SECURE ACT 2.0: More Ways To Fund Your Roth Bucket

February 24th, 2023 by Blake Pinyan

We are proponents of building up the Roth bucket as much as you can. Prior to the passing of SECURE Act 2.0, Roth IRAs and Roth retirement plans (401(k)s, 403(b)s, etc.) were known as the primary methods for getting Roth money in a retiree’s nest egg. Now, with SECURE Act 2.0, there are a significant number of new Roth-related rules and additions.

We believe that they are a big win for taxpayers overall; the ways to fund the Roth bucket have been greatly expanded. Nonetheless, it’s wise to acknowledge all the details and implications that come with these changes. I’ll provide an overview of the four and then dig into some of the considerations from a Financial Planning and Tax perspective.

The major changes are the:

1. Elimination of Required Minimum Distributions (RMDs) for Roth employer plans
2. Introduction of SIMPLE & SEP Roth IRAs
3. Availability of employer contributions to be Roth instead of pre-tax
4. Requirement of catch-up contributions to be Roth for high wage-earners

Elimination of RMDs for Roth employer plans

SECURE Act 2.0 abolished the RMD mandate for Roth employer plans starting in 2024. Before this, individuals would be subject to RMDs once reaching the designated age if they had Roth money in an employer plan (401(k), 403(b), etc.). It was then a common practice to roll over the Roth plan money upon retirement into a Roth IRA because they don’t require RMDs. Now, in 2024, the decision to keep the Roth money in the employer plan vs. moving it to the Roth IRA will mirror the pre-tax 401(k) vs. IRA one. Some of the considerations that go into this analysis are the account’s investment availability, the fees/level of management, and the retirement income plan design.

Investment Options

By keeping the money in the employer plan, you generally limit your investment options. You are typically subject to investing in the plan’s chosen funds (mutual funds most likely) and may not have the flexibility/freedom to self-direct.

Fees and Investment Management Time/Expertise

As far as fees go, an employer plan typically is cheaper (compared to an investment advisor) but it may cost more of your time and be beyond your expertise to comfortably manage. Furthermore, employer plans predominantly offer mutual funds, which tend to have higher investment costs (expense ratios) compared to exchange-traded funds (ETFs) and stocks offered through an Investment Advisor.

Income and Distributions

It’s crucial to have an established, thought-out plan around the design of your retirement income. Employer plans typically send withdrawals in the form of proportionate distributions rather than selective distributions. This means that they may sell a portion of your stocks to fulfill your withdrawal request. This may not be relevant when the market is performing well.  It’s when stocks are declining that it can become problematic. Also, most company retirement plans do not have an automatic rebalancing feature, so each participant is required to periodically reallocate or rebalance their retirement plans after distributions to stay within the guidelines of his/her Retirement Income Goal(s).  For our retirement income plans, we try to avoid selling stocks while they are at a loss and rather use bond and/or cash money to fulfill the income need.

Introduction of SIMPLE and SEP Roth IRAs

Effective now, SIMPLE and SEP Roth IRAs can be opened and funded. Prior to SECURE Act 2.0, they only contained Pre-tax dollars. These plans are intended for small businesses and have distinct sets of adoption/administration documents. Consequently, even though the law says that these new accounts can be created now, it’s expected to take some time until they can be actually implemented. Specifically, new policies and procedures will need to be developed for employers, custodians, and the IRS on how to handle this change. The rule says that the Roth tax treatment can be applied if an election is made, but must be “approved” by the IRS. This begs the question of how the election gets added to plan adoption documents and what constitutes approval by the IRS. Forms will need to be updated by custodians and employers will have to educate their employees on this new contribution option.

Tax Considerations

Employees must first understand that employer contributions to their SIMPLE or SEP Roth accounts will be considered taxable income. The good news is that it’s believed to be only taxed as W-2 income, and not subject to FICA taxes. However, this additional taxable income may not trigger withholding and could come with an unexpected tax bill. Therefore, the employer Roth contributions should be analyzed as part of the tax projection to determine if additional withholding is prudent.

