Adam C. Pozek | 02/02/23
Yeah, we know that’s not how the saying goes, but it appears Congress doesn’t.
SECURE 2.0 (S2), signed into law on December 29, 2022, after being tacked on the omnibus budget bill at the last minute, includes several provisions related to catch-up contributions. We’ll get into those details in a second, but there is one unintended consequence that could render those new provisions moot.
In its attempt to Roth-ify certain catch-up contributions, Congress accidentally deleted a section of the Tax Code that makes catch-up contributions possible in the first place. The American Retirement Association describes the situation here. Since this is an obvious error, it seems like it would easy enough to just fix it. The challenge is that it looks like it will literally take an act of Congress to fix what is now broken, and last we checked, those in Congress are not playing nicely in the sandbox these days. The increasingly polarized partisanship aside, intra-party angst on both sides of the political aisle is making compromise even more elusive.
Assuming lawmakers and/or regulators are able to find a way to get catch-up contributions back on track, there are a couple of key changes coming soon to a retirement plan near you.
Rothification of Catch-Ups
Beginning in 2024, any participant with compensation exceeding $145,000 in the immediately preceding year will be required to have any catch-up contributions they choose to make designated as Roth contributions. On its face, it’s pretty easy to see the motivation behind this provision – raise additional tax revenue by eliminating the current tax deduction on catch-up contributions for those who are paid enough to be able to “afford” it. Ideological debates aside, let’s take a look at some of the challenges this provision creates.
New Limit to Track
For starters, the $145,000 limit is indexed for inflation, which means we now all have a new limit to track each year. That certainly isn’t the end of the world, and it’s far from the most convoluted provision in S2. But why not simply tie this to the existing highly compensated employee limit, which was $135,000 in 2022 and jumped to $150,000 for 2023.
Linking the catch-up-as-Roth requirement to being an HCE makes sense beyond just avoiding another annual limit. Consider a situation in which an owner of an S-Corporation only takes W2 compensation of $100,000 per year but receives significant distributions of profits after the close of the year. That’s a very common practice for a whole host of completely legitimate reasons. Since anyone who owns more the 5% of the company is an HCE, this owner would fall into that category; yet because W2 compensation is well below the new $145k limit, this individual would be able to make all catch-up contributions as pre-tax. At the same time, a non-owner employee making $145,000.01 is not an HCE but would be required to go the Roth route for any catch-ups. That certainly seems counterintuitive to us.
Oh, and do you know who is not subject to this new rule no matter how much they make? Sole proprietors (or LLC members taxed as sole props) and partners of partnerships or LLPs. The logical question would be why not…it appears to be a mistake in how Congress wrote the law. When setting the $145,000 limit, it points to the part of the Tax Code that essentially addresses W-2 employees. Sole props and partners are considered “self-employed” and receive “earned income.” Even if that earned income is $1 million per year, none of it is W-2 compensation; therefore, their pay for purposes of this is $0.
Recharacterizations
New limit notwithstanding, this rule seems easy enough to manage for “regular” catch-up contributions, but what about catch-up contributions that occur due to recharacterization? When a plan fails the annually required ADP nondiscrimination test, the Plan must either issue refunds to the HCEs, or the company must make additional contributions to non-HCEs (or a combination of both). Plans that go the refund route must first recharacterize any otherwise refundable amounts as catch-up contributions for those HCEs who are at least age 50 and haven’t already hit the limit. That is mandatory, but it’s all done on paper without any need for an actual transaction.
Under this new rule, any amounts that are recharacterized in this way would have to also be converted to Roth for any of the HCEs who had prior year compensation in excess of $145,000. That means not only will employers be required to initial actual transactions to move the money from pre-tax to Roth, but also those HCEs could find themselves stuck with an unexpected tax bill without actually receiving the cash refund to cover it. Not a great result.
Increased Catch-Up Limit
Effective in 2025 (a year after the Roth provision kicks in), participants who are age 60 – 63 by the end of the year are able to increase the amount they contribute as catch-up. The new limit is the greater of:
- $10,000, or
- 150% of the regular catch-up limit in effect for 2024.
This limit is indexed for inflation, so we have yet another new one to track each year. With that said, S2 doesn’t make clear how the indexing works, exactly. Is if the $10,000 that’s indexed, or does the 150% apply to the indexed regular catch-up limit, or both? Thankfully, we have a couple years for that to get sorted out.
Generally speaking, a participant would need to earn a fairly healthy paycheck to be able to afford to first max out his/her regular deferrals at $22,500 (for 2023, indexed) and then exceed the regular catch-up limit of $7,500 (for 2023, indexed). Given that, it is highly likely that anyone eligible to take advantage of the new limit will have to do so as Roth.
You may be wondering what happens after age 63. Well, for the year in which a participant hits age 64, the limit drops back to the regular age 50 catch-up maximum.
Damage Control
Going back to where we started, the first order of business is for Congress to undo the damage it did to the catch-up provisions…and by damage, we mean complete destruction. If that does not happen, then catch-up contributions cease to be a thing at all starting in 2024. Assuming they are able to manage that, we have some new catch-up fun on the horizon.
For more information, please visit our SECURE 2.0 Act Resource Page.
