My job is being eliminated and I will get a severance package. Is that considered income for IRS limits on Roth IRA contributions?

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I know my job is being eliminated at the end of March 2023. I will receive a severance package paid out over a period of almost one year. I understand I will not be able to make 401(k) deductions from my severance once I stop working. Because of my severance and my existing cash flow, I could comfortably make the full $22,500 contribution to my 401(k) by the end of March.

My company will only match my contributions up to 6% of salary so there’s no additional matching benefit for contributing to the IRS limit. I am anticipating it could take me a while to find a new job so I am looking to maximize my contribution.

Is my severance considered income for the IRS income limits on Roth IRA contributions? If I am below the income limit, is there any circumstance where it would be more advantageous to contribute less to my 401(k) and contribute something towards a Roth IRA?

What if I contribute the full $22,500 before my old job ends, and then I get another job before the end of the year? Is it possible to contribute to a new 401(k) account to get additional matching?

Strategic on Severance

Dear Strategic,

I am sorry to hear about your impending layoff. Sadly, pink slips in some industries as recession fears cloud the horizon. Many tech sector workers know this all too well. IBM
Lam Research Corp.
and SAP
are just some of the latest major companies trimming staff.

On the brighter side, the tax code has options on where to deploy and stash money amid these macroeconomic question marks. But it’s not necessarily a simple task, particularly right now. “You are trying to make decisions in the face of uncertainty, and that’s tough,” said Eric Bronnenkant, head of tax at the robo-adviser Betterment.

The starting point is a 401(k) contribution limit in 2023 that goes up to $22,500. Catch-up contributions allow an extra $7,500 for workers over age 50. Then there’s the income limits to put money into Roth IRAs, which are funded with after-tax money. Individuals need to make under $153,000 and married couples filing jointly need to make $228,000 in order to contribute anything to these accounts, IRS rules say.

The IRS regards severance as supplemental wages, and it’s subject to income-tax withholding and payroll taxes. “Generally speaking,” severance money does count towards the Roth IRA income limits said Nilay Gandhi, senior wealth adviser at Vanguard — “unless the severance is specifically excluded by the employer, and the employee should ask their employer if it’s going to be considered taxable income or not.”

Even if salary, plus severance, knocks you out of contention for direct Roth IRA contributions, Bronnenkant noted you might still have the potential option of a “backdoor” Roth IRA conversion, despite your income.

You ask how much you can pour into a new 401(k) plan if you’ve already maxed out contributions at your current employer. The answer is $0, said Bronnenkant, because the IRS will not allow people to add more money to a new plan after reaching the maximum yearly contribution limit elsewhere. “Notably, what is not aggregated is employer contributions,” he said.

There’s nothing stopping the new employer from making its own 2023 contributions to your shiny new 401(k) account, even if you can’t add more for the year, Gandhi said.

It’s something to ask potential employers about, Gandhi said. “That’s the reason plan rules are so important here. Plan rules will govern what contributions are going to happen by employees and what the employer is also going to do,” he said. There’s more on the rules surrounding employer contributions from MarketWatch investing columnist Beth Pinsker here.

Then there’s your question as to whether there are scenarios where it’s more helpful to put less money into your current 401(k) and more direct contributions into a Roth IRA. You could put the full $22,500 into your 401(k), you say, but you want to know if you should.

‘Pouring more into Roth IRA could be a way of establishing a money source that serves as a retirement account but also a savings fund.’

Holding back on the 401(k) contributions may possibly get you a chance at more employer matching money in a new account, Bronnenkant said. That presumes the new job is coming this year (and I hope it is). “That scenario requires you to have visibility into the future that you may not have today,” he noted.

Pouring more into Roth IRA could be a way of establishing a money source that serves as a retirement account but also a savings fund for a potential storm.

“Contributions can come out tax and penalty free at any time, so it can serve as an emergency fund while growing as well,” Gandhi said.

If withdrawals exceed contributions, taxes and penalties can kick in for a person under age 59 ½, Vanguard notes. In traditional IRAs, the taxes and penalties apply on the withdrawals of contributions before age 59 ½, it said.

Among the multitude of 2023 economic predictions, Vanguard foresees a 90% chance of a recession in the United States. But it would likely be part of a worldwide recession that would be “modest,” according to the asset management giant’s chief global economist.

That emergency cash could prove to be of “high importance” if it will take some time before the next job comes along, Gandhi said.

Come March, how will the economy and the job market look? Is there is a soft, even a softish, landing? An incoming recession? We all wish we had more certainty. “You make the best decision you can with the information you know at the time,” Bronnenkant said.

Got a tax question? Write me at: [email protected]

Thanks for reading. I want to help you think more broadly about the issues that affect your taxes. I’m not offering tax advice, just an attempt to look at what the swirl of tax rules and economic conditions could mean for your wallet.

I’m here for the reader who faces their taxes with an air of resignation. You’re just not that into taxes, I get it. I was once that guy. Underneath the jargon, think of your taxes like a maze — with money at the end. Or a trap that you need to avoid.

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