Summer 2023 Fiduciary Commentary
At the end of 2022, the SECURE Act 2.0 was signed into law. This legislation influences virtually all types of retirement plans, with sweeping changes to boost coverage and access and to further employees’ retirement readiness. A few months have passed since the new law was enacted. Since, countless practitioners have analyzed the legislation.
Roth Employer Contributions
This article discusses one of the more ambitious provisions of the law. Section 604 of SECURE 2.0 is an optional provision that allows plan sponsors to offer any fully vested employer contributions funded as a Roth. SECURE 2.0’s emphasis on Roth-type plan funding is a highlight of the new law and one that may ultimately prove to be the most significant part of the legislation. Section 604 is one of several plan “Rothification” provisions within SECURE 2.0 that legislators hope will raise revenue to help pay for the new law.
Here’s how it works. A participant who elects their employer’s matching or nonelective contributions (or both) to be made as a Roth will owe income tax on the contributions. Taxes are avoided on qualified distributions of both principal and income of the Roth contributions, if the Roth conditions are satisfied.
Surprisingly, the effective date of the new Roth employer contributions was the date of the law’s enactment— December 29, 2022. While many industry observers have praised this new provision providing a meaningful tax opportunity to savers and permitting them to better diversify their savings, the new employer-funded Roth contributions produce many new challenges for sponsors and service providers alike.
For example, there is an important requirement of the provision – a plan sponsor must fully vest the matching or nonelective Roth contributions. This stipulation will likely reduce the attractiveness of this feature to employers since many employers prefer that their funding be subject to a vesting schedule to encourage employee retention. This fully vesting requirement begins to make sense if you consider a situation where a terminated participant paid taxes on an employer Roth contribution and later forfeited a portion of the unvested contribution, resulting in the terminated employee being taxed on money that they never received.
Furthermore, SECURE 2.0 does not identify how a Roth employer funding should be reported for tax purposes by workers (for example, Form W-2 or Form 1099-R). Additional guidance from the IRS is anticipated to resolve this uncertainty.
Additionally, many questions remain on how this new feature will work within the current framework of retirement plan programming and systemization. Recordkeepers will need to update their systems to create new buckets for each type of employer contribution, and tax reporting will need to be updated for Form 1099-R, Form 5500s, and other various revisions. This programming will take a considerable amount of time and effort which cannot even begin until clarification on the rules is provided. Recordkeepers will be reluctant to offer this option until the IRS clarifies several administrative issues, such as how employee taxes on Roth employer contributions will be reported.
Roth Catch-Up Contributions
The complexity of US tax and labor laws is well known. It is not surprising that when writing extensive and technical laws like SECURE 2.0, Congress can make drafting errors resulting in the misinterpretation of its intent. Once these laws are finalized, an error cannot easily be fixed. The IRS and Treasury cannot interpret the intent of Congress, only administer the laws as written.
Another concern in the law’s Roth provisions is a drafting error included in the Roth catch-up provision rules. The legislation identified a threshold of $145,000 of FICA wages as the limit for participants to make pre-tax catch-up contributions – participants earning wages more than this amount would only be permitted to make Roth catch-up contributions. The specification of FICA wages in the legislation would permit those individuals who do not earn FICA wages (e.g., sole proprietors and partners) to continue to be able to make pre-tax catch-up contributions regardless of their earned income. Legislators have stated that this was an error and was not the intent of the provision. It is not clear if the IRS can find a way to interpret the statute differently than the way the law was written without a technical correction to the legislation.
As a result, there has been increasingly active and vocal lobbying to postpone the Roth catch-up provisions in SECURE 2.0. The American Retirement Association, along with several large plan sponsors and recordkeepers, have been attempting to persuade Congress to postpone the Roth catch-up rule by two years.
The SECURE 2.0 Act is one of the broadest pieces of retirement plan legislation produced in decades. It influences virtually all types of retirement plans and reflects the desire of lawmakers to boost retirement coverage and access. The employer Roth optional provision will likely be popular with plan sponsors that employ younger and higher paid employees, as Roth savings are most effective when the participants anticipate being in a higher tax bracket in retirement and have a longer period for their savings to compound tax free. These new Roth features create additional educational needs to help participants make informed decisions about what is best for them.
We anticipate that a technical corrections bill will be advanced in Congress to address the corrections needed to the original legislation. There is strong bipartisan support for the SECURE 2.0 technical corrections, but it’s still a tax bill that will draw political attempts to add additional provisions to it. North Pier will continue to monitor and report as necessary.