The 401(k) Catch-Up Contribution Rule is Changing

Key Points

• Starting in 2024, higher-earning workers who make catch-up contributions to employer-sponsored retirement plans will have to put that money in a Roth account.
• Catch-up contributions are additional contributions allowed for individuals aged 50 or older in tax-advantaged retirement accounts. These contributions are above the regular contribution limits and are designed to incentivize retirement savings.
• These changes apply to employer-sponsored plans like 401(k)s, but do not affect IRA plans.
• The new rules will require employers to offer Roth plans in addition to their standard pretax retirement plans, which has led to some concerns and pushback within the retirement industry. 

Catch-up contributions, a popular feature of employer-sponsored retirement plans like a 401(k), are set to undergo significant changes starting in 2024. If you're among the workers who make these additional contributions to your retirement plan, you'll need to start allocating this money to a Roth account. This means that you won't be able to deduct these contributions from your income taxes. However, you will be able to withdraw the earnings from these contributions tax-free when you retire. This change will affect those who earn $145,000 or more annually. Here's what you should know. 

Understanding Catch-Up Contributions 

Every tax-advantaged retirement account has a maximum contribution limit, which is the highest amount you can contribute to the account each year without incurring taxes. For instance, in 2023, an individual can only contribute up to $22,500 to their 401(k) account and $6,500 to an IRA. 

To encourage retirement savings, the IRS permits individuals aged 50 or older to make "catch-up contributions." In 2023, if you're over 50, you can contribute an additional $7,500 to a 401(k) and an extra $1,000 to an IRA, above the standard contribution cap. 

Traditionally, the tax rules for catch-up contributions have been based on the type of account. For instance, if you make catch-up contributions to a 401(k), you receive the standard tax deduction for that account. Conversely, if you put catch-up contributions in a Roth IRA, you pay taxes upfront but none on withdrawals. 

However, these rules are about to change for high-income households. 

Changes to Catch-Up Contributions Under Section 603 

In 2022, Congress passed the SECURE 2.0 Act, a comprehensive collection of changes to U.S. retirement laws. While it introduced several key changes, including transitioning 401(k) programs from opt-in to opt-out, the law also includes many detailed changes to numerous programs. 

Section 603 of the SECURE 2.0 Act is one such detailed change that significantly alters how catch-up contributions work for high-income households. Specifically, for employer-sponsored plans like a 401(k), if you earned more than $145,000 in the previous tax year, you must make all catch-up contributions on a Roth basis. This means you cannot deduct the income used for catch-up contributions, but you won't have to pay taxes on the money or its earnings when you withdraw it later in life. 

Impact on IRA Plans 

While contribution limits will remain unchanged, employers allowing catch-up contributions will need to start offering Roth plans alongside their standard pre-tax retirement plans. This has led to some resistance, with retirement industry groups citing the costs and time associated with establishing new Roth plans. 

These changes will take effect on January 1st, 2024. 

Implications for Taxes 

The first thing to note is that Section 603 does not phase in. Individuals earning $144,999 or less are exempt. They may fully deduct the income that they contribute to an employer-sponsored retirement account, including any catch-up contributions. 

Meanwhile, those earning $145,000 or more are fully subject to this section. They may fully deduct the income contributed to a 401(k) account up to the standard annual limit. However, they cannot deduct any income used for catch-up contributions and must pay taxes on that money. This money must be placed into a Roth account, allowing them to withdraw its growth tax-free later in life. For some, placing more money into a Roth can help them minimize taxes in retirement. But for others, a Roth contribution will result in having less retirement savings later on.

 The specific tax impact will depend entirely on an individual’s income. For instance, someone earning $150,000 and making the maximum catch-up contributions would essentially have $1,800 less to invest under the new rules. However, while this will make retirement saving more expensive upfront, it will also incentivize employers to establish more Roth options in their retirement plans. These plans offer larger tax advantages in the long run, as investors pay no taxes on the larger amount withdrawn in retirement, rather than the smaller amount invested upfront. 

In WealthTrace you can find out just how big of an impact this will have on you. I looked at plan where a person is saving the maximum to his 401(k) plan including the catch-up contribution. I moved $7,500 of this contribution (the full catch-up amount) to a Roth 401(k) because his income is above the threshold. 

This person makes $175,000 a year, is 51 years old, and will retire at age 65. Because he now has less after-tax money to save, his overall contributions have to be reduced by $1,800. After changing the contributions I found that he will have $35,000 less when he retires and about $100,000 less at age 85. 

For individuals looking to avoid this tax issue, opening an IRA could be a good option. These are pre-tax accounts, and you can have both a 401(k) and an IRA simultaneously. While IRAs have much lower maximum contribution limits, you can generally invest almost as much in an IRA as you could through catch-up contributions, making this a good alternative investment strategy. 

The Bottom Line

Beginning in 2024, if your annual income exceeds $145,000, the catch-up contributions you make to a plan sponsored by your employer will no longer be tax-deductible. Instead, these additional contributions will have to be directed into a Roth account. While this means you'll pay taxes on the contributions initially, you won't be taxed when you withdraw the profits at a later stage. 

Do you know how this change to retirement contributions will affect you? If you aren’t sure, sign up for a free trial of WealthTrace to get started on your financial and retirement planning.