You may have missed it, but there’s a bit of a kerfuffle of late about Roth conversions—and this week, we wondered if the strategy had taken hold with the plans with which readers work.
The trouble began shortly before the Independence Day holiday when ProPublica published an article lengthily titled, “Lord of the Roths: How Tech Mogul Peter Thiel Turned a Retirement Account for the Middle Class Into a $5 Billion Tax-Free Piggy Bank.” Thiel is founder of PayPal (he’s also said to be a Lord of the Rings fan, hence the reference), and the report claims that, “over the last 20 years, Thiel has quietly turned his Roth IRA” (which the article characterizes as “a humdrum retirement vehicle intended to spur Americans to save for their golden years) … into a gargantuan tax-exempt piggy bank,” citing confidential IRS data. Basically that his retirement account worth less than $2,000 in 1999 is now a $5 billion “windfall.”
Conversion Plans
We started by asking readers if the plans with which they worked currently allowed for Roth conversions:
32% – Some do, most don’t.
26% – Most do.
17% – Only a few do.
13% – Some do, most don’t—but it’s been talked about.
12% – No.
Even though available, most do not use. A few have kicked the tires with their CPA, but decided not to do it for one reason or another. Mostly due to the resources to pay the tax bill.
We have more and more asking about it and we are making it a default to yes in the Cycle 3 restatement.
Plans have more inquiries on adding this feature.
We’re a TPA. I have had some plans ask to add it, and so we have, but I don’t think anyone actually has done it.
Most of our employers are concerned about the taxes that need to be paid by employees outside of the 401(k) for the Roth conversion.
Remember when the government changed the depreciation on real estate? The government will come calling for taxes on Roth distribution. There is way too much money in Roth plans that has never been taxed.
And we structure it to allow all amounts/not restricted to “otherwise distributable amounts.” We see it as a part and parcel provision to the Roth 401k contribution feature. We have had absolutely 0 participants do this thus far.
Most employees aren’t doing it because they can’t pay the taxes from the trust.
If you’re going to offer Roth contributions and the 401(k) provider is quality, I don’t know why you wouldn’t also add Roth conversion at the same time.
To date has never been an issue given the resulting immediate tax consequences associated with such.
They should, but need to make clear exactly how to pay the tax; is it out of pocket or out of the account?
If we are doing an amendment to the plan document I usually recommend they add it, even though it is rarely used. Under certain circumstances we have made it a priority to add it, so that money can be converted right away.
This is a complicated transaction for most “rank-and-file” employees. The potential taxable effects of a conversion is under appreciated or unknown by most employees. I believe that this type of transaction being offered to employees has too many unintended consequences to offer without significant counseling.
We recommend that this provision be included in all of our plan documents.
Most plan sponsors are concerned about the tax consequences participants may not understand fully.
There is always a pull from Highly Compensated Employees. The after-tax contributions get tested separately from the match. There is no safe-harbor, only an ACP test. So most every Plan would fail the test. So the people that want it, can’t have it. It turns out that “larger plans” don’t bother to do an ACP test, so they just give anyone who wants this “back door” trick the OK. I suspect that most of them would fail their ACP test.
While most of our existing 401(k) plans permit in-plan Roth conversions, we see (and have seen) very little transaction activity in this area. By and large when most participants realize they need to have the resources outside of the plan to pay the anticipated taxes on the conversion, they opt not to proceed but rather direct all FUTURE 401(k) payroll deductions via the Roth vs. pre-tax.
There is an interesting dynamic here that Roth conversions for a distributable event were permitted a few years prior to all Roth conversions being allowed, so a few plans do not permit all Roth conversions because they adopted the earlier provision.
Adding in-plan Roth conversion usually stems from the ability to add Additional After-Tax contributions as well. That that hinges on the plans ability to pass NDT. Many plans like the idea of adding the two features, but are unable to pass the testing.
Discussion ‘Points’
Next, we asked readers if they had discussed adding/implementing in-plan Roth conversions with the plans they work with:
42% – With some, not most.
