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If your business has co-owners, you probably need a buy-sell agreement

Management Advisory Services & Business Consulting|August 29, 2024

Are you buying a business that will have one or more co-owners? Or do you already own one fitting that description? If so, consider installing a buy-sell agreement. A well-drafted agreement can do these valuable things:

Transform your business ownership interest into a more liquid asset,
Prevent unwanted ownership changes, and
Avoid hassles with the IRS.

Agreement basics

There are two basic types of buy-sell agreements: Cross-purchase agreements and redemption agreements (sometimes called liquidation agreements).

A cross-purchase agreement is a contract between you and the other co-owners. Under the agreement, a withdrawing co-owner’s ownership interest must be purchased by the remaining co-owners if a triggering event, such as a death or disability, occurs.

A redemption agreement is a contract between the business entity and its co-owners (including you). Under the agreement, a withdrawing co-owner’s ownership interest must be purchased by the entity if a triggering event occurs.

Triggering events

You and the other co-owners specify the triggering events you want to include in your agreement. You’ll certainly want to include obvious events like death, disability and attainment of a stated retirement age. You can also include other events that you deem appropriate, such as divorce.

Valuation and payment terms

Make sure your buy-sell agreement stipulates an acceptable method for valuing the business ownership interests. Common valuation methods include using a fixed per-share price, an appraised fair market value figure, or a formula that sets the selling price as a multiple of earnings or cash flow.

Also ensure the agreement specifies how amounts will be paid out to withdrawing co-owners or their heirs under various triggering events.

Life insurance to fund the agreement

The death of a co-owner is perhaps the most common, and catastrophic, triggering event. You can use life insurance policies to form the financial backbone of your buy-sell agreement.

In the simplest case of a cross-purchase agreement between two co-owners, each co-owner purchases a life insurance policy on the other. If one co-owner dies, the surviving co-owner collects the insurance death benefit proceeds and uses them to buy out the deceased co-owner’s interest from the estate, surviving spouse or other heir(s). The insurance death benefit proceeds are free of any federal income tax, so long as the surviving co-owner is the original purchaser of the policy on the other co-owner.

However, a seemingly simple cross-purchase arrangement between more than two co-owners can get complicated, because each co-owner must buy life insurance policies on all the other co-owners. In this scenario, you may want to use a trust or partnership to buy and maintain one policy on each co-owner. Then, if a co-owner dies, the trust or partnership collects the death benefit proceeds tax-free and distributes the cash to the remaining co-owners. They then use the money to fund their buyout obligations under the cross-purchase agreement.

To fund a redemption buy-sell agreement, the business entity itself buys policies on the lives of all co-owners and then uses the death benefit proceeds buy out deceased co-owners.

Specify in your agreement that any buyout that isn’t funded with insurance death benefit proceeds will be paid out under a multi-year installment payment arrangement. This gives you (and any remaining co-owners) some breathing room to come up with the cash needed to fulfill your buyout obligation.

Create certainty for heirs

If you’re like many business co-owners, the value of your share of the business comprises a big percentage of your estate. Having a buy-sell agreement ensures that your ownership interest can be sold by your heir(s) under terms that you approved when you set it up. Also, the price set by a properly drafted agreement establishes the value of your ownership interest for federal estate tax purposes, thus avoiding possible IRS hassles.

As a co-owner of a valuable business, having a well-drafted buy-sell agreement in place is pretty much a no-brainer. It provides financial protection to you and your heir(s) as well as to your co-owners and their heirs. The agreement also avoids hassles with the IRS over estate taxes.

Buy-sell agreements aren’t DIY projects. Contact us about setting one up.

Certain charitable donations allow you to avoid taxable IRA withdrawals

Tax Prep, Planning & Strategy|August 22, 2024

If you’re a philanthropic individual who is also obligated to take required minimum distributions (RMDs) from a traditional IRA, you may want to consider a tax-saving strategy. It involves making a qualified charitable distribution (QCD).

How it works

To reap the possible tax advantages of a QCD, you make a cash donation to an IRS-approved charity out of your IRA. This method of transferring IRA assets to charity leverages the QCD provision that allows IRA owners who are age 70½ or older to direct up to $105,000 of their IRA distributions to charity in 2024. (For married couples, each spouse can make QCDs for a possible total of $210,000.) When making QCDs, the money given to charity counts toward your RMDs but doesn’t increase your adjusted gross income (AGI) or generate a tax bill.

