Roth Conversions Part of the Tax Diversification Tool Belt

Under IRS guidance, participants can select to convert their entire pre-tax balance or a portion of it; they often have a lot of questions about the right amount to convert, and when to make the move.

Roth defined contribution (DC) retirement plan accounts have seen a surge in interest, especially with retirement plan sponsors, since their introduction in 2001.

According the 2017 PLANSPONSOR Defined Contribution Survey, 68.5% of plan sponsors offered Roth accounts in 2017, compared to 52.4% in 2013.

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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.

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. The 2017 PLANSPONSOR Defined Contribution Survey found 41.2% of plan sponsors offered an in-plan Roth conversion.

“A Roth conversion involves taking assets that have been contributed on a pre-tax basis and just like it sounds, converting them into Roth dollars,” says Meghan Murphy, vice president of Fidelity Investments. “But, in the process, that means you have to take taxes within the year that you complete the conversion on that dollar amount.”

Participants can select to convert their entire pre-tax balance or a portion of it. According to Murphy, most participants will choose a specific dollar amount, in order to promote tax diversification in retirement. Additionally, Jana Steele, senior vice president and defined contribution consultant at Callan Associates, says taxes can play a part in considering the amount of money to convert.

“If you’re going to convert your entire balance, depending on what that balance is, [taxes] can be a significant amount,” she says.

Once participants complete a conversion, they are issued a record of the conversion amount to be included as income for that year, says Murphy. Going forward, dollars converted will be treated as Roth dollars in any earnings of that money, and as long as the cash remains invested for five years (meaning no distributions from the account can be taken), it will stay tax-free for retirement.

Roth DC plan accounts can serve as a notable benefit for participants within a lower tax bracket than they expect to be in the future, since these taxes would be paid now rather than higher taxes in years to come. Furthermore, Steele says smaller taxes are dependent upon legislation, including the recent joint Tax Reform bill reported in December of last year. 

“It depends how much legislation changes over the next couple of years, but the way the tax cut bill was written in December, the individual tax rates will increase over five years, which means that participants know they’re paying a lower tax rate now than in the future,” she says.

As the money grows within the Roth DC plan account, participants will need to be aware of its requirements. Whereas distributions for a Roth IRA can be made at any point, if participants want a penalty-free distribution from Roth DC plan accounts, there are specific requirements.

Steele explains, “In order to take a qualified distribution from a Roth, and take advantage from the tax efficiencies, you have to leave the money in the plan for at least five years, and you have to be older than 59 and a half.”

Considerations for plan sponsors

For those plan sponsors who are considering a Roth feature in their plan’s design, Steele says they must amend their plan document and update their summary plan description (SPD). She recommends implementing a strong education blast aimed towards participants, given the complicated benefit.

Even before adding the feature, Steele suggests plan sponsors run a “test” to understand its impact towards deferrals being made into the plan.

“We’d recommend doing a cost-analysis, or a cost review in order to understand if there’s going to be any implications to the actual cost to the plan, and if there are going to be any implications to [discrimination] testing from ongoing Roth contributions,” she says. Unlike other after-tax contributions made by participants, Roth contributions are included in the actual deferral percentage (ADP) test and not the actual contribution percentage (ACP) test.

Having an understanding about how conversions will impact the plan gives plan sponsors an idea about how to work the amendment, Steele says. Other considerations include available sources [of assets] for Roth in-plan conversions, timing of availability to convert amounts and what the recordkeeper can accomplish. The plan can permit amounts in pre-tax, match, after-tax and/or profit sharing accounts to be converted.

“Not all recordkeepers can administer the Roth in-plan conversions with the same degree of flexibility, so [plan sponsors] may be curtailed somewhat depending on who their recordkeeper is,” she says.

Murphy says that from a recordkeeping standpoint, plan sponsors should focus on the operational process associated with Roth, since it impacts taxes.

“We would always explain the process and how long it would take, for the most part, and we work with employers on communicating how it works with their employees,” she says. “We would want to develop a campaign where employees are aware of their options and that they’re getting the education they need to make the right decision for them.”

