Helping You ‘Jump’ into Your Roth 401(k) with Confidence
Retirement is a time to enjoy the fruits of your labor, not stress about the perils of financial mistakes. No matter if you are 70, 50 or 30 years old, utilizing a Roth 401(k) investment account serves as a fantastic tool to lessen future RMD strangleholds and enhance withdrawal (and tax) strategies down the road.
When you hear the word “Roth” do you immediately do your best David Lee Roth imitation and start singing the Van Halen song “Jump” in your head? No? Just me?!
My GenX brain is transported back to the fourth grade Catholic school fair, playing the penny carnival games including cake walk and gone fishing. I remember winning one of those album print mini-pictures made of glass, which happened to be for the Van Halen album “1984”. It had a baby angel smoking a cigarette. I thought I was SO COOL. Naturally, I always used to think “David Lee” whenever anyone said Roth to me.
When did that change, exactly? I am not quite sure. Probably when I figured out that the smoking angel babies don’t pay taxes. (Oh to be an 80’s child again and not worried about taxes). At some point in the 2000s I grew up and “Roth” assumed new meaning for me.
Don’t Be a One Man Band
Understanding the Roth 401(k) and Roth IRA RMD rules and exceptions offers a valuable planning opportunity for you and your family. Do you know about in-plan conversions and “back-door” Roth IRA options? I’ll save those for another post. But for now…
Need to roll-out your Roth? I can help.
Want some thoughts on WHEN the best time to do this is? I can help.
Need advice on HOW MUCH you should put into your Roth 401(k)? I can help.
Want to avoid other mistakes that might derail your retirement plans? I can help.
Hold Onto Your Hat
Fair warning: I am going to geek out on you for this blog post. I am going to go all finance nerd and talk about strategies for your 401(k) including something called a “Roth” (not the David Lee kind, although similarly bad-ass in nature). It will be joyful for me, but painful for many of you.
But I implore you to please keep reading - I promise you it will be worth it. And the information, graphics and explanations below will likely make your heart sing. Why? Because when it comes to what is likely your largest retirement account, it’s important to understand where your money is going and the tax implications for you now and into retirement.
So without further ado, let me introduce you to one of the lead singers of your retirement ensemble: The (David Lee) Roth 401(k).
What Is a Roth 401(k) Option?
For some eligible individuals, your employer may offer you what is called a Roth 401(k) option. What does this mean and why is it important? It’s critical to understand the rules on Roth 401(k)s and Required Minimum Distributions (RMDs), which should not be a secret, but sometimes it feels like they can be.
If you’re in the lucky group that is offered a 401(k) plan with a Roth option, it’s important to decide whether a traditional or Roth account will be best for you. Generally speaking, those who believe they will retire in a higher tax bracket than they’re earning in today find a Roth account may be beneficial.
Or, if retirement is still quite far away, the investment earned on a Roth account over several decades may make it worth passing over tax breaks now. Either way, it’s a great idea to take a look at your specific earnings and projected future path to best decide which type may be best for you now and into retirement. (Note: I can help you with that)
Traditional 401(k) Versus Roth 401(k)
Just like its 401(k) counterpart, eligible participants can choose whether to partake in a traditional plan or Roth 401(k) plan. While the main difference between the two are the tax advantages, there are a few other important variations to consider as well.
Roth 401(k)
Post-Tax Savings Account
Your contributions are made after they’ve been taxed.
Traditional 401(k)
Pre-Tax Savings Account
Your contributions are made before they’ve been taxed.
Traditional 401(k)
When using a traditional 401(k), you are funding your retirement account with pre-tax contributions. This lowers your taxable income amount, meaning you pay fewer taxes the year the contributions are made.
Roth 401(k)
Alternatively, a Roth account is made using after-tax contributions. That means this type of account does not reduce your income level for the year, and the money added to this account is taxed alongside the rest of your earned income.
