The House recently passed H.R. 2954 Securing a Strong Retirement Act, often referred to as SECURE Act 2.0, putting a full-court press on the need for Americans to add more to their retirement accounts. So for all of you who have been searching for ways to invest in Roth retirement plans, the bill should make you feel like Christmas came early. However, the aspects of the bill that would tax retirement contributions, as opposed to distributions, could be surprising for some. The reason? Congress is looking to collect revenue now, not when the current workforce retires.
Even though Roth retirement plans must be funded with after-tax dollars, the main tax advantage of participating in one is that none of the growth in the plan should be taxed. Alternatively, retirement plans, including an IRA, 401(k), 457 and 403(b), are funded with pre-tax dollars, and the growth is taxable when distributed at an individual’s ordinary federal income rates.
Another negative aspect of regular, i.e., non-Roth, retirement plans is the requirement to take taxable required minimum distributions (RMDs). As the contributions are made with pre-tax dollars, the federal government has instituted a required minimum distribution age to ensure taxation in the taxpayer’s lifetime. IRA, 401(k), 403(b), and 457 plans require a taxpayer to receive a minimum distribution amount once a certain age is met. Alternatively, taxpayers are usually not required to take RMDs from a Roth IRA. The SECURE Act passed in 2019 increased the required minimum distribution age to 72. The current House Bill would increase the required minimum distribution age to 73 starting on January 1, 2023, and further increase the age to 74 beginning on January 1, 2030, and 75 starting on January 1, 2033.
If individuals anticipate being in a lower tax bracket when they start to receive retirement distributions, they may be more inclined to invest in pre-tax investment vehicles. Alternatively, if a higher federal effective income tax rate is expected upon retirement, then individuals may prefer to be involved in retirement plans that are taxed upon contributions. Many experts recommend diversification between pre and post-tax contributions. This allows retirees to receive the maximum amount of cash distributions while optimizing their federal effective income tax.
Here are some key takeaways of the House Bill that would require taxpayers to pay federal income tax in the year of contribution/matching:
- Employer Matching: Under current law, plan sponsors are not permitted to provide employer matching contributions in their 401(k), 403(b) and governmental 457(b) plans on a Roth basis. The House proposal would allow plans to provide participants the option of receiving matching contributions on a Roth basis, effective after the date of enactment.
- Catch-Up Contributions:Many individual taxpayers have enjoyed the catch-up contribution provided if they have obtained the age of 50 by the end of the taxable year.
- The 2022 catch-up contributions for 401(k), 403(b), and 457 retirements plans allow a taxpayer an additional contribution amount of up to $6,500 (limited to $3,000 for SIMPLE plans) to be made on top of the annual elective salary deferral limit. Under the House Bill, all catch-up contributions to a qualified retirement plan must be made on an after-tax or Roth basis (if permitted by the plan). The effective date of this proposal would be for all catch-up contributions made after December 31, 2022.
In addition, the House Bill would increase the 401(k), 403(b), and 457 retirements plan catch-up amount to $10,000 ($5,000 for SIMPLE plans) for individuals who have attained the age of 62 but not the age of 65, during the taxable year. The bill also would allow the IRA catch-up limit (currently $1,000) to be indexed for inflation. The increased catch-up amounts would be effective for taxable years beginning after December 31, 2023.
- SIMPLE IRAs: Under current law, SIMPLE IRAs cannot accept Roth employee contributions. SIMPLE IRAs are often used by small businesses and employers with less than 100 employees because they are easy to set up and generally are less expensive than other plans. The proposed plan would allow SIMPLE IRAs to accept Roth contributions. This change would permit all plans, including 401(k), 403(b), and governmental 457(b) plans to accept Roth contributions.
Close attention should be given to the progress of the House Bill as it had overwhelming bipartisan support in the House, with 414 voting in favor of the bill and only 5 opposing. The increased flexibility being allowed to individuals to diversify their pre- and post-tax retirement contributions could significantly adjust their retirement planning strategies. If the House Bill is passed, a careful review of one’s retirement portfolio should take place with their financial and tax advisor.
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