If you have not already done so, now is a great time of the year to review your current company 401k plan elections. Although most employer plans now allow changes to elections and contributions at any time, year end seems like an ideal opportunity to evaluate and plan for 2017. One important question to answer is if your employer 401k plan has a designated Roth option, and if so, how can you best take advantage of it.

What Is a Designated Roth 401k Account?

A designated Roth account is a feature in a 401(k), 403(b), or governmental 457(b) plan that allows employees to designate some or all of their elective deferrals as designated Roth contributions rather than traditional, pre-tax elective contributions. In other words, you are splitting your elective deferral into two buckets instead of the one traditional account. Roth designated contributions will be included in your gross income for the year, where traditional contributions are not.

The Benefit of a Roth Designated Account

The main benefit of a Roth designated account is that funds placed into the account can grow without ever paying taxes on the gains. The starter funds must be earned income with the income taxes already paid on them. At retirement, you will be able to withdraw all of the funds for your use and no taxes will be due upon them. In contrast, monies placed into a traditional 401k consist of salary deferrals on which taxes have not yet been paid. When you retire and withdraw these funds, you will need to pay income taxes on the amount taken out at your then current tax bracket.

Both Roth IRA’s and Roth Designated 401k accounts have a five year holding period in order to obtain the tax benefits. If you withdraw money out of your Roth account before the five year waiting period is up, any earning you made up to that date must be included in your gross income. This negates the advantages of why you used a Roth in the first place, so holding for five years is critical.

401k & the Designated Roth Option

If your company does offer a Roth designation, not only can you begin to contribute to the Roth next year, but the IRS also allows you to take some of the current money you have in your traditional 401k and convert it to the Roth. However, whatever amount you swap into the Roth will be added to your gross income for the year you make the switch. For example, if you have $100,000 in your 401k and would like to allocate 10% into a Roth 401k, you will need to pay income taxes on the $10,000. Your 401k plan administrator will send you a notice at tax time to include the $10,000 in your gross income. From that point on, the $10,000 will grow tax free and gains also will be tax free upon withdrawal in retirement.

The Roth feature of your 401k can come in handy for high income earners who are not eligible to open a Roth IRA. There are no income restrictions on employer Roth designated accounts. However, the contribution limits for 401k’s do apply. The total of your traditional and Roth contribution is limited to $18,000 for 2017. If you are age 50 or older, you can make a contribution of up to $24,000 to your 401(k), 403(b), or governmental 457(b) plan consisting of $18,000 regular and $6,000 catch-up contributions.

Splitting your 401k into two buckets, taxed and untaxed allows for a lot of flexibility. While your account is growing, you can allocate more aggressive, high growth investments, such as equities, to the Roth portion. These can grow with the anticipated faster gains and be distributed back to the employee without paying any taxes on the growth. More conservative assets that are designed to balance out the portfolio, and which appreciate at slower rates, can be held in the taxable portion.

Questions About Opening a Roth Account? Geier Asset Management Can Help

If your company offers it, take advantage of a Roth designated account. Try to allocate at least a small amount of taxed contributions to the Roth every year. Over time, these amounts will grow significantly and will be a most welcomed benefit to you in retirement.

Please feel free to call Geier Asset Management if you have any questions about the Roth designated 401k account. We can help you prepare for the questions you may have for your Human Resources department and can walk you through some of the more complicated aspects.

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© Geier Asset Management, Inc. December 2016. The above blog reflects the opinions of Mr. Geier and not necessarily the firm. Any advice given is general in nature and investors must consider their own individual circumstances. Past performance is no indicator of future performance. The firm makes no warranties or representations of any kind relating to the accuracy or timeliness of the information provided.