Keeping the donation amount out of your AGI may be important for several reasons. When distributions are taken directly out of traditional IRAs, federal income tax of up to 37% in 2024 will have to be paid. State income taxes may also be owed. That tax is avoided with a QCD. Here are some other potential benefits of a QCD:

It can help you qualify for other tax breaks. For example, having a lower AGI can reduce the threshold for itemizers who can deduct medical expenses, which are only deductible to the extent they exceed 7.5% of AGI.
You can avoid rules that can cause some or all of your Social Security benefits to be taxed, and some or all of your investment income to be hit with the 3.8% net investment income tax.
It can help you avoid a high-income surcharge for Medicare Part B and Part D premiums, which kick in if AGI is over certain levels.

Keep in mind: You can’t claim a charitable contribution deduction for a QCD not included in your income. Also keep in mind that the age after which you must begin taking RMDs is now 73, but the age you can begin making QCDs is 70½.

To benefit from a QCD for 2024, you must arrange for a distribution to be paid directly from the IRA to a qualified charity by December 31, 2024. You can use QCDs to satisfy all or part of the amount of your RMDs from your IRA. For example, if your 2024 RMDs are $20,000 and you make a $10,000 QCD, you’d have to withdraw another $10,000 to satisfy your 2024 RMDs.

Other rules and limits may apply. QCDs aren’t right for everyone. Contact us to see whether this strategy would make sense in your situation.

Vote WCS for Cecil’s Best Accounting Firm

Tax Prep, Planning & Strategy|August 21, 2024

We’re happy to announce that we’re up for Cecil’s Best Accounting Firm. Help us win this esteemed title by voting for us! Follow the link below to vote.

Click here to vote >>

Social Security tax update: How high can it go?

Tax Prep, Planning & Strategy|August 20, 2024

Employees, self-employed individuals and employers all pay Social Security tax, and the amounts can get bigger every year. And yet, many people don’t fully understand the Social Security tax they pay.

If you’re an employee

If you’re an employee, your wages are hit with the 12.4% Social Security tax up to the annual wage ceiling. Half of the Social Security tax bill (6.2%) is withheld from your paychecks. The other half (also 6.2%) is paid by your employer, so you never actually see it. Unless you understand how the Social Security tax works and closely examine your pay statements, you may be blissfully unaware of the size of the tax. It’s potentially a lot!

The Social Security tax wage ceiling for 2024 is $168,600 (up from $160,200 for 2023). If your wages meet or exceed that ceiling, the Social Security tax for 2024 will be $20,906 (12.4% x $168,600). Half of that comes out of your paychecks and your employer pays the other half.

If you’re self employed

Self-employed individuals (sole proprietors, partners and LLC members) know all too well how hard the Social Security tax can hit. That’s because they must pay the entire Social Security tax bill out of their own pockets, based on their net self-employment income. For 2024, the Social Security tax ceiling for net self-employment income is $168,600 (same as the wage ceiling for employees). So, if your net self-employment income for 2024 is $168,600 or more, you’ll pay the maximum $20,906 Social Security tax.

Projected future ceilings

The Social Security tax on your 2024 income is expensive enough, but it could get worse in future years — much worse, according to Social Security Administration (SSA) projections. That’s because the Social Security tax ceiling will continue to go up based on the inflation factor that’s used to determine the increases. In turn, maximum Social Security tax bills for higher earners will go up. The latest SSA projections for Social Security tax ceilings for the next nine years are:

$174,900 for 2025,
$181,800 for 2026,
$188,100 for 2027,
$195,900 for 2028,
$204,000 for 2029,
$213,600 for 2030,
$222,900 for 2031,
$232,500 for 2032 and
$242,700 for 2033.

These projected ceilings are not always accurate (they could be higher or lower). If the projected numbers pan out, the maximum Social Security tax on wages and net self-employment income in 2033 will be $30,095 (12.4% x $242,700).

Your future benefits

Despite what you pay in, you might receive more in Social Security benefits than you pay into the system. An Urban Institute report looked at some average situations. For example, a single man who earned average wages every year of his adult life and retired at age 65 in 2020 would have paid about $466,000 in Social Security and Medicare taxes. But he can expect to receive about $640,000 in benefits during retirement. Of course, there are many factors involved and each situation is unique. Plus, these calculations don’t account for the interest the Social Security tax dollars would have earned over the years.

