Millions of Americans are set to lose a popular 401(k) benefit — are you one of them? Here’s what it is and what it means for you
Higher earners, heed this warning: If you’ve been persistently socking away money for retirement through a traditional 401(k) plan, a big change is coming.
Thanks to one of the changes Congress made in 2022 to help American workers enhance their retirement savings, starting in 2026, you may lose some of the “catch-up” and tax friendly benefits you’ve been used to.
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Here’s what you need to know so you can avoid a nasty surprise later.
What’s changing
The SECURE 2.0 Act approved by Congress last year disrupts the “catch-up” contributions used by older, higher earners. Starting in 2026, those catch-ups will have to be designated as after-tax Roth contributions instead of regular 401(k) ones.
The switch is more than a mere name change, as traditional 401(k) and Roth IRA accounts are very different retirement vehicles with distinctly different tax advantages and considerations.
Employer-sponsored 401(k) accounts have become a default retirement vehicle for millions of American workers. Nearly 70% of Americans working in the private sector had access to employer-sponsored retirement plans as of March 2022, according to the Bureau of Labor Statistics. However, only 52% of private-sector workers take advantage of them.
The set-it-and-forget-it approach of 401(k)s provides employees with a sure and steady wealth-builder. The focus on pre-tax contributions also lowers the contributor’s taxable income, though that tax bill is kicked down the road to retirement when withdrawals from 401(k)s become taxable events.
Roths are different. While contributions to these accounts are taken straight from one’s bottom line net pay, the Roth advantages arrive at age 59.5 — when contributors can start withdrawing their Roth funds tax-free.
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So how will the SECURE 2.0 change things for savers trying to catch up for retirement? In 2023, for example, workers 50 and older can make additional contributions of up to $7,500 to their 401(k) accounts. The total annual contribution limit for all 401(k) contributions is $30,000.
Starting in 2026, high-income earners over the age of 50 who make more than $145,000 can no longer make catch-up contributions to regular 401(k)s. Instead, those catch-ups will head to Roth accounts. That carries significant tax implications.
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The ‘Roth-ification’ of retirement savings
Among the many changes contained in the act, the catch-up contribution change stands out because it fundamentally alters the tax advantages pursued by those older workers who use catch-ups to make up for lost time.
For higher-earning Americans, who have long benefitted from the significant upfront tax break offered by traditional 401(k)s, the shift to Roth accounts removes that benefit, which is likely to raise that earner’s near-term tax liability.
Meanwhile, those who want to stay the course on their catch-up contributions but are further into their career and have higher paychecks are likely to see their paychecks shrink. That’s because for traditional 401(k) accounts, the contributor’s tax bracket is calculated after their contribution. To contribute the same amount in a Roth will cost them more upfront since the taxes are treated differently with those accounts.
Retiring in the same tax bracket
That being said, people often choose a traditional 401(k) account over a Roth account because they believe their tax bracket will be lower in retirement. But high earners who’ve accumulated large 401(k) and traditional IRA balances may find themselves in the same — or even higher — tax bracket when required minimum distributions, or the minimum that must be withdrawn from retirement accounts each year, begin at age 73. In this case, the Roth’s tax-free growth proves attractive.
And their situation may change over retirement, which would make those tax-free growth and withdrawals then much more attractive. Should things really go sideways, you also have more flexibility with these accounts. Unlike a traditional 401(k), you can withdraw Roth contributions at any age, for any reason, without taxes or penalties, though financial experts advise against it.
However, it should be noted that withdrawing Roth earnings before age 59.5 and before the Roth account has been open for five years will trigger a penalty.
Late change
The retirement account catch-up contribution changes as outlined in the SECURE 2.0 Act were originally meant to take effect in 2024. However, a large number of companies expressed concern about the amount of time needed to implement the changes, and on Aug. 25 the IRS announced a two-year transition period with respect to the changes to allow high-income earners to consider their options.
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This article provides information only and should not be construed as advice. It is provided without warranty of any kind.