However, once you are ready to begin withdrawing from your Roth 401(k) you will not have to pay taxes on the contributions or any earned income within the account. Here’s a simple example from the WSJ. (or BELOW, however please pay special attention to the assumptions, which are (1) your tax rate does not change and (2) your investment triples. We all know real life can look much different than this…)
Rate Debate
Projecting your future tax rates a crucial part of the decision to pick a Roth 401(k). The following example shows that if your income tax rate is the same in retirement as it is when you make retirement contributions, you’d wind up with the same amount whether you contribute to aRoth 401(k) or a Traditional 401(k). As long as you are living, you are not required to begin withdrawing from this account at a certain age – AND HERE COMES THE SECRET – UNLESS it still resides in your 401(k) plan.
Don’t Overpay Uncle Sam
Rolling a Roth 401(k) into a Roth IRA can eliminate required distributions for investors who want their money to continue to grow tax-free. Why is this important? Because no one wants to “tip” Uncle Sam, especially when they are busy enjoying retirement. Why should you care? Because you can take action today to avoid overpaying him later.
Typically when you reach the age of 70.5, a 401(k) or profit-sharing participant is required to start taking taxable withdrawals, also known as required minimum distributions (RMDs). The same RMD rules apply to pre-tax IRAs.
Are you in the lucky minority that also has a defined benefit? Retirement or pension plan benefits must also generally commence by age 70.5. The idea is to get you to draw down your account over your remaining life span. And one motivation is so Uncle Sam can get his share before you die. Lovely thought, isn’t it?
Then Party Like It’s 1984
You don’t have to spend the money, but it has to come out. You can have it reinvested in a taxable account, put it in the bank, under your mattress, whatever, but you cannot funnel it back into the retirement account.
So much money coming at you when you are 70.5! Probably a great year to throw a massive over-priced birthday party for yourself and play Van Halen’s 1984 album. And all that additional income means that Uncle Sam finally gets his share of the tax-free growth you have been enjoying.
Maybe you just don’t need or want that much income at that time. Or maybe these rules will mess with other long-term plans for your money like charitable gifts or leaving money to your family.
Might As Well Jump
Roth IRAs, which consist of after-tax contributions and can generate tax-free returns, do not require RMDs until after the death of the owner or his/her spouse. SAY WHAT?!?! This is a BEAUTIFUL exception to the RMD rules. But be careful! It only applies if the balance is not “housed” in your employer’s 401(k) Plan.
If it is in the 401(k), then your money is subject to those rules, which include RMDs. This means your best option may be to roll it out of your employer plan. In other words…YOU MIGHT AS WELL JUMP. (So, so sorry. I couldn't help myself!)
If a plan participant nearing or over the age of 70.5 has a Roth 401(k) account in a 401(k) plan, the individual can directly rollover the Roth funds to a Roth IRA tax-free.
That’s Right. Go Ahead and Jump
This leaves the Roth 401(k) account with a zero balance, avoiding the RMD rules since a Roth IRA is not subject to the RMD rules. Hooray! This gives you some flexibility in future distributions and you can avoid giving Uncle Sam a major tip if your tax rates are higher in retirement.
For example, Mindy is 69 years old and has $185,000 in her Roth 401(k) plan. If Mindy left the Roth 401(k) funds in the 401(k) plan she would become subject to the RMD rules at 70.5 years old.
However, if Mindy elected to directly rollover the Roth 401(k) plan funds tax-free into a Roth IRA, she would be able to avoid the RMD rules and thus gain the opportunity to continue increasing the value of the Roth account without having to take yearly withdrawals.
By rolling your Roth 401(k) into a Roth IRA, you will avoid RMDs during your lifetime. And if your spouse inherits a Roth IRA, he can roll it over into his own Roth IRA and continue to avoid RMDs. But if a child or other non-spouse inherits your Roth IRA, your heir will have mandatory — but tax-free — withdrawals.
Move Forward with Confidence
If you have a balance in a Roth 401(k), you plan to leave your job or retire, and you have no idea what the hell to do and want to run it by someone, please feel free to give me a quick call. I offer a complimentary 30-minute Discovery Meeting, and would love to help you get into the 80’s groove with your 401(k) decision making.
All investing involves risk, including the potential for loss of principal. There is no guarantee that any investment plan or strategy will be successful.
