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Picture of Christopher A. Hopkins, CFA

Christopher A. Hopkins, CFA

Big changes coming for 401(k) catch-up contributions

Employees participating in deferred contribution retirement plans like 401(k), 403(b), or 457 plans can (and should) elect to stuff extra dough into their accounts after age 50. This can be a boon for older workers trying to make up for lost time but is especially beneficial for higher-income savers who get an immediate tax break on their pre-tax deferrals. That is about to change.

Beginning January 1, employees with W2 income over $145,000 for the previous year must channel any catch-up contributions into a Roth account and pay taxes up front on the income that would otherwise have been deductible. Maybe. That’s because new law contains a technical error that must be corrected by Congress before year end and will also require thousands of employers to revise their plan options by then. The clock is ticking.

A sweeping revision to retirement plans called the SECURE 2.0 Act was adopted by Congress and signed by the President last December. The measure includes some new incentives to encourage additional retirement savings by individuals in IRA accounts as well as company retirement plans. One of the most interesting elements is the additional inducement to utilize the potentially tax-free Roth account structure in employer-sponsored plans. Specifically, employer matching contributions can now be directed into a Roth 401(k), 403(b), or 457 account at the behest of the employee, assuming the plan sponsor has adopted the option in its specific plan document.

Under current law, any plan participant over age 50 can defer an additional $7,500 in a defined contribution plan (if the employer permits) and choose whether to make the contribution tax-deductible or opt for an after-tax Roth account. But the SECURE Act also contained a little-noticed mandate for higher income earners, requiring all catch-up deferrals to be made after tax into a Roth. The incentive for the Government is the immediate recognition of the tax revenue on the salary deferral, but in the end the advantage may belong to the employee.

At first glance, the lost tax deduction is most substantial and beneficial to workers in the highest tax brackets. Take for example a manager earning above the threshold who makes the maximum $7,500 additional contribution. Assuming a 32% marginal tax rate, the taxpayer can currently take an immediate $2,400 deduction and enjoy tax-deferred growth until such time as they chose to take taxable distributions in retirement.

Under the new provision, the taxpayer would no longer be entitled to a deduction but would shovel the catch-up contribution into a Roth after income taxes have been paid on the wages. Yet in the long run, the employee is likely to benefit more from the new arrangement due to the power of tax-free growth.

Roth IRA accounts were introduced as part of the Taxpayer Relief Act of 1997 and have enjoyed increasingly wide adoption as savers become more aware of their advantages. While contributions are made with after-tax money, any growth in the account over the lifetime of the owner can be distributed entirely tax free once the account has been open at least 5 years and the owner attains the age of 59 ½. Furthermore, there are no required minimum distributions, and they may be inherited tax-free subject to a 10-year distribution window. What’s not to like?

Company 401(k) plans with a Roth deferral option have been around for a while, but SECURE 2.0 allowed employer matches to also go into Roth pockets at the option of the employee, again assuming the employer’s plan includes such a provision. The impending requirement that high-income catchups must go into a Roth-type account may present a problem for some employers who must now scramble to amend their plan documents before year end if they do not currently allow Roth accounts.

Defined contribution plans must comply with broad guidelines but in fact vary widely across employers. Companies set their own policy regarding eligibility, vesting schedules, matching contributions, and even whether to allow catch-up contributions or offer a Roth option.  Many firms will need to amend their plans to allow for the new catch-up requirement, which can be complicated for a large enterprise. In fact, over 200 large employers and plan administrators have petitioned the leaders of the Congressional tax-writing committees for a delay in implementation. In addition, a few states do not currently allow Roth-type plans for state employees and must adopt laws to comport with the new requirements.

Meanwhile, as is often the case with major legislation, SECURE 2.0 contained several technical drafting errors that need to be cleaned up. But in this case, the error is a doozy: in creating the new requirement for high-income Roth contributions, the drafters of the legislation inadvertently deleted the entire section authorizing catch-up contributions entirely. Unless corrected timely, the law technically forbids ALL catch-up contributions after January 1. This was clearly not Congress’s intention, but so far there has been little progress in fixing the goof.

The change does not apply to self-employed workers or pass-through entities like partnerships or LLCs, and only applies if the employee earned above the threshold the previous year from the same employer. New hires are exempt, even if their previous year income was over $145,000.

Some high earners may lament the loss of the immediate tax deduction, but the huge benefits of tax-free earnings and exemption from required distributions will most likely make the Roth option more profitable in the long run.

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