Some people think the government has set up an account with their name on it to hold money to pay their future Social Security benefits. After all, that must be where those Social Security taxes on wages and self-employment income go. Sorry, but this is incorrect. There are no individual accounts — just a promise from the government.

Is the Social Security system financially solid? It’s on shaky ground. Congress has known that for years and has done nothing about it (although there have been many proposals on how to fix things). A Social Security Administration report states that “benefits are now expected to be payable in full on a timely basis until 2037, when the trust fund reserves are projected to become exhausted. At the point where the reserves are used up, continuing taxes are expected to be enough to pay 76% of scheduled benefits.”

The agency adds that “Congress will need to make changes to the scheduled benefits and revenue sources for the program in the future.” These changes could include a higher age to receive full benefits, additional Social Security tax hikes in the form of higher rates, some tax-law revision that effectively implements higher ceilings or a combination of these.

Stay tuned

The Social Security tax paid by many individuals will continue to go up. If you operate a small business, there may be some strategies than can potentially cut your Social Security tax bill. If you’re an employee, you need to take Social Security into account in your financial planning. Contact us for details.

House rich but cash poor? Consider a reverse mortgage strategy

Tax Prep, Planning & Strategy|August 13, 2024

Are you an older taxpayer who owns a house that has appreciated greatly? At the same time, you may need income. Thankfully, there could be a solution with a tax-saving bonus. It involves taking out a reverse mortgage.

Reverse mortgage basics

With a reverse mortgage, the borrower doesn’t make payments to the lender to pay down the mortgage principal over time. Instead, the reverse happens. The lender makes payments to you and the mortgage principal gets bigger over time. Interest accrues on the reverse mortgage and is added to the loan balance. But you typically don’t have to repay anything until you permanently move out of the home or pass away.

You can receive reverse mortgage proceeds as a lump sum, in installments over a period of time or as line-of-credit withdrawals. So, with a reverse mortgage, you can stay in your home while converting some of the equity into much-needed cash. In contrast, if you sell your highly appreciated residence to raise cash, it could involve relocating and a big tax bill.

Most reverse mortgages are so-called home equity conversion mortgages, or HECMs, which are insured by the federal government. You must be at least 62 years old to be eligible. For 2024, the maximum amount you can borrow with an HECM is a whopping $1,141,825. However, the maximum you can actually borrow depends on the value of your home, your age and the amount of any existing mortgage debt against the property. Reverse mortgage interest rates can be fixed or variable depending on the deal. Interest rates can be higher than for regular home loans, but not a lot higher.

Basis step-up and reverse mortgage to the rescue

An unwelcome side effect of owning a highly appreciated home is that selling your property may trigger a taxable gain well in excess of the federal home sale gain exclusion tax break. The exclusion is up to $250,000 for unmarried individuals ($500,000 for married couples filing jointly). The tax bill from a really big gain can be painful, especially if you live in a state with a personal income tax. If you sell, you lose all the tax money.

Fortunately, taking out a reverse mortgage on your property instead of selling it can help you avoid this tax bill. Plus, you can raise needed cash and take advantage of the tax-saving basis “step-up” rule.

How the basis step-up works. The federal income tax basis of an appreciated capital gain asset owned by a person who dies, including a personal residence, is stepped up to fair market value (FMV) as of the date of the owner’s death.

If your home value stays about the same between your date of death and the date of sale by your heirs, there will be little or no taxable gain — because the sales proceeds will be fully offset (or nearly so) by the stepped-up basis.

The reverse mortgage angle. Holding on to a highly appreciated residence until death can save a ton of taxes thanks to the basis step-up rule. But if you need cash and a place to live, taking out a reverse mortgage may be the answer. The reason is payments to the lender don’t need to be made until you move out or pass away. At that time, the property can be sold and the reverse mortgage balance paid off from the sales proceeds. Any remaining proceeds can go to you or your estate. Meanwhile, you stay in your home.

Consider the options

If you need cash, it has to come from somewhere. If it comes from selling your highly appreciated home, the cost could be a big tax bill. Plus, you must move somewhere. In contrast, if you can raise the cash you need by taking out a reverse mortgage, the only costs are the fees and interest charges. If those are a fraction of the taxes that you could permanently avoid by staying in your home and benefitting from the basis step-up rule, a reverse mortgage may be a tax-smart solution.

