The Froth Over Roth - September 2023 Newsletter

By: Lawrence J. Zeller, MSEA

What are Roth contributions?

Traditionally, contributions to an IRA or 401(k) plan are tax-deductible when made, and taxable when withdrawn in retirement. Roth contributions1 on the other hand, are taxable in the year when they are made, but can be withdrawn tax-free during retirement. As long as certain requirements are met, both the contributions and earnings in a Roth account are non-taxable when withdrawn.

What conditions must be met for Roth 401(k) distributions to be tax-free?

In order to avoid paying taxes on Roth account withdrawals, the Roth account must have been established at least 5 years ago. There are complex rules regarding this 5-year “clock,” but in most cases the rule is that the 5-year period begins on the first day of the year in which you make the first Roth contribution to the account. So, for example, if your first contribution was made on December 30th, 2021, the clock starts on January 1, 2021 and you would be eligible to make tax-free withdrawals beginning on January 1, 2026, even though that’s only 4 years and 2 days after the actual contribution. In addition to meeting the 5-year rule, the participant must be at least age 59½ at the date of distribution 2.

Why have Roth 401(k) contributions been in the news lately?

The SECURE 2.0 Act 3 added a provision that requires catch-up contributions 4 to be made on a Roth basis for individuals with more than $145,000 in wages 5 in the previous year (indexed). Originally, this provision was set to be effective January 1, 2024. But the new rule gave rise to many complicated questions and logistical issues. Pension practitioners, professional retirement plan organizations, and payroll companies explained to the government why more time was necessary before this provision becomes effective. On August 25, 2023, the IRS and the Treasury Department announced that enforcement of the Roth catch-up mandate would be delayed until January 1, 2026. This was a big relief!

Must all 401(k) plans offer Roth contributions?

No, many 401(k) plans do not offer Roth contributions. But if a plan does offer Roth, then all participants must be allowed to elect whether to make Roth contributions or stick with traditional (tax-deductible) treatment for all or part of their contributions. The same is true regarding catch-up contributions: if they are offered, all participants must be eligible to elect them. Therefore, beginning in 2026, with limited exceptions, if a 401(k) plan does not offer Roth contributions, then participants will not be able to make catch-up contributions.

So, does it make sense to make traditional 401(k) contributions or Roth 401(k) contributions?

Ah, this is the big question, and of course the answer is “it depends.” If the goal is to minimize the total amount of taxes paid, then it helps to consider whether you’re likely to be in a higher tax bracket when you make the contribution or when you receive the distribution from the account. In general, if you’re in a higher tax bracket when you make the contribution, traditional is favored; if you’ll be in a higher tax bracket when you receive the distribution, Roth is favored. But there are a lot of exceptions to this rule, and it depends on the specifics of your situation. Here are a few examples of different situations that favor one type of contribution or another.

I’m just starting my career and want to start saving for retirement early!

You would generally favor Roth, since you are likely to be in a lower tax bracket now

than you will be later in your career.

I want to save the largest possible amount for retirement.

You would generally favor Roth, since you are effectively pre-paying the taxes on your

retirement savings.

I want to put some money aside for retirement, but I am worried about the impact on my current finances.

You would generally favor traditional in order to minimize the impact on your paycheck.

Traditional contributions aren’t subject to income tax withholding, so for example a $500

contribution might only result in a $350 reduction in your paycheck.

I am in the later part of my career and have high earnings. I am considering retiring in the near future, and expect to fall into a lower tax bracket.

You would generally favor traditional contributions. You should take the tax deduction

now while in a higher tax bracket and pay taxes later at a lower bracket. This also

avoids having to meet the 5-year rule in case funds are needed before the end of the 5

years.

I want to maximize the amount I leave for my heirs.

You would generally favor Roth. That’s because traditional accounts are subject to

something called the Required Minimum Distributions (RMD) rule, meaning that a

certain percentage must be taken out of the account each year starting at a certain age.

Starting in 2024, RMDs will no longer be required from Roth 401(k) accounts while you

are still alive.

There are many more situations than the five shown above. In addition, more than one of these situations can apply at the same time, some favoring traditional, some favoring Roth. You should consult with your tax advisor about what’s best for you.

---

1 Income limitations may restrict the ability to make Roth IRA contributions. This article deals mostly with Roth 401(k) accounts.

