Roth Conversions Part of the Tax Diversification Tool Belt

Under IRS guidance, participants can select to convert their entire pre-tax balance or a portion of it; they often have a lot of questions about the right amount to convert, and when to make the move.

Roth defined contribution (DC) retirement plan accounts have seen a surge in interest, especially with retirement plan sponsors, since their introduction in 2001.

According the 2017 PLANSPONSOR Defined Contribution Survey, 68.5% of plan sponsors offered Roth accounts in 2017, compared to 52.4% in 2013.

The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) introduced Roth accounts to defined contribution plans. The accounts allow plan participants to contribute after-tax money to their savings on which they will owe no taxes on qualified distributions. The provision of Roth accounts was set to end in 2010, but the Pension Protection Act (PPA) in 2006 made the accounts permanent.

The Internal Revenue Service (IRS) issued guidance in 2010 allowing for participants to do an in-plan rollover, called conversions, of pre-tax accounts to Roth accounts upon a distributable event. But, in 2012, it expanded that ability to non-distributable amounts. The 2017 PLANSPONSOR Defined Contribution Survey found 41.2% of plan sponsors offered an in-plan Roth conversion.

“A Roth conversion involves taking assets that have been contributed on a pre-tax basis and just like it sounds, converting them into Roth dollars,” says Meghan Murphy, vice president of Fidelity Investments. “But, in the process, that means you have to take taxes within the year that you complete the conversion on that dollar amount.”

Participants can select to convert their entire pre-tax balance or a portion of it. According to Murphy, most participants will choose a specific dollar amount, in order to promote tax diversification in retirement. Additionally, Jana Steele, senior vice president and defined contribution consultant at Callan Associates, says taxes can play a part in considering the amount of money to convert.

“If you’re going to convert your entire balance, depending on what that balance is, [taxes] can be a significant amount,” she says.

Once participants complete a conversion, they are issued a record of the conversion amount to be included as income for that year, says Murphy. Going forward, dollars converted will be treated as Roth dollars in any earnings of that money, and as long as the cash remains invested for five years (meaning no distributions from the account can be taken), it will stay tax-free for retirement.

Roth DC plan accounts can serve as a notable benefit for participants within a lower tax bracket than they expect to be in the future, since these taxes would be paid now rather than higher taxes in years to come. Furthermore, Steele says smaller taxes are dependent upon legislation, including the recent joint Tax Reform bill reported in December of last year. 

“It depends how much legislation changes over the next couple of years, but the way the tax cut bill was written in December, the individual tax rates will increase over five years, which means that participants know they’re paying a lower tax rate now than in the future,” she says.

As the money grows within the Roth DC plan account, participants will need to be aware of its requirements. Whereas distributions for a Roth IRA can be made at any point, if participants want a penalty-free distribution from Roth DC plan accounts, there are specific requirements.

Steele explains, “In order to take a qualified distribution from a Roth, and take advantage from the tax efficiencies, you have to leave the money in the plan for at least five years, and you have to be older than 59 and a half.”

Considerations for plan sponsors

For those plan sponsors who are considering a Roth feature in their plan’s design, Steele says they must amend their plan document and update their summary plan description (SPD). She recommends implementing a strong education blast aimed towards participants, given the complicated benefit.

Even before adding the feature, Steele suggests plan sponsors run a “test” to understand its impact towards deferrals being made into the plan.

“We’d recommend doing a cost-analysis, or a cost review in order to understand if there’s going to be any implications to the actual cost to the plan, and if there are going to be any implications to [discrimination] testing from ongoing Roth contributions,” she says. Unlike other after-tax contributions made by participants, Roth contributions are included in the actual deferral percentage (ADP) test and not the actual contribution percentage (ACP) test.

Having an understanding about how conversions will impact the plan gives plan sponsors an idea about how to work the amendment, Steele says. Other considerations include available sources [of assets] for Roth in-plan conversions, timing of availability to convert amounts and what the recordkeeper can accomplish. The plan can permit amounts in pre-tax, match, after-tax and/or profit sharing accounts to be converted.

“Not all recordkeepers can administer the Roth in-plan conversions with the same degree of flexibility, so [plan sponsors] may be curtailed somewhat depending on who their recordkeeper is,” she says.

Murphy says that from a recordkeeping standpoint, plan sponsors should focus on the operational process associated with Roth, since it impacts taxes.

“We would always explain the process and how long it would take, for the most part, and we work with employers on communicating how it works with their employees,” she says. “We would want to develop a campaign where employees are aware of their options and that they’re getting the education they need to make the right decision for them.”

Educating participants about Roth accounts

Given its confusing nature of Roths—not only in the conversion process—Murphy recommends plan sponsors educate their employees about Roth as a whole. 

“Roth is one of those areas that we always advocate for more education,” she says. “Not only about Roth conversion, but Roth in general.”

Steele says that typically, plan sponsors would apply larger educational campaigns focused on displaying the features’ availability, explaining how it is used, and what it means. However, she believes applying personalization and customization tactics can influence greater impact.

“By providing the specific account balance or the different types of sources that the participant currently has in the plan, that helps the argument because it becomes a more intimate conversation rather than a less specific blast that doesn’t address the participants or their current needs,” she says.

Murphy agrees, adding that it all boils down to understanding participants’ needs.  

“A lot of it goes back to knowing your employees,” she says. “Targeting communications to people who may be interested. Getting the right message to the right person.”