Written by Thomas M. Geier, CPA, CFP®, PFS
Since 2006, most employers have been able to offer their employees both a traditional tax deferred 401(k) and a Roth version of the company’s retirement plan. However, data show that many employees do not take advantage of the Roth option, for a few reasons:
- First, they may not understand what a Roth 401(k) is and the potential benefits.
- Second, they may be in their peak earnings period and high tax bracket, and wish to get the full tax deferral benefit of the traditional 401(k).
- Third, these employees may not have any extra dollars to add to the Roth option.
Main Benefit of Roth IRA & Roth 401(k)
The main benefit of the Roth IRA and Roth 401(k) 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 401(k) 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. Therefore, Roth accounts are an extremely attractive option for younger investors and those in a low tax bracket.
Moving Funds Between the Two Accounts
The IRS has published some guidance recently on how monies held in a 401(k) may be split between a traditional designation and a Roth designation. The great news is that you can take a percentage of your traditional 401(k) and move it into a Roth. This is advantageous for those investors who are above the income limits for contributions to a Roth IRA , have built up sufficient amounts within their traditional 401(k), and want the tax advantages of a Roth account.
You will need to pay any income taxes on the amount moved, however. For example, if you have $100,000 in your 401(k) and would like to allocate 10% into a Roth 401(k), you will need to pay income taxes on the $10,000. Your 401(k) 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.
Some employers have additional features within their 401(k)’s that pay taxed amounts into the plans, such as money purchase plans and ESOP’s. These contributions, or a portion of them, are already taxed to the employee. The IRS allows these employer contributions to be moved into a Roth 401(k), and no taxes are owed on them when moved. Your plan administrator can tell you which features your plan has and what, if any, of your current 401(k) assets are already taxed.
Utilizing Both the Traditional and Roth 401(k)
A good advantage of utilizing both the traditional and Roth designations is that the five year waiting period for tax free treatment of gains for a Roth can be met while the employee is working and accumulating assets in the plan.
Splitting your 401(k) 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.
Rollover into a Roth IRA
Usually, at age 70.5, required minimum distributions must be made from a 401(k). These can be avoided through the Roth 401(k) by a rollover into a Roth IRA. RMD’s are not required to be taken from Roth IRA’s. Therefore, if income is not needed in a certain year, the RMD is not a problem. However, if you rollover your Roth 401(k) into a newly opened Roth IRA, a new five year waiting period starts for non-taxation status.
Roth 401(k)’s allow for management of tax burdens. For example, during retirement, if you are hitting up against the next tax bracket upon normal 401(k) distributions, your income can be balanced between already taxed and untaxed by utilizing the Roth designated portion. You can manage your distributions for Social Security payments, pensions, and rental income. Also, if you need an extra distribution for the purchase of a car or some other spending need, you can take it from the Roth bucket and not have to worry about paying extra income taxes. Most of us can only guess as to what tax rates will be in the future. Being able to access tax free income if rates shoot up will be a huge advantage.
If you have not already done so, ask your employer about the Roth 401(k). You most likely will be able to take advantage of it, if offered, and even qualify for the employer match. Or, if your employer does not match employee contributions, 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 401(k). 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.
For additional information regarding Roth 401(k)’s, check out the Comparison Chart found at the Internal Revenue Service.
© Geier Asset Management, Inc. April 2015. Thomas M. Geier is a Vice President of Geier Asset Management, Inc., a Registered Investment Advisor. 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.