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The New Emphasis On Roth Contributions

By January 27, 2023No Comments

According to a recent Plan Sponsor Council of America (PSCA) study, approximately 76% of about 2,400 surveyed Plans allow ROTH contributions.  Similarly, Vanguard reported last year that 77% of its approximately 1,700 Plans have a ROTH feature.

We reviewed our clients’ 401k and 403b Plans and were surprised that more than a few do not include the ROTH employee deferral option.  Our percentage is similar to the percentages cited above.  Many are Plans established long ago when ROTH was not as popular, or before ROTH was allowed.

For several years, some in Washington have talked about the “rothification” of Retirement Plans.  This has included suggestions to “rothify” employer contributions.  In other words, how can Congress promote Retirement Plans and retirement savings, but make the contributions be ROTH to avoid giving away Federal tax dollars because of the tax deductibility of the contributions.

The year-end legislation that was passed to fund the Federal government through September 2023 included almost 100 provisions changing Retirement Plan and IRA rules or requiring IRS or U.S Department of Labor regulatory action or studies regarding Retirement Plan-related issues.  This part of the law is referred to as SECURE 2.0 because it enhances changes made by the SECURE Act passed in December 2019.

SECURE 2.0 includes an emphasis on ROTH.  Why, and why now?  The Federal Government needs tax revenue to offset the tax “losses” included in the new law.

Given the law changes described below, Plans without a ROTH component will have to be amended to add ROTH.  Furthermore, the law changes complicate the day-to-day operation and the IRS-required administrative compliance for Plans that use a Trustee-directed single “pooled” account with all participants’ monies commingled, or for Plans that use individual brokerage accounts that are not linked to an institutional recordkeeping platform (i.e., standalone “FBO accounts”).  These Plans likely will be significantly more difficult to manage and more expensive to administer.

One of the ROTH-based changes involves pre-death “minimum required distributions” (MRDs or RMDs).  Under current law, ROTH IRAs are exempt from RMDs, but ROTH accounts in 401k and 403b Plans are not.  The RMD exemption will apply to the ROTH accounts in 401k, 403b, profit sharing, and money purchase plans beginning with the 2024 required distribution year.

Why did we include profit sharing and money purchase plans in the preceding sentence?  Because an employer now has the option to amend its 401k, 403b, profit sharing, or money purchase plan to permit an employee to voluntarily elect to treat some or all employer contributions (for example, match, safe harbor 3% nonelective, profit sharing) as ROTH contributions.  If so elected, these contributions must be 100% vested, notwithstanding the otherwise applicable vesting schedule under the Plan.

This option is immediately available, but for the following reasons, we believe it is too soon to implement the feature.

  1. Recordkeepers need to ramp-up to have separate sourcing for pre-tax match and ROTH match, pre-tax profit sharing and ROTH profit sharing, etc.
  2. Employers need a process to have employees designate which employer contributions are to be treated as ROTH contributions.
  3. The feature is optional, not mandatory. Therefore, Plan Documentation should be amended or updated to reflect the terms and conditions of the feature.  We do not yet know what provisions need to be included in that Plan Documentation.
  4. Payroll providers need to ramp-up to be able to tax-withhold and/or report the taxable income related to the employee’s election to “rothify” employer contributions. We assume the tax-related issues will be addressed through payroll and W-2s, but maybe the IRS will modify Form 1099-R reporting or adopt another method for tax reporting.

Another “rothification” item is mandatory, and it applies to employee deferral catch-up contributions under 401k and 403b Plans.  Catch-up, available for those 50 or older, must be made as ROTH contributions rather than pre-tax employee contributions, for certain “highly paid” employees, beginning with the 2024 Tax Year.  The “highly paid” are those whose prior years wages were at least $145,000 (indexed for inflation).

There are issues that need to be addressed by the IRS soon, to give employers, payroll providers, recordkeepers, and TPAs time to prepare for 2024, including, for example,

  1. Some contributions are not catch-up when made at the time of payroll deductions, but are recharacterized as catch-up contributions, for example, to “fix” an average deferral percentage (ADP) test failure in a non-safe-harbor 401k Plan.
  2. Some contributions are believed to be catch-up when made but become pre-tax (not catch-up) because of subsequent events, for example, an employee contributing $2,500 per month ($1,875 as “regular” and $625 as catch-up), expecting to maximize at $30,000 of total deferrals for the year, stops contributing after 8 months and $20,000 – all of which “morphs” into being “regular”, non-catch-up contributions.

It seems obvious that employee contributions will have to be re-sourced, moving from pre-tax to ROTH, or vice versa, at the recordkeeper or between FBO accounts.  What about the associated earnings?  What will be the mechanism to correctly report on the W-2, or some other IRS Form, what started as pre-tax “regular” and became ROTH catch-up, or vice versa?

There is much to do to get ready for these changes.  We are watching for IRS guidance, and we plan to provide updates as we learn more.

In the meantime, ACSI is available to help clients learn more about the SECURE 2.0 changes that apply to your Retirement Plan.

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