*NOTE- Regulatory guidance on the information contained in the article remains pending as of its posting date and is subject to change and/or clarification*
UPDATE Aug 28, 2023: Effective date has been delayed two years, now required after December 31, 2025
In case there’s any confusion about how Federal and State governments think retirement plans can be improved in future years, it’s two things: More auto-enrollment and more Roth (i.e., post-tax) contributions. This blog attends to one expansion of the increased appetite for Roth contributions, the new requirement for “Catch-up” contributions from some employees to only be allowable on a Roth basis.
First, some important housekeeping (because even the title of this article can be confusing to some):
- Roth contributions are similar to “after-tax” contributions as they both consist of funds which have already been taxed as income to the participant. Roth contributions are different compared to after-tax contributions since the investment returns are not subject to taxation upon distribution once they’ve been qualified (the Roth account is generally qualified after it has existed for five years).
- Catch-up contributions, more often than not, are pre-tax or Roth deferral contributions made by employees which exceed the limit prescribed by the IRS but are allowable if the individual is age 50 or older. The logic here is that individuals close to retirement ought to have an opportunity to catch up on saving for retirement if they can afford to. However, if necessary to pass some plan testing restraints, deferrals of less than the prescribed limit may be classified as Catch-up contributions but, again, this option is only allowable for employees who are at least 50 years old.
The big change coming in 2026 as it pertains to Catch-up contributions (well, one of them!) is that individuals who earned $145,000 or more in FICA wages in 2023 will be required to make their Catch-up contributions as Roth, meaning those contributions cannot be tax-deferred starting in 2026. So, no: Not all Catch-up contributions must be Roth starting in 2026, only those made by individuals whose FICA wages exceeds this indexed amount in the applicable prior year.
Seems straightforward, but here are some questions from the industry that require clarification (hence the reason the IRS has agreed to stay the change another couple of years!):
- What if Roth contributions are not available to plan participants? The answer to this appears to be “Then Catch-up contributions are not available to that participant.”
- To make the plan easier to administer, can the plan make all Catch-up contributions be made on a Roth basis? In absence of IRS guidance, it is unclear that a plan can make all Catch-ups to be made as Roth contributions.
- What if the Owner of a sub-chapter “S” Corporation decides to keep their salary just below the indexed $145,000 limit and take the rest on their Schedule K-1? This appears to be totally fine from the guidance I’m hearing.
- What about sole-proprietors and partners? The Catch-up rules for Participants earning more than the indexed $145,000 refers to FICA wages, which does not apply to partners or self-employed individuals unless the statute is amended in technical corrections or the IRS and Treasury Department believe they have the regulatory authority to extend the rules to these individuals.
- What if a deferral amount equal to the available Catch-up opportunity is made before the deferral limit is reached (e.g., equal amounts Roth and pre-tax each pay period)? In other words, does the statute require that all deferrals beyond the deferral limit are made as Roth or can it be determined per plan year regardless of when it was segregated from pay.
- What if an affected participant did not exceed the deferral limit for the year but testing restraints required the existing deferrals to be recharacterized as Catch-up contributions? Do they get a 1099 to correct it (probably late by that point!) or will they need to accept a distribution from the plan even though prior regulations would have allowed them to keep it in the plan?
If you maintain a 401(k) or 403(b) plan which does not contain a Roth deferral feature, you may have received a notification from your TPA or recordkeeper about your plan in this regard. While Roth deferrals are not required to be allowed from 401(k)/403(b) plans you will certainly want to be aware of whether any current participants may be affected by this change. If you maintain a fiscal year plan (i.e., one whose cycle is not the calendar year) and are confused about when this provision may affect you, remember that Catch-up contributions are always determined each calendar year for your participants regardless of the annual cycle of the plan.
Ultimately, this change represents an inconvenience for big savers age 50+ who would prefer to make their salary deferrals on a pre-tax basis for planning purposes. Since Catch-up contributions represent only about 25% of the annual deferral opportunity, though, it likely won’t have too big an impact on them. From a plan administration perspective, however, this adds a whole new element of oversight and anticipation of how your participants might make use of the plan so you’re able to ensure that deferral contributions are taxed properly. Payroll service providers should already been well on their way working this change into their systems to get in front of this potential issue, but if you do payroll in-house then it will be on you to continue to work this oversight into your process!
Benefit Resources will continue to keep our ear to the rail on this important change so please check in every once in a while and consider subscribing to our blog so you don’t miss anything. Better yet, consider making BRI your TPA and get a direct channel to some of the best administrators in the business along with assurance that your plan is getting the attention it needs; it’s what we do!