27% – Yes, with most.
17% – Yes, with all.
13% – No.
1% – Not yet, but I’m getting ready to.
If they ask, but we don’t offer information on it.
It’s a gradual conversation. If they are making other changes then we discuss it being a good time to add even if no participants take advantage of it, but I don’t think it’s necessary to do an amendment just to add this feature.
Not unless they ask us about it first.
it makes sense with some plans based on specific circumstances. A number of plans will run into other issues if they allow for such contributions.
Only with a few of my plans. It’s a tricky subject, as plan sponsors want to be sure their participants are well informed before making a decision to potentially convert. I’ve scheduled participant education with these plans regarding this topic specifically.
If we are doing an amendment to the plan document I usually recommend they add it, even though it is rarely used.
Primarily b/c of prior experience with Roth IRA conversions and subsequent recharacterizations once the tax consequences came to bear. Also service providers don’t sound super confident about their ability record keep the transactions effectively.
Taxes can become a financial burden and unknow liability for retirement. Roth conversions eliminate that potential risk.
We sent out an article we wrote to every client discussing the subject (and the way that the testing works).
Per TPA, after tax contributions have to be included in the ACP test which will cause the plan to fail (except for solo 401k).
Participant reads article or something and goes to employer wanting to convert his account to Roth. Plan does not currently allow for in-plan Roth conversions. Participant (a valued employee) insists he be allowed to convert to Roth. Employer amends plan. Participant begins conversion paperwork and finds out he has to pay taxes on the conversion. Still waiting to get that paperwork back (and not holding my breath).
Participant Promotion?
We then asked if Roth conversions were something readers are currently promoting as a strategy to participants with whom they work:
49% – With some, not most.
32% – No.
9% – Yes, with most.
5% – Not yet, but I’m getting ready to.
3% – Yes, with all.
2% – Not yet, but I expect that to change.
This isn’t a good fit for everyone. Participants must have funds outside their 401k to pay the taxes required during the conversion.
I educate participants and plan sponsors about the feature. It may not be right for everyone so I don’t promote it
We have found that there is such massive confusion already about what a Roth 401k is and if you should even contribute on a Roth basis. Once we get more clarity on that with participants, we’ll take it to the next level and talk about why you might/might not want to make a Roth in plan conversion. Sadly, there is still so much confusion and misunderstanding about the differences between a Roth IRA and a Roth 401k.
With the potential sun setting of the Tax Cut Jobs Act in several years, in plan Roth conversions seemed poised to pick up.
Most 401(k) participants don’t want the tax burden.
Not getting a lot of interest, and with all 250 Plans having the ROTH option, if they want they simply change their current deferrals from regular to ROTH.
I don’t promote it where it won’t work. I do inform Plan Sponsors about the idea.
Yes, we are recommending it for individuals based on their tax bracket.
It all depends on their current and expected cash flow and the resulting tax bracket arbitrage opportunities.
Government ‘Response’
And then, last but certainly not least, we asked readers for their thoughts on Congress moving to prevent the kinds of “abuse” cited with Roth conversions:
42% – It’s well-intentioned, but probably do more harm than good.
17% – This won’t end well.
14% – Who knows?
10% – That ship has sailed—why bother?
8% – What could possibly go wrong?
6% – It’s overdue.
4% – I applaud it.
And on this one, the comments really came out—here’s a sampling:
Another example of limiting the masses due to the actions of only a slight few who have done well. First they tout Roths as the best thing ever and all Americans should use them (because they can get their hands on more taxes now if they do). Then when some have the ability to make great use of it and build a very nice next egg (that they can’t tax) it is all of a sudden a bad thing. And we didn’t see this coming??
Not necessary for Congress to Act.
I believe that although there are some that have made millions, as stated in your article, however, there are many more hard working Americans who benefit from this without making it a “tax loophole.”
How many billionaires are there, really? Why take anything away from the little guy?
