Why More Employers are Offering Roth Options: SECURE 2.0 and Beyond

by Prof. Robert Bloink and Prof. William H. Byrnes

While Roth 401(k)s have been around for a long time, it’s widely expected that many more employers will start offering the option given the SECURE Act 2.0’s mandate that higher-income taxpayers classify catch-up contributions as Roth contributions. That means advisors should expect an uptick in questions surrounding the Roth 401(k) retirement savings vehicle—namely, questions regarding rollovers and conversions. Today’s high-inflationary environment may be a great time to execute a Roth conversion and create a source of tax-free retirement income. Clients with Roth 401(k) balances may also wish to roll those balances into Roth IRAs when leaving employment. The rules governing Roth conversions and rollovers can be complicated and it’s important for clients to understand how to maximize these planning opportunities in today’s climate.

Tax Treatment of Roth 401(k) Rollovers

It may seem like it would be fairly simple to roll over Roth 401(k) funds into an individually maintained Roth IRA. After all, the two types of accounts share the same tax treatment. In reality, there are many several often-misunderstood rules that apply.

The tax treatment that applies to distributions will first hinge on whether the Roth 401(k) distribution was qualified or not qualified. A Roth 401(k) distribution is qualified if (1) the owner was at least 59 1/2 or disabled and (2) at least five years have passed since January 1 of the year the owner made their first Roth contribution to the employer’s plan (whether via direct contribution, in-plan conversion or rollover). Contributions to other Roth accounts don’t start the clock with respect to any other account.

If the distribution is qualified, the entire amount that was rolled over can be withdrawn tax-free (including earnings). Earnings after the rollover are only tax-free if a separate five-year holding period is met. The IRA holding period requirement is satisfied when five years have passed since the date the owner made a contribution to any Roth IRA. If the five-year Roth IRA holding period is not satisfied, the earnings generated after the rollover are taxable.

If the original Roth 401(k) distribution is not qualified, the earnings (both pre- and post-rollover earnings) can only be withdrawn tax-free if the Roth IRA distribution is qualified (meaning (1) the owner was at least 59 ½, disabled or using the funds for a first-time home purchase and (2) five years have passed since their first Roth contribution). It’s also possible that a 10% early withdrawal penalty may apply.

Is Now a Good Time to Execute a Roth Conversion?

When traditional retirement funds are converted to a Roth account, the entire amount converted is subject to ordinary income taxes. Many individuals attempt to time Roth conversions based on predictions about their future income levels and changing tax rates over time. Of course, tax rates today are at a historic low—and we have no way of concretely knowing whether those rates will be extended past 2025. We also know that prolonged inflation is putting a strain on many individuals.

That said, a high inflation environment is actually positive from a tax standpoint. Every year, the tax brackets expand, while the tax rates themselves remain the same. When inflation is high, these cost-of-living adjustments are more substantial. Many lower tax brackets are now much wider than they were just a few years ago.

Because of the marginal nature of the tax code, that means that more of a taxpayer’s income is taxed at the lower rates. In the context of Roth conversions, that means it may be possible for a taxpayer to convert more funds at the lower rates.

For example, in 2025, the 24% tax rate applies to income between $206,701 and $394,600 for joint filers. A couple with a $300,000 income level would have $94,600 left in the 24% bracket. The couple may wish to execute a Roth conversion to “use up” the rest of their 24% bracket. Waiting until a future year to convert could mean that more of the converted amount would be taxed at a higher rate.

Conclusion

The rules governing Roth accounts are nuanced and can be incredibly challenging. These accounts are also extremely valuable in giving individuals an option for controlling their tax rates in the future. With access expected to become much more widespread, understanding the rules is critical to minimizing taxes and avoiding penalties.

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