Diving In Again: Roth 2.0

Michael Carrico, CFP®, CRPC® Wealth Manager

It seems the only things discussed these days in financial publications are interest rates, inflation, and labor markets. It makes sense. The disconnect between the stories the Fed officials are telling and the one the market seems to be sketching makes for a mesmerizing experience akin to staring into a campfire. It is hard to look away. One of these parties will have to be wrong, but which one?

Diving In Again: Roth 2.0
Diving In Again: Roth 2.0

Although we have received new economic data since our article last week, the story is roughly the same.  Inflation data was revised up for December and the CPI data for January, released on Tuesday, showed continued slowing of inflation, although not as rapidly as predicted.  Yesterday PPI (producer price index) data was released.  PPI measures changes in prices from the perspective of producers rather than consumers and can often be somewhat predictive of future CPI changes.  The data showed the largest month-over-month increase since last June.  This seems to indicate that the Fed could be right about rates staying higher for longer and we have heard Fed speakers this week reinforcing this theory.  The markets have been choppy as a result and the bull and bear narratives continue to fly as the markets grapple with the news.  Next week may bring more of the same with reports on manufacturing data, 4th quarter GDP revision, and PCE (Personal Consumption Expenditures Price Index) data which is a figure watched by the Fed for policy decisions.

Rather than parsing through the economic data for a second week in a row, I thought we might step back to some news that came and went quickly amidst the noise of economic data and the stock rally in January.  Today I’m writing about the changes to Roth accounts under the SECURE Act 2.0 and implications from those changes.  In the article “Diving into the SECURE 2.0 Act” there were two changes to Roth rules which we highlighted as having broad impact.  These were: employees having the option to elect that their employer match with Roth contributions instead of pre-tax contributions, and the elimination of RMDs on Roth plan accounts (Roth 401k, Roth 403b, etc.).  However, there are some other rule changes that impact small business owners and high-income earners which we left out for the sake of space.  It’s worth a closer look to understand the changes.  So, let’s break things down a bit more.

First, we’ll examine the employer Roth match option. 

This option is technically already available as of January 1, 2023.  However, employers may not have adopted the practice quite yet as they will need to update plan documents, systems, and processes to accommodate the change.  If you have interest in this option, you’ll have to check your retirement plan for details or keep an eye out for updates.  But why would you want to choose this option if it does become available to you?

Historically employer matching contributions were always pre-tax. You may have elected to make Roth contributions to your 401k years ago, but your employer has been making their matching and other contributions on a pre-tax basis.  These employer contributions are not taxable to you until withdrawal.  This means that, upon withdrawal, you will have some portion of your account in Roth (the money you deposited and associated earnings) and some in traditional pre-tax (deposits and associated earnings from your employer).  This also means that the pre-tax portion is subject to RMDs in the future.

Electing employer Roth contributions going forward would mean a few things.  The Roth contributions your employer makes will be taxable to you now, grow tax-deferred, be distributed tax-free later under the standard Roth rules, and not be subject to RMDs.  The employer Roth contributions must also be nonforfeitable, meaning those contributions cannot be subject to a vesting schedule and must be immediately 100% vested (owned by you).  The question then arises, does this mean that employees can elect Roth employer contributions to skip the vesting schedule or can employees only elect Roth contributions that are otherwise not subject to vesting?  We will have to wait for further guidance from the IRS, but I expect it is the latter.  Employees will likely only have the option to elect employer Roth contributions if those employer contributions are not subject to vesting. This means that, even if you elect employer Roth contributions, there may still be some pre-tax contributions coming your way from the employer.  That said, retirement savers who do not mind paying taxes on contributions now for tax-free withdrawals later and those who want to limit RMDs in the future can consider this option.

The next big change to consider is the elimination of Required Minimum Distributions for employer Roth accounts. 

Currently if an investor of RMD age has Roth assets in an employer sponsored retirement plan (401(k), 403(b), governmental 457(b), or TSP accounts), they must distribute Roth assets from their account annually.  As I had previously noted in a Street$marts video, this is different from the rules that apply to Roth IRAs which are not subject to RMDs.  Effective January 1, 2024 Roth balances in employer retirement plans will no longer be subject to RMDs.  It also appears that this change applies not only to those accounts newly subject to RMDs, but to all Roth plan balances.  This means that investors who must take an RMD from plan Roth balances in 2023 will be able to stop those withdrawals from the Roth balance in 2024.  The good news is this now means less worry about the different Roth clocks and pre-retirement planning around Roth IRAs and rollovers from employer plans.  This is the most clear-cut positive change to Roth rules for investors in the bill.

Another rule change with less reach is the mandatory Roth election for high-income earners on catch-up contributions. 

This rule goes into effect on January 1, 2024 and only affects those making catch-up contributions in employer plans, who earned over $145,000 in wages in the prior year (indexed to inflation in future years).  Let’s break that down.  If you are of catch-up contribution age (50 or older) and participate in an employer sponsored plan (401(k), 403(b), or governmental 457(b) plan), then whether you can elect pre-tax catch-up contributions depends on your prior year wages from that employer.  If the prior year wages exceed the limit, then you are forced into Roth election for catch up contributions, which means less deferral of taxable income for high-income earners.  Due to the complexity of the language in the bill (“wages for the preceding calendar year from the employer sponsoring the plan”), there appear to be a number of loopholes.  Specifically, an individual changing jobs mid-year who exceeds the threshold in total, but not from one single employer, may not be subject to the rule.  Self-employed individuals may also be exempt from the rule.  If the plan does not offer Roth contributions at all, then it appears that catch-up contributions simply will not be allowed in the plan at all.  Clear as mud.  Expect the IRS to release further guidance in the future to clear up these rules.  For now, the takeaway is that there are likely to be further limits on tax deferral for high-income earners age 50 and over beginning in 2024.  This means that people subject to this rule who have been making pre-tax catch-up contributions may need to expect higher taxable income in future years.  It is also important to note that this rule does not impact catch-up contributions to IRAs.

The final Roth change that may benefit small business owners is the creation of Roth SEP and SIMPLE IRAs. 

This is another change that is already effective but will lag in reality as employers catch up to the rules.  Before 2023 SEP and SIMPLE IRA owners could only contribute pre-tax assets to these accounts.  They should soon have the option to choose Roth if they want it.  SEP and SIMPLE IRAs are most common for owners and employees of small businesses and have higher contribution limits than Traditional and Roth IRAs.  The rules here will be like all other Roth contributions: taxable now, tax-deferred growth, tax-free withdrawals later.

While there aren’t any major overhauls for Roth strategies in the bill, there may be some decisions for retirement savers to make soon and it is always good to understand your options.

Michael Carrico

Michael Carrico is a Wealth Manager at Howe & Rusling.


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