Roth or Pre-Tax Decision

Albeit we are strong advocates of supporting the Roth bucket, it’s not always the answer. We believe that the current income tax situation should be evaluated for determining whether to contribute Pre-tax vs. Roth. For example, a business owner that is in his/her top earnings years (highest tax bracket) may benefit more from a tax standpoint with the upfront pre-tax deduction. We’d then expect them to have a lower tax bracket in retirement, which would serve as a more optimal period to supercharge the Roth bucket by way of Roth Conversions. A Roth Conversion is when you transfer money from your Pre-tax IRA to your Roth IRA. The amount that is moved over is taxable in the year of transfer, but it paves the way for future tax-free growth and withdrawals. You are essentially paying tax today on the seed, with the expectation that the money will grow over time and harvest a larger amount that is tax-free.

Availability of employer contributions to be Roth instead of Pre-tax   

Another immediately effective change is the availability of employer contributions to go to the Roth account instead of the Pre-Tax;

Employer Match Contributions

Employers can now match an employee’s 401(k) or 403(b) contribution with Roth dollars. This wasn’t possible in the past as matching contributions only went to the Pre-tax bucket.

Non-Elective Employer Contributions (Safe Harbor)

Non-elective employer contributions (where the employee doesn’t have to contribute) can also be made to the Roth account but profit-sharing contributions aren’t eligible. The employer Roth contribution must be nonforfeitable, which means that it’s not subject to a vesting schedule. This is good news for employees as the money becomes immediately theirs.

Adoption Timeframe

Much like the SEP and SIMPLE Roth Account Introductions, it’s anticipated that it will take some time before this Employer contribution to Roth retirement accounts is available. Plan administrators and employers must modify their policies, procedures, and systems to reflect the new Roth rule. Documents may also need to be amended and employers will be responsible for informing employees of their options. It’s also worth mentioning that not all employers offer a Roth 401(k) or 403(b) account. This means some employees may be excluded from getting this alternative account funding (unless the employer plan is amended).

Tax Consequences

Like the SIMPLE/SEP, employees should consider that the employer’s Roth contribution is included in their income. Once again, this could lead to an unforeseen tax bill. This is why proper tax planning is necessary if an employer’s Roth contribution is expected.

Requirement of catch-up contributions to be Roth for high-wage earners

The requirement of catch-up contributions to be Roth for high-wage earners is potentially viewed as the only negative change in SECURE Act 2.0. It’s controversial because individuals don’t have a choice.

• Starting in 2024, employees that have wages more than $145,000 will have their 401(k), 403(b), and/or 457 plan catch-up contributions be treated as Roth only. The salary paid by the employer in the previous calendar year is used to determine if the line is crossed.
• Fortunately, the $145,000 threshold will be adjusted for inflation in the future but this doesn’t change the fact that the Roth election is forced.
• Pre-tax catch-up contributions won’t be available for high-income taxpayers. This rule applies only to qualified employer retirement plans and not to catch-up contributions for IRAs.

There are a few nuances in the language of this law.

• First off, it speaks to wages and not net earnings. Therefore, self-employed individuals would not be subject to this requirement.
• Furthermore, the text focuses on wages paid out from the employer in the “previous calendar year.” Well, what happens when you have two employers in one year, such as in the case of changing jobs? In this common scenario, an individual could be exempt from the requirement if wages paid out from both employers in the previous year were under $145,000.

Catch-Up Contributions

The most striking detail of this new rule is the way that catch-up contributions are treated when there’s no Roth option. As noted earlier, not all employers offer a Roth account. They are not required to do so. According to the bill, when an employer doesn’t include a Roth option, no employees can make catch-up contributions – irrespective of their wages in the previous year. This is a substantial statement that came out of the bill and likely will force employers to amend their plans. They will most likely be persuaded to add a Roth option if they don’t have one already. Failing to do so would potentially result in very disgruntled employees.

From our perspective, this change is negative for two reasons.

1. Employees don’t have much control over the matter. If “wages” is defined as what’s reported in box 1 of their W-2, some tax planning can be done to work towards moving that lower than $145,000. But, for the most part, employees will lose their tax election flexibility.
2. The Roth election may not be the best choice for the individual. As stated earlier, an individual in the highest tax bracket may benefit more from the Pre-tax deduction rather than the Roth. With this new rule, the employee won’t even get a chance to do an analysis on what is more prudent for their tax situation.

Final thoughts

On the surface, the many new Roth-related rules & additions that came out of SECURE Act 2.0 are a win for employees/taxpayers. But, as discussed above, there are multiple layers to sort through in this legislation. Each decision should be thoroughly thought-out, as every detail matters!