2 Withdrawals can also be made if the participant dies or becomes totally disabled (under the Social Security definition of total disability)

3 For more information about SECURE 2.0, see https://www.preferredpension.com/news/2023/1/17/secure-20-act

4 https://www.investopedia.com/401k-catch-up-contributions-5499024

5 This is defined as wages for FICA (e.g. Social Security) from the employer sponsoring the 401(k) plan. If you have wages from more than one unrelated employer, or wages not subject to FICA, then this limit will apply separately to each employer’s wages, or not at all.

Mining Form 5500 Data for Sales Opportunities - August 2023 Newsletter

By Brian Kane, CPC, QPA, QKA

Advisors to retirement plan sponsors who are looking for prospects, or looking to add value to existing clients, can get that chance by using data on plans’ annual filing report to the DOL, known as Form 5500.

Form 5500 contains a lot of plan details that can create opportunities to approach a prospective client on how to potentially improve their plan. Form 5500 is public information available at https://www.efast.dol.gov/5500Search/. There are also subscription services that will aggregate the information for you and allow for searches of the information by plan size, type of plan, location, etc.

Small plans with less than 100 participants will usually file a "Short Form" 5500-SF, but in some cases will file a full Form 5500 with financial information reported on Schedule I.

Here are 5 sales ideas based on reviewing a plan’s Form 5500:

No employer contribution being made to the plan (5500-SF line 8a(1); Schedule I line 2a(1))

It may never have been explained to the employer the advantages of making a Safe Harbor or Profit Sharing contribution. The Highly Compensated Employees of the company may not be maximizing their contribution due to the required nondiscrimination testing.

Your Approach to the Prospect: Have you and your Highly Compensated Employees been able to maximize your 401(k) contribution? Did you know that by adding a Profit Sharing contribution, you can make a total contribution of up to $66,000 in 2023?

Large employer contribution being made to the plan (5500-SF line 8a(1); Schedule I line 2a(1))

If there is a sizeable employer contribution being made to the plan, more than likely they are taking advantage of the Safe Harbor and Profit Sharing components of the plan. In this scenario, the demographics of the employees are allowing the plan to work out to the advantage of the Owners/Key Employees, which means a Cash Balance Plan will most likely work even better for them if they are looking to increase their retirement plan contribution.

Your Approach to the Prospect: I see that you are maximizing your contribution to your current plan, did you know that you can add a Cash Balance Plan which would significantly increase your overall tax- deductible contribution? Most likely there will only be slight increase in the amount you are already contributing to your employees in the 401(k) Profit Sharing Plan.

Low Employee Participation (5500-SF lines 5b & 5c; 5500 lines 6f & 6g )

You can determine if a plan has low employee participation by comparing Line 5b-Total Number of Participants at the End of the Plan Year and Line 5c-Participants with an Account Balance. If there is a large discrepancy between the number of eligible employees and the number of employees participating, the plan may benefit by having an Automatic Enrollment feature. Automatic Enrollment makes it the default option that the employee contributes to the plan at a certain percentage, unless they opt out. This has been shown to increase plan participation and the employer also receives a credit of $500 per year for 3 years on their company’s taxes for implementing the Automatic Enrollment option. If the plan is not a “Safe Harbor” plan, then additional contributions by Non-Highly Compensated Employees may also result in the ability of owners and other Highly Compensated Employees being able to increase their contributions to the plan.

Your Approach to the Prospect: Are you aware of the Automatic Enrollment option which should help increase Plan participation and will allow you to receive a credit of $500 on your company’s taxes for the next 3 years just for implementing the option?

Corrective Distributions (5500-SF line 8e, Schedule I line 2f)

If there is amount listed under Corrective Distributions, it is usually because the plan failed a nondiscrimination test referred to as “the ADP test,” and the Highly Compensated Employees received a refund of overcontributions to the plan to correct the failed test. There are several different advanced techniques that can be used to both perform the plan’s nondiscrimination testing and to correct a failed nondiscrimination test that may not have been explored by the plan’s TPA or bundled administrator. Also, the ADP test can be eliminated if the plan is a Safe Harbor Plan which can be implemented after the year is completed and the testing results are known.

Your Approach to the Prospect: Your plan failed the ADP test and there were refunds issued to your Highly Compensated Employees. Did your plan administrator offer you any options to correct the failed test other than to issue refunds? Did they explain the option of implementing a Safe Harbor Non-Elective contribution of 4% of pay instead of issuing refunds?

No Fidelity Bond (5500-SF line 10c, Schedule I line 4e)

A Fidelity bond is required to cover at least 10% of plan assets. If they checked the box that they do not have a Fidelity bond, or if the amount of the bond is less than 10% of plan assets, then the plan is out of compliance. This not only calls into question how the plan’s compliance work is being handled by the plan’s current administrator, but can also lead to large fines and penalties assessed to the plan sponsor.

