Millions of Americans are set to lose a popular 401(k) benefit — are you one of them? Here is what it is and what it means for you – Yahoo Finance
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.
Among dozens of changes aimed at enhancing retirement savings options for workers, the SECURE 2.0 Act approved by Congress in late 2022 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.
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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-sponsord 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.
What exactly does SECURE 2.0 change when it comes to catch-ups? 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.
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.
Let’s consider the potential downsides of the catch-up change.
Higher-earning Americans have long benefitted from the significant upfront tax break offered by traditional 401(k)s. The shift to Roth accounts removes that benefit for catch-up funds, likely raising that earner’s near-term tax liability.
In traditional 401(k) accounts, the contributor’s tax bracket is calculated after the contribution. That means paychecks would naturally shrink for higher, older earners who maintain their catch-up contributions through this change. These folks will be stung by paycheck amounts that drop by the exact amount they contribute to the Roth.
So how can this change work in your favor?
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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 have 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.
While higher taxes on upfront contributions work against higher earners at first, tax-free growth and withdrawals in retirement will go a long way toward recovering what was lost.
Even the savviest savers can find themselves in a jam. 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, withdrawing Roth earnings before age 59.5 and before the Roth account has been open for five years will trigger a penalty.
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.
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This article provides information only and should not be construed as advice. It is provided without warranty of any kind.
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