By Alison J. Cohen, Esq., APR
By now, everyone is well aware that SECURE 2.0 was signed into law on December 29, 2022. One of the provisions in SECURE 2.0 is Section 604, a fundraiser provision that allows plan participants to elect to have any fully vested employer contributions funded to a defined contribution plan made as Roth for tax purposes. A participant making such an election will owe income tax on the contributions but will avoid tax on qualified distributions of both principal and income. (A qualified distribution is one that is made after age 59½, on death, or due to a disability but only after the participant has had, or is deemed to have had, a Roth account in the plan for at least 5 years).
The effective date for this new and ambitious provision was surprisingly the date of SECURE 2.0’s enactment. Many have welcomed this provision, particularly including financial advisors helping clients to manage their tax situation. However, as we will discuss below, notwithstanding the immediate effective date of this provision, it is impractical and inadvisable to consider initiating Roth employer contributions at this time.
So, like those of us anxiously awaiting the next season of our favorite show, we need to sit and wait patiently for this process to play out. Why so hesitant, you may ask? Well, we see several hurdles that need to be overcome before Roth employer contributions can be practically, and effectively, implemented.
Hurdle 1: Should an Employer Offer This in its Plan … Now??
Roth employer contributions do not need to be made available in all plans – the plan sponsor must elect to permit the Roth election for employer contributions in its plan. While many, if not all, employers will have or need to add a Roth 401(k) provision in 2024 to enable employees making more than $145,000 to contribute catch-up contributions, this doesn’t mean they necessarily want to further expand Roth elections to encompass employer contributions.
Because we have no guidance from the IRS on this provision, we don’t know whether it will be easy or complex to administer, nor even whether it will be available in all defined contribution plans with employer contributions (such as non-401(k) profit-sharing plans). We don’t know yet how much flexibility or inflexibility will be given to the employer in the guidance. In short, we are woefully ignorant of how this will all play out.
All these unknowns raise an obvious problem: what will be the administrative burden attendant to offering this option? While the employer contribution is deductible to the employer whether it is allocated to the participant’s account on a pre-tax or after-tax basis, how the election will affect the tax administration for the electing participant is totally up in the air. The result: there’s no financial incentive for the employer to offer the option, and lots of questions about the effect on employees that the employer will need to answer … with no answers available. Meanwhile, there is a tool that has been around for over a decade which can reach the same result in a 401(k) or 403(b) plan – an in-plan Roth rollover. This provision allows Roth conversions without the attendant uncertainty.
Consider the following administrative issues:
- We need to amend the plan to provide for the feature. We know that SECURE 2.0 amendments won’t be due until 2025, but nonetheless, we would need to communicate the addition of this feature to participants when it’s installed. What language will be acceptable to the Internal Revenue Service (“IRS”) and the Department of Labor (“DOL”)? And, as we are so unclear as to how this will actually work, what information can we impart at this time?
- How much can the employer tailor the provision to suit its particular needs? For example, what if the employer wants to permit this election for the annually deposited nonelective contribution, but doesn’t want to make this available for per-payroll-period matching contributions? Can they do that?
- Will the Roth employer contribution be subject to employment taxes? If so, how are those paid?
Hurdle 2: How Does a Participant Make This Election?
Once the plan sponsor decides to permit Roth employer contributions, the ball goes to the participants’ court. How would a willing participant make this election? While many, if not most, 401(k) plans have online elections available, adding this new option online takes programming. Even modifying a paper election form takes time and effort, particularly when no one knows what the election needs to say and disclose. Even creating, distributing, and collecting these elections adds an administrative step for the plan sponsor that may or may not be easily done. And, of course, if a participant’s election is missed in the process, we now have a situation where that error needs correction … insert EPCRS drama here (which is even more problematic, as we have no idea what the IRS would require for a proper correction).
Which leads to the point about how this election would be handled for any employer that funds its employer contribution on a per-payroll basis. Are these elections for Roth permanent for the plan year, or may they be changed during the year back-and-forth? May the employer limit these number of these changes to something less frequent than the normal deferral election modifications? Can a participant elect to have only a portion of his/her employer contributions made as Roth amounts? (Imagine the administrative fun if there is an election that says that x% of an employer contribution or only contributions up to $y will be Roth, with the balance contributed as pre-tax funds).
Hurdle 3: How Do We Tax the Roth Employer Contribution?
We have had quite a bit of discussion about this here in the Nerd Herd known as Ferenczy Law. There are conceivably two methods by which that this could be handled from a tax perspective. Depending on which one is chosen by the IRS in its guidance, that may drive the participant election method discussed in Hurdle 2 above.
Option 1: The employer might be required to reflect the taxable Roth employer contribution on the participant’s Form W-2 for the year.
Under this option, the plan sponsor would direct the deposit of the Roth contributions directly into a new source, such as the Roth Nonelective Contribution Account. (We’ll discuss this technology hurdle below.) Then, the employer will need to report the amount to its payroll provider in a manner that doesn’t confuse this taxable amount with regular wages or salary deferrals or other employer amounts.
