The US Internal Revenue Service (IRS) has unveiled a significant shift in the rules governing retirement savings for higher-earning workers. The change specifically affects the popular 401(k) workplace pension plans and similar schemes.
What is Changing for 401(k) Catch-Up Contributions?
Currently, workers aged 50 and older can make additional catch-up contributions to their 401(k) plans on top of the standard annual limit. Historically, these extra payments could be made with pre-tax income. However, under the new IRS rule, this will change for those on higher incomes.
From 2027, any employee aged 50 or over who earned more than $145,000 in the previous year must make their catch-up contributions on an after-tax basis. This means the money will be directed into a Roth account within their 401(k) plan. Retirement schemes are permitted to start implementing this policy as early as 2026.
Understanding the New Threshold and Contribution Limits
The $145,000 threshold is based on a worker's FICA wages from the prior year. FICA wages generally refer to earnings subject to Social Security and Medicare taxes. The standard contribution limits are also set to rise.
In 2025, the base 401(k) contribution limit is $23,500, rising to $24,500 in 2026. For catch-up contributions, the limit is $7,500 in 2025, increasing to $8,000 in 2026. Workers aged 60 to 63 have a special higher catch-up limit of $11,250 for both 2025 and 2026.
Samantha Prince, an associate law professor at Penn State Dickinson Law, emphasised the importance of these contributions. "At age 50, they're closer to the milestone of being able to retire, and better situated to assess what their retirement needs are," Prince told The Independent. "So, these catch-up contributions are really important."
Tax Implications and Planning Considerations
While moving from pre-tax to after-tax contributions may seem like losing an immediate tax break, experts point out there are strategic trade-offs. With traditional pre-tax contributions, you pay income tax when you withdraw the funds in retirement. The assumption is that you will be in a lower tax bracket by then.
With Roth (after-tax) contributions, you pay the tax upfront. The significant benefit is that all future investment growth and earnings within the account can be withdrawn tax-free in retirement, provided certain conditions are met.
"When you do this additional catch-up contribution, it's actually a bit of a boon, in a way, that you are paying the tax now, but on all those earnings, you will never pay tax," Professor Prince explained.
A crucial caveat is that workers subject to the new rule must have access to a Roth option within their employer's 401(k) plan to make catch-up contributions at all. Fortunately, data from the Plan Sponsor Council of America indicates roughly 93% of plans offered this feature in 2023. For those without a Roth option, alternative savings vehicles like brokerage accounts may be necessary.