Hiring your child to work at your business this summer

Tax Prep, Planning & Strategy|August 8, 2024

With school out, you might be hiring your child to work at your company. In addition to giving your son or daughter some business knowledge, you and your child could reap some tax advantages.

Benefits for your child

There are special tax breaks for hiring your offspring if you operate your business as one of the following:

A sole proprietorship,
A partnership owned by both spouses,
A single-member LLC that’s treated as a sole proprietorship for tax purposes, or
An LLC that’s treated as a partnership owned by both spouses.

These entities can hire an owner’s under-age-18 children as full- or part-time employees. The children’s wages then will be exempt from the following federal payroll taxes:

Social Security tax,
Medicare tax, and
Federal unemployment (FUTA) tax (until an employee-child reaches age 21).

In addition, your dependent employee-child’s standard deduction can shelter from federal income tax up to $14,600 of 2024 wages from your business.

Benefits for your business

When hiring your child, you get a business tax deduction for employee wage expense. The deduction reduces your federal income tax bill, your self-employment tax bill and your state income tax bill, if applicable.

Note: There are different rules for corporations. If you operate as a C or S corporation, your child’s wages are subject to Social Security, Medicare and FUTA taxes, like any other employee’s. However, you can deduct your child’s wages as a business expense on your corporation’s tax return, and your child can shelter the wages from federal income tax with the $14,600 standard deduction for single filers.

Traditional and Roth IRAs

No matter what type of business you operate, your child can contribute to an IRA or Roth IRA. With a Roth IRA, contributions are made with after-tax dollars. So, taxes are paid on the front end. After age 59½, the contributions and earnings that have accumulated in the account can be withdrawn free from federal income tax if the account has been open for more than five years.

In contrast, contributions to a traditional IRA are deductible, subject to income limits. So, unlike Roth contributions, deductible contributions to a traditional IRA lower the employee-child’s taxable income.

However, contributing to a Roth IRA is usually a much better idea for a young person than contributing to a traditional IRA for several reasons. Notably, your child probably won’t get any meaningful write-offs from contributing to a traditional IRA because the child’s standard deduction will shelter up to $14,600 of 2024 earned income. Any additional income will likely be taxed at very low rates.

In addition, your child can withdraw all or part of the annual Roth contributions — without any federal income tax or penalty — to pay for college or for any other reason. Of course, even though your child can withdraw Roth contributions without adverse tax consequences, the best strategy is to leave as much of the Roth balance as possible untouched until retirement to accumulate a larger tax-free sum.

The only tax law requirement for your child when making an annual Roth IRA contribution is having earned income for the year that at least equals what’s contributed for that year. There’s no age restriction. For the 2024 tax year, your child can contribute to an IRA or Roth IRA the lesser of:

His or her earned income, or
$7,000.

Making modest Roth contributions can add up over time. For example, suppose your child contributes $1,000 to a Roth IRA each year for four years. The Roth account would be worth about $32,000 in 45 years when he or she is ready to retire, assuming a 5% annual rate of return. If you assume an 8% return, the account would be worth more than three times that amount.

Caveats

Hiring your child can be a tax-smart idea. However, your child’s wages must be reasonable for the work performed. Be sure to maintain the same records as you would for other employees to substantiate the hours worked and duties performed. These include timesheets, job descriptions and W-2 forms. Contact us with any questions you have about employing your child at your small business.

The tax consequences of selling mutual funds

Tax Prep, Planning & Strategy |August 1, 2024

Do you invest in mutual funds or are you interested in putting some money into them? If so, you’re part of a large group. According to the Investment Company Institute, 116 million individual U.S. investors owned mutual funds in 2023. But despite their widespread use, the tax rules involved in selling mutual fund shares can be complex.

Review the basic rules

Let’s say you sell appreciated mutual fund shares that you’ve owned for more than one year. The resulting profit will be a long-term capital gain. As such, the maximum federal income tax rate will be 20%, and you may also owe the 3.8% net investment income tax. However, most taxpayers will pay a tax rate of only 15% and some may even qualify for a 0% tax rate.

When a mutual fund investor sells shares, gain or loss is measured by the difference between the amount realized from the sale and the investor’s basis in the shares. One challenge is that certain mutual fund transactions are treated as sales even though they might not be thought of as such. Another problem may arise in determining your basis for shares sold.