If the amount is first reported on a Form W-2, as opposed to any payroll “stub,” there is no facility by which income tax withholding may be taken on the contribution. So, the participant will have a tax burden on April 15 of the following year that was unanticipated with tax withholding, unless the participant has had the foresight to take extra withholding from his or her normal pay, or has made an estimated tax payment. The result of this is likely to be that the participant will have insufficient taxes withheld, and may be hit at tax time with an underpayment penalty and a requirement to pay estimated taxes prospectively on a quarterly basis.
Form W-2 reporting of these amounts would require a modification of both the payroll system used by the employer, as well as the recordkeeper’s system. More programming needs, more possibilities for misclassification errors, more need for very clear communications to make sure the money ends up where it is supposed to go.
Option 2: Report the taxable amount on Form 1099R at year end
Fingers crossed this is where we end up. This option is a piggyback on the already existing in-plan Roth rollover mentioned above. The employer contribution would go into the plan’s pre-tax employer contribution account. The recordkeeper system will then implement the participant’s election similarly to what it does when an in-plan Roth rollover is elected: move the funds to the Roth Employer Contribution Account and issue a Form 1099-R at year end for the employee’s taxes. With this option, we don’t have to deal with the payroll provider or confuse the employer with the deposit procedure.
Although this option makes plan reporting easier, it doesn’t come near resolving the problem of preparing the participant for the end-of-year tax bite.
It would be nice to believe that a participant sophisticated enough to make this election would also understand the tax impact the election will have on April 15. In our experience, however, that may be a little too Pollyanna-ish. Many of the participants interested in Roth are younger workers who have been advised that Roth is the way to avoid taxes on the benefit earnings accumulations, which are substantial when the money has been in a plan for a long time (like, from your 20s to your 60s). It is not axiomatic that these same people understand how their annual taxes are calculated and how the Roth election will impact them.
Under either option, we need to also consider the impact for the plan service providers. Many plans define compensation for plan purposes as W-2 Compensation or Compensation under Code section 3401(a). How this taxable amount is shown on the Form W-2, and how it is treated for reporting purposes may make census form completion by employers more complex, giving rise to more potential for error. Compensation is already more of a challenge than many employers understand (we see this as an EPCRS issue time and again); this will further complicate it.
Hurdle 4: System Updates
Splattered throughout all the above hurdles is one recurring theme: programming and systemization. This new election touches all sorts of systems that cannot conceivably be updated in time for such an election to be made – even if we had guidance – for the employer funds flowing into plans for 2023 plan years.
First, we have the payroll systems that will need to be updated to accommodate this election and to properly calculate withholding of taxes. The payroll system will need to prepare proper government reporting of withholding and Forms W-2, as well as the information needed by the employer and other service providers for the annual census. The development of these system changes will take a significant amount of time and can’t even begin until the IRS provides guidance on how this election should be handled from an operational and taxation perspective.
Second, there are the obvious recordkeeper updates. Recordkeepers will need to create new money source buckets for each type of employer contribution. That doesn’t just mean adding a facility to have the right monies deposited into the right categories. It means programming new reports for the employers and the participants. There is also the issue of possibly needing to create a mechanism to process these Roth employer contributions as an in-plan conversion, rather than as a different infusion source. And, finally, recordkeepers will need to overhaul their Form 1099-R reporting. Again, all this programming takes lots of time and effort and cannot even begin until the government tells us what the “correct result” is for all of this effort.
And, last but not least, the TPAs of the world need systems to reflect these amounts being made to the plan, report them properly on Form 5500, and do whatever is needed to fill in all the little administrative nooks and crannies.
Okay, So What Do We Suggest?
It is not our way to complain about a situation without offering recommendations, and this FlashPoint is no exception.
First and foremost, we are not saying that this provision should be avoided forever. There are many participants who will want to take advantage of the opportunity to pay taxes now and avoid higher rates later. There are many estate planners and financial advisors who are waiting to help their clients make bolder plans for their financial future. What we are saying is that the immediate effective date for this provision was ill-conceived by Congress.
Our main recommendation is do not jump the gun. This is not something that should be instituted before we know the rules and systems for the provision. Resist the urge to be the first on your block to have this shiny new toy. Do not institute this provision in 2023. Wait until all the pieces are in place: the government guidance that will let us all know how to make this happen, the payroll systems to enable us to put the money in the correct buckets and to inform both the employer and the participants of what was done, the recordkeeping systems to ensure that elections can be administered and the money can be categorized properly, and the administrative procedures to oversee the whole process reasonably.
In the meantime, whether you are an employer or a service provider, start to think through the options and how it could be implemented in your realm. Consider whether your participants will be interested; perhaps poll the audience, so to speak, to see if anyone is quivering in their chair with great anticipation. Consider what your needs as a plan sponsor or a service provider are likely to be.
If you have any questions about this, or any other provision in SECURE 2.0, the Nerd Herd at Ferenczy Benefits Law Center is here to be your ERISA solution.
 Look for a forthcoming Flash specifically on the catch-up contribution changes and challenges.
 Keep in mind that according to Vanguard’s Research Paper, “How America Saves 2022,” of the retirement plans that offer Roth 401(k), only 15% of participants utilize this feature and only 4% use the in-plan Roth rollover provision when offered. (https://institutional.vanguard.com/content/dam/inst/vanguard-has/insights-pdfs/22_TL_HAS_FullReport_2022.pdf)
- Posted by Ferenczy Benefits Law Center
- On May 1, 2023