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Roth 401(k) - New Benefits

Combining a 401(k) with the benefits of a ROTH can be very powerful, especially for those in the top tax brackets. In addition to the many benefits of a ROTH 401(k), the recently enacted American Taxpayer Relief Act (ATRA) adds one more reason to take a closer look at this strategy.

A Roth 401(k) has many of the same benefits of a Roth IRA (see whitepaper – Roth IRA in an increasing Tax World), but with some added twists. Contributions to a Roth 401(k) are on an after-tax basis which means you get no immediate tax benefit from the contribution. However, all growth of the investments inside the Roth 401(k) is tax-deferred. Even better, when the monies are pulled out at retirement, they are free of federal income tax (and in most cases free of State tax as well). In order to receive tax-free “qualified” treatment, distributions must occur five years after the Roth 401(k) was initially established. (A 10% penalty may apply if certain rules are not followed.)

Employee contributions to a Roth 401(k) are limited to $17,500 in 2013. This is the same limit available if contributing to a regular 401(k). If your employer matches your contribution, you will still receive the match, but it will be a regular 401(k) matching contribution. That means you will have two accounts within your 401(k): a Roth account you’ve contributed to and a regular pre-tax account contributed by your employer. This distinction between the two accounts is important to note before taking distributions or rolling over funds to another account.

A Roth 401(k) has an advantage over a Roth IRA in that it has no contribution limits. Many high income earners cannot contribute to a Roth IRA because the eligibility completely phases out at $188,000 of modified adjusted gross income (MAGI) for joint filers (and $127,000 MAGI for single filers). To be fair, Roth IRAs do have an advantage over Roth 401(k)’s because required minimum distribution (RMD) rules don’t apply to Roth IRAs. However, there is a fairly simple way to avoid this limitation that we will talk about next.

The American Taxpayer Relief Act (ATRA) of 2012 changed an import rule concerning Roth 401(k) accounts. Pre-Act, you could only convert an existing regular 401(k) to a Roth 401(k) after becoming eligible for a “distribution”. This usually occurred as a result of attaining a certain age or leaving the company. Now, thanks to ATRA, a 401(k) participant can convert his/her regular 401(k) to a Roth 401(k) at anytime. However, keep in mind tax will be due for the year you convert a pre-tax account to a Roth. Depending on the potential tax impact it may be a smart choice to convert over several years. This spreads out the tax burden and potentially avoids pushing you into a higher tax bracket (please consult your tax expert before making any retirement account conversion).

Converting your regular 401(k) to a Roth 401(k) means future growth remains untaxed and distributions (if taken as “qualified” distributions) will be tax-free. At retirement you can roll your Roth 401(k) into a Roth IRA and never be subject to the RMD rules. Meaning you don’t have to take the money out of the account if you don’t need it. The account can be inherited and stretched out (paid out) over the life of your heirs.

Converting to a Roth 401(k) is good choice for someone that believes they will pay higher taxes later when they begin to take the money out. Remember, it’s not just a higher tax bracket that can result in higher taxes, but a limitation on deduction, adjustments, and exemptions too. Given the US Government’s and the States’ fiscal situation, higher taxes are a good bet.

Let’s take a look at an example of a 50 year old that is currently paying an effective tax rate of 31% but expects to be paying higher taxes in retirement. As a result of tax increases, let’s assume in retirement she will be paying an effective tax rate of 42% (State taxes are no part of this example).

Roth conversion within her 401(k) today that is worth $250,000 would result in tax of $77,500 (assuming all contributions were pre-tax). Let’s assume that the $250,000 grows to $690,000 at retirement (approximately 7% per year). For comparison purposes, assume she did not convert her 401(k) and at retirement she withdrawals all $690,000. After taxes she would net $400,200. In order to make a comparison, we must add back the opportunity cost of the $77,500 used to pay the Roth conversion tax to the $400,200. The growth of the $77,500 plus the after-tax $400,200 still falls short of the tax-free amount of the Roth 401(k) at retirement by $75,800.

The bottom line is if you believe that you will pay more taxes later than now, conversion to a Roth within your 401(k) make sound financial sense. Plus, ATRA allows high income earners to make the conversion at any time. And if you need one more incentive, converting to a Roth 401(k) and later rolling to a Roth IRA avoids the need to take RMDs potentially preserving assets for children and grandchildren.

Douglas Lyons is a Certified Financial Planner(CFP®) (www.cfp.net) and Chartered Financial Analyst (CFA) (www.cfainstitute.org). Two of the “best designations” as rated by Money Magazine (July 2011 –Advice you can trust).

 Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.


Douglas J Lyons Financial Group does not provide legal, tax or accounting advice.  Any statement contained in this communication (including any attachments) concerning U.S. tax matters was not intended or written to be used, and cannot be used, for the purpose of avoiding penalties under the Internal Revenue Code, and was written to support the promotion or marketing of the transaction(s) or matter(s) addressed.  Clients of Douglas J Lyons Financial Group should obtain their own independent tax advice based on their particular circumstances.

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