A sale may unknowingly occur

It’s obvious that a sale occurs when an investor redeems all shares in a mutual fund and receives the proceeds. Similarly, a sale occurs if an investor directs the fund to redeem the number of shares necessary for a specific dollar payout.

It’s less obvious that a sale occurs if you’re swapping funds within a fund family. For example, you surrender shares of an income fund for an equal value of shares of the same company’s growth fund. No money changes hands, but this is considered a sale of the income fund shares.

Another example is when investors write checks on their funds. Many mutual funds provide check-writing privileges to their investors. Although it may not seem like it, each time you write a check on your fund account, you’re making a sale of shares.

Figuring the basis of shares

If an investor sells all shares in a mutual fund in a single transaction, determining basis is relatively easy. Simply add the basis of all the shares (the amount of actual cash investments), including commissions or sales charges. Then, add distributions by the fund that were reinvested to acquire additional shares and subtract any distributions that represent a return of capital.

The calculation is more complex if you dispose of only part of your interest in the fund and the shares were acquired at different times for different prices. You can use one of several methods to identify the shares sold and determine your basis:

First-in, first-out. The basis of the earliest acquired shares is used as the basis for the shares sold. If the share price has been increasing over your ownership period, the older shares are likely to have a lower basis and result in more gain.
Specific identification. At the time of sale, you specify the shares to sell. For example, “sell 100 of the 200 shares I purchased on June 1, 2020.” You must receive written confirmation of your request from the fund. This method may be used to lower the resulting tax bill by directing the sale of the shares with the highest basis.
Average basis. The IRS permits you to use the average basis for shares that were acquired at various times and that were left on deposit with the fund or a custodian agent.

As illustrated, mutual fund investing may result in complicated tax situations. We can answer any questions you may have and explain how the rules apply to your situation.

Inflation enhances the 2025 amounts for Health Savings Accounts

Management Advisory Services & Business Consulting |July 30, 2024

The IRS recently released guidance providing the 2025 inflation-adjusted amounts for Health Savings Accounts (HSAs). These amounts are adjusted each year, based on inflation, and the adjustments are announced earlier in the year than other inflation-adjusted amounts, which allows employers to get ready for the next year.

Fundamentals of HSAs

An HSA is a trust created or organized exclusively for the purpose of paying the qualified medical expenses of an account beneficiary. An HSA can only be established for the benefit of an eligible individual who is covered under a high-deductible health plan (HDHP). In addition, a participant can’t be enrolled in Medicare or have other health coverage (exceptions include dental, vision, long-term care, accident and specific disease insurance).

Within specified dollar limits, an above-the-line tax deduction is allowed for an individual’s contribution to an HSA. This annual contribution limitation and the annual deductible and out-of-pocket expenses under the tax code are adjusted annually for inflation.

Inflation adjustments for 2025

In Revenue Procedure 2024-25, the IRS released the 2025 inflation-adjusted figures for contributions to HSAs, which are as follows:

Annual contribution limits. For calendar year 2025, the annual contribution limit for an individual with self-only coverage under an HDHP will be $4,300. For an individual with family coverage, the amount will be $8,550. These are up from $4,150 and $8,300, respectively, in 2024.

In addition, for both 2024 and 2025, there’s a $1,000 catch-up contribution amount for those who are age 55 or older by the end of the tax year.

High-deductible health plan limits. For calendar year 2025, an HDHP will be a health plan with an annual deductible that isn’t less than $1,650 for self-only coverage or $3,300 for family coverage (these amounts are $1,600 and $3,200 for 2024). In addition, annual out-of-pocket expenses (deductibles, co-payments and other amounts, but not premiums) won’t be able to exceed $8,300 for self-only coverage or $16,600 for family coverage (up from $8,050 and $16,100, respectively, for 2024).

Heath Reimbursement Arrangements

The IRS also announced an inflation-adjusted amount for Health Reimbursement Arrangements (HRAs). An HRA must receive contributions from an eligible individual (employers can’t contribute). Contributions aren’t included in income, and HRA reimbursements used to pay eligible medical expenses aren’t taxed. In 2025, the maximum amount that may be made newly available for the plan year for an excepted benefit HRA will be $2,150 (up from $2,100 in 2024).

