On December 23, while most of us were beginning to celebrate the holidays the president signed a massive $1.7 Trillion Omnibus bill to fund the government. Tucked away in this 4,000 page bill were significant changes that will impact retirement savers known as Secure Act 2.0. While there were many changes in the new law today I will be focusing on the enhancements to the Roth IRA.
As always, I will point out that an early-retired financial planner’s blog isn’t the place to get specific tax and investment advice. I hope this will be helpful for you as a starting point for further research on your own and/or consultation with your CFP or CPA. I also will not be addressing the decision to invest in a Roth vs. a traditional pre-tax retirement plan in this post. Depending on your individual situation, it may make more sense to invest in a pre-tax account.
Why a Roth IRA?
First, a quick brief on the Roth IRA. For those already familiar with the Roth, feel free to skip this section and get right into the new changes and strategies:
One of the first things I did when I started my first career job was to open a Roth IRA. Roth IRAs had been introduced only a couple of years earlier in 1998 after the passage of the Taxpayer Relief Act of 1997 and are named after Delaware Senator William Roth. This initial Roth IRA investment has compounded tax free for over 20 years!
The Roth IRA allows you to invest after tax savings into a retirement account. Those funds can then grow without being subject to taxation and at retirement can be withdrawn tax-free after you turn 59 ½ and have held the funds for at least five years. In 2022 you were allowed to contribute up to $6,000 into a Roth IRA, and an extra $1,000 if you were age 50 or older. These contributions need to be made from earned income and will phase out at higher income levels ($144,000 Modified Adjusted Gross Income for single filers in 2022).
Higher income investors have other options to supercharge their Roth IRAs through conversions. This involves transferring funds from a traditional retirement plan into the Roth IRA. When converting with pre-tax dollars, such as from a traditional 401k or IRA plan you would owe the tax in the year of the conversion and then the future growth would be tax free. Often a Roth conversion makes sense to do in years when your income will be lower, such as the early years of retirement before required minimum distributions.
There is a strategy called a back door Roth conversion which involves contributing post-tax dollars to a retirement plan that allows it and then converting to a Roth. This is a strategy that high income investors use to get around the income limits. So far the IRS appears to allow this, but as always I recommend consulting with your tax advisor. The new legislation does not make any changes to the back door Roth strategy.
Using the above techniques and planning carefully over a long career it is possible to have most of your retirement funds in a tax free position!
Secure Act 2.0 Roth IRA Changes and Strategies:
With the SECURE Act 2.0 it appears that congress would like to incentivize saving into a Roth IRA. The new law makes several enhancements:
SEP IRAs and SIMPLE IRAs can now accept Roth contributions.
This is great news for self-employed professionals and small business owners who will now have a direct way to contribute significant amounts into a Roth. For example the 2023 maximum SEP contribution is $66,000. I may need to start a business so I can fund a SEP!
Strategy: If you’re currently contributing to one of these plans on behalf of yourself or your employees, consider adding a Roth option. It may take a little while for the custodians to update their systems and processes to accept Roth contributions so this may be something best addressed later in the year.
Employer matching contributions can be made into a Roth 401k.
Previously, even if the employee was directing funds into a Roth 401k, the employer match would be made with pre-tax dollars. Now there will be an option for the employer to contribute after-tax dollars into the participant’s accounts.
Strategy: Consider if you would be better served with a Roth match. This would mean that taxes would be owed on the amount your employer is putting into the plan. It is important to note that having a Roth option is not a requirement. It will be up to your employer if they add this feature to your plan.
No Required Minimum Distributions (RMDs) for Roth 401ks.
One advantage of the Roth IRA is that unlike the traditional pre-tax retirement plans there are no RMDs required at age 72 (moving ultimately to 75 as a result of this same law). Previously, Roth 401ks did have RMDs, which compelled many investors to roll over their Roth 401ks into a Roth IRA. With SECURE Act 2.0 Roth 401ks will have the same RMD treatment as Roth IRAs.
