When it comes to money, take advantage of what the government gives you. And that includes any rule changes that work in your financial favor today or in the future — including catch-up contributions.
And that's certainly the case when it comes to the IRS' recent decision to announce a two-year delay to a new rule. This rule requires higher-income 401(k) savers who are 50 or older to fund their catch-up contributions with after-tax Roth contributions.
The upside of the IRS delay for higher earners is twofold. They can shield their catch-up contributions from taxation for two more years. That lowers their tax bill. What's more, when the new Roth catch-up rule goes into effect in 2026 it will benefit 50 or over savers. How? By forcing them to diversify their retirement accounts from a tax standpoint, personal finance pros say.
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Catch-Up Contributions Snagged By Secure Act
First, some quick background. In the Secure 2.0 Act enacted by Congress in 2022, the new provision to force high earners to fund catch-up contributions in Roth accounts was slated to start in 2024. The new rule applies to participants in a 401(k), 403(b), or government 457(b) plan whose prior-year Social Security wages exceeded $145,000.
But the IRS determined that there was not enough time to ensure a smooth transition to the new Roth catch-up rules. So, in late August the IRS extended the start date to 2026.
From a personal finance perspective, the eventual Roth catch-up rule change is all about taking advantage of the tax treatment of the contributions. For the U.S. Department of the Treasury, of course, the new rule eventually will boost its revenue as catch-up contributions will come from already-taxed income, says Ed Slott, a CPA and co-founder of IRAHelp.com.
Catch-Up Contributions And Taxes
Under current rules, catch-up contributions for high-earners are made with pretax dollars, as are deposits to traditional 401(k)s. That means 401(k) plan participants 50 or older can reduce their taxable income by the amount of their catch-up contribution. (For 2023 — and most likely in 2024, according to a forecast by consulting firm Mercer — the maximum catch-up contribution is $7,500.) However, under current law, retirement savers pay taxes on their catch-up contributions when they withdraw funds in retirement.
Under the new requirement, however, catch-up contributions would go to a Roth account. And they would be funded with dollars that have already been taxed. The upside to a Roth, however, is that both contributions and earnings can be withdrawn tax-free in retirement. Another benefit of a Roth is there are no required minimum distributions (RMDs). And that means all Roth investments can grow tax-deferred for longer.
Keeping Up With Congress
Sure, keeping up with money-related rule changes enacted by Congress or the IRS can be a chore. But, in this case, the IRS delay works to the advantage of catch-up savers in both the short-term and long run.
Rule delay saves on taxes in short-run. High earners age 50 or older are typically in their prime earning years. In short, their paychecks are bigger. And that means those dollars are taxed at higher IRS tax brackets.
The goal of this high-earner retirement saver is likely to trim their tax bill and keep more of their hard-earned money. That's why the IRS decision to extend the start date of the new catch-up requirement to 2026 works in the favor of high-earners. They can now shield up to $7,500 of income from the IRS for two more years.
"The delay actually helps higher-income wage earners because it allows them to continue to get the tax benefit now rather than later," said Rob Burnette, CEO and investment advisor representative at Outlook Financial Center. "When you get into the higher-income tax brackets (the top two brackets are taxed at 33% and 37%), that tax-deferred deduction is actually more valuable to you."
IRS Rule Delay With Catch-Up Contributions
In contrast, when the new Roth catch-up rule goes into effect, the high-earner saver is going to have to pay taxes upfront on the contribution.
And yet, the new rule adds to tax diversity later. Nobody likes the government telling them what to do. But the new Roth catch-up rule "nudges" savers toward Roth retirement accounts. These accounts come with long-term sweeteners such as tax-free withdrawals and no RMDs.
And those two Roth benefits can add up down the road, especially if tax rates in retirement are higher than they are now — which many pundits predict.
Diversify Your Tax Liability
By having more money in Roth accounts, retirement savers avoid getting hit with a large tax bill in retirement. This hit is dubbed the "tax torpedo," which results from taking distributions from a traditional 401(k) or IRA, says Slott. "You avoid getting hit with taxes at the worst possible time: in retirement," said Slott.
In fact, moving more retirement savings into Roth accounts via catch-up contributions or Roth conversions isn't a bad thing, says Burnette. "I call it tax diversity," said Burnette.
What To Do Now With Catch-Up Contributions
In a nutshell, having an array of accounts with different tax treatments gives retirement savers more flexibility. That flexibility is helpful when it comes to limiting the tax hit caused by withdrawals. "It gives the saver a choice," said Burnette. "What's the tax code giving us today."
Withdrawals from taxable brokerage accounts, of course, get the capital gains tax treatment. And most Americans, based on their taxable income, pay either 15% or zero on capital gains, according to the IRS. In contrast, traditional tax deferred accounts like traditional 401(k)s and IRAs are taxed at the individual's regular income tax rate. That rate often is higher. Of course, dollars parked in Roth accounts can be withdrawn tax-free.
Slott says moving more retirement dollars into Roth accounts is a bet worth taking. Why? "Because there's a risk of taxes being higher in the future," Slott said.
Buying Tax Insurance
What you get with a Roth is what Slott calls "tax insurance." It removes the uncertainty of what the tax rate will be in the future. And most high-earners tend to stay in a high tax bracket in retirement anyhow, adds Slott.
"You never have to worry about the uncertainty of what future higher tax rates could do to your standard of living in retirement," said Slott.
Many of the longest-tenured workers likely have a large portion of their savings in traditional pretax retirement vehicles like 401(k)s. So savers will ultimately benefit from the Roth catch-up rule change. It makes financial sense to get more money into a Roth 401(k), says Slott.
The bottom line: when the government changes money-related rules, do what you can to take advantage of any edge they give you.
"What I look at is what are the cards that are dealt to me," said Burnette. "And how do we play this hand to our maximum benefit."