Collect the benefits

There are a variety of benefits to HSAs that employers and employees appreciate. Contributions to the accounts are made on a pre-tax basis. The money can accumulate tax-free year after year and can be withdrawn tax-free to pay for a variety of medical expenses such as doctor visits, prescriptions, chiropractic care and premiums for long-term care insurance. In addition, an HSA is “portable.” It stays with an account holder if he or she changes employers or leaves the workforce. Many employers find it to be a fringe benefit that attracts and retains employees. If you have questions about HSAs at your business, contact us.

What might be ahead as many tax provisions are scheduled to expire?

Tax Prep, Planning & Strategy |July 23, 2024

Buckle up, America: Major tax changes are on the horizon. The reason has to do with tax law and the upcoming elections.

Our current situation

The Tax Cuts and Jobs Act (TCJA), which generally took effect in 2018, made sweeping changes. Many of its provisions are set to expire on December 31, 2025.

With this date getting closer each day, you may wonder how your federal tax bill will be affected in 2026. The answer isn’t clear because the outcome of this November’s presidential and congressional elections is expected to affect the fate of many expiring provisions. A new political landscape in Washington could also mean other tax law changes.

Corporate vs. individual taxes

The TCJA cut the maximum corporate tax rate from 35% to 21%. It also lowered rates for individual taxpayers, with the highest tax rate reduced from 39.6% to 37%. But while the individual rate cuts expire in 2025, the law made the corporate tax cut “permanent.” (In other words, there’s no scheduled expiration date. Tax legislation could still change the corporate tax rate.)

In addition to lowering rates, the TCJA revised tax law in many other ways. On the individual side, standard deductions were increased, significantly reducing the number of taxpayers who benefit from itemizing deductions for certain expenses, such as charitable donations and medical costs. (You benefit from itemizing on your federal income tax return only if your total allowable itemized write-offs for the year exceed your standard deduction.)

In addition, through 2025, certain itemized deductions are eliminated. Others are more limited, including those for home mortgage interest and state and local tax (SALT).

For small business owners, one of the most significant changes is the potential expiration of the Section 199A qualified business income (QBI) deduction. This is the write-off for up to 20% of QBI from noncorporate pass-through entities, including S corporations and partnerships, as well as from sole proprietorships.

The expiring provisions will affect many taxpayers’ tax bills in 2026, unless legislation extending them is signed into law.

Possible scenarios

The outcome of the presidential election in less than five months, as well as the balance of power in Congress, will determine the TCJA’s future. Here are four possible scenarios:

All of the TCJA provisions scheduled to expire will actually expire at the end of 2025.
All of the TCJA provisions scheduled to expire will be extended past 2025 (or made permanent).
Some TCJA provisions will be allowed to expire, while others will be extended (or made permanent).
Some or all of the temporary TCJA provisions will expire — and new laws will be enacted that provide different tax breaks and/or different tax rates.

How your tax bill will be affected in 2026 will partially depend on which one of these scenarios becomes reality and whether your tax bill went down or up when the TCJA became effective back in 2018. That was based on a number of factors including your income, your filing status, where you live (the SALT limitation negatively affects more taxpayers in certain states), and whether you have children or other dependents.

Your tax situation will also be affected by who wins the presidential election and who controls Congress. Democrats and Republicans have competing visions about how to proceed when it comes to taxes. Proposals can become law only if tax legislation passes both houses of Congress and is signed by the President (or there are enough votes in Congress to override a presidential veto).

The tax horizon

As the TCJA provisions get closer to expiring, it’s important to know what might change and what tax-wise moves you can make if the law does change. We’ll keep you informed about what’s ahead. We’re here to answer any questions you may have.

SECURE 2.0: Which provisions went into effect in 2024?

Tax Prep, Planning & Strategy |July 18, 2024

The Setting Every Community Up for Retirement Enhancement (SECURE) 2.0 Act was signed into law in December 2022, bringing more than 90 changes to retirement plan and tax laws. Many of its provisions are little known and were written to roll out over several years rather than immediately taking effect.

Here are several important changes that went into effect in 2024:

Pension-Linked Emergency Savings Accounts (PLESAs). More than half of U.S. adults would turn to borrowing when confronted by an emergency expense of $1,000 or more, according to a Bankrate survey — a figure that has held steady for years. In response, SECURE 2.0 contains provisions related to emergency access to retirement savings, including PLESAs. PLESAs are defined contribution plans designed to encourage workers to save for financial emergencies.

