Administration November 18, 2015

Roth Conversions Helpful to Retirement Savings Strategy

There are benefits of converting pre-tax retirement plan accounts to a Roth account, but plan participants, and perhaps even sponsors, don’t understand them.
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“A lot of retirement plan participants don’t even know what a Roth account is, and many that do wish they had known sooner,” says Meghan Murphy, director of thought leadership at Fidelity Investments in Boston.

The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) introduced Roth accounts to defined contribution plans. The accounts allow plan participants to contribute after-tax money to their savings on which they will owe no taxes on qualified distributions. The provision of Roth accounts was set to end in 2010, but the Pension Protection Act (PPA) in 2006 made the accounts permanent.

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The Internal Revenue Service (IRS) issued guidance in 2010 allowing for participants to do an in-plan rollover, called conversions, of pre-tax accounts to Roth accounts upon a distributable event. But, in 2012, it expanded that ability to non-distributable amounts.

Tim Steffen, director of Financial Planning at Robert W. Baird & Co. in Milwaukee, tells PLANSPONSOR the primary reason a retirement plan participant would want to convert pre-tax money to a Roth account is that the tax cost on the amount converted today would be less than the tax cost of distributions from pre-tax accounts later. “Participants must compare the tax benefit during the contribution period to that of the distribution period,” he says.

For example, a high-income individual may decide tax-deferral during his peak earning years is more valuable than paying no tax on distributions during retirement when he will be in a lower tax bracket, Steffen explains. On the other hand, Baird tells younger participants who are entering the workforce and in their lowest earning years, they would probably get a better value by putting retirement savings into a Roth account.

Murphy adds that Fidelity sees younger people doing Roth conversions because they realize they have 30 or more years until retirement and see it as a great opportunity to not have to pay taxes in the future.

NEXT: Rules about Roth conversions

Lisa H. Barton, a partner with law firm Morgan, Lewis & Bockius LLP in Philadelphia, Pennsylvania, notes that, in order for a DC plan participant to initiate a Roth conversion, the plan document must allow for that. She tells PLANSPONSOR, the plan document will specify what amounts can be converted; the plan can permit amounts in pre-tax, match, after-tax and/or profit sharing accounts to be converted.

Even if an account that is already made up from after-tax contributions is converted, the earnings in those accounts that are converted would not be taxable, so there is a tax benefit for every type of account, Barton points out.

Participants can only convert amounts in which they are fully vested. And, the plan document will specify how often participants are allowed to initiate a conversion.

According to Barton, taxes cannot be taken out at the time of the conversion. Steffen explains this is because that would make the converted amount an early withdrawal, subject to a penalty. Murphy adds that the recordkeeper provides a statement to participants at year end and they report the converted amount as income with their annual return. Fidelity always tells participants who want to initiate a conversion that they should consult with a tax adviser before making a move that would impact income taxes.

When offering the ability to do Roth conversions, plan sponsors should consider what their recordkeeper can handle and what the recordkeeper requires, Barton says. “It gets tricky from a recordkeeping perspective.”

She explains that whatever withdrawal provisions apply to amounts before conversion have to apply after conversion—if a withdrawal type wasn’t available for the amounts before, it cannot be afterward, and vice versa—except for hardship withdrawals. In addition, amounts converted must be held in the account for five years starting at the date of conversion before they can be distributed or they will be subject to a pre-tax penalty. These two conditions create the possibility of the recordkeeper having to keep up with several different buckets of money.

Finally, Barton says, participants are not required to get spousal consent to do an in-plan conversion. If a converted account has an outstanding loan, it is treated the same in the Roth account. If the plan is a safe harbor plan, it cannot be amended to add a Roth conversion provision mid-year.

NEXT: What participants need to know

According to Murphy, Roth conversion ability is so much more common among large plans; 1,800 of Fidelity’s clients offer the option. “Normally the option to convert to Roth is being added to the plan because participants are telling plan sponsors they want it, yet a small percentage of participants use the option,” she says.

“There is a big need to educate participants about Roths,” Murphy says. “They already have two choices—how much to save and how to invest—and now they must make a decision about the tax treatment of their contributions. Most people don’t even know what tax bracket they are in.”

She suggests plan sponsors educate participants when the feature is adopted for the plan, upon hire, and during open enrollment. Roth education should also be part of information available to participants through advice programs, and if the plan has an adviser, sponsors should make sure advisers are educating participants.

Participants need to understand whether contributing to or converting to a Roth account is right for them. For participants who are underprepared for retirement or plan to rely mostly on Social Security in retirement, Roth may not be right for them, Murphy explains. And, highly compensated participants who will return to a lower tax bracket in retirement should not convert to a Roth.

Also, Murphy says, participants who have tax concerns already should consider whether they are prepared to add to their tax bill now. Participants need to understand that there is a tax-cost, Steffen adds. He says sometimes they do a large conversion and are taken aback by how much taxes are. He notes that one of the things participant education should highlight is that they don’t have to convert an entire account balance at once; they can do smaller pieces each year.

There are reasons other than tax treatment that participants may consider converting amounts to Roth accounts. Steffen notes that they can avoid having to take a required minimum distribution (RMD) on some of their savings; while money in a qualified retirement plan is subject to RMDs, participants can roll those accounts to a Roth individual retirement account (IRA) upon retirement which is not subject to RMDs.

The allowance of conversions of after-tax amounts to a Roth account may help people put away more money for retirement in Roth accounts. Barton explains that after-tax contributions are not subject to the IRS 402(g) limit on deferrals, but they still are subject to non-discrimination testing, so this may not help some participants put away more savings.

