For companies that have 50 or fewer employees, the employer contribution tax credit phase-down schedule is as follows:

• Year 1: 100%

• Year 2: 100%

• Year 3:    75%

• Year 4: 50%

• Year 5: 25%

50 or Less Employee Example

Company XYZ starts a new 401(k) plan for their employees in 2023 and offers a safe harbor employer matching contribution.  The company has 20 eligible employees, 18 of the 20 are making less than $100,000 for the year in compensation, all 18 employees contribute to the plan and each employee is eligible for a $1,250 employer matching contribution. 

Since the tax credit is capped at $1,000 per employee, that credit would be calculated as follows:

$1,000 x 18 Employees = $18,000

The total employer contribution for these 18 employees would be $1,250 x 18 = $22,250 but the company would be eligible to receive a tax credit in year 1 for $18,000 of the $22,250 that was contributed to the plan on behalf of these 18 employees in Year 1.

Note: If an employee only receives a $600 employer match, the tax credit for that employee is only $600. The $1,000 per employee cap only applies to employees that receive an employer contribution in excess of $1,000.

51 to 100 Employees

For companies with 51 – 100 employees, the employer contribution credit calculation is slightly more complex.  Same 5 years phase-down schedule as the 1 – 50 employee companies but the amount of the credit is reduced by 2% for EACH employee over 50 employees.  To determine the amount of the discount you multiply 2% by the number of employees that the company has over 50, and then subtract that amount from the full credit percentage that is available for that plan year.

For example, a new startup 401K has 80 employees, and they are in Year 1 of the 5-year discount schedule, the tax credit would be calculated as follows:

100% - (2% x 30 EEs) = 40%

So instead of receiving a 100% tax credit for the eligible employer contributions for the employees making under $100,000 in compensation, this company would only receive a 40% tax credit for those employer contributions.

Calculation Crossroads

There is a second step in this employer contribution tax credit calculation for companies with 51 – 100 that has the 401(K) industry at a crossroads and will most likely require guidance from the IRS on how to properly calculate the tax credit for these companies when applying the $1,000 per employee cap. 

I’m seeing very reputable TPA firms (third-party administrators) run the second half of this calculation differently based on their interpretation of WHEN to apply the $1,000 per employee cap and it creates different results in the amount of tax credit awarded.

Calculation 1: Some firms are applying the $1,000 per employee cap to the employer contributions BEFORE the discounted tax credit percentage is applied.

Calculation 2: Other firms apply the $1,000 per employee cap AFTER the discounted tax credit is applied to each employee’s employer contribution for purposes of assessing the $1,000 cap per employee.

I’ll show you why this matters in a simple example just using 2 employees:

Sue and Peter both make under $100,000 in compensation and work for Company ABC which has 80 employees.  Company ABC just implemented a 401(K) plan this year with an employer matching contribution, both Sue and Peter contribute to the plan, Sue is entitled to a $1,300 matching contribution and Peter is entitled to a $900 matching contribution.

Since the company has over 80 employees, the company is only entitled to a 40% credit for the eligible employer contribution:

100% - (2% x 30 EEs) = 40%

Calculation 1: If Company ABC applies the $1,000 per employee limit BEFORE applying the 40% credit, Sue’s contribution would be capped at $1,000 and Peter’s contribution would be $900, resulting in a total employer contribution of $1,900. To determine the credit amount:

$1,900 x 40% = $760

Calculation 2:  If Company ABC applies the $1,000 per employee limit AFTER applying the 40% credit:

Sue: $1,300 x 40% = $520

Peter: $900 x 40% = $360

Total Credit = $880

Calculation 2 naturally produces a high tax credit because the credit amount is being applied against Sue’s total employer contribution of $1,300 which is then bringing her contribution in the calculation below the $1,000 per employee limit. 

Which calculation is right? At this point, I have no idea.  We will have to wait and see if we get guidance from the IRS.

Capturing Both Tax Credits In The Same Year

Companies are allowed to claim both the 401(K) Startup Tax Credit and the Employer Contribution Tax Credit in the same plan year.  For example, you could have a company that establishes a new 401(k) plan in 2023, that qualifies for a $4,000 credit to cover plan costs and another $40,000 credit for employer contributions to total $44,000 in tax credits for the year.

Automatic Enrollment Tax Credit

The IRS and DOL are also incentivizing startup and existing 401(K) plans to adopt automatic enrollment in their plan design by offering an additional $500 credit per year for the first 3 years that this feature is included in the plan.  This credit is only available to employers that have no more than 100 employees with at least $5,000 in compensation in the preceding year. The automatic enrollment feature must also meet the eligible automatic contribution arrangement (EACA) requirements to qualify.

