Editor's Note
Rules on Catch-up Retirement Contributions Will Change for Higher Earners
Retirement plans have been a way for people to reduce their taxable income by contributing to the plan with pre-tax dollars. The idea has been that you are taxed on the money when you withdraw it, presumably after you stop working and your tax rate is lower.
There is another option, the Roth IRA, where you contribute after tax dollars now, but can withdraw the money later tax-free.
For lawmakers, the great thing about payroll taxes is that they are much easier to collect from employers than from individual taxpayers. So, for higher earners, they are going to start collecting the taxes upfront for catch-up contributions and eliminate the option to make pre-tax contributions.
The change doesn't apply to all contributions and it's possible to continue to make catch-up contributions, but they will be made with taxed dollars and you may have to make some adjustments to your plan.
Here are the details.
- Heather Bussing
Our prior bulletin summarized the multitude of changes applicable to 401(k) and other retirement plans under the recently enacted “SECURE 2.0” law. This bulletin focuses on one of those changes and a potential reason for amending plans before 2024.
Background:
401(k) contributions by employees are subject to an annual limit each year ($22,500 in 2023). However, an employee who has reached age 50 is permitted to make “catch-up” contributions up to an additional amount ($7,500 in 2023). Thus, an employee who has reached age 50 can make 401(k) contributions as high as $30,000 this year.
Currently, 401(k) contributions up to the applicable limit can be made in the form of traditional pre-tax contributions, after-tax Roth contributions, or any combination of the two. For example, a 50-year-old employee can make traditional pre-tax contributions of $30,000, after-tax Roth contributions of $30,000, or contributions of $15,000 of each type.
The Change:
SECURE 2.0 dictates that catch-up contributions by employees with annual compensation in excess of $145,000 can only be made on an after-tax Roth basis, effective in 2024 and subsequent calendar years. (For this purpose, compensation is defined to mean wages subject to FICA taxes in the prior calendar year. For years after 2024, the compensation threshold will be as adjusted.)
The reason behind this change appears to be purely one of revenue-raising; generally, Congress is a proponent of Roth contributions because they get tax dollars into government coffers now, as compared to traditional tax-deferred accounts that push tax revenue down the road.
Employer Decision:
For those plans that currently permit Roth 401(k) contributions, there is no decision to be made by the employer on this point; procedures will simply need to be modified to make sure that all catch-up contributions made by the affected group are directed into their Roth accounts within the plan. For those sponsors of plans that do not currently permit Roth contributions, however, a decision will need to be made. Options include the following:
- Do Not Add Provisions for Roth 401(k) Contributions. Some employers may wish to adhere to the principles that have caused them to forego the opportunity to add provisions for Roth contributions to their plans in the past – most notably, simplicity. In this case, systems will need to be updated to make sure that affected higher-paid employees are precluded from making catch-up contributions, and this limitation will need to be communicated to them.
- Add Provisions for Roth 401(k) Contributions. To permit higher-paid employees to continue to make catch-up contributions, sponsors of plans that do not currently permit Roth contributions should consider amending their plans to add the Roth feature, effective on or before January 1, 2024. Importantly, the Roth feature cannot be limited to higher-paid employees who wish to continue to make catch-up contributions; if the opportunity to make Roth contributions is offered to any plan participants, it must be offered to all participants generally. Although the addition of a Roth feature adds a layer of complication to any plan, maximum flexibility for all employees can be a valuable benefit.
Plan Amendment:
While plan amendments to comply with the requirements of SECURE 2.0 need not be adopted before the end of the plan year beginning in 2025, this extended deadline does not apply to discretionary amendments that are adopted to add new provisions such as a Roth feature (as opposed to amendments that are required for legal compliance). In addition, if a Roth feature is added to a plan, that feature must be communicated to employees via an updated Summary Plan Description, updated enrollment forms, etc. Therefore, employers who elect to implement option #2 above should act sooner rather than later.