Strategy: The playing field has been leveled between Roth IRAs and 401ks. You can now evaluate whether it makes sense to stay with your employers plan or roll over to a Roth IRA based on other factors such as cost, investment selection, and service.
More time before Required Minimum Distributions on traditional pre-tax retirement plans.
While this change isn’t directly related to the Roth, it could have a significant impact on your ability to get more funds into your Roth IRA. The SECURE Act 2.0 changes will phase in so that eventually RMDs will need to be taken starting at age 75 for anyone born after 1960. This is an increase from age 72 previously.
Strategy: A common strategy is to do partial Roth conversions in the years after retirement and prior to required minimum distributions. Without your employment income you will likely find yourself in a much lower tax bracket during this phase of life. With careful tax planning and enough years you may be able to move a significant amount into the tax-free Roth IRA while paying taxes on these funds at a lower rate than if you had converted while working or after having to also take taxable RMDs.
With an extra three years this strategy will be more compelling for many retirees!
Transfers of 529 college savings plan funds into a Roth IRA.
This is the big SECURE Act 2.0 change that has gotten significant attention. While there are many limits, this new option should make for some interesting strategies between college and retirement planning.
A 529 plan can be thought of as a Roth IRA for college funds. They do have many differences, but the tax treatment is similar (after-tax contributions and tax free growth if used for college). Secure Act 2.0 allows for transfer of unused college funds into the 529 beneficiary’s Roth IRA under the following conditions:
- The 529 plan must have been established at least 15 years and only funds contributed more than 5 years ago are eligible.
- The annual amount that can be transferred equals the current Roth IRA contribution amount ($6,500 in 2023). Importantly, this also counts as the Roth contribution for that year. So, you couldn’t transfer $6,500 from a 529 and also make a $6,500 contribution from earned income.
- There is a lifetime maximum transfer of $35,000.
Potential 529 to Roth IRA Strategies.
Given the combination of the long time-frame and relatively low limits you may be wondering what is the big deal? This is something that will benefit people who do long term careful financial planning. Retirement planning and college funding tend to be two of the biggest financial goals and this change will allow increased flexibility when considering the tradeoffs between the two. I can see a couple of scenarios where there could be significant benefits for long term planners.
Strategy #1: The first is the often heard advice that retirement savings should come before college savings. After all, there are loans for college, but no one will be making you a loan for your retirement. With the 529 plan, there can be a concern on the part of parents who would like to save for their child’s education that if they “over-fund” the plan and the child ends up not needing the money for college (either due to scholarships, choosing a lower cost education, or not going to college at all) the funds would then be trapped in the 529 plan. With the option to move the funds to the Roth IRA of a parent1, perhaps near to their own retirement, this could encourage putting more funds into the 529 plan in the first place.
Strategy #2: Another option for wealthy families thinking about legacy planning would be to supercharge their children’s start to retirement savings. In this case the parent would purposely “over-fund” the 529 plan with the idea that $35,000 will ultimately end up in the child’s Roth IRA. These transfers could happen early in the child’s career or even while they are still in school. A legacy minded grandparent could do this as well. This would allow for a great start on compound growth for retirement!
There were several other non-Roth related changes in the SECURE Act 2.0 which I may get to in a future post. Hopefully these initial Roth IRA strategies are helpful. As time goes on I’m sure even more strategies will emerge for retirement investors to manage their tax situation and move closer to realizing their retirement goals.
1 The specific rule is that the funds must transfer into the beneficiary’s 529 plan. Because 529 plans allow beneficiary changes it appears the beneficiary could be changed from the student to a parent prior to transferring the funds from the 529 to the parent’s Roth. I can’t find anything that says you can’t do this although it may be against the intent of the legislation and should be watched closely. It would be wise to wait for clarification from the IRS or congress prior to implementing this strategy.
