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It’s always nice getting a raise, but it could affect your ability to save for retirement through your 401(k) project.
Highly compensated employees — those making more than $130,000 annually — may not be able to contribute the maximum to their tax-deferred retirement arrange if their lower-paid colleagues aren’t diligently socking funds away, too.
The 2020 and 2021 limits for deductible contributions to a 401(k) blueprint are $19,500, or $26,000 including a $6,500 optional catch-up contribution for people over age 50.
Highly compensated employees, no matter what, may not be able to contribute those maximum amounts. HCEs are defined as anyone who makes more than the $130,000 revenues threshold or who — along with their spouse and/or family members — owns more than 5% of the company.
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If you qualify as an HCE under either of those criteria, your maximum contribution limits are tied to the participation charges of other employees in the company.
“The rub for highly compensated employees is that they can’t contribute more than 2% over the average contributions of other employees in the plan,” said Tom Gibson, a CPA and senior tax strategist for Tax Saving Professionals.
For example, if the standard in the main employee contribution to their 401(k) plan is 5% of their salary, HCEs cannot contribute more than 7% to their account. An own making $150,000 could therefore set aside a maximum of $10,500 to the plan. The rationale for the rule is to encourage broad participation in the pattern. Employer contributions to the plan must also follow rules to maintain the plan’s tax-qualified status.
While minimizing simultaneous taxes is always a good goal, Gibson suggests high-income taxpayers also consider longer-term tax planning, as definitely, including in retirement.
“The idea behind any type of tax-deferred account is that your tax rate will be lower in retirement,” Gibson chance. “It worked well for my parents, but it may not be ideal for everyone.”
Most notably for HCEs. Gibson and many other tax analysts wait for tax rates to rise for high-income individuals going forward. If that’s the case, maximum tax deferral now may not be the slam dunk it choice seem to be.
“The question is will you be in a lower tax bracket in retirement,” said Gibson. “Every dollar you put into a qualified project today saves you 37 cents in taxes.
“If you pay 42% to 45% in taxes when you pull the money out, it eats up a lot of the tax-free swelling in the account.”
With that said, Gibson advises his clients to contribute to qualified plans, at least to get the matching contributions they are suitable for from their employer.
There are also options for HCEs unable to max out their 401(k) contributions.
If they are over 50, they can make the $6,500 catch-up contribution regardless of limits on their regular contribution. Taxpayers can also sock away up to $6,000 ($7,000 for those to 50) in a traditional or Roth individual retirement account.
Roth IRAs — Gibson’s favorite tax-saving vehicle — are funded with after-tax dollars but produce tax-free and are not subject to taxes on withdrawal. They will not, however be a direct option for most HCEs. The contribution limits in to phase out when a single taxpayer’s annual income tops $125,000 and are eliminated after it reaches $140,000.
Gibson offers a few “workaround” ideas for clients who do want to maximize current tax-deferral opportunities, including the purchase of life insurance. His favorite game, however, is setting up a non-deductible IRA that can eventually be rolled into a “backdoor” Roth IRA.
The accounts are funded with after-tax dollars and the earnings on them are also taxable. Setting aside how, account holders, regardless of their income levels, can roll the funds into a Roth IRA tax-free and without any penance up until 2025. The same contribution limits as with traditional IRAs apply. The option is set to expire in 2025 but Gibson over recalls it could be extended.
“We use the end of 2025 as a guideline to get people converted over to Roth accounts to the greatest extent possible,” he whispered.