The Internal Revenue Service delayed the start date of a new rule that will require higher earners’ catch-up 401(k) contributions to be made on an after-tax basis into a Roth account, rather than pretax.
Originally scheduled to go into effect next year, the change—made under the Secure Act 2.0 in December last year—has been bumped to 2026.
Here’s what you need to know about the change:
What Are the Current Rules?
Participants in 401(k)s and similar employer retirement plans including 403(b)s and 457(b)s who are 50 or older are permitted to make catch-up contributions on top of the annual contribution limit.
The 401(k) contribution limit this year is $22,500. Folks ages 50 or older can kick in an additional $7,500 contribution for a total of $30,000. Contributions to 401(k)s and similar employer plans usually are made on a pretax basis, so money socked away reduces annual taxable income. The trade-off for this tax break is that any assets withdrawn from a 401(k) are taxed at income-tax rates.
Assets in 401(k)s and similar retirement accounts must be held until after age 59½, or be subject to a 10% penalty.
How Will This Change?
The Secure Act 2.0 calls for catch-up contributions by folks who earned more than $145,000 in the prior year to be made on an after-tax basis into a Roth account within the 401(k).
Pretax contributions will still be allowed up to the standard annual 401(k) contribution limit, but higher earners will have to pay taxes up front on any catch-up contributions. Assets in the 401(k)s Roth account—-both the principal and any growth—can be withdrawn tax-free after age 59 1/2.
What Is the Reason for This Change?
When Congress passes a bill with tax breaks, it aims to offset the revenue loss for the government with changes that will bring in money. The Secure Act 2.0 included a host of provisions that lower revenues, including raising the age for required minimum distributions, indexing catch-up contributions to inflation and other tweaks to encourage more retirement savings.
“This rule requiring catch-up contributions to be made after tax is a revenue raiser. The objective was to make the bill revenue neutral so it wouldn’t be adding to the deficit,” says Mark Friedlich, vice president of government affairs for Wolters Kluwer . “When Congress was looking for revenue raisers this one was favored because it goes after wealthier individuals.”
Why Did the IRS Delay the Rule Change?
In July, the American Retirement Association and major retirement plan sponsors requested a delay to establish after-tax Roth deposits at more places. While some 401(k) plans currently offer a Roth option, many don’t and face an administrative challenge in complying with the new rule.
What Happens During the Delay?
Pretax catch-up contributions are permitted in 2024 and 2025 before the new rule goes into effect.
Is the Delay Good News or Bad News for Wealthier Savers?
For many savers, the rule change is unwelcome—and the delay is a reprieve, says
Michael Finke, professor of wealth management at the American College of Financial Services. “People who are older than 50 are in their peak earnings years, meaning they’re in their highest marginal tax bracket,” Finke says. “If your tax rate before retirement is going to be higher than after retirement, then you benefit from the old rules versus using a Roth.”
An upfront tax break while your tax rate is high is usually better than a tax-free
withdrawal later in retirement when your tax rate is lower—particularly if you don’t have many years to allow your assets to growth between the time you contribute and your withdrawal.
For some folks, however, making catch-up contributions on an after-tax basis to a
Roth could mean more money in the long term. Income-tax rates are scheduled to go up in 2026 after provisions in the Tax Cuts and Jobs expire. Unless Congress extends the current income-tax rates, the top rate will rise to 39.6% from 37%.
If You Aren’t Already, Should You be Making Catch-up Contributions?
Yes. Most folks aren’t taking advantage of catch-up contributions. “In 2022, only 16% of eligible employees did,” Friedlich says. That means the majority of savers are missing out on a big potential boost to their nest eggs.
How Big a Boost?
Pretty big. Consider two savers, each aged 49 with $600,000 saved in their 401(k)s. When they turn age 50, only one takes advantage of the catch-up contribution. According to an illustration by T. Rowe Price assuming a 7% average annual return and steady annual contributions, by age 65, the saver who socked away catch-up contributions had $2,462,061—$202,000 more than the saver who didn’t make them.
This article was originally published in Barron’s on August 29, 2023, and was written by Karen Hube. Image courtesy of iStock.
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