“The decision to contribute to or convert to Roth accounts is really specific to each individual,” she concludes.

Compliance November 17, 2015

Industry Questions Wisdom of Latest PBGC Rate Hikes

One career actuary tells PLANSPONSOR pension plan clients have voiced a range of strong emotions—even a sense of betrayal—after yet another round of PBGC premiums hikes was announced. 
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Following the debate and approval of the Bipartisan Budget Act in recent weeks, sponsors of defined benefit plans are facing the unsavory prospect, yet again, of dramatic increases in Pension Benefit and Guaranty Corporation (PBGC) default insurance premiums.

This newly programed series of increases comes on top of the significant premium hikes plan sponsors have already had to absorb in recent years, says Cammack Retirement Group Managing Actuary Art Scalise. Under the terms of the bipartisan budget accord, PBGC premiums are expected to reach up to $78 by 2019, far higher than they were just a few years ago, and the increased cost has many plan sponsors looking, more and more desperately, for an exit strategy, he says.

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The budget agreement provides that the single-employer fixed Pension Benefit Guaranty Corporation (PBGC) premium will be raised to $68 for 2017, $73 for 2018, and $78 for 2019, and then re-indexed for inflation after that. The variable rate premium would continue to be indexed for inflation, but would be increased by an additional $2 in 2017, and additional $3 in 2018, and an additional $3 in 2019.

Scalise says he has been in his role at Cammack for nearly three years, after spending 16 years working at Aon Hewitt, coming from the Aon side. Throughout that time the PBGC has slowly shifted from being perceived as an ally of the DB system to a major obstacle to its survival.

“It has undoubtedly become more difficult for plan sponsor clients to deal with PBGC premiums and requirements since I joined the industry,” Scalise tells PLANSPONSOR. “Especially in the market where I have had an opportunity to concentrate, which is health care systems, plan sponsors have become increasingly cash strapped. Right now they’re trying to figure out how to continue to fund their DB plan required contributions, which are also increasing on an annual basis. When you layer on the extra PBGC premiums each year, it’s taking a real toll on them.”

NEXT: Third time’s a charm 

Scalise observes this is the third round of announced PBGC premium increases “in something like a four-year period.”

“What’s worse, each time the premium hikes are put forward, they’re presented as the solution that will finally get the PBGC system to be sustainable and prevent the need for further hikes down the road,” Scalise explains. Years of conflicting messaging have left plan sponsors skeptical and embittered, “and they are clearly worried about what has been going on. Heading into the last month when additional increases were announced, PBGC premiums were believed to have been capped for the foreseeable future. The constant changes leave sponsors with no idea about where the DB plan environment is going.”

Also troubling, Scalise says, is the PBGC decisionmaking doesn’t exactly line up with wider market indicators.

“Sponsors have been doing their best at funding the plans, and many are putting in more money than required by law in the interest of getting ahead of the PBGC premiums and in the interest of the health of the plan,” he says. “From that perspective, and when one considers where markets and interest rates are going, I think this latest news took a lot of people by surprise.”

Part of the problem, as with other federal agencies, Scalise says, is that thinking and decisionmaking at PBGC is too closely tied to the current, short-term fiscal and economic environment. For a lot of plan sponsors, and the PBGC by extension, the current environment indeed looks pretty dismal from an asset versus projected liability perspective. But, as Scalise observes, we also know markets have been at historically low interest rates for a long time, and that plans’ funded statuses will almost inevitably bounce back as interest rates climb.

“What’s going to happen when interest rates start to rise for real and the liability the PBGC is reporting starts to dwindle significantly?” he asks. “What happens if rates rise enough to get plans close to 100% funding, what are you going to do with any excess monies? Do they refund it? Do they give credits to the plans somewhat? We don’t know what they will do.”

NEXT: The industry agrees

On Tuesday The Pension Coalition—which represents the pension-related interests of financial industry associations and individual companies across all major economic sectors—sent an open letter to lawmakers and the PBGC echoing many of Scalise’s arguments.

The letter urges lawmakers and regulators “to protect job-creators, workers, retirees, and their retirement security by opposing any further increases in premiums paid to the PBGC by sponsors of single-employer defined benefit plans.” It argues the recent premium increases “come on top of nearly $17 billion in premium increases already imposed over the last three years. In that same time, Congress has almost doubled the flat rate premium from $35 per participant to $64 per participant. The variable rate premium has also tripled from $9 per $1,000 of underfunding to $30 per $1,000 of underfunding.”

Annette Guarisco Fildes, president and CEO of the ERISA Industry Committee (ERIC), which is a founding member of the Pension Coalition, agrees that large employers have worked very hard in recent years and historically to create benefits plans that offer their employees the best options for their future.

“Increasing premiums only serves to hurt those employees and employers participating in defined benefits plans,” she says. “The most frustrating thing about this latest hike is that the PBGC’s own analysis does not call for an increase in premiums on single-employer defined benefit plans.”

National Association of Manufacturers Director of Tax Policy Christina Crooks highlights the fact that businesses are clearly already struggling with PBGC premium increases enacted over the past few years, “with nearly half of that amount being paid by manufacturers.” The additional premium hikes in the budget deal equate to a tax on employers, she adds, diverting dollars away from funding participant benefits, creating jobs and growing the economy.

The letter also argues that counting increased PBGC premiums as general revenue for purposes of budgetary scorekeeping is inconsistent with good governance and does not strengthen the nation’s retirement system. By law, PBGC premiums go directly to the PBGC, not to the Treasury and can only be used to pay benefits to plan participants and beneficiaries.

Read the Pension Coalition’s letter on ERIC’s website here.

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