Congress seems to be in a continual love fest with two retirement concepts – automatic enrollment and Roth contributions – and SECURE 2.0 (S2) continues the trend for both. I guess it’s not surprising. Automatic enrollment means more tax-deferred contributions (and, therefore, less tax revenue), whereas Roth contributions kick the tax can down the road by foregoing current tax benefits and bringing in more tax revenue in the here and now.
While many of S2’s provisions are not effective for a little while, there is a Roth-related provision that was effective immediately on the date of enactment (December 29, 2022). That is the provision that allows company contributions such as match and profit sharing to get the Roth treatment at the time of contribution.
It’s not a terrible concept, but the value proposition gets murky pretty quickly when looking at all the moving parts that come along with it…especially given the fact that another, much easier way to accomplish the same result has existed for more than a decade.
Let’s take a look at some of the issues.
Any company contributions made as Roth must be fully vested when contributed. Although it makes complete sense that a participant who is going to be taxed on a contribution be vested, this requirement creates all sorts of headaches in implementation when thinking about participants who aren’t already 100% vested.
Before getting into some examples, a quick reminder is in order. A participant receives vesting credit for a year as soon as he or she completes the plan-specified requirements, not at the end of the year. So, for example, if the plan says a participant must work 1,000 hours in a year to get vesting credit for that year, the additional vesting credit applies as soon as the participant completes that 1,000th hour. That means each participant in a plan could get vesting credit at a different time within the year, depending on his or her work schedule.
Ingrid is 40% vested and is due a profit sharing contribution of $1,000. It’s not clear whether she would be prohibited from electing to have the contribution made as Roth (because she isn’t fully vested) or only the vested portion ($400) could be contributed as Roth with the remaining $600 as tax-deferred.
Things get more challenging in that vesting is determined when the contribution is physically deposited. So, if the 2022 plan year profit sharing contribution is deposited sometime in 2023, someone has to determine whether or not Ingrid has worked enough hours by the deposit date to get additional vesting credit. If only fully vested participants can elect this Roth treatment, that mid-2023 review determines whether Ingrid is even eligible to make this election. If only the vested portion can be Roth, it determines whether that means 40% or 60% for Ingrid.
If we’re talking about a March 2023 deposit date, it’s highly unlikely anyone would have worked enough hours yet to receive the extra vesting credit. However, it’s a different story if the deposit occurs closer to the middle of the year.
But wait, there’s more:
- What if there are significant variations in work schedules – full time vs. part time, hourly vs. salaried, etc.?
- What if the plan uses the elapsed time method (runs on employment anniversary year) rather than actual hours (runs on plan year)?
- What if, instead of a profit sharing contribution (which is often made in a single deposit), we are talking about a matching contribution deposited each pay period?
If your head is spinning right now, that means you get it. And these are just the “easy” scenarios.
After figuring out vesting, this seems like a walk in the park; but someone has to keep track of which participants have elected Roth treatment and which have not. But the vesting factor makes this less straightforward than it should be. What happens if a participant has elected Roth but isn’t fully vested at the time? Do you disregard that election or “hold” it until the participant becomes fully vested? Can a participant who is otherwise fully vested make a split election with some Roth and some tax-deferred? Does the participant have to make a new election for each deposit, for each plan year or for each contribution type? Can the plan require that an election be all or nothing?
We simply don’t know the answers to these questions, because S2 doesn’t address them.
Taxation and Reporting
The hallmark of Roth contributions is that a participant gives up the current tax deferral in exchange for tax-free distribution down the road. When it comes to 401(k) deferrals, that’s all pretty easy to manage. Each pay period, those who elect to make Roth deferrals have their tax withholding calculated with those deferrals included in their gross compensation, while those who make pre-tax deferrals have their gross comp reduced before taxes are determined. And the company reports deferrals on Form W2 each year with different codes for pre-tax vs. Roth.
How does all this work for company contributions made as Roth? All S2 says on the matter is that these contributions “shall not be excluded from gross income.” Not the most helpful of statements, especially since we already knew that given that we’re talking about Roth contributions.
Let’s tackle the taxation part first. Logic would dictate that the contributions are taxed to the participant in the year of deposit rather than the year to which the contribution relates. If we look at Roth 401(k) deferrals, however, a deferral from a December 2022 paycheck that is deposited in January 2023 is still treated as a 2022 deferral for tax purposes. So what about a Roth matching contribution made on those same deferrals? Taxable in 2022 or 2023?
What about reporting? Matching and profit sharing contributions have not previously been reportable for participants – not on the W2, not on a 1099, not on anything that gets distributed to participants. In order for a participant to properly include Roth match or profit sharing contributions on their tax returns, those contributions will have to be reported somewhere, but S2 doesn’t tell us where.
How Soon Is Now?
There are just as many, if not more, questions related to other provisions in S2. What raises the stakes with this provision is that it is effective pretty much immediately. Theoretically, at least, a plan could have offered this treatment for any match or profit sharing contributions deposited on December 30 – 31, 2022. While it’s highly unlikely anyone jumped on it that quickly, we have had calls from those interested in implementing this option ASAP in 2023. With so many really critical open questions, it’s hard to suggest even attempting to implement this until we have more guidance on how it is all supposed to work.
The good news is that there is a much easier path to the same destination, and that has been in place for more than a decade. Plans can already offer in-plan Roth transfers, and a lot of plans actually already include that provision.
Each participant can choose to convert some or all of the vested portion of any plan accounts (determined at the time of each transaction) from tax-deferred to Roth. These participant-initiated elections are “one and done”. That means not only do companies not have to keep track of elections, but also there are no ongoing obligations with respect to future contributions. Participants can convert as often as they’d like, but the onus is on them to initiate those transactions.
And the taxation and reporting rules are clearcut and well-established. The transferred amount is taxable in the year of the transaction and is reported on Form 1099.
Eventually, the Treasury Department will get around to issuing regulations that will (hopefully) answer at least some of these open questions. Even then, there is no guarantee those answers will make any of this any less daunting to manage. Until those answers come, the relatively tried and true in-plan transfer seems to be the most expedient path to the land of Roth.
For more information on all things S2, check out our SECURE 2.0 Resource Page.