You May Have to Put Catch-Up Contributions in a Roth 401(k): That's Not a Bad Idea

Thanks to the recent stock market rally, checking your 401(k) balance is no longer a cause for fear and trepidation. Fidelity Investments reported that the average 401(k) account balance in plans it manages rose nearly 8.3% in the second quarter of 2023 from a year earlier. Meanwhile, the number of 401(k) participants with $1 million or more in their accounts rose nearly 29% from a year earlier.

Whether you have $1 million or $100,000 in your account, there’s no question that contributing to a 401(k) or similar employer-provided plan is one of the most effective ways to ensure you’ll enjoy a comfortable retirement. But there’s a downside to traditional 401(k) plans, especially if you fall into the millionaire category: All of that money will be taxed when you take it out — possibly at a higher tax rate than you’re paying now.

One way around this dilemma is to direct some of your savings to a Roth 401(k). As is the case with a Roth IRA, contributions to a Roth 401(k) are after-tax, but withdrawals will be tax-free as long as you’re 59½ and have owned the Roth for at least five years. While income thresholds prevent high earners from contributing to a Roth IRA, there are no income limits on contributions to a Roth 401(k) plan.  More than 75% of large employers offer Roth 401(k)s, but only about 14% of employees invest in them, according to Fidelity.

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By 2026, some workers may be required to contribute to a Roth 401(k), whether they like it or not. The legislation known as SECURE Act 2.0, a broad package of changes to rules governing retirement and retirement savings plans, will require workers age 50 and older who earned $145,000 or more in the previous year to funnel catch-up contributions to Roth 401(k) plans. The change was originally scheduled to take effect in January 2024, but the IRS announced in late August that it would postpone implementation of the rule until 2026. 

The IRS announcement came after major employers and plan providers —particularly those who don’t yet offer a Roth 401(k) — said they needed more time to implement the provision. 

Plan providers “can’t just cut and paste a new plan when they’re not even sure of the rules,” says Ed Slott, founder of IRAhelp.com. 

In a July 14 letter to the House Ways and Means Committee, the American Benefits Council, which represents large employers and plan providers, said that without a delay, many retirement plan participants would lose the ability to make catch-up contributions at all.

In its August 25 guidance, the IRS also clarified that plan participants age 50 and older can make pretax catch-up contributions in 2023. Earlier, plan sponsors said technical language in SECURE Act 2.0 may have inadvertently banned all catch-up contributions. In 2023, workers 50 and older can make catch-up contributions of up to $7,500, in addition to the standard $22,500 maximum for 401(k) and other employer-provided plans.

The case for Roth contributions

Even with the delay, employees who have access to a Roth 401(k) should consider contributing to it, especially those who have accumulated a large balance in a tax-deferred 401(k) plan. 

Although you’ll lose the up-front tax break you receive when you contribute to a traditional 401(k) plan, that deduction is “really a loan that will have to be paid back in the future,” Slott says.

Many high earners resist contributing to a Roth 401(k) because they assume their tax rate will be lower in retirement when they’ll eventually be required to take taxable required minimum distributions. But that’s not a safe bet, especially if you’re a serious saver, Slott says. The funds you invest in a tax-deferred account will continue to compound and grow until you’re required to take RMDs (currently at age 73, increasing to age 75 in 2033). 

Depending on the size of your account, those RMDs may be larger than your pay was during your final year of work, he says. And with a traditional 401(k), you’ll have to take taxable RMDs for the rest of your life; starting in 2024, though, you won’t have to take RMDs from your Roth 401(k). In addition, Slott says, many retirees lose other tax breaks, such as tax credits for dependent children and deductions for mortgage interest. The loss of those tax breaks, combined with substantial RMDs, could easily push you into a higher tax bracket in retirement, he says.

Large RMDs can lead to other issues as well, including increasing taxes on your Social Security benefits and triggering a surcharge on your Medicare Part B and Part D premiums.

Sheltering some of your retirement savings in an after-tax account can help avoid that, and it will protect you from future tax increases, Slott notes. The personal income tax cuts included in the 2017 Tax Cuts and Jobs Act are scheduled to expire at the end of 2025, and while some lawmakers who support the law have vowed to extend it, there’s no guarantee that will happen. The end of the 2017 tax cuts would be particularly painful for high earners because the top tax rate would increase to 39.6% from 37%. If you invest in a Roth 401(k) (or Roth IRA), “you never have to worry about higher rates,” Slott says.

Roth 401(k) — not only for high earners

Even if you make considerably less than $145,000 a year or are too young to make catch-up contributions, you should consider investing some of your 401(k) contributions in a Roth, if your employer offers one. In fact, the case for contributing to a Roth 401(k) is often even stronger for a young person, financial planners say. If you’re not making a lot of money, the tax deduction provided by a traditional 401(k) is less valuable. Plus, your funds will have more time to grow tax-free.

Note: This item first appeared in Kiplinger's Personal Finance Magazine, a monthly, trustworthy source of advice and guidance. Subscribe to help you make more money and keep more of the money you make here.

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