Educating participants about Roth accounts

Given its confusing nature of Roths—not only in the conversion process—Murphy recommends plan sponsors educate their employees about Roth as a whole. 

“Roth is one of those areas that we always advocate for more education,” she says. “Not only about Roth conversion, but Roth in general.”

Steele says that typically, plan sponsors would apply larger educational campaigns focused on displaying the features’ availability, explaining how it is used, and what it means. However, she believes applying personalization and customization tactics can influence greater impact.

“By providing the specific account balance or the different types of sources that the participant currently has in the plan, that helps the argument because it becomes a more intimate conversation rather than a less specific blast that doesn’t address the participants or their current needs,” she says.

Murphy agrees, adding that it all boils down to understanding participants’ needs.  

“A lot of it goes back to knowing your employees,” she says. “Targeting communications to people who may be interested. Getting the right message to the right person.”

DISRUPTION: AssetMark Executive on Outsourcing and Practice Growth

Matt Matrisian, SVP of strategic initiatives at AssetMark, is passionate about the topic of advisory practice management, enough so that he wrote a 300 page book on the subject; chatting off-the-cuff with PLANADVISER, he argues outsourcing is the way of the future.

Matt Matrisian is an advisory practice management expert and senior vice president of strategic initiatives for AssetMark, a financial services technology firm dedicated to supporting the adviser industry through outsourced investment management and practice support capabilities.

In the role, Matrisian provides leadership and oversight to AssetMark’s Practice Management, Digital Channels, and Strategic Initiatives teams. Through these, he leads the development of thought leadership and digital resources to support advisers and their businesses in areas such as sustainable growth, mergers and acquisitions, human capital, and technology.

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Recently, Matrisian sat down with PLANADVISER to continue our “DISRUPTION” series, aimed at examining pressing practice management and client service challenges facing defined contribution (DC) plan and wealth advisers in the marketplace today. In particular, Matrisian is quite a strong advocate of advisers outsourcing the processes surrounding portfolio management, but he says there are quite a few other opportunities to benefit from outsourcing as well.

PLANADVISER: Given your interest in practice management topics and the subject of outsourcing, it makes sense that you would have joined up with a firm like AssetMark. Can you explain your role at the firm and how your team interacts with advisers on a daily basis?

Matt Matrisian: I have been with AssetMark for a little more than eight years now, and currently my responsibility extends over our business consulting team, which includes our advisory practice management team of consultants working out in the field. They all report up to me, and we drive a lot of thought leadership for the company. Today, much of our time is spent doing consulting with independent registered investment advisers (RIAs). We try to help them with best practices, whether that is around human capital, business management, operational efficiency, or branding and marketing.

Overall, there are many different discussions we find ourselves having in the marketplace when it comes to outsourcing and practice efficiency; it depends a lot on the nature of the adviser and the firm with which we are speaking. In an important sense, however, a lot of the conversations we have are similar, because they are about advisers contemplating major behavioral changes they may have to make in the near- or mid-term future.

Frankly, there have not been all that many new concepts or new ideas to emerge in practice management over recent years—but what is clear is that advisers need help understanding what these concepts mean for their daily work and their practice offerings and team structure. To the extent that advisers buy into these behavioral changes, moving away from investment processes in favor of client relationship management, they will see significant changes in their business. A lot of people use the analogy of fitness and working out—we all know what will make us healthier, but that is not enough. You need to embrace the lifestyle and make behavioral changes. The same is true when it comes to advisory firms and how they think about the future; the evidence is pretty clear for what works to promote growth and what does not.

PA: And when you are talking with advisers out in the field, are they struggling to grow? Do they see outsourcing as a means to achieve new efficiency and better growth potential?

MM: The picture is actually pretty complicated. What we are seeing from an increasing number of advisers is that they are not necessarily growth challenged. Rather, I should say, those advisers that really want to grow and who put in the necessary effort are in fact seeing strong success in gathering new assets. Much of this growth is coming from the rollover market and from referrals, I would say.

Now, when I say not all advisers want to grow, what I mean is that there are clearly advisers out there who are still more comfortable in what you can call a ‘lifestyle practice.’ They are not actively going out to beat the bushes expeditiously, so to speak, and they are not seemingly concerned with building out great scale in their business. Other advisers are actually focused on growth and are trying to accelerate growth in their business, and they are having success in a couple different ways.

