Understanding the SECURE 2.0 Act: New 401(k) Contribution Rules

The SECURE 2.0 Act, signed into law in December 2022, brings significant changes to retirement savings plans in the United States. Building on the original SECURE Act of 2019, SECURE 2.0 aims to enhance retirement savings and improve financial security for Americans. Among its many provisions, the new 401(k) contribution rules stand out for their potential to impact how individuals save for retirement. The law is complex and this article will help to summarize the key changes introduced by SECURE 2.0 regarding 401(k) plans.

Increased 401(k) Catch-Up Contributions for Ages 60-63

One of the most notable changes under SECURE 2.0 is the increase in catch-up contributions for individuals aged 60 to 63. Starting in 2025, these individuals will be allowed to make catch-up contributions that are significantly higher than the current limits. The new limit will be the greater of $10,000 or 150% of the regular catch-up contribution amount for that year, adjusted for inflation. This change acknowledges that individuals in this age bracket may need to accelerate their retirement savings as they approach retirement age, providing them with a valuable opportunity to boost their retirement funds.

Changes to 401(k) Catch-Up Contributions for Higher Earners

Beginning in 2026, catch-up contributions for employees who earn more than $145,000 (adjusted for inflation) in the previous year will need to be made on a Roth (after-tax) basis. This means that while the contributions will be taxed in the year they are made, the qualified distributions will be tax-free. The downside for high earners will be an increase in taxable income but the upside will be tax-free growth and withdrawals for in the future. 

Initially, the rule was set to begin in 2024.  However, after intense feedback from plan sponsors and administrators who voiced their strong concerns about needing more time to adjust to the new requirements and update their systems accordingly, the IRS pushed back the new rule until 2026. This transition period is intended to facilitate a smoother implementation process and ensure compliance.

Additionally, the IRS clarified that during this transition period, employees will still be able to make catch-up contributions on a pre-tax basis if permitted by their plans. Employers who do not currently offer Roth contributions are not required to implement them until 2026.

Automatic Enrollment and Escalation

To encourage more workers to participate in retirement savings plans, SECURE 2.0 mandates automatic enrollment for new 401(k) and 403(b) plans established after December 31, 2024. New companies in business for less than three years and businesses with 10 or fewer workers are excluded from this requirement. 

Under this provision, eligible employees will be automatically enrolled with a contribution rate of at least 3% of their salary, which will increase annually by 1% until it reaches at least 10%, but not more than 15%.  Employees have the option to opt out, but the automatic enrollment and escalation are designed to encourage individuals toward saving more for retirement.

Increased RMD Age

The age at which individuals must make Required Minimum Distributions (RMDs) from their qualified accounts has been increased under SECURE 2.0. Starting in 2023, the age for RMDs increased from 72 to 73, and then to 75 starting in 2033. This change allows individuals to keep their retirement savings invested for a longer period, potentially benefiting from additional growth. 

Emergency Savings Accounts

Recognizing the importance of financial security beyond retirement, SECURE 2.0 introduces a provision for pension-linked emergency savings accounts (PLESA). Starting in 2024, employers can offer these accounts to non-highly compensated employees, providing a dedicated space for emergency savings within the retirement plan. Starting in 2024, SECURE 2.0 allows employers to offer participants an emergency savings account as part of their retirement (regular 401k) plan. Participants can be automatically enrolled at up to 3% of their pay — with the ability to opt out — and after-tax (Roth) contributions are capped at $2,500. 

Contributions to emergency savings accounts must be eligible for the same matching contributions that apply for elective deferrals, but the employer matching contributions are made to the retirement plan instead of the emergency savings account.

Another provision allows a participant to make tax-free withdrawals for any reason.  However, Participants can only make one penalty-free withdrawal from their 401(k) account of up to $1,000 per year for "unforeseeable or immediate financial needs relating to personal or family emergency expenses." The withdrawal may be repaid within three years and only one withdrawal per three-year repayment period is permitted if the first withdrawal has not been repaid.

Conclusion

The changes introduced by SECURE 2.0 have significant implications for retirement planning. For individuals nearing retirement age, the increased catch-up contributions offer a valuable opportunity to enhance their retirement savings.  However, the shift to Roth treatment for high earners' catch-up contributions will require a careful evaluation of the impact this change will have on an individual's tax structure.  High-income individuals must weigh the benefits of tax-free withdrawals against the immediate tax impact of Roth contributions.

Automatic enrollment and escalation are likely to increase participation rates in 401(k) plans, particularly among younger people and those who might otherwise not contribute.  Employers will need to update their plan designs to comply with these new requirements, ensuring that employees are informed and supported throughout the process.

The extended RMD age provides greater flexibility in retirement planning, allowing retirees to keep their funds invested longer. This change may influence decisions about when to retire and how to manage income streams in retirement. Financial advisors will play a more significant role in helping clients navigate these new timelines and optimize their withdrawal strategies.

The introduction of emergency savings accounts acknowledges that financial security extends beyond retirement. By offering a separate account for emergencies, SECURE 2.0 aims to reduce the likelihood of early withdrawals from retirement savings, thereby preserving those funds for future retirement needs. Employees should be encouraged to take advantage of these accounts to build a financial cushion for unexpected expenses.