Category Archives: Roth

Recent guidance relating to pretax and after-tax distributions

Smith-SuzanneRecent guidance from the IRS (Notice 2014-54) is good news that should make it easier for defined contribution plan participants with pretax and after-tax amounts to split their accounts when taking distributions. The guidance makes Roth 401(k) accounts more attractive for participants and, as a result, employers who have not yet added Roth deferrals to their 401(k) plans may want to re-consider adding the Roth feature to their plans.

With an increase in the number of retirement plans that offer Roth after-tax contributions, more participants may be retiring with pretax and after-tax amounts in their plan accounts.

At distribution time, it is common for participants who have both pretax and after-tax amounts in their plan accounts to want to continue to defer tax on the pretax amount by directly rolling the pretax amount over to an individual retirement account (IRA) or other employer plan. At the same time, participants often want to receive the after-tax amounts in cash with no tax consequences.

In the past, the rules required that each distribution from a plan account had to include a pro rata share of both pretax and after-tax amounts. This made it hard for a plan participant to directly roll over the pretax portion and take the after-tax portion in cash.

There was a work-around solution, but it wasn’t easy. If a participant took an indirect rollover, instead of a direct rollover, that participant could accomplish the goal of rolling over the pretax amount. With an indirect rollover, distribution amounts are treated as consisting of pretax amounts first, rather than a pro rata share. But 20% withholding would apply, which means the participant would have to come up with money outside the plan account to make up for the withholding. Thus, while this approach was doable, it was not convenient.

Now, the IRS has changed the rules. The new rules assign the pretax amount to the direct rollover portion first. This allows participants to directly roll over the pretax portions. Any excess pretax amount is next assigned to any indirect rollover and remaining pretax amounts are taxable.

This is great! We love it when the IRS guidance is helpful for plan administrators and participants! Industry organizations had requested these changes and the IRS listened, understood, and made the change.

With this guidance and the earlier expansion of Roth in-plan rollovers, employers who permit pretax salary deferrals only may want to take another look at adding Roth deferrals to their plans. And let’s hope for more beneficial guidance like this from the IRS in the future!

What’s the additional guidance on in-plan Roth rollovers all about?

Tedesco-KaraOn December 11, 2013, the IRS issued additional guidance (Notice 2013-74) on in-plan Roth rollovers (also known as “conversions”). As background, the Small Business Jobs Act of 2010 (SBJA) allowed 401(k), 403(b), and governmental 457(b) retirement plans that permit Roth deferrals to offer participants (or their surviving spouses) an in-plan Roth conversion of distributable vested pretax accounts (e.g., because age 59-1/2 has been attained) into an after-tax Roth option within the same plan.

The American Taxpayer Relief Act of 2012 (ATRA) added a twist to the existing law by removing the requirement that the in-plan Roth rollover amount had to be eligible for distribution. Effective January 1, 2013, as long as the plan allows Roth elective deferrals and in-plan Roth rollovers under the expanded guidance, participants can take advantage of an in-plan Roth rollover of both vested distributable and otherwise non-distributable pretax amounts.

The additional IRS guidance clarifies the questions surrounding ATRA and in-plan Roth rollovers of otherwise non-distributable amounts. In-plan Roth rollovers are permitted within 401(k), 403(b), and governmental 457(b) plans, irrespective of any otherwise applicable in-service distribution restrictions based on contribution type or other conditions (such as age). The amount must be vested prior to rollover, must retain the same distribution restrictions that applied before the rollover, and, being a rollover, no mandatory or voluntary withholding applies even though the conversion is taxable in the year it occurs. Participants may want to increase their withholding on sources outside of the plan to pay for the taxes on the conversion of the pretax account.

Plans need to be amended to allow for in-plan Roth rollovers. The guidance states the plan amendment needs to be adopted by the later of the last day of the first plan year in which the amendment is effective, or December 31, 2014. A calendar year 401(k) or 457(b) governmental plan that began allowing in-plan Roth rollovers in 2013 or 2014 has to be amended by December 31, 2014. A yet-to-be determined extended amendment deadline applies to 403(b) plans (but not before 2015 according to the IRS).

The additional guidance also provides that the plan can limit the types of contributions eligible for in-plan Roth rollovers and the frequency of the rollovers, and it can be amended to discontinue allowing them. If a participant has never made a Roth contribution to the plan, but requests an in-plan Roth rollover, the rollover is considered a Roth contribution and starts the participant’s five-taxable-year holding period for converted amounts and related earnings to be ultimately distributed from the plan tax-free (subject to certain other conditions).

