When Congress passed the Secure 2.0 legislation, it changed the rules on catch-up contributions to 401(k) plans for people aged 50 and up. Under the new rules, high earners -- those earning above $145,000 -- can only make catch-up contribution to Roth-style 401(k) plans, and no longer to traditional-style ones.
Initially, that new restriction was expected to go into effect in 2024, but the IRS granted a two-year extension for "administrative transition" purposes. As a result, this "gotcha" rule for retirement savings won't hit you in 2024, but instead, it's expected to go into effect in 2026.
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Why this makes a difference
In general, people under age 50 can contribute as much as $23,000 to their 401(k) plans in 2024, and those aged 50 and up can add an additional $7,500, bringing their totals to $30,500. While those are the general rules, there's an additional restriction on people considered highly compensated employees.
In essence, if you're a highly compensated employee, your base contribution limit will be reduced from that $23,000 amount, but if you're over 50, you still have the full $7,500 catch-up available to you. Until this new rule is fully put into place, you can direct your entire available contribution limit to either a Traditional 401(k) or a Roth 401(k).
Once the new rules go into effect, if you're over 50 and make over $145,000, the catch-up part of your contribution must go to a Roth 401(k). You can still contribute the base amount to a Traditional 401(k) if you'd like. Just be forewarned that if you're a highly compensated employee, you may hit your base limit earlier than you expect, thus converting to the Roth catch-up sooner than you anticipated.
Where can this cause issues?
For people who have been contributing a significant amount to Roth IRAs for a while, this change won't make much of a difference. For those who had instead prioritized other uses for their money before saving for retirement, this change may cause problems.
One of the key reasons to pick a Traditional 401(k) over a Roth 401(k) is if you don't expect to have a large balance in your retirement accounts by the time you stop working. That's because if you contribute to a deductible Traditional 401(k) while you have a high income, you get a tax break at your marginal income tax rate. Once you're withdrawing money in retirement, if those withdrawals are your only source of income and are low enough, your taxes can be quite low.
By forcing those catch-up contributions to a Roth-style 401(k), those who start saving for retirement later in their careers after they've reached a higher income can end up with a suboptimal result. While their total contribution limits aren't affected, the fact that Roth-style 401(k) contributions are made with after tax dollars makes it more expensive to fund than a pre-tax Traditional-style 401(k).
Get started now
If you're in the situation where you could be impacted by this rule change, now is the time to take advantage of the fact that you've still got two years before it comes into effect. If you want a bigger balance in your Traditional 401(k) than you'll be likely able to get under the new rules, then now is a great time to get more into that type of plan.
If, on the other hand, you earn a high income and are OK with your catch-up contributions being put into a Roth 401(k), then it's still a good idea to start contributing to one today. This is because a Roth 401(k) has a five-year rule before you can take out your earnings tax-free, even if you've reached age 59 and a half. The sooner you start contributing, the sooner you will reach that five-year rule and thus get the key benefit of contributing to a Roth-style retirement account.
Either way, getting started now gives you a great opportunity to be ready once this change takes place. So make today the day you get your 401(k) ready for this upcoming rule change, and minimize the impact to yourself once it does.