Beginning this year, employers can offer PLESAs linked to employees’ retirement accounts, with the PLESA treated as a Roth, or after-tax, account. Non-highly-compensated employees can be automatically enrolled with a deferral of up to 3% of compensation but no more than $2,500 annually (indexed for inflation) — or less if the employer chooses. Employees can make qualified withdrawals tax- and penalty-free. Employers must allow at least one withdrawal per month, with no fee for the first four per year.

Starter 401(k) plans. SECURE 2.0 creates a new kind of retirement plan for employers not already sponsoring a qualified retirement plan, called a starter 401(k). Employers must automatically enroll all employees at a deferral rate of at least 3% of compensation but no more than 15%. The maximum annual deferral is $6,000 (indexed for inflation), plus the annual IRA catch-up contribution of $1,000 for those age 50 or older. No actual deferral percentage (ADP) or top-heavy testing of the plan is required, reducing the compliance and cost burden for employers.

Employers can impose age and service eligibility requirements, and employees may elect out. They also can choose to contribute at a different level. Employer contributions aren’t allowed, so less record keeping is required.

Top-heavy rules. Defined contribution plans that are considered “top-heavy” must make nonelective minimum contributions equal to 3% of a participant’s compensation. This can represent a significant expense for small employers. Top-heavy plans are those where the aggregate of accounts for key employees exceeds 60% of the aggregate accounts for non-key employees.

Starting in 2024, employers can perform the top-heavy test separately on excludable employees (those who are under age 21 and have less than a year of service) and non-excludable employees. The goal is to eliminate the incentive for employers to exclude employees from the plan to avoid the minimum contribution obligation.

SIMPLE IRAs. SECURE 2.0 boosts the annual Savings Incentive Match Plans for Employees (SIMPLE) IRA and SIMPLE 401(k) deferral limit and the catch-up limit to 110% of the 2024 contribution limits (indexed for inflation) for employers with 25 or fewer employees. Employers with 26 to 100 employees can offer the higher deferral limits if they provide a 4% matching contribution or a 3% employer contribution.

Employers now can make additional contributions to each employee in the plan, as well. Additional contributions must be made in a uniform manner and can’t exceed the lesser of up to 10% of compensation or $5,000 (indexed for inflation) per employee.

Early withdrawal exceptions. SECURE 2.0 allows penalty-free early withdrawals from qualified retirement plans for “unforeseeable or immediate financial needs relating to personal or family emergency expenses.” Employees have three years to repay such withdrawals; no additional emergency withdrawals are permitted during the three-year repayment period, except to the extent that any previous withdrawals within that period have been repaid. The withdrawals are otherwise limited to once per year.

Victims of domestic abuse by a spouse or partner also are exempt from early withdrawal penalties for the lesser of $10,000 (indexed for inflation) or 50% of their vested account balances. The law’s detailed definition of domestic abuse includes abuse of a participant’s child or another family member living in the same household. Withdrawals can be repaid over a three-year period, and participants can recover income taxes paid on repaid distributions.

Note: An early withdrawal penalty exception for terminally ill individuals took effect in 2023.

Employer-provided student loan relief. Younger employees with large amounts of student debt have sometimes missed out on their employer’s matching contributions to retirement plans. SECURE 2.0 tackles this catch-22 by allowing these employees to receive matching contributions based on their qualified student loan payments. Employers can make matching contributions to 401(k) plans or SIMPLE IRAs. Note that contributions based on student loan payments must be made available to all match-eligible employees.

Section 529 plan rollovers. Beginning this year, owners of certain 529 plans can transfer unused funds intended for qualified education expenses directly to the plan beneficiary’s Roth IRA without incurring any federal tax or the 10% penalty for nonqualified withdrawals.

A beneficiary’s rollover amount is limited to a lifetime maximum of $35,000, and rollovers are subject to the applicable Roth IRA annual contribution limit. Rollover amounts can’t include contributions made to the plan in the previous five years, and the 529 account must have been maintained for at least 15 years.

Required minimum distributions (RMDs). Designated Roth 401(k) and 403(b) plans provided by employers have been subject to annual RMDs in the same way that traditional 401(k)s are. As of 2024, though, the plans aren’t subject to RMDs until the death of the owner.

Act now

Many employers need to amend their plans due to changes related to SECURE 2.0. Fortunately, they generally have until the end of 2025 to make these amendments as long as they comply by the law’s deadlines. Contact us for additional details.

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