Reader Mail: More on Roth Conversions
We love reader feedback – and to our excitement, we have been receiving a lot lately! After our recent blog post on Roth Conversions, Jack Towarnicky of the American Retirement Association (check out his blog here), sent us some interesting insights and graciously allowed us to share them with you:
- Roth conversions are different than Roth deferrals, and many plans allow one but not the other — A Roth conversion is different from a deferral, in that it allows a participant to take existing pre-tax retirement plan assets and pay taxes on them, so they can be treated as Roth assets going forward. Some plans allow for deferrals, but not conversions. Most of the plans that allow for conversions only allow them for distributable events, since, previously, that was all the law permitted (this has since changed). Jack suggests that plan sponsors allow Roth conversions for any reason, and I agree (along with allowing Roth deferrals, of course). Plan sponsors should carefully review their plan language to confirm what they offer and amend if necessary.
- Plan sponsors of plans that do not permit loans / loans on employer contributions may want to consider allowing loans for the sole purpose of paying taxes on Roth conversions — As the CARES Act reminded us, loans are not an all-or-nothing proposition for plan sponsors; for example, a plan sponsor can allow loans ONLY for participants directly affected by COVID-19, as defined under the CARES Act. Jack makes a novel suggestion that plan sponsors, who otherwise prohibit loans, should consider permitting them in order for participants to pay the taxes owed on Roth conversions. The primary barrier to Roth conversions is that participants are often unable to pay the taxes owed, since a Roth generates income taxes on the amount converted (in exchange for this, future distributions are tax-free, with limited exceptions). Thus, Jack suggests eliminating this barrier by allowing the retirement plan to pay the taxes via a plan loan. That way, the money never leaves the plan. Note that this idea also applies to plans that do not typically permit loans against employer contributions.
- If a plan automatically enrolls new hires, consider Roth as the default auto-enrollment option — Younger, shorter-service employees are among the strongest candidates for Roth. Since most earn less income, and given that tax rates are at historic lows, it is likely that the current tax brackets for these employees might be the lowest they experience in a lifetime. Earnings on Roth deferrals are completely tax-free upon withdrawal, with limited exceptions. Thus, this tax break favors younger employees, who will likely see additional tax-free earnings by retirement age, due to compounding. Yet, in my experience, 99% of retirement plans default the auto-enrolled to pre-tax deferrals, instead of Roth, despite the fact that a default to Roth is permitted. I discussed this issue in detail in a PLANSPONSOR Ask the Experts column last year. Jack believes it makes a lot of sense to default to Roth, and I agree with this position, as well.
- Roths are not just for the young — Executives and other highly-compensated employees with higher marginal tax rates can effectively be saving much more than their maximum $19,500/$26,000 each year; an example of this math can be found here. Of course, from a plan sponsor’s perspective, it could be a problem if every executive maxes out on his/her deferral if the plan is subject to ADP testing, but that is a relatively minor issue.
Jack had many additional thoughts and we thank him for taking the time to provide feedback and allowing us to share it with our readers!
Note: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice. Opinions expressed are those of the author, and do not necessarily represent the opinions of Cammack Retirement Group.
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