For 401(k) plans that started after December 29, 2022, Secure Act 2.0 REQUIRES those plans to adopt an automatic enrollment by 2025.  While a new plan could technically opt out of auto-enrollment in 2023 and 2024, since it’s now going to be required starting in 2025, it might be easier just to include that feature in your new plan and capture the tax credit for the next three years.

Note: Automatic enrollment will not be required in 2025 for plans that were in existence prior to December 30, 2022.

Simple IRA & SEP IRA Tax Credits

Both the Startup Tax Credit and Employer Contribution Tax Credits can also be claimed by companies that sponsor Simple IRAs and SEP IRAs. 

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

Mandatory Roth Catch-up Contributions for High Wage Earners - Secure Act 2.0

Starting in 2026, individuals that make over $145,000 in wages will no longer be able to make pre-tax catch-up contributions to their employer-sponsored retirement plan.  Instead, they will be forced to make catch-up contributions in Roth dollars which means that they will no longer receive a tax deduction for those contributions.

This, unfortunately, was not the only change that the IRS made to the catch-up contribution rules with the passing of the Secure Act 2.0 on December 23, 2022.  Other changes will take effect in 2025 to further complicate what historically has been a very simple and straightforward component of saving for retirement.

Even though this change will not take effect until 2026, your wage for 2025 may determine whether or not you will qualify to make pre-tax catch-up contributions in the 2026 tax year.  In addition, high wage earners may implement tax strategies in 2025, knowing that they are going to lose this sizable tax deduction in the 2024 tax year.  

Effective Date Delayed Until 2026

Originally when the Secure Act 2.0 was passed, the Mandatory 401(K) Roth Catch-up was schedule to become effective in 2024. However, in August 2023, the IRS released a formal notice delaying the effective date until 2026. This was most likely a result of 401(k) service providers reaching out to the IRS requesting for the delay so the IRS has more time to provide much need additional guidance on this new rule as well as time for the 401(k) service providers to update their systems to comply with the new rules.

Before Secure Act 2.0

Before the Secure Act 2.0 was passed, the concept of making catch-up contributions to your employer-sponsored retirement account was very easy.  If you were age 50 or older at any time during that tax year, you were able to contribute the maximum employee deferral amount for the year PLUS an additional catch-up contribution.  For 2023, the annual contribution limits for the various types of employer-sponsored retirement plans that have employee deferrals are as follows:

401(k) / 403(b)

EE Deferral Limit:  $22,500

Catch-up Limit:       $7,500

Total                          $30,000

Simple IRA

EE Deferral Limit:  $15,500

Catch-up Limit:       $3,500

Total                          $19,000

You had the option to contribute the full amount, all Pre-tax, all Roth, or any combination of the two.  It was more common for individuals to make their catch-up contributions with pre-tax dollars because normally, taxpayers are in their highest income earning years right before they retire, and they typically prefer to take that income off the table now and pay tax in it in retirement when their income is lower and subject to lower tax rates.

Mandatory Roth Catch-Up Contributions

Beginning in 2026, the catch-up contribution game is going to completely change for high wage earners.  Starting in 2026, if you are age 50 or older, and you made more than $145,000 in WAGES in the PREVIOUS tax year with the SAME employer, you would be forced to make your catch-up contributions in ROTH dollars to your QUALIFIED retirement plan.   I purposefully all capped a number of the words in that sentence, and I will now explain why.

Employees that have “Wages”

This catch-up contribution restriction only applies to individuals that have WAGES over $145,000 in the previous calendar year. Wages meaning W2.  Since many self-employed individuals do not have “wages” (partners or sole proprietors) it would appear that they are not subject to this restriction and will be allowed to continue making pre-tax catch-up contribution regardless of their income.

On the surface, this probably seems unfair because you could have a W2 employee that makes $200,000 and they are forced to make their catch-up contribution to the Roth source but then you have a sole proprietor that also makes $200,000 but they can continue to make their catch-up contributions all pre-tax.  Why would the IRS allow this?

The $145,000 income threshold is based on the individual’s wages in the PREVIOUS calendar year and it’s not uncommon for self-employed individuals to have no idea what their net income will be until their tax return is complete, which might not be until September or October of the following year.   

Wages in the Previous Tax Year

For taxpayers that have wages, they will have to look back at their W2 from the previous calendar year to determine whether or not they will be eligible to make their catch-up contribution in pre-tax dollars for the current calendar year. 

For example, it’s January 2026, Tim is 52 years old, and his W2 wages with his current employer were $160,000 in 2025.  Since Jim’s wages were over the $145,000 threshold in 2025, if he wants to make the catch-up contribution to his retirement account in 2026, he would be forced to make those catch-up contributions to the Roth source in the plan so he would not receive a tax deduction for those contributions.

