Last week, the IRS announced new changes to the 401k catch-up rule.  Previously, the IRS required  high-earners to place their catch-up savings in Roth  accounts with no immediate tax benefit.  The new rule allows savers age 50 and older to make catch-up contributions to pre-tax accounts for two more years.  The change preserves an immediate income tax benefit.

Background

The SECURE Act 2.0 is now amended thanks to the law change.  Starting in 2024, the Act requires 401k savers who are 50 or older to put catch-up contributions in Roth accounts only.  The policy applies to high-earners with prior-year Social Security wages of 145,000 or more.  Last week’s announcement means high wage earners can now put their catch-up contributions in pre-tax 401k accounts. For clarity, the extended 401k catch-up rule does not apply to Individual Retirement Accounts (IRAs).

According to the IRS,

“The administrative transition period for the 401k catch-up rule will help taxpayers transition smoothly to the new Roth requirement and is designed to facilitate an orderly transition for compliance with that requirement.” 

The IRS also clarified that the 401k catch-up rule doesn’t bar anyone from making catch-up contributions, regardless of income, in 2023 or beyond. Some feared a textual error had accidentally banned catch-up contributions altogether. 

Roth vs Traditional IRAs

Unlike contributions to traditional IRAs, Roth contributions do not reduce a saver’s current-year taxable income.  Instead, the Roth payoff comes later, as qualified distributions have no income tax. Conversely, tax-deferred savings accounts are fully taxable when distributed. 

The original use of Roth accounts would have penalized higher earners who anticipate being in a lower tax bracket when they retire.  Those folks seek to reap current-tax-year savings from pre-tax contributions rather than tax-free withdrawals in retirement. 

An Example

For 2023, the regular 401k contribution limit is $22,500. The 401k catch-up rule allows savers who are 50 and older to contribute another $7,500 in contributions, for a total of $30,000. Vanguard estimates that 16% of eligible savers made catch-up contributions in 2022.  

A participant in the 35% tax bracket can cut his income tax bill an extra $2,625 by making a $7,500 pre-tax, catch-up contribution — in addition to tax savings from the other regular contribution. 

Conclusion

The new transition period for the 401k catch-up rule will benefit savers in their peak or late earning years.  The change postpones the need to set up a Roth IRA account and it simplifies making maximum contributions to pre-tax savings.  Over time, increased use of Roth accounts also have a silver lining as they introduce new flexibility to manage taxes in retirement, especially for participants who routinely save the maximum amount.

Have questions about your retirement savings and after-tax income? Schedule time with us here.