Changes to 401(k) Catch-Up Contributions: What You Need to Know

Millions of Americans over 50, that earn more than $145,000 per year, are about to face a significant change in their retirement savings strategy. Starting next year, a popular tax deduction allowing catch-up contributions to 401(k) accounts will undergo a transformation.

1. The Catch-Up Contribution Shift:

Currently, individuals aged 50 and older can make catch-up contributions to their 401(k) accounts, allowing them to save more toward retirement. In 2023, the limit for an employee contribution is $22,500 and the catch-up provision is an additional $7,500. However, beginning next year, these catch-up funds will only be funneled into after-tax Roth accounts for individuals who earned more than $145,000 in the previous year.

2. Tax Implications:

Under the new rules, workers will need to pay taxes on catch-up contributions upfront during high-earning years instead of during retirement when they may be in a lower tax bracket. This shift has the potential to reshape retirement savings strategies and alter financial and estate planning approaches.

3. Benefits of Roth Accounts:

While some individuals may face higher taxes, there are distinct advantages of Roth accounts. Contributions made to Roth accounts grow tax-free and can be withdrawn without incurring taxes. This tax-free growth can be particularly beneficial in retirement, especially if tapping into other accounts would push individuals into higher tax brackets or trigger higher Medicare premiums. Furthermore, Roth accounts offer significant benefits to heirs, who receive tax-free income from these accounts.

4. Implementation Challenges and Potential Delay:

Some companies and plan providers are requesting a two-year delay in implementing the new requirement. According to Fidelity, 30% of employers lack a Roth feature in their plans. There are also logistical challenges including identifying those who earned over $145,000 in the previous year and adjusting payroll and systems to ensure catch-up funds are allocated to Roth accounts. However, it remains to be seen whether the request for a delay will be granted.

5. Congressional Fix:

Another aspect to consider is a drafting error in the retirement bill passed by Congress last year. This error, if not corrected, could potentially prohibit catch-up contributions for all workers starting in 2024. Lawmakers have expressed their intention to introduce technical corrections legislation to rectify this issue.

Conclusion:

The upcoming changes to catch-up contributions in 401(k) accounts will have significant implications for high-earning Americans and their retirement savings. While the shift towards after-tax Roth accounts may result in higher upfront taxes, it offers the potential for tax-free growth and more flexibility in retirement. As this transition takes place, consider the adjustments you will need to make to your retirement savings strategy and contact us with your questions.