When contemplating retirement savings, individuals often face the quandary of when to pay taxes on their contributions. Nevertheless, recent legislation, known as Secure Act 2.0, has taken a definitive stance for certain retirement accounts held by older Americans.
The newly passed Secure Act 2.0, ratified in the previous December, stipulates that any employee aged 50 or above, earning over $145,000 in the preceding year, and opting for a catch-up or additional contribution to their 401(k) must do so on a Roth basis, utilizing after-tax funds. Consequently, such employees will be unable to claim a tax deduction for this contribution, which can amount to an additional $7,500 for the year 2023. Instead, they will have the advantage of making tax-free withdrawals during their retirement years.
However, the slated implementation of this change, scheduled for 2024, has encountered an array of challenges that may impede its timely execution. These issues encompass legislative oversights, operational hurdles, and fundamental questions regarding the government’s authority to dictate retirement savings strategies—an amalgamation of obstacles that could potentially thwart the law’s effectiveness altogether.
According to Ed Slott, a seasoned retirement adviser, he strongly believes that the implementation of the Secure Act 2.0 in 2024 is highly improbable. He asserts that major financial institutions require significant time to construct the necessary infrastructure to assimilate new laws, and in this case, they lack clarity about the specific regulations governing the Act.
Who is affected by the catch-up contribution change?
Only people who earned $145,000 or more in wages in the prior year at their company will be able to fully deduct their contributions to a 401(k) account up to a standard annual limit but can’t deduct income used for catch-up contributions. Instead, they must pay taxes on that money and then contribute it to a Roth account, which returns growth untaxed.Â
The proposed alteration to the retirement savings system will not affect contribution limits, as individuals will continue to allocate these funds to their employer-sponsored plans. In the year 2023, individuals aged 50 and above will still have the opportunity to make an additional contribution of $7,500, thereby reaching a total contribution limit of $30,000.
Based on a comprehensive report by Vanguard, approximately 16% of eligible employees availed themselves of catch-up contributions in the year 2022. The report drew data from around 1,700 retirement plans to arrive at this insightful statistic.
As it stands in its current form, the law allows self-employed individuals who do not earn a wage to have the flexibility to save their catch-up contribution in any account of their preference, irrespective of their earned income.
What are the problems with the law?
There are three main issues:
In their rush to pass the legislation, an inadvertent error occurred, leading to the accidental deletion of a paragraph within the Act. This paragraph was intended to increase the general pre-tax deferral limit by the exact amount of any catch-up contribution. Consequently, without this crucial paragraph, Congress unintentionally rendered any catch-up contributions illegal. Recognizing this oversight, Congress addressed the issue by sending a letter to the Treasury at the close of May, clarifying that such a result was not their intent. However, the necessary corrective measures are yet to be taken.
Given the lack of clarity surrounding the law’s functioning, the American Retirement Association (ARA) alongside more than 200 employers, 401(k) record-keepers, and payroll providers have jointly urged Congress for a two-year delay in implementing the changes.
The need for guidance from regulators is apparent, particularly concerning whether high earners must obtain permission to allocate their catch-up contributions to a Roth account or if it can be done automatically.
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Additionally, certain state and local plans require approval from their respective legislatures and unions to offer a Roth 401(k) option, while other plans currently do not provide such a choice. The uncertainties surrounding these matters have prompted the collective appeal for a postponement to ensure smoother implementation.
According to the letter, “Clearly, the introduction of any new rule necessitates additional administrative efforts for its successful implementation.” However, the letter also highlights that the retirement community has expressed significant concerns, asserting that the specific task at hand simply cannot be accomplished within the allotted time frame for a substantial number of plans.
There is a possibility that some individuals might harbor feelings of outrage, perceiving the government’s involvement in dictating their retirement savings strategy as intrusive. Critics argue that the Roth catch-up contribution could lead many workers to pay taxes on their additional funds now, during their high-earning years, rather than deferring taxation until retirement when they might find themselves in a lower tax bracket.
In response to these sentiments, Ed Slott counters that such reactions stem from psychological factors. He posits that if the government did not impose mandatory measures, individuals would willingly take appropriate actions. However, when the government enforces a requirement, it can provoke a political backlash.
From Slott’s perspective, Roth accounts prove advantageous for higher earners since they are exempt from taxes on withdrawals, and there is no compulsion to withdraw funds. Notably, Secure Act 2.0, effective in 2024, eliminates the obligation for required minimum distributions from a Roth 401(k) before the account holder’s demise, a distinct contrast to traditional retirement accounts.
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What happens if Congress doesn’t act in time?
The impending changes may result in millions of Americans losing the opportunity to make catch-up contributions in the coming year. The American Retirement Association (ARA) has cautioned Congress that without a delay in the requirements, numerous plans may be left with no alternative but to entirely eliminate catch-up contributions for the year 2024 as a means of compliance.
JB Beckett, the founder of Beckett Financial Group, expressed concern over such a scenario, deeming it highly unfavorable. He emphasized that if individuals are deprived of the opportunity to make catch-up contributions, they would not only lose the chance to save more for their retirement but also miss out on the potential growth of that money over time.
Is there anything that can be done?
In the event that Congress fails to take action, the American Retirement Association (ARA) suggests that the IRS and U.S. Treasury could step in to provide relief. ARA proposes a straightforward solution, wherein the IRS announces that it will not impose taxes, interest, penalties, or any other sanctions on any party for noncompliance with the new Roth catch-up contribution rule before January 1, 2026. The letter highlights that numerous precedents exist for such actions.
To illustrate, the IRS has previously waived penalties on multiple occasions while attempting to clarify the confusing rules surrounding required minimum distributions (RMD) for specific beneficiaries of certain inherited retirement accounts and the time frames within which they must empty these accounts. Penalties were waived in 2020, 2021, 2022, and 2023 as part of addressing these complexities.
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