Your Approach to the Prospect: Your plan does not have the required Fidelity bond. Did anyone inform you of this? We can provide a full plan compliance review free of charge from our partner TPA firm.

If you are able to engage the client further after your initial discussion and they are willing to share their current plan document and employee census, we can run a full plan analysis free of charge for them to evaluate their options.

These are just a few of the many ideas to engage your prospects or clients based on information on Form 5500. As always, please contact us if you have any questions regarding a prospective client or how we can help you win retirement plan business.

For more information on Form 5500, please see:

https://www.irs.gov/retirement-plans/form-5500-corner

https://www.dol.gov/agencies/ebsa/employers-and-advisers/plan-administration-and-compliance/reporting-and-filing/form-5500

Real Estate as a Retirement Plan Investment: Likely a Bad Idea - July 2023 Newsletter

In general, there is no law that prohibits investing qualified retirement plan funds in real estate, provided it’s not property that will be used by a disqualified person or a party-in-interest. It may be tempting to use retirement funds for real estate investments since the money appears to be available and real estate often has the potential for appreciation over a long time period. However, in many cases, real estate is a poor choice for qualified plan investments.

One exception: investing a small portion of plan assets, say 5% or so, in a real estate mutual fund, ETF, or REIT may provide some diversification and not have the problems listed below. But direct investments by the plan in real estate are generally a bad idea for some (or all) of the following reasons.

Liquidity: Real estate is not a liquid investment. It can take weeks, months, or years to divest the plan of real estate property, and liquid funds may be needed to pay benefits or plan expenses.

Market Value Determination: Any plan asset that does not have a readily determinable market value requires an annual independent qualified party appraisal. This is a time-consuming and potentially costly procedure.

Fiduciary Bond: Retirement plans must have a fiduciary bond equal to 10% of the plan’s assets to cover plan losses from theft of assets or fraud. However, if the plan invests more than 10% of its assets in non-qualifying assets (those that do not have a readily determinable market value), then either the bond must be increased to cover at 10% of the qualifying assets, plus 100% of the non-qualifying assets; or the plan must engage an independent accountant to conduct an audit of plan assets, which can be costly and time-consuming.

Plan Documentation: Some plans have limits on the amount or percentage of plan assets that can be invested in real estate, or they prohibit real estate investment outright. It’s possible the plan could be amended, but it’s also possible such an amendment could take the plan out of pre-approved status.

Real Estate Management: Land and buildings require maintenance. If the plan owns the property, the Trustees will need to be sure it is managed properly. The plan will be responsible for payment of property management fees, real estate taxes, repairs and maintenance, utilities, and other expenses.

Leveraged Real Estate: This refers to real estate that is debt-financed, i.e., a mortgage is taken out on the value of property. This is a particularly bad idea in a qualified plan. Since the plan is not in the real estate management business, income earned from the property (such as rental income) would be deemed to be unrelated business taxable income, or UBTI. This would require the plan to file a Trust tax return and pay Federal income taxes on the earnings from real estate and if applicable, file a state level return and pay state taxes as well.

Nondiscrimination issues: Do all participants have equal rights to invest in real estate? If not, the plan has to perform complex nondiscrimination tests referred to as the “current availability” and “effective availability” tests; if they can’t be passed, the plan could potentially be disqualified.

Distributions: Some plans allow participants to elect in-kind distributions; i.e., taking part or all of their benefits in the form of securities or other non-cash assets. In-kind distributions must be nondiscriminatory, meaning that they can’t be available only to Highly Compensated Employees. And it’s often impractical or impossible to offer distributions of a small percentage of the real estate investment as a distribution option. The plan usually must sell the real estate assets before all assets can be distributed to participants.

Fiduciary Issues: Plan fiduciaries must act in the best interests of plan participants and avoid conflicts of interest. Investments must be prudent, and they must be sufficiently diversified to minimize the risk of large losses. Fiduciaries who do not follow these principles may be personally liable to restore any losses to the plan, or to restore any profits made through improper use of plan assets. They may be personally subject to fines or other penalties.

Did we convince you not to invest plan assets in directly real estate? If you still are interested in using plan funds for real estate investments, better options would include real estate mutual funds as mentioned earlier, or applying for a plan loan or taking a partial distribution (if your plan allows these) and then investing the proceeds in real estate outside of the plan. As always, we recommend that you consult with a knowledgeable advisor before proceeding.