The additional guidance should help plan sponsors decide whether to allow for the expanded in-plan Roth rollovers. Now that there is increased potential for a participant to convert his or her vested pretax account to after-tax dollars and pay the associated taxes now to save on taxes in retirement, plan sponsors may want to consider adding this feature to their retirement plan.

For more perspective on this new guidance, click here.

Judging tax implications of Roth 401(k) contributions

Guanella-Jay-EContributing to a retirement plan is widely considered a no-brainer if the goal is to attain a meaningful retirement. But the decision on how to invest contributions within the plan can be daunting. Determining what type of contributions to make further complicates things. While tax-deferred contributions reduce taxable income in the year in which they are made, the taxes owed on those contributions as well as the investment earnings are deferred until a later time, possibly at retirement. Roth contributions don’t reduce current taxable income, but the tradeoff is no tax liability on the investment earnings when a distribution is taken (provided the individual is at least age 59½ and has held the account for at least five years).

The decision to contribute to a Roth 401(k) instead of deferring at a tax-deferred level is often based on an anticipation of changes to future tax rates. While this is a personal decision based on future income, several other factors should also be considered. The truth behind the decision is similar to other choices in life, more complicated than we’d like it. For example, the reduction in tax-deferred income can affect tax liability, possibly increasing refunds. If tax-deferred contributions increase a tax refund, how can the “newly found” money be taken advantage of? Depending on a person’s filing status, different advantages or disadvantages may exist.

None of us are fortune-tellers. It’s difficult to predict future income or tax brackets over a period of several years. It becomes even more complex when trying to anticipate things that are out of anyone’s control, such as politicians altering tax rates to address policy changes and deficits. Recent history underscores this fact with significant changes occurring at the top rate, ranging from 50% in 1982 to 38.5% in 1987, 28% in 1988, 31% in 1991, 39.6% in 1993, 35% in 2003, and settling at back at 39.6% starting in 2013 (with rates exceeding 90% at certain points in the last century). Accordingly, depending on when money is taken out of a retirement plan, the tax results can dramatically change over a period of years.

A diversified investment strategy has long been considered a way to optimize investment returns over time while reducing risk. A diversified tax strategy may be equally important. By utilizing tax-deferred and Roth savings options, tax liabilities may be mitigated, ultimately creating more flexibility to reduce individual tax burdens.

New rules, same question: Is a Roth right for you?

Most individuals are beginning the process of preparing their income tax returns this time of year—paying taxes later is not an option that presents itself. However, an item in the American Taxpayer Relief Act of 2012 has added the flexibility for retirement plans to allow individuals to choose to pay income taxes on their retirement accounts now, so that it won’t be necessary when they retire and begin to draw the money out.

That is the primary attraction of a Roth account. If your 401(k) plan currently has a Roth option, the good news is that you may be eligible for this conversion. However, it will require some research to determine if it’s the right decision for you.

At face value, the trade-off is simple. If you convert pretax dollars to a Roth account within your plan you are essentially taking a distribution, within the plan, and opting to pay taxes in the year of conversion at your current income tax rate. This, of course, leads to an increase in taxes that are due for that year, and may even increase the tax bracket you are in. Once done, the new Roth dollars and any future earnings will grow tax-free as long as you hold the account for at least five years and are at least age 59 and a half years old before you withdraw it from the plan. A word of caution: the conversion is irreversible and therefore requires some forethought and analysis.

The types of individuals that may benefit most from this include people who anticipate making a significantly higher income as they near retirement, or believe they will be in a higher tax bracket in retirement. Individuals who believe this will find that a Roth account may fill a need in their estate planning. It’s important to project how these changes will affect individual tax situations and to make sure the available resources outside of the plan are there to pay for the taxes now. Specific details on the new Roth conversion are still being researched and guidance is needed before most retirement plans will consider adding this provision.

As an employee you can consult your summary plan description or talk to your employer’s benefits department to find out if your plan currently allows Roth accounts and whether the plan will add the feature to allow you to convert your pretax dollars. It’s great to have options when it comes to saving for retirement because it’s within those options that you’re able to develop an effective strategy to meet your retirement goals.

