What to Know About Catch-Up Contributions

January 26, 2024 Beginner
SECURE 2.0 requires higher earners to put their catch-up retirement savings in a Roth 401(k).

If you're a higher-income employee age 50 or older looking to make "catch-up" contributions to employer-sponsored retirement plans, the SECURE 2.0 Act of 2022 had a surprise in store for you. Beginning in 2026, if your wages are higher than $145,0000, any catch-up contributions you make will have to be done after taxes to a designated Roth account, which means you won't get a tax deduction. Here's what you need to know as you update your retirement savings plans between now and then.

As a reminder, employees who are 50 and older are allowed to contribute additional money to their employer-sponsored retirement plan, known as a catch-up contribution. For 2024, the catch-up contribution is an extra $7,500 on top of the $23,000 limit for everyone else, for a total limit of $30,500. Starting in 2026, though, 50-plus savers will be divided into two groups based on annual income:

  1. Those making less than $145,000 can continue making catch-up contributions to their regular pre-tax 401(k)s. 
  2. Those making $145,000 or more will have to put their catch-up dollars in a Roth 401(k)—which means those contributions will be after-tax, though their withdrawals in retirement will be tax-free.

The change to catch-up contribution rules was initially supposed to take effect in 2024, which could've been a problem for those without access to a Roth 401(k). However, the IRS then decided to grant a two-year reprieve, giving savers, employers, and retirement plan administrators more time to prepare. As a result, all plan participants 50 and older will be allowed to continue making catch-up contributions to their regular tax-deferred 401(k)s for the next two years, regardless of income. 

Depending on your goals, this delay could be great news or a bit of a letdown. On one hand, having to characterize your catch-up contributions as Roth contributions would mean giving up some of the up-front tax benefits. On the other hand, savers who don't have a Roth 401(k) today might've been looking forward to having one sooner, rather than later. 

So, if your strategy is to make the most of your pre-tax savings, congratulations. You have two more years to do so. But if you were looking forward to diversifying your savings by tax treatment with a Roth, you might need to get creative. Here are some ideas.

Diversifying savings

The following options may not be as simple as automated catch-up contributions to your existing accounts, but they can help you get closer to where you want to go.

Consider contributing your catch-up amount to a Roth IRA

Assuming your income is under the IRS income threshold, you could set aside the value of your catch-up contribution to a Roth IRA. For 2023, the annual maximum IRA contribution is $7,500—including a $1,000 catch-up contribution—if you're 50 or older. For 2024, that limit goes up by $500 for a total of $8,000. Note that in the past, catch-up contribution levels for IRAs did not change, but under SECURE Act 2.0, they'll be indexed to inflation beginning in 2024.

Consider a Roth conversion

If you make too much to use a Roth IRA, you could consider a backdoor Roth conversion. You'll need to have a traditional IRA and a Roth IRA to make this work. First, you make after-tax contributions up to the annual maximum to the traditional IRA (make sure to file IRS Form 8606 every year you do this). Then, transfer the assets from the traditional IRA to the Roth IRA. You can make this transfer and conversion at any point in the future. 

The conversion triggers income tax on any appreciation of the after-tax contributions—but once in the Roth IRA, earnings compound tax-free. Earnings distributed from the Roth IRA are tax free as well, as long as you're 59½ or older and have held the Roth for at least five years (note that each conversion amount is subject to its own five-year holding period as it relates to tax-free withdrawals). 

If you have no other IRAs, figuring out the tax due will be simple. However, it can be more complicated if you have other IRAs. The IRS' pro-rata rule requires you to include all your traditional IRA assets—that means your IRAs funded with pre-tax (deductible) contributions as well as those funded with after-tax (nondeductible) contributions—when figuring the conversion's taxes. Then, you pay a proportional amount of taxes on the original account's pre-tax contributions and earnings. 

Let's look at an example. Say you contribute $6,000 to a nondeductible traditional IRA. You also have a rollover IRA worth $94,000 from a previous 401(k) made with pre-tax contributions. In this case, 94% of any conversion would be taxable. Here's the math:

Total value of both accounts = $100,000

Pre-tax contributions = $94,000

After-tax contribution = $6,000

$6,000 ÷ $100,000 (expressed as percentage) = 6%

$6,000 (the amount converted) x 6% = $360 tax free

$6,000 – $360 = $5,640 subject to income tax

Although this strategy has existed for many years, the IRS hasn't weighed in on it definitively, so it's highly recommended that you work with a tax advisor. 

Save more in your traditional brokerage account

You may be tempted to overlook your taxable brokerage account, but don't let the name fool you: Taxable accounts can be pretty tax efficient if you're careful. There's no up-front tax break, and income is taxed in the year you recognize it. But if you hold assets for more than a year, your gains may qualify for a long-term capital gains tax rate that is lower than your regular income tax rate. Qualified dividends can also benefit from the lower capital gains tax rates. Tax-efficient investments (like certain municipal bonds) may also offer tax benefits. In addition, losses may be deductible and can be used to reduce your taxable income through a process known as tax-loss harvesting. And unlike with some tax-advantaged accounts, the IRS won't restrict contributions, withdrawals, or when you can spend the money.

Looking ahead

The new catch-up rules won't be here until 2026, but you still have options for saving more. Think of it this way: There's no reason not to make your own catch-up contributions to an IRA or taxable account now.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision. 

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed. 

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

Investing involves risk including loss of principal.

Roth IRA conversions require a 5-year holding period before earnings can be withdrawn tax free and subsequent conversions will require their own 5-year holding period. In addition, earnings distributions prior to age 59 1/2 are subject to an early withdrawal penalty.

The information and content provided herein is general in nature and is for informational purposes only. It is not intended, and should not be construed, as a specific recommendation, individualized tax, legal, or investment advice. Tax laws are subject to change, either prospectively or retroactively. Where specific advice is necessary or appropriate, individuals should contact their own professional tax and investment advisors or other professionals (CPA, Financial Planner, Investment Manager) to help answer questions about specific situations or needs prior to taking any action based upon this information.

A rollover of retirement plan assets to an IRA is not your only option. Carefully consider all of your available options which may include but not be limited to keeping your assets in your former employer's plan; rolling over assets to a new employer's plan; or taking a cash distribution (taxes and possible withdrawal penalties may apply). Prior to a decision, be sure to understand the benefits and limitations of your available options and consider factors such as differences in investment related expenses, plan or account fees, available investment options, distribution options, legal and creditor protections, the availability of loan provisions, tax treatment, and other concerns specific to your individual circumstances.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.