For most individuals, Roth is a helpful tool to balance out pre-tax and after-tax retirement income. I hope they leave it alone.
The wealth prevention team is at it again!
I think there could be a limit on the annual dollar amounts for Roth conversions without eliminating them altogether. On the plus side, Washington is collecting tax revenue now. But, there is a negative result in the future when withdrawals occur. Congress needs to understand the implications for future budgets as they look at the amount of money in retirement plans—I hope their data is robust enough to accurately project future revenue vs. overstating it (meaning they can see the split between Roth accounts and pre-tax).
If some are abusing the strategy then I get it.
I don’t have any problem with people taking high amounts of risk in their Roth and being rewarded for it if they get lucky. Congress should focus on how these multi-millionaires and billionaires pay 0-15% in taxes. How did they even qualify to contribute to a Roth in the first place? I wouldn’t take away the average Joe’s ability to make a penny stock investment and get lucky. However, I believe most people would use more traditional forms of investing and not turn a few thousand into millions, let alone billions.
The issue is less about Roth and the tax code and an ability for a few to get in very early on pre-IPOs and make a fortune. That the dollars are tax free is frustrating to hear about when so many plan participants struggle to save at all. Seems to me Congress’ attempt to cap Roth contributions would affect a very very small number of people who have access to investment opportunities most investors don’t. Therefore I’m okay with this mostly symbolic “capping” of Roth accounts.
Abuse??? Using the tax laws to your advantage? Shouldn’t that be “applauded” or at least expected?
People paid their taxes on this and the Gov. needs to learn to live within their means. The “abuses” cited also mentions people who are in the highest income tax brackets, again these people have paid a lot of taxes throughout their career. Now in retirement, they followed the rules and the gov is saying “we need some of that!” I don’t think so. Our money is our money, unfortunately the gov sees it differently. Get the gov out.
Good for Thiel, he did it by the letter of the law!
The situation article is about a Roth IRA in a brokerage account, which most qualified plans don’t have. He was able to leverage his knowledge about a company he knew about and buy extremely low in individual stocks. An average person isn’t going to buy individual stocks with their Roth IRA.
When Congress offered the Roth contribution source, they were trading “pay me later” for “pay me now.” The cost of that decision was the loss of gain on Roth sources. Too look back now and realize that some took advantage of the tax free gain is disingenuous. Pointing to a few wealthy individuals with large accounts and claim it is an abuse is antidotal and little more than an exercise in class warfare. Question: What is the difference between one taxpayer with a $20 million Roth and 20 people with a $1 million Roth. Answer: There is no difference other than the perception that there should be a limit on tax-free gain in a Roth account. The fact that someone made an investment in a Roth and experienced a large gain is not abuse.
When the Government says they are here to help—RUN away!
Tempered Government Regulations and Oversight to prevent abuse, fraud, etc., is ultimately a good thing. We are unconditionally in favor of protecting the consumer.
It is a bit silly to be so concerned about Roth conversions when the Secure Act 2.0 is requiring all catch-up contributions to be contributed as Roth. Inconsistency thy name is Congress.
Only if Congress can eliminate the “conversion” for high tax bracket individuals.
Great they want to crack down on abuses. However if done properly they should not harm hard working folks who have saved and can afford to convert or save.
I don’t see this kind of abuse inside 401k plans unless it would be accomplished thru a SDBA as most people would invest in funds and you wouldn’t see the ‘PayPal’ type growth.
They’re upset because they don’t have a $5.0 billion Roth account.
I was under the belief that ROTH would eventually become double-taxed. The Government would say “only rich people have ROTH IRAs.” Well, now that states like Illinois, California, and Oregon will default all IRAs to ROTH, we have thousands of ROTH IRAs covering minimum-wage workers. So there goes the argument about the “rich.”
As long as the rules were followed, it would be reprehensible for the government to tax accounts that were promised to be tax-free upon withdrawal. If conditions on the taxability of amounts in Roth accounts are based on amounts accumulated, it will either be a tax and accounting nightmare, or will result in broken promises by the government, undermining our entire private retirement savings system.