Wages With The Same Employer

When the Secure Act 2.0 mentions the $145,000 wage limit, it refers to wages in the previous calendar year from the “employer sponsoring the plan”.   So it’s not based on your W2 income with any employer but rather your current employer.  If you made $180,000 in W2 income in 2025 from XYZ Inc. but then you decide to switch jobs to ABC Inc. in 2026, since you did not have any wages from ABC Inc. in 2026, there are no wages with your current employer to assess the $145,000 threshold which would make you eligible to make your catch-up contributions all in pre-tax dollars to ABC Inc. 401(K) plan for 2026 even though your W2 wages with XYZ Inc. were over the $145,000 limit in 2025.

This would also be true for someone that is hired mid-year with a new employer.   For example, Sarah is 54 and was hired by Software Inc. on July 1, 2026, with an annual salary of $180,000.  Since Sarah had no wages from Software Inc. in 2025, she would be eligible to make her catch-up contribution all in pre-tax dollars.  But it gets better for Sarah, she will also be able to make a pre-tax catch-up contribution in 2026 too.  For the 2026 plan year, they look back at Sarah’s 2024 W2 to determine whether or not here wages were over the $145,000 threshold, since she only works for half of the year, her total wages were $90,000, which is below the $145,000 threshold. 

If Sarah continues to work for Software Inc. into 2027, that would be the first year that she would be forced to make her catch-up contribution to the Roth source because she would have had a full year of wages in 2026, equaling $180,000.

$145,000 Wage Limit Indexed for Inflation

There is language in the new tax bill to index the $145,000 wage threshold for inflation meaning after 2024, it will most likely increase that wage threshold by small amount each year. So while I use the $145,000 in many of the examples, the wage threshold may be higher by the time we reach the 2026 effective date.

The Plan Must Allow Roth Contributions

Not all 401(k) plans allow employees to make Roth contributions to their plan.  Roth deferrals are an optional feature that an employer can choose to either offer or not offer to their employees.  However, with this new mandatory Roth catch-up rule for high wage earners, if the plan includes employees that are eligible to make catch-up contributions and who earned over $145,000 in the previous year, if the plan does not allow Roth contributions, it does not just block the high wage earning employees from making catch-up contributions, it blocks ALL employees in the plan from making catch-up contributions regardless of whether an employee made over or under the $145,000 wage threshold in the previous year.

Based on this restriction,  I’m assuming you will see a lot of employer-sponsored qualified retirement plans that currently do not allow Roth contributions to amend their plans to allow these types of contributions starting in 2026 so all of the employees age 50 and older do not get shut out of making catch-up contributions.

Simple IRA Plans: No Mandatory Roth Catch-up

Good news for Simple IRA Plans, this new Roth Catch-up Restriction for high wage earners only applies to “qualified plans” (401(k), 403(b), and 457(b) plans), and Simple IRAs are not considered “qualified plans.”   So employees that are covered by Simple IRA plans can make as much as they want in wages, and they will still be eligible to make catch-up contributions to their Simple IRA, all pre-tax.   

That’s a big win for Simple IRA plans starting in 2026, on top of the fact that the Secure Act 2.0 will also allow employees covered by Simple IRA plans to make Roth Employee Deferrals beginning in 2025.  Prior to the Secure Act 2.0, only pre-tax deferrals were allowed to be made to Simple IRA accounts.  

Roth Contributions

A quick reminder on how Roth contributions work in retirement plans.  Roth contributions are made with AFTER-TAX dollars, meaning you pay income tax on those contributions now, but all the investment returns made within the Roth source are withdrawn tax-free in retirement, as long as you are over the age of 59½, and the contributions have been in your retirement account for at least 5 years. 

For example, you make a $7,000 Roth catch-up contribution today, over the next 10 years, let’s assume that $7,000 grows to $15,000, after reaching age 59½, you can withdraw the full $15,000 tax-free.  This is different from traditional pre-tax contributions, where you take a tax deduction now for the $7,000, but then when you withdraw the $15,000 in retirement, you pay tax on ALL of it.

It’s So Complex Now

One of the most common questions that I receive is, “What is the maximum amount that I can contribute to my employer-sponsored plan?”

Prior to Secure Act 2.0, there were 3 questions to arrive at the answer:

1. What type of plan are you covered by?

2. How old are you?

3. What is your compensation for this year?

Starting in 2024, I will have to ask the following questions:

1.  What type of plan are you covered by?

2. If it’s a qualified plan, do they allow Roth catch-up contributions?

3. How old are you?

4. Are you a W2 employee or self-employed?

5. Did you work for the same employer last year?

6. If yes, what were your total W2 wages last year?

7. What is your compensation/wage for this year? (max 100% of comp EE deferral rule limit)

While this list has become noticeably longer, in 2025, the Secure Act 2.0 will add additional complexity and questions to this list when the “Additional Catch-up Contributions for Ages 60 - 63” go into effect.  We will cover that fun in another article. 

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.