How the Secure Act 2.0 Affects ESOPs, 401(k)s, and Other Retirement Plans

This article was originally published on April 5, 2023, and updated on October 18, 2023.

The Secure Act 2.0 of 2022, enacted in the closing days of 2022, makes a substantial number of changes to tax-qualified retirement plans, most of which are intended to increase plan coverage and retirement savings. Although we continue to digest the hundreds of pages of new law, here we summarize certain key changes that affect ESOPs, KSOPs, and 401(k) plans:

• Cash-Out Limits. The limit for involuntary distributions to a participant prior to attaining normal retirement age is increased from $5,000 to $7,000 for distributions after 2023.  The current maximum cash-out limit in ESOPs, KSOPs, and 401(k) plans is $5,000 and generally applies to participants that terminate employment with a vested account balance lower than the cash-out threshold in the plan.
• RMD Age. The age to start taking “required minimum distributions” increases to age 73 in 2023 for participants who reach age 72 in 2023 through 2032 and to age 75 for participants who reach age 74 in or after 2033. Also, beginning in 2024, plans will not be required to include Roth contribution balances in required minimum distributions prior to the participant’s death.  This represents a further change from the increase to age 72 under the first Secure Act, which took effect January 1, 2020, for distributions to participants born after June 30, 1949.
• Deferral of Gain on Stock Sales to ESOPs. The rule allowing C Corporation shareholders to defer gain on the sale of shares to an ESOP is expanded to cover S Corporation shareholders, but only for sales to an ESOP after 2027 and only for up to 10% of the gain. 
• Standards for FMV on sales to ESOPS. The Department of Labor, in consultation with the Internal Revenue Service, is directed to provide guidance on acceptable standards and procedures for establishing the “good faith fair market value for shares of a business” to be acquired by ESOP. We will provide additional information on this topic as it is released.
• Mandatory Automatic 401(k) Enrollment. Starting in 2025, new KSOPs and 401(k) plans (those adopted after the December 29, 2022 enactment date) will be required to automatically enroll eligible employees, at a contribution rate of at least 3%. Thereafter, these new plans must increase a participant’s automatic contribution rate by 1% each year until the participant’s contribution rate reaches at least 10% (but the plan may provide for increases up to 15%). As under the current law, participants may stop contributions or change their deferral rates.
• Coverage of Part-Time Employees in KSOPs and 401(k) Plans. Current law requires part-time employees who worked at least 500 hours in three consecutive years beginning after 2020 and reach age 21 be allowed to make 401(k) contributions.  January 1, 2024, is the first date that this provision could require a part-time employee be eligible. The new law reduces the service requirement to two years effective for plan years beginning after 2024. Neither the prior law nor the new law requires that the part-time employees be allocated employer contributions.
• Vested Employer Contributions may be treated as Roth Contributions. Beginning with contributions made after the December 29, 2022 enactment date, plans may allow participants to elect to have employer-matching contributions and nonelective contributions that are fully vested when made to be treated as Roth contributions.
• Catch-up Contributions by Highly Compensated Participants must be ROTH. This change was originally to be effective in 2024, but in August, the IRS announced a deferral until 2026. Once this change becomes effective, 401(k) catch-up contributions by a participant who had compensation over $145,000 (adjusted for cost of living) for the prior calendar year must be treated as Roth contributions. Participants earning no more than $145,000 in the prior year must be allowed to elect Roth treatment for their catch-up contributions (assuming at least one participant eligible for catch-up contributions earned over $145,000 in the prior year).

If you have any questions about Secure Act 2.0, please reach out to a member of LP’s ESOP Team.