There really should be a cap on account balance size—say, 10 million—but knowing Congress, they’ll come up with something more complicated than that…
If it is abuse that tells me it is not legal. In those instances, they should be prosecuted and fined. If it is being done legally, I have not issues with it.
I believe Roth IRAs should have upper limits on balances with the excess subject to capital gains and step-up treatment upon death. But withdrawals should be “MY”FO, i.e. MY choice re when and whether to take gains or tax-free withdrawals. The math should focus on those who really need their Social Security to be tax-free in order to meet a median budget. This would be at a joint Combined Income level of less than $32,000. The average current SS benefit of $1543/person would allow about $13,000 in additional taxable income before benefits would be taxable (($1543x2x12)/2 = $18,576. $32,000 – $18,576 = $13,484. So, to meet the average budget of $56,268 without taxing Social Security would only necessitate $5752/yr in tax-free Roth withdrawals & $13,484 of taxable withdrawals: $56,268 – 37,032 SS – 13,484 remaining Combined income available after 50% of SS. = $5752 from Roth account. At a safe withdrawal rate of 2.5% 5752/.025 = $230,080 Roth balance needed. I think increasing that to $1.0 million would be a fair Roth limit for a large swath of taxpayers.
Other Comments
There were a lot of comments to this week’s question—and here I feel the need to point out that I referred to the “abuse”—in quotes—my way of signaling that, while that was how some were viewing the actions, the actions were not illegal.
I have never embraced Roth contributions in general because I don’t trust Congress not to change the tax break laws on that in the future, as they did with SS. I would rather take my tax break now, when it is guaranteed. The uproar doesn’t surprise me and I believe there will be limits or future taxation on Roths.
There is no abuse going on here, the money is being taxed. Congress will screw this up and ruin it for everyone else if they get involved.
Congress overreaches on just about everything—if that wanted to do some good perhaps the trading they do personally should be banned…
Here’s what I don’t get—they complain in DC because all this money is going into the system on a pre-tax basis, and they don’t get to use that tax revenue. But then they complain because “rich people” convert that money to Roth, which triggers the tax on that money. How is it considered “abuse” when someone simply follows the rules???
Has there been a study of how many conversions ended with a loss of money/account? In those cases, the gov’t received their taxes but the account holder lost out. There are always two side to a coin and all aspects must be visited. Making money in this country is not a crime.
I don’t think actually using your Roth accounts/converted accounts is an abuse if it’s within the law. Yay for those who made excellent investment decisions. That shouldn’t result in Congress taking away those opportunities from the millions of those whose Roth accounts will never exceed millions (or maybe even one million). If they feel they have to do “something” maybe going forward put a cap (a large one) on the amount of earnings that may continue to accrue tax-free so nothing changes for the average American.
Unfortunately Congress often intervenes in financial products but doesn’t understand them, leading to problems and inconsistencies for the end user.
Mixed feelings. I applaud anyone taking advantage of the rules to better their position.
But, in general Roth deferrals have been attractive to more and more people and I think they’re a good thing. Roth conversions, on the other hand, are really only for those who have enough money to be paying tax now. I’ve primarily seen conversions being utilized by HCEs in our clients’ plans. So, if that’s considered an abuse, I would agree. These individuals are increasing their taxable income and are possibly being bumped into a higher tax bracket now, so that can be viewed as a good thing. With our enormous deficit, I’m concerned about future tax flows.
Why is it abuse when it is allowable under the law. For the people who have the money to pay the taxes it is a great tax strategy.
Congress made it easier to convert pre-tax accounts to Roth as a way to increase tax revenue in the short term without considering the long term implications. They now realize it was a long term tax revenue loser so they want to change the rules again. They can’t have it both ways. Either allow in-plan conversions so you can have the short term revenue advantages or tighten up the rules on a go forward basis. However, it’s inaccurate to say that certain individuals are abusing the rules when they are playing by the rules Congress created.
