The IRS recently made a welcome announcement for higher-income workers with 401(k) and similar retirement plans.
A new rule set to take effect in 2024, which would have required catch-up contributions made by individuals earning over $145,000 to be directed into an after-tax Roth account, has been postponed until 2026.
This two-year administrative transition period provides savers nearing retirement and earning above the specified income threshold with additional time to make catch-up contributions on a pre-tax basis.
The requirement to direct catch-up contributions into a Roth account is part of the SECURE Act 2.0, which was signed into law in late 2022.
According to this provision, starting in 2024, any catch-up contributions made to a 401(k) or similar workplace retirement account by individuals earning over $145,000 in the prior year must be made on a Roth basis.
With Roth contributions, taxes are paid upfront in exchange for tax-free growth and withdrawals.
However, an oversight in the legislation accidentally deleted the provision allowing catch-up contributions for savers at every income level. In its current form, the law indicated the end of catch-up contributions altogether after 2023.
While Congress has acknowledged this error, it has not yet passed corrective legislation to restore catch-up contributions.
The IRS has taken a proactive approach to address this issue. The agency’s stance is that it will act as though the legislative glitch never occurred.
Therefore, catch-up contributions can continue as before in 2024 and beyond, irrespective of the law’s language.
In its announcement, the IRS clarified, “The notice also clarifies that the SECURE 2.0 Act does not prohibit plans from permitting catch-up contributions, so plan participants who are age 50 and over can still make catch-up contributions after 2023.”
This accidental removal of catch-up contributions could have had significant implications for individuals over 50 and approaching retirement.
Catch-up contributions provide an opportunity for those 50 and over to make additional contributions above the regular annual limits, boosting retirement savings during the crucial years leading up to retirement.
The requirement to make catch-up contributions on a Roth basis posed a different set of challenges.
This change would have forced savers to pay taxes on catch-up contributions immediately instead of deferring them pre-tax.
While Roth accounts offer potential benefits through tax-free withdrawals, the immediate tax obligation could push savers into a higher tax bracket.
Employers would have faced a substantial burden as well, as they would have had limited time to add Roth options to their retirement plans to accommodate catch-ups for employees earning at least $145,000.
The uproar from employers over this added complexity likely played a role in the IRS’s decision to create the transition period.
Thanks to the IRS’s transitional relief, retirement savers have gained more flexibility with their catch-up contributions until 2026. Additionally, they can be reassured by the agency’s willingness to overlook the SECURE Act 2.0’s error that would have eliminated all catch-up contributions starting in 2024.
For those aged 50 or older, this extension provides an opportunity to make two more years of pre-tax catch-up contributions, helping lower taxable income before the Roth rule becomes effective.
Savers may also consider using this additional time to allocate some catch-up funds to a Roth account voluntarily as a hedging strategy.
Finally, developing a plan for 2026 and beyond, when catch-ups must be made on a Roth basis, is essential.
Consulting with a financial advisor to incorporate these changes into your retirement plan can also be a prudent step for making the most of this new flexibility.
Source: SmartAsset via Yahoo