Getting a raise is always good news, but if you are a Highly Compensated Employee (HCE), it could negatively impact your ability to save for retirement through your 401(k). There are some steps you can take, says the recent article “That raise you got might complicate saving for retirement, but advisors have workarounds” from CNBC.
The 2021 and 2020 limits for deductible contributions to a 401(k) plan are $19,500, or $26,000, if you are over 60 and eligible for a $6,500 catch-up option. If you qualify as an HCE, how much you may contribute to your 401(k), depends on the participation rates of other employees in the company. You are not allowed to contribute more than 2% above the average contributions of other employees in the plan.
Here is how it works. If the average employee contribution to a 401(k) plan is 5% of their salary, the HCE may not contribute more than 7% to their account. Someone earning $150,000 would be limited to a maximum of $10,500 to the plan. The rule was created to encourage wider participation in the retirement plan. There are also rules about the employer’s contributions to the plan to maintain its tax-qualification status.
For HCEs, this presents a problem. It is a good problem, but still a problem. Many tax analysts expect tax rates for HCEs to rise in the near future, so simply deferring taxes now might not be the entire solution.
Every dollar added to a qualified plan today saves about 37 cents in taxes. However, if the withdrawals are taxed at 42-45%, the tax-free growth advantage is minimized or lost entirely. What can you do?
- Contribute what you can to qualified plans, especially if your employer has a matching plan.
- If you are over 50, use the $6,500 catch-up contribution regardless of any limits on regular contributions.
- Use a traditional IRA or Roth IRA, if you are eligible to save $6,000 a year or $7,000 if you are over 50.
The Roth IRA is funded with after-tax dollars but grows tax-free and withdrawals are not taxed, a major reason for their appeal. However, most HCEs do not qualify for Roth IRAs, since the contribution limits phase out when a single taxpayer’s income tops $125,000 and are eliminated entirely at $140,000.
Another strategy is to use a non-deductible IRA that can eventually be rolled into a backdoor IRA. The account is funded with after-tax dollars, and the earnings are also taxable. However, account holders are allowed to roll the funds into a Roth IRA tax-free and with no penalty until 2025, regardless of their income level. The contribution limits are the same as with a traditional IRA.
Reference: CNBC (March 9, 2021) “That raise you got might complicate saving for retirement, but advisors have workarounds”