SECURE 2.0 surprise: The ROTH catch-up contribution and ROTH employer match proposal
Legislative summary
The House approved H.R. 2954 in a landslide bipartisan vote, 414-5 on March 29. This bill of proposed changes to U.S. tax-qualified retirement plans, which builds on the Setting Every Community Up for Retirement Security (SECURE) Act of 2019, is commonly known as SECURE 2.0 and could soon be headed to the Senate for coordination with a 2022 version of S. 1770. Sections 107, 108, 115, 603, and 604 of the bill offer options, as Title I of the bill states, toward "Expanding Coverage, and Increasing Retirement Savings."
Sections 107 and 108 of SECURE 2.0 would assist savings plans participants who could be at the cusp of retirement by permitting a $10,000 Roth-only catch-up contribution to the savings plan ($3,500 more than the current limit). That new higher catch-up limit would then be annually indexed. Plan sponsors would have until plan years beginning after December 31, 2023, to set up and administer these changes. Under Section 603, the $10,000 Roth contribution carries with it a safe harbor provision guaranteeing that the plan will avoid failing the statutory IRS savings plan “annual addition” limit under tax code §415(c).
Section 604 would permit (but not mandate) the employer to treat the common matching contributions as Roth contributions.
Section 115 offers a safe harbor correction protocol for the periodic unintentional hiccups in plan administration of elective deferrals. But, and this is the key, the effective date of this provision would be immediate when SECURE 2.0 reaches the finish line at the president’s desk for enactment.
How could SECURE 2.0 affect your savings plans?
Proposed changes in Sections 107 and 108 would affect tax code §414(v) (Catch-up Contributions for Individuals Age 50 or Over). Section 603 would require that the employer eliminate the option to make catch up contributions if it is unable or unwilling to add a ROTH feature to the savings plan.
In plan years starting after December 31, 2023, participants who attain at least age 62, but are not age 65, can make enhanced catch-up contributions by electing to contribute up to $10,000 for the plan year. However, the catch-up contribution must be Roth-only for all plan participants, even those who are between ages 50 and 62. The $10,000 limit will be indexed annually using a consumer price index (CPI). As an incentive for doing this, the saving plan would qualify for a safe harbor exemption from contributing more than the IRS limits that constrain defined contribution (DC) plan annual additions to no more than $61,000 per year (in 2022). Separately, employer matching contributions could be made as Roth contributions.
There are several considerations for plan sponsors:
1. The provision needs much more detail from the IRS on the application to a savings plan, i.e., how it “would work.” For example, if the plan sponsor complies with the proposal, all employees eligible for the current catch-up (ages 50 to 61) would be forced to make a Roth catch-up contribution if they elect to do so. This appears punitive.
2. The exemption from the annual limit test does not, by itself, appear to offer much of an incentive to offer the new catch-up. Given that the 2022 annual addition limit is $61,000, and the 2022 annual limit for an employee’s contributions is $20,500, there would have to be an extraordinarily generous employer match or profit-sharing contribution to reach $61,000.
3. A plan sponsor would need to prudently assess how many of the newly defined cohort of participants age 62 to 64 would avail themselves of the higher limit, perhaps reviewing how many participants have made catch-up contributions already. Another consideration here is that the effective date is in 2024 (plan years starting after December 31, 2023), and most participants who are 62 to 64 now (in April 2022) will age out of the eligible cohort.
4. This catch-up increase would mandate the need for a complex change in administrative systems and coordination with payroll services provider because there would be two age cohorts with different catch-up limits.
a. For an administrative system that currently does not separate catch-up contributions uniquely from the total tax-deferred or Roth deferral limit, the year-end allocation to the proper categories will be complex.
b. For an administrative system that does currently separate catch-up contributions from the total tax-deferred or Roth deferrals, at the very least the system will need to create two catch-up limit cohorts.
5. Section 108 of SECURE 2.0 then provides that indexing of the catch-up limit will be based on CPI, which is likely to be somewhat more generous than the current annual technical update to the catch-up amount.
6. In Section 115 of SECURE 2.0, the IRS would establish a safe harbor for corrections when the plan sponsor fails (inadvertently or, in very few instances, willfully) to deposit the elective deferrals in a timely manner. Section 115 refers to and defines how to classify these flaws as "Corrected Errors."
When there is a reasonable administrative error to auto-enroll a participant or to auto-escalate the deferral percentage stated in the plan, Section 115 offers relief. The correction must be done 9½ months after the end of the plan year during which the error occurred, and in a manner that is favorable to the participant.
The phrase favorable to the participant is opaque, and guidance would be required to determine qualification for the safe harbor.
7. Section 604 of SECURE 2.0 would permit the plan sponsor to adopt a change to the nature of employer matching contributions, as they would become Roth contributions, and therefore current taxable compensation to the employee. This feature will add to the administrative complexities cited in item 4 above.
8. SECURE 2.0 is silent on any changes for the standard (and long-existing) annual nondiscrimination technical tests. These tests are administered to determine whether the plan favors highly compensated employees (HCEs), defined in 2022 as earning more than $135,000, over non-HCEs (NHCEs). These tests will continue to be mandatory.
Next steps
The Joint Committee on Taxation, in JCX-3-22, estimates that the new Roth-only catch-up provision, which fans out to all catch-up contributions, and the optional change to Roth employer matching contribution, would increase federal tax revenue by $34.7 billion from 2022 to 2031. If SECURE 2.0 becomes pension law (and early handicapping suggests it could be enacted in 2022) plan sponsors and governance boards will need to make the necessary fiduciary actions, including plan amendments, communications, and system changes. Two of these actions will need to take place well in advance of the effective dates in 20 months, while one would be immediately effective.
For additional information about possible impacts of SECURE 2.0 legislation, please contact your Milliman consultant.