One, as you would expect, they are leveraging their referral networks. Two, they are creating a voice in the marketplace, perhaps through social media channels and by leveraging digital thought leadership components—or even through traditional presentations. Our conclusion is that, any time good advisers get in front of prospective clients, we see they have a real chance of winning new business. The third growth engine is that more advisers are focused on the rollover market. We are seeing advisers being able to leverage their 401(k) and plan sponsor relationships with great effect, even as the regulatory framework is shifting.

Stepping back, though, the bigger issue for a lot of advisers who are focused on growth is how to build efficiency as you grow in scale. We are hearing more and more from advisers that the issue of fee compression continues to come up, putting the emphasis on the efficiency of serving new and old clients alike.

PA: What concerns and points of optimism do you hear from advisers when having this discussion about fee compression, scale and efficiency?

MM: One thing that is clear is that if the adviser doesn’t have a strong value proposition, then the question of falling fees becomes even more challenging for them to address. So we are doing two things in an effort to help these advisers. First we are helping advisers build out and demonstrate their value proposition, structured around a goals-based financial planning approach. And then, of course, we are focused on helping them add value to the client relationship through quality service support. We see clear evidence that when advisers can do both of these things effectively, add value and demonstrate the value, they can achieve strong and sustainable growth.

That being said, the advisers that are more investment-planning centric, their fee structure is starting to be compromised the most, alongside the commoditization of access to quality investments and model portfolios. From this perspective, we are seeing real fee compression going on. It is creating major challenges for advisers when they are still focusing their value proposition on investment management.

PA: It sounds like you would strongly agree with industry research reports showing that advisers focusing on ‘client service’ or ‘relationship management’ are proving themselves to be able to grow faster and more efficiently than their peers still focused on the traditional tenants of investment management?

MM: Absolutely. As we are talking with advisers in the field we are constantly touting the positive aspects of outsourcing. Outsourcing is a way for advisers to boost their value proposition from the investment perspective while also securing the operational efficiencies they must build into their business in order to survive profitably for the long term. Especially in the realms of compliance and general operations around investment due diligence and recommendation suitability—all of these are ripe for outsourcing.

Supporting this outsourcing is what AssetMark does at its core, so I am coming at this from a certain perspective, but I believe a lot of advisers will continue to draw the conclusion that outsourcing is becoming a smarter way to go in these areas. We want to help advisers understand what gaps they have in their business, and how do they go about filling those gaps with the right people, the right roles and the right processes. It’s all about getting the proper tools in place, the right CRM solutions and procedures.

If advisers can build proper workflows around the outsourced services, they will be amazed by just how much time and effort they can save on the investing and client service process, freeing up much more time to focus on drumming up new business. Again, the deeper theme across this whole conversation is that advisers have to focus more on relationship management and on defining and proving their value proposition. They must move away from spending time and effort on the repeatable and outsourceable tasks that might previously have been the focus of a traditional advisory business.

PA: And do you find that this messaging around outsourcing is resonating with advisers? What are some of the hang-ups you run into?

MM: There are certainly some. Even advisers that are willing to use a firm like AssetMark, we have found many of them do not want to outsource all the elements that they could or that we would recommend. So, for example, we see a lot of advisers that continue to want to build their own portfolios using our vetted funds and strategies, believing they can add value from the portfolio management perspective. I understand why advisers want to hold on to this process, but honestly the advisers that we see who are truly winning out there in the marketplace go all the way and they are willing to outsource the end-to-end portfolio management process. Instead they are focusing on helping the clients to set and pursue longer-term goals.

In other cases we have seen advisers embrace full outsourcing only for a part of their book of business; say they have outsourced the investment management for only a quarter of their clients. But they still have legacy mutual fund business or they are still doing annuities—these folks don’t get to experience the full benefit of leveraging an outsourced provider. We are trying to educate advisers on the fact that, if they really want to embrace outsourcing and experience the potential benefits, they have to commit strongly. That’s going to maximize your efficiency—not a piecemeal approach.

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