With so many people moving between states (out of CA), I think it does not make sense for most participants living in CA ( with very high-income tax rates). Secondly, we can control the income tax impact on pre-tax monies to minimize tax rate impact.
If there’s a strategy available and investors learn how to use it to their advantage, how is it an abuse? There are many things Congress does (we’re not privy to) that could be considered an abuse. Who knows what’s right or wrong? It’s a legal strategy.
Those using Roth conversions are paying their taxes and playing by the rules. In my opinion, what “abuse” is there to speak of?
Congress’ heart is in the wrong place. Hit the super wealthy in their pocket book with fair taxation. Close the tax loop holes, stop letting them borrow money at low interest rates to live their lavish lifestyles to avoid taxes and we probably would not be having this discussion.
Naturally of course the article fails to address the issue of non-Roth after-tax contributions potentially triggering ACP testing failures. Putting that aside: in our experience, many participants like the concept of Roth in-plan conversion, however, the moment you tell them they have to come up with the cash to pay the tax due out-of-pocket, it’s not surprising they quickly lose interest… (Obviously that concept does not apply to this “after-tax non-Roth then immediately convert” concept because if the conversion is done quickly there is little or no gain on which to pay tax!) The “after-tax non-Roth then immediately convert” strategy is one that it would be reasonable for Congress to shut down—surely this was never the intent, and, furthermore, the benefit of which surely inures almost entirely to the highest wage earners, i.e., those folks who have enough income into their households to first max out on their regular Roth deferrals at $19,500, and then save even more above and beyond that. It would not be unreasonable for this to be legislated out.
It’s not abuse. They paid the tax to get it into the Roth. It’s grown and they followed the rules written.
Congress should ban themselves from being allowed to trade public securities before they focus on middle America trying to save for retirement within their own rules.
It almost appears Congress is mad that some people had the ability to take advantage of it and they are not getting the tax dollars they want.
Like every other tax related initiative, the well to do will exploit for their gain. They are the ones who can afford access to accountants (and plan advisors) who are more than willing to help them to earn their business.
As I state above, a gain in a Roth account is not an abuse. The taxpayer is assuming the risk of the investment. Question: If a taxpayer invested after-tax funds and experienced a loss, is that an abuse by the taxing authority?
Roth is not going away. Congress is too stuck on getting a little bit of revenue now by forgoing a lot more revenue later.
Put a limit on ROTH balances allowed per individual. Some plan providers do promote back door Roth for ERISA DC plans, but non-discrimination testing has shut the back door for most plans.
Should not allow private stock or pre ipo’s if they want to crack down, everything else seems fine from saving and converting.
If it’s legal, it’s not abuse.
Don’t forget that the Obama administration sought to tax ROTH IRAs in their budget proposals. Congress ignored it, and then expanded ROTH in many ways. It’s a great way to balance the budget.
The availability of Roth w/in 401(k) beginning in 2006 I believe was a welcome feature for plans and more importantly plan participants to provide more flexibility for tax diversification. The plan initial adoption rate was low with lack of clarity on the “sunset” provision. Once the sunset issue was resolved, the vast majority of our plan sponsors clients amended their plans to permit Roth contributions.
The few bad actors might make the news, but I’d guess that 99.9 percent of people do not use Roths as a quasi-abusive tax shelter…
I’m not aware of activity I would refer to as abusive, other than backdoor “contributions,” which should be eliminated.
Remove the 5 year rule starting over when a Roth 401k is rolled to Roth IRA. allow after tax contribution to 401k without including in ACP.
The “fine print” within 401k plans with After-Tax contributions (unintended testing consequences, greatly reducing the actual benefit of After-Tax contributions since it’s usually ONLY HCEs who take advantage of this, etc…) is a reason we don’t push it to our clients. Seems like a great opportunity for lots of “gotchas” that can just make clients upset.
Thanks to everyone who participated in this week’s NAPA-Net Reader Poll! And those interested in the topic should check out Robert Kaplan’s post on the subject in today’s Daily!