Last call for 401(k) Roth conversion strategies?

Employers 12.06.2021 3MIN

Roth conversion strategies—including “backdoor” Roth and 401(k) in-plan conversions—have received a lot of media attention this year. After some back and forth, the most recent version of the Build Back Better bill puts this powerful retirement strategy for converting after-tax retirement savings into a Roth account in jeopardy. Employers may want to remind any employees with an after-tax balance that they’ll have through December 31 to take advantage of this opportunity If the current version of the bill is passed.

As Washington considered changes around this strategy, the number of companies implementing 401(k) in-plan Roth conversion features has climbed.

Source: Goldman Sachs Ayco Personal Financial Management, December 2021.

What is the “backdoor” conversion strategy?

Many higher income earners can’t contribute directly to a Roth IRA due to IRS income limitations.

These income limitations don’t apply for individuals converting balances from other retirement savings accounts to a Roth account. The so-called “backdoor” Roth conversion technique allows employees to move an after-tax balance in their 401(k) out of that plan and into a Roth IRA. This Roth conversion enables individuals to put more retirement dollars into a Roth account, which has the advantage of tax-free growth and distributions, if certain requirements are met.

Alternatively, plans that offer an in-plan Roth conversion feature enable employees to convert savings without rolling money out of the plan. For more on this strategy, read this resource from Ayco’s Tax Policy & Research group.

Education and planning considerations for employees

Conversion strategies can be complicated. Employees considering this option must understand the technical rules, as well as the tax and financial planning considerations, which can be complex.

For example, pro-rata conversion rules apply if there is an existing after-tax balance. This means the taxable portion of any conversion is prorated over all after-tax or non-Roth IRA balances. A financial or tax advisor can assist with specific steps to minimize the tax consequences of a conversion.

As employers consider adding an in-plan Roth conversion feature, providing education and financial guidance is critical to ensure employees have the resources needed to make an informed decision.

Automatic in-plan conversion feature

Automatic Roth conversion is a relatively new plan feature first introduced in 2018. It provides an easier and more efficient way to maximize Roth conversions and minimize tax ramifications on earnings. Most plan administrators don’t currently offer this capability, but an increasing number of companies are adding or planning to add it.

This feature lets employees contribute to their 401(k) on an after-tax basis and have those contributions automatically converted into their Roth 401(k) account. As frequently as daily, the recordkeeper performs a search for new after-tax employee contributions (including loan repayments and rollover contributions) and automatically converts them.

The conversion is done as contributions are made, minimizing the risk of incurring taxable earning before conversion. In most cases, the process includes only a one-time call to the plan administrator to set up the automatic election and will then continue indefinitely, or until the employee chooses to cancel it.

Interested in offering a comprehensive financial planning benefit to your employees? Learn more about how Ayco can help your employees