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Hierarchy of Payroll Deductions

An advisor asked, “I’ve run across the client situation where an individual’s paycheck is too small to handle all the mandatory deductions or withholdings (e.g., payroll taxes, health insurance premiums, FSA contributions, life insurance, garnishments for child support and taxes, repayment of qualified loans, union dues, elective deferrals to a 401(k) plan, etc.) Is there a hierarchy of deductions that a payroll department should follow?

ERISA consultants at the Retirement Learning Center (RLC) Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, and Social Security and Medicare.  We bring Case of the Week to you to highlight the most relevant topics affecting your business. A recent call with a financial advisor from California is representative of a common inquiry related to withholding on payroll.

Highlights of the Discussion

First, check to see if the employer or payroll processor have a written policy. With respect to 401(k) salary deferrals, you could check the governing plan documents to see if there is a written policy (although few plans contain such information).

If no policy exists, it is best to put one in place. ERISA does not prescribe a hierarchy of withholding, neither is one specified in federal tax law. For guidance, it would be prudent to discuss the issue with a tax attorney. For reference, here’s one example of withholding order that applies to Federal civilian employees issued by the United States Office of Personnel Management.

Generally, payroll deductions are either mandatory or optional. Mandatory deductions would include those identified under federal, state, and local law. An employer is legally obligated to collect this money and remit it to the proper authority. Optional deductions, on the other hand, are voluntary, and an employee must provide written authorization to have such amounts withheld from a paycheck.  Notice that 401(k) salary deferrals are akin to Thrift Savings Plan deferrals and, therefore,  are considered “optional.”

Conclusion

If an employer does not have a policy regarding the hierarchy of payroll withholdings, a best practice is to put one in place with the help of a tax advisor, and apply it consistently.

 

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Is Congress Closing the Backdoor to Roth IRAs?

An advisor asked: “Is Congress Closing the Backdoor to Roth IRAs?”

ERISA consultants at the Retirement Learning Center (RLC) Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, and Social Security and Medicare. We bring Case of the Week to you to highlight the most relevant topics affecting your business.

A recent call with a financial advisor from California is representative of a common inquiry related to Roth conversions.

Highlights of the Discussion
Potentially, yes, as well as restricting other Roth conversion strategies. As part of the tentative measures to help fund the proposed $3.5 trillion budget reconciliation package (a.k.a., Build Back Better Act ), the House Ways and Means Committee has suggested, among other tactics, restricting “back-door Roth IRAs,” a popular tax-reduction strategy where individuals convert traditional IRA and/or retirement plan assets to Roth IRAs. If enacted as proposed, after-tax IRA and after-tax 401(k) plan conversions would be eliminated after 12/31/2021. For amounts other-than after-tax (i.e., pretax assets), traditional IRA and plan conversions for taxpayers who earn over the following taxable income thresholds would cease after 12/31/2031:

• Single taxpayers (or taxpayers married filing separately) with AGI over $400,000,
• Married taxpayers filing jointly with AGI over $450,000, and
• Heads of households with AGI over $425,000 (all indexed for inflation).

The buildup of Roth assets can be a source of tax-free income later if certain conditions are met. Ending Roth conversions using after-tax contributions in a defined contribution plan or IRA, and restricting Roth conversions of pre-tax plan or IRA assets would materially limit many taxpayers’ ability to accumulate Roth assets in a tax-free or tax-reduced manner.
You won’t find the phrase backdoor Roth IRA in the Internal Revenue Code or Treasury regulations. Nor is it a specific product, but the industry has known about the phenomena for years. A backdoor Roth IRA is merely a series of transactions or steps an individual can take to have a Roth IRA—regardless of income level. While initially poorly understood and lacking clear IRS guidance, so called “back-door Roth IRAs” have been legitimized over the years by the IRS.

The ability to make a 2021 Roth IRA contribution is phased out and eliminated for single tax filers with income between $125,000-$140,000; and for joint tax filers with income between $198,000-$208,000. Consequently, if a person earns too much, he or she cannot make a Roth IRA contribution directly (i.e., through the front door). But many can still take another route—by converting traditional IRA or qualified retirement plan assets, a transaction that has become known as the backdoor Roth IRA.

Congress repealed any income limitations for Roth IRA conversions in 2010. Consequently, regardless of income level, anyone could fund a Roth IRA through a conversion. For example, if a person exceeds the income limitation for contributions to a Roth IRA, he or she could contribute amounts (deductible or nondeductible) to a traditional IRA based on earned income and, shortly thereafter, convert the contribution from the traditional IRA to a Roth IRA. Similarly, a person with a 401(k)-plan account balance could convert eligible plan assets either in-plan to a designated Roth account (if one exists) or out-of-plan to a Roth IRA through a plan distribution. Assets that are taxable at the point of conversion would be included in the individual’s taxable income for the year. Going forward, earnings would accumulate tax-deferred and, potentially, would be tax-free upon distribution from the Roth IRA. Under the authority of IRS Notice 2014-54, a qualified plan participant can rollover pre-tax assets to a traditional IRA for a tax-free rollover and direct any after-tax assets to a Roth IRA for a tax-free Roth conversion.

Conclusion
Plan participants and IRA owners need to be aware that as part of the 2021 budget reconciliation process, the ability to convert assets to Roth assets may be sunsetting. If revenue-generating provisions of the Build Back Better Act are enacted as currently proposed, Roth conversions of after-tax IRA and after-tax 401(k) plan assets would be eliminated after 12/31/2021; and Roth conversions of pre-tax IRA and plan assets would cease after 12/31/2031.

Click here for an RLC webinar on the proposed changes.

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