Ready or Not, Rothification is on the Way

Is “rothification” even a word? Probably not, but to me it seems a fitting term to describe several of the changes in store for retirement plans as a result of new legislation signed by Congress at the end of 2022. Rothification is the idea of eliminating tax deductions and deferrals for retirement savings and instead mandating Roth after-tax contributions, with the benefit of tax-free earnings down the road. SECURE Act 2.0 brings with it over 92 legislative changes to retirement plans, all to be phased into effect over the next several years. The focal point of this overly ambitious legislation is to enable more individuals to save for their retirement, while also encouraging more people to save through Roth retirement accounts.

In the March 2023 edition of Perspectives, Wendy Cox wrote an article titled “SECURE Act 2.0 – More Changes to the Rules,” which covered several key provisions of the Act. This article will delve further into the specifics of the Rothification that will be taking place in the years ahead as more Roth savings options (mandatory and optional) become available within retirement plans.

Historically, retirement plans have not been required to include Roth dollars and, prior to 2023, employer contributions have only been permitted on a pre-tax basis. While contributing on a Roth basis makes eminent sense for many, especially for those individuals facing contribution restrictions due to compliance requirements, Roth contributions are not ideal for everyone. Since higher-earning, older participants are likely in high tax brackets, it may not make sense for many of them to make catch-up deferrals on a Roth basis. Generally, the tax treatment of a Roth contribution is ideal when the Roth deferrals are made in lower-income years and later withdrawn in higher-income years. Based on the current legislation, it is likely that for older high-earning executives and managers, their catch-up contributions will be made when they are earning a higher income and therefore in a higher tax bracket, to only then be withdrawn in the lower income years of retirement.

In Congressional budgeting, the analysts only consider a ten year period, so taxes paid in the next ten years are considered as revenue, but any tax benefits after the end of the ten year window are not considered as tax losses. It can be debated that the decision to add a variety of new Roth provisions was simply a math problem aimed at capturing tax dollars in the near term because the reality is that the more money individuals save for their retirement using Roth accounts, the more tax revenues Congress currently generates. It appears that the intent of Congress is to push income tax revenues forward, to assist with making the Act revenue-neutral by offsetting some of the other tax breaks created under the Act.

Mandatory Roth Catch-Up Contributions

Perhaps one of the most controversial provisions of the SECURE Act 2.0 is the mandatory provision that all catch-up contributions will be taxed as Roth contributions for individuals who earn more than $145,000 of FICA wages in the previous calendar year. The earnings amount used to determine the Roth threshold will be indexed to inflation beginning in 2026. This change will force some individuals to make catch-up contributions in Roth dollars which means they will no longer receive a tax deduction for those contributions. However, Roth 401(k)/403(b) accounts are optional by the plan sponsor; Roth provisions are not mandated by ERISA. The Act is silent when a plan participant over the age of 50 wishes to make a catch-up contribution to their account when their employer does not adopt a Roth 401(k)/403(b) feature to its retirement plan. Must the plan sponsor add a Roth account to its existing plan? If the plan sponsor refuses to amend its plan to include a Roth 401(k)/403(b) feature, does that mean that no participant in the plan can make any catch-up contributions, regardless of wage? Clearly, regulations will need to be outlined to help existing qualified plans navigate this new mandatory Roth catch-up rule, effective for tax years beginning after December 31, 2023.

Since the Act is over several hundred pages in length, it should come as no surprise that some mistakes were made in the adoption of the Act. In particular, due to an inadvertent drafting error, the opportunity for any individuals who are over age 50 to make catch-up contributions to their retirement accounts was eliminated, effective at the start of 2024. Consequently, as it stands now, neither higher earners, nor any income-level, plan participants can make any catch-up contribution in 2024 to either a pre-tax or a Roth retirement account. Thus, participants cannot make catch-up contributions in 2024, unless changes are made by Congress. It is worth noting that the Treasury Department has stated they are expecting a technical correction prior to 2024.

Optional Roth Employer Contributions

If an employer permits the addition of this provision, employees can elect Roth treatment for matching and non-elective contributions. The intent behind this new provision is to provide employees with more tax diversification options. The Roth option can aid lower-income employees who do not overly benefit from income pre-tax retirement plan deferrals, especially early in their careers. Accordingly, the Roth income tax treatment is intended to give these plan participants a better overall tax outcome in retirement.

While Roth employer contributions became immediately effective under SECURE Act 2.0, considerable IRS clarification is needed before they can be implemented. Questions abound. When are wages are taxable? When are dollars vested? Are the contributions treated as wages? Are the contributions subject to FICA? The IRS will also need to provide updated plan document language. Retirement plan providers and payroll vendors need time to update their systems to accurately track the new sources.

At Greenleaf Trust, we are actively working through and preparing for the many changes brought about by SECURE Act 2.0. Our software provider has assured us that engineers are updating systems to incorporate the multitude of changes. The onus will be on payroll providers to adopt systems that are able to properly track Roth contributions and tax withholding. Additionally, Greenleaf Trust is actively working through establishing payroll integration with many of our retirement plan clients. Payroll integration will provide automation to a complex process, which has been made even more complex through recent legislation.

In conclusion, Rothification is expected to immediately generate large gains in short-term tax revenue, but it does so by sacrificing an equal or greater amount of future revenue. On the net, and over a long enough time horizon, Rothification will not increase federal revenue and it might even reduce it. In researching for this article, I came across Vanguard’s How America Saves 2023 edition, which lists the average retirement savings balance as approximately $112,500, with an overall median savings of about $27,000. If a retiree with an average retirement savings of $112,500 opts to follow a recommended demand on capital rate of 4%, they will only receive about $4,500 annually. When you incorporate the behemoth math problem that is the Social Security system, there is no question that more needs to be done to ensure participants are saving for their retirement. On the whole, SECURE Act 2.0 provides additional incentives to save for retirement, while also recognizing that most individuals now save for their future through contributions to their retirement accounts. SECURE Act 2.0 provides many provisions aimed at empowering individuals to increase their retirement readiness and build a stronger financial future.