Rothification 
What is this about?
Tax free? Or tax revenue?

On December 30th, 2022, President Biden signed the SECURE Act 2.0 into law. The bill lacks anything as radical as the changes to IRA beneficiary rules that were part of the first SECURE Act (went into law January 1, 2019).

If there is a theme to the bill, it is Rothification. That’s not a word. But it sounds more dramatic than “expanding rules, access, and contribution limits to Roth accounts.”

Roth accounts are attractive because of the long term tax advantages they promise. Only funds that have already been taxed can be contributed, but once inside the safe confines of the Roth account, investments can grow tax deferred, and funds may be withdrawn tax free after age 59 ½, as long as you follow the rules.

Some of the SECURE ACT 2.0 rules make Roth accounts more enticing to people who may already have access to them. For example, one of the drawbacks of using a Roth 401k was that you would have RMDs the same way you would with a Traditional 401(k). And if you had multiple Roth 401(k) accounts, you would have to take RMDs from each one separately.

Now, employer Roth plans will have no RMDs. Two birds, one stone.

The availability of Roth plans has also expanded. Starting in 2024, you will be able to contribute to Roth SEP IRAs and Roth SIMPLE IRAs.

SEPS and SIMPLES have been Rothified. But wait, there’s more:

Employers will be able to make matching contributions into employee Roth plans. Currently, if an employee is contributing to a Roth 401k, the employer’s match has to go into a Traditional 401k. Now employers can match Roth contributions with Roth contributions of their own.

Employer matching contributions? Rothified. Keep waiting, there’s still more. Catch up contributions to retirement accounts also have a nice, Rothy shine to them now:

As described in this article at Kiplingers (all quotes italicized):

The SECURE 2.0 Act adds a "special" catch-up contribution limit for employees 60 to 63 years of age starting in 2025. In the case of most 401(k) plans and other employer-sponsored retirement plans, the special catch-up contribution maximum for workers 60 to 63 years old is the greater of $10,000 or 150% of the "standard" catch-up contribution amount for 2024. The $10,000 amount will be adjusted for inflation each year starting in 2026.

Those workplace plans will include Roth options, remember. People in lower tax brackets tend to benefit more from Roth accounts due to the reduced benefit of tax deferral. People in higher tax brackets have the option to defer taxes now and convert to Roth later when they may be in a lower tax bracket.

But wouldn’t you know it…

Starting in 2024, the SECURE 2.0 Act also requires all catch-up contributions for workers with wages over $145,000 during the previous year to be deposited into a Roth (i.e., after-tax) account. The wage threshold will be adjusted annually for inflation beginning in 2025 (rounded down to the lowest multiple of $5,000).

One last provision regarding catch-up contributions to IRAs (including Roths) is:

The SECURE 2.0 Act unsticks the catch-up contribution amount for IRAs. Starting in 2024, the $1,000 amount will be adjusted annually for inflation just like the base amount. Note, however, that if the inflation adjusted amount is not a multiple of $100, the new amount [will] be rounded down to the next lower multiple of $100. As a result, the $1,000 amount might not rise right away.

Also of note is what is NOT in the SECURE Act 2.0.

There were rumblings early in the Biden Administration of legislation eliminating or restricting Roth Conversions and eliminating Backdoor Roth Contributions altogether. This did not happen.

Whew! It’s a 500 page bill which, admittedly, I have not read. I am relying on other, smarter, harder working people than me for that job.

It’s also so new that there have not been any cases yet to test the SECURE Act 2.0 in tax court, so we won’t know for a while exactly how the rules will be enforced.

“How much fun it shall be to learn about tax court cases,” say the smart, hard-working people.

The United States is in a well-documented hole regarding its debt obligations relative to Gross Domestic Product. According to the US Treasury, the current debt to GDP ratio is at 124%. It’s at least trending in the right direction, as it was at 128% in Quarter 2 of 2020. The debt is $31.38 Trillion as of the time of this writing.

The Roth provisions in SECURE 2.0 strongly imply that the government wants people to use Roth accounts. Why on earth would the government expand access to tax free accounts under these circumstances? What better proof of regulatory incompetence could there be?

A reasonable explanation may be that the more people use Roth accounts, the less they are deferring their income. The less they defer their income, the more taxes they are paying, meaning more tax revenue for the government.

If a 35 year-old professional contributes to an IRA or Traditional 401k, the government will have to wait until at least age 55 (in the case of the 401k) or age 59 ½ (in the case of the IRA) before the account owner can withdraw funds – and pay taxes on them - without penalty. That’s a long time.

That 35 year old, meanwhile, doesn’t have to take any money out of the account, where it will be taxable as ordinary income, until age 75. This is thanks to a provision in the SECURE Act 2.0 that raises the Required Minimum Distribution age to 73 for people born between 1951-1959, and 75 for people born in 1960 or later.

Might this all come back to bite Uncle Sam in the hiney in the future? Absolutely. It is a fair concern that there might someday be a problematic amount of wealth concentrated in tax free Roth accounts. If this happens, all Congress has to do is pass a bill that adds taxable features to Roth accounts.

The rebuttal to this is that the majority of tax revenue in the United States does not come from retirement plan withdrawals. Only half of all US tax revenue comes from income taxes, that includes retirement plan distributions. But it also includes income from wages and bonuses.

This means more than 50% of all tax revenue comes from sources other than retirement account distributions. As long as this holds true, payroll taxes, corporate taxes, and taxes on wages will be more efficient sources of tax revenue for the government compared to retirement account withdrawals.

The question for the taxpayer, as it always has been since Roth accounts came into existence in 1997 (as part of the Taxpayer Relief Act), is whether the long term tax benefit of the Roth outweighs the current year tax benefit of the Traditional IRA or employer retirement plan.

Applying the government’s own logic, the taxpayer should be wary about decreasing current income by increasing current tax expenses. On this question, the government favors current income.

As a planner, one of the more interesting parts of the job is helping guide people through the “To Roth, or not to Roth” question. There are no one-size fits all answers. There is a mathematical component to the solution, but there’s much more to it than that.

People have value systems wrapped around their financial decisions, and where there are values there are emotions. The hard part is knowing when the emotional commitment to a value system might be at odds with a person’s financial well-being.

If you have questions about how you are managing your taxes, or what kind of accounts might be of most benefit to your financial health, we’d love to hear from you.