Solo 401k Catch Up Contributions May Soon Be After-Tax

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Many people don’t focus on retirement until later in life. Most are not able to significantly contribute towards retirement until their highest-earning years which tend to be later in life. Both of these and other reasons make it smart to take advantage of the Solo 401k catch-up provisions.

Pending Legislation – SECURE 2.0 and the Retirement Security & Savings Act

Solo 401k accounts currently allow catch-up contributions beginning at age 50. However, there are legislative bills in both the U.S. Senate and House of Representatives that intend to make changes to catch-up contributions. They agree to further encourage Americans to maximize funding to their 401k accounts as they approach retirement age. Both bills have strong bipartisan support. Many experts expect legislative differences to resolve with a final bill signed into law by the end of 2021.

The House of Representatives version is known as the Securing a Strong Retirement Act, which is commonly shortened to “Secure 2.0” based on it being a follow up to the Secure Act of 2019. The House Ways and Means Committee unanimously approved the bill and passed it to the full House on 5/4/21.

The Senate version is known as the Retirement Security and Savings Act. The Senate referred the bill to the Committee on Finance on 5/20/2021. Before sending it back to the Senate, the Finance Committee will mark it up beginning as early as this fall.

Before President Biden gives his final review, both the House and Senate must reconcile any differences between their respective passed bills. Although exact deadline is unknown, we can expect this to occur at the end of the year.

What May Change for Catch-up Contributions

Catch-up contributions are for those age 50 and up. In 2021, the catch-up contribution for people above age 50 is $6,500. This is in addition to the $58,000 allowed to all Solo 401k account holders. Combined, the standard and catch-up total adds up to a $64,500 tax-deferred contribution if you are age 50 or over.

You don’t have to wait until after our 50th birthday to make catch-up contributions.

You can begin doing so in the year you turn 50. Better yet, both the House and Senate bills aim to expand the allowed catch-up amounts, although the specifics differ a bit.

The House version proposes to annually adjust the catch-up amount upward based on inflation. It would also immediately increase your annual Solo 401k catch-up contribution to $10,000 for individuals who are age 62, 63, or 64. That is a $3,500 increase over what is allowed in 2021 for everyone above age 50.

The Senate version would also immediately increase your Solo 401k catch-up to $10,000. The difference is that this version would apply to everyone age 60 or older. The Senate version would benefit more people.

Another difference between the House and Senate versions is the House version shifts catch-up contributions to an after-tax basis — i.e., as a Roth contribution. The Senate version does not have this provision. In the House version, there would be no upfront tax benefit, but qualified withdrawals would be entirely tax-free. The reasoning behind the House version is to avoid a drop in near-term tax revenue while also raising the catch-up limit. This could be a major difference that needs to be worked out between the two proposed bills.

Whichever version or a compromise that passes could make a big difference for people with a Solo 401k who are nearing retirement with less than what they will need to live comfortably in their golden years.

Why a Higher Solo 401k Catch-up Might Matter to You

To produce a dollar of savings at retirement, you need to put in more when you’re 50 than when you’re 20. This is the simple principle of compounding interest. For instance, a 20-year-old who invests $10,000 today and parks it in Treasury bills, earning 4% on average for the next 50 years will find he has $71,067 if the investment was made through an IRA. Had he invested in real estate or another alternative investment with a Solo 401k earning a 12% average rate of return over the same time, he would have $2,890,022. Adding asset classes with higher returns would result in over 40 times more money, thanks to the power of compounding.

At age 50, you can still invest in higher-paying alternative investments with a Solo 401k but you don’t have 50 years for it to compound. On the other hand, you are almost certain to be earning much more income than you were at age 20. Catch-up contributions provide you a different strategy to increase your retirement savings. If the Senate pre-tax catch-up contributions version becomes law, you will not only be able to contribute more but it will also reduce your current taxable income even further. The additional tax deduction could save you over $1,000 on your annual tax bill. You’ll also likely be in a lower tax bracket during retirement, which will increase your spendable income.

The House version will mean paying taxes on the catch-up contributions while still working. On the flip side, this means more tax-free money in your retirement years. A version allowing a choice between either pre-tax or after-tax catch-up contributions would provide the most flexibility to benefit the most people.

Yes, more reasons!

There are other reasons why catch-up contributions make a good retirement strategy, such as having more investment funds after your kids’ college tuition is no longer part of your budget. Another real-life possibility is your home is paid off or the mortgage payment is a substantially smaller portion of your budget. That money could be going into a Solo 401k as a catch-up contribution to lower your current taxes and increase your retirement savings.

A non-financial reason could be that your time is more valuable than money. Not making catch-up contributions could delay your retirement while you work to save more money. The net effect would be shortening your golden years.

Never underestimate the tax advantages of catch-up contributions that can be huge. A person over age 50 in a 35% tax bracket that makes the full employee contribution of $19,500 in 2021 plus the currently allowed catch-up contribution of $6,500 lowers their taxable income by $9,100 – for an extra $2,275 in tax savings. If the catch-up contribution increases to $10,000, it will mean an additional $1,225 in tax savings. That doesn’t even include the employer contribution that raises the total Solo 401k tax advantage to $64,500 if you are age 50 or over. And you can expect it to be higher in 2022.

Bottom line – if you are contributing a percentage of income to your Solo 401k each month, it’s important to be sure that the percentage is sufficient to meet the new maximum each year as well as any increase in catch-up contributions.

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