American Taxpayer Relief Act of 2012, fiscal cliff legislation, and in-plan Roth conversions

Effective January 1, 2013, the recently negotiated and signed American Taxpayer Relief Act of 2012 includes provisions for in-plan Roth conversions. The new provision is akin to the in-plan Roth rollover, with the difference being that the provision is applicable for amounts that are not currently eligible for distribution. The legislation benefits plan sponsors and participants but it also provides a revenue stream for the federal government.

Roth contributions to a qualified 401(k) or 403(b) plan or to a governmental 457(b) plan are made on an after-tax basis. This means participants pay taxes on contributions now, not later. Before the new rules, if a plan permitted an in-plan Roth “rollover,” then a participant could move money from a non-Roth plan account (pretax salary deferrals, employer match, employer nonelective contributions) to the Roth account within the same plan. Participants were only allowed to do this if they had distributable events (i.e., distribution at age 59½, severance from employment) and the amount was eligible for rollover. Under the new law, if a plan permits an in-plan Roth “conversion,” then a participant may move money from a non-Roth plan account to the Roth account within the same plan, without having a distributable event.

If participants decide to take advantage of an in-plan Roth conversion, they will pay income taxes at their current tax rates. The conversion is not subject to mandatory or optional withholding, nor to the early 10% penalty tax, although a recapture rule may apply a 10% penalty if in-plan Roth amounts are distributed within a five-year period. This means the participant needs to think about the following: Is my tax bracket at retirement going to be higher than it is now and do I have the money outside of my plan assets to cover the taxes?

If participants expect to remain in the same tax bracket for the remainder of their working careers, there is no advantage to paying the tax now. However, for participants who believe they will be in higher brackets as they go through their working careers and in retirement, and have other money available to cover the income tax, then conversion of a non-Roth account may be beneficial. The converted amount would be considered tax-free, as are the future earnings on it, if certain requirements are met, including a five-year holding period. If the participant will cross multiple tax brackets, it may be beneficial to spread the Roth conversions over multiple years. This helps the participant accumulate resources to pay the taxes and makes the conversion more affordable.

There are additional questions and considerations the participant needs to address, such as when to retire, whether to work after retirement, how much money will be needed in retirement, whether estate taxes must be paid, and how much Social Security provides. These are not easy questions to answer, but taxes and taxable income may impact the answers. Most participants want to maintain a standard of living in retirement that is not less than what they currently have. Considering after-tax investment vehicles, such as a Roth account, may help participants achieve their financial retirement goals.

The Roth question: Should I pay or should I stow?

Timothy Connor

Your employer offers you the opportunity to make contributions to a Roth 401(k). You may even have the choice to convert the current balance in your regular 401(k) into a Roth 401(k). So should you? 

It goes without saying the key questions involve tax implications.  After all, you’re deciding whether to pay taxes now or perhaps pay them later on an investment.  Let’s put aside for a moment estate planning and other special circumstances where Roths are very effective. In a more general use, there exists a common viewpoint that warrants some scrutiny. It goes something like this:  “I think tax rates are going to increase. Therefore, I should go Roth now.” Hmm, is that the right way to go? 

Perhaps not. Rather than just trying to guess which way tax rates will move, you may wish to consider the difference between your “marginal” tax rate today versus your “effective” tax rate in retirement.

Your marginal tax rate today is the tax bracket that would apply to your next dollar of income. A single filer making $200,000 is in the 33% marginal tax bracket, meaning a raise to $200,001 would result in an extra 33 cents of taxes. However, because of our progressive tax system, the effective tax rate we pay is a combination of all the tax brackets that apply to our income (only 25.4% for the single filer making $200,000). When you contribute to a Roth instead of a regular 401(k), you’re effectively adding a slice to the top of your income, which gets taxed at your marginal tax rate. In retirement, your income may be comprised of virtually nothing but annual distributions from your retirement balances. And so the question to consider is this: When you take those retirement distributions, how will the effective tax rate you’ll pay on that income compare to the marginal tax rates you were subject to at the time you were deciding to go Roth or not? Even if you predict tax rates will increase, you may have been better off not going Roth. 

It’s not a simple subject, and certainly not as simple as laid out here, as there are many other factors involved including state taxes, account purposes, and other retirement assets. If you talk to experts, or search for help online, you’ll find arguments for either side. Many individuals in many situations are better off with Roth. Read up as much as you can. Ultimately, it’s a question you should explore with your tax planner and financial advisor.

DISCLAIMER: This post is for informational purposes only. Milliman does not provide tax advice. For more, see our terms of use.