#roth401k

By:  Henry VanBuskirk, CFP®, Wealth Manager

Investing is a broad concept that has a wide array of definitions that differ depending on whom you ask.  If you ask a recent college graduate, parents in their early 40s with two young children, and an elderly retired couple to define what investing means to them, you will probably get three wildly different answers. They all have different goals, and their investment accounts need to match those goals. My goal with this article is to help define some of these different investment accounts and why they would be used. There are many different types of investment accounts, and it may be overwhelming to keep tabs on the goals and rules for each account type. While I’m not going to go through every single investment account type in existence, I am going to help define some of the more common and lesser-known investment account types and why they would be used in each stage of life. Let’s start with the recent college graduate.

College graduate:

Say you are a recent college graduate of 24 and you started working for ABC Company. You probably aren’t thinking much about your retirement (…that’s 40 years from now…). You probably are thinking about making sure you can pay rent on time and hoping your date on Friday night goes well. The recent college graduate would probably answer, “I have a 401(k) at work, social security when I’m older, and I’ll be fine. There are a few stocks I like, and I follow the market, but I don’t have enough money to set aside to focus on investing. I don’t need to focus on investing right now.” The sentiment towards investing is understandable, but there are a lot of things that this college graduate can do now. This could be the prime time in this person’s life to start thinking about investing. Assume that ABC Company offers a match of 4%, you make $50,000, your salary never increases, and you contribute 10% to the 401(k).  Below is how much you would have at your projected retirement at age 65 assuming a 7% rate of return.   

Now compare this to someone at ABC Company who is 40 years old, makes $100,000 per year, their salary increases by 5% per year, and contributes 10% to the 401(k) each year. We will use the same 7% rate of return assumption.

The college graduate (24-year-old), who makes half as much as the 40-year-old, would have more saved in retirement. This is due to what Einstein calls “The Eighth Wonder of the World”, compound interest. 

A Traditional 401(k) also would offer tax-deductible contributions that would lower your pre-tax income, would you lower your tax bill, and the investments would grow tax deferred. The catch is that you would be required to take distributions in retirement starting at age 72. This is called the required minimum distribution (RMD). The college graduate is probably not thinking about RMDs right now, but what they are thinking of is getting a break on their taxes and saving for their future retirement. There is also a Roth 401(k)that does not allow for tax-deductible contributions, the earnings would grow tax-deferred, but you would not be required to take any distributions ever (not all plans offer this option).

Now assume that ABC Company offers a High Deductible Health Plan. Since you are a 24-year-old, you probably are in good health and would be okay signing up for a high deductible health plan.  Doing so would give you access to a lesser-known account, a Health Savings Account (HSA). This account type offers the trifecta of tax savings:

• Tax-deductible contributions
• Tax-free growth
• Tax-free distributions when used for qualified health expenses

Think of this account as a Traditional 401(k) where you don’t have required distributions. If you don’t use it for qualified health expenses, then distributions are taxed at ordinary income tax rates. There is also a limit to how much you can contribute to an HSA in any given year (for 2022, $3,650 for individual coverage and $7,300 for family coverage). As we illustrated before, time is your friend when it comes to investing.

Parents in their early 40s with two young children:

Now assume that you are a 43-year-old parent with two young children, ages 5 and 6. You may be thinking about what’s best for your children. Fortunately, there are investment accounts that you can consider for their goals as well. Some investment account types that would fit this bill are Uniform Transfer to Minors Act (UTMA) accounts, Uniform Gift to Minors Act (UGMA) accounts, and Roth IRAs.

Uniform Transfers to Minors Act (UTMA) accounts or Uniform Gifts to Minors Act (UGMA) accounts are accounts where you can set aside money each year to invest for a minor. The adult family member is the custodian (person in charge of the account) and when the child reaches the age of majority (normally 18 but can be as high as 25 in some states), the account legally changes ownership to the child. There are very few differences between a UTMA and a UGMA, which is why I lump them together and will refer to them as a custodial accounts. A custodial account is taxed with the following schedule:

• The first $1,100 of unearned income is free from tax
• The next $1,100 is taxed at the minor’s tax rate
• Earnings above $2,200 are taxed at the parent’s tax rate

It generally would require filing a tax return to report any gains or losses attributed to the investment account’s performance. The taxation in a custodial account is not dependent on whether or not the child or grandchild uses it for qualified education expenses. The UTMA or UGMA account after the child or grandchild reaches the age of majority becomes a non-qualified investment account. This means that it is taxed at the more favorable capital gains tax rates.

One account that can help pay for future college expenses is a 529 plan. 529 Plans (sometimes referred to as college savings plans) are a great investment vehicle if your child goes to college or a private school. This is because the earnings are tax-free, and distributions are tax-free as long as the funds are used for qualified education expenses. The downside is if the distribution is not for qualified education expenses, then the earnings are taxed at ordinary income tax rates and a 10% penalty is assessed. If your child has goals of wanting to be an astronaut, doctor, or another profession that requires post-secondary education, it may be a good opportunity to talk to them about what needs to happen to realize that goal. Maybe during Christmas, you have the child open a letter that has a $100 check made out to a 529 plan. The kid would naturally have questions. You could then give them the same gift every Christmas and show them the 529 plan statement on how you are working together to make that goal a reality.

Another way to save for a minor child would be a Roth IRA. Roth IRAs are available to anyone that has an earned income below $144k for single taxpayers or $214k for married filing jointly. This isn’t just for people 16 and older that work part-time after school. You can have even younger people than that contribute (with the parent’s help as custodian) to a Roth IRA provided that they have earned income.  Earnings on a Roth IRA are tax-free, as long as it has been longer than 5 years since you first contributed to a Roth IRA account, and you have reached age 59.5. There is a 10% early withdrawal penalty if funds are withdrawn before age 59.5 and it is possible that you would owe ordinary income taxes on the earnings received. Your basis in the Roth IRA is never subject to taxation.

For example, I worked with a client who owned an educational toy company, and her 2-year-old was a ‘toy tester’. She gave the 2-year-old a salary, and then matched that salary in the form of a Roth IRA. Think outside the box, but also make sure everything is well documented since you are reporting all of this to the IRS. We are all about tax saving strategies at BFSG, but we will never recommend illegal tax avoidance strategies.

An elderly retired couple:

The elderly couple isn’t thinking about accumulating and is instead thinking about maintaining their lifestyle and passing on their successes to future generations in their household. This is also the time when you are taking required minimum distributions (RMDs) from your Traditional 401(k) or Individual Retirement Account (IRA).

This elderly retired couple has a sizable estate and are concerned about making sure their grandchildren can attend college. They can put the RMD funds (net of taxes) into a 529 Plan that would grow tax-free and withdrawals can be tax-free if the funds withdrawn from a 529 Plan are used for qualified educational expenses. With a 529 plan, you can build an educational legacy for your grandchild while taking advantage of tax and estate planning benefits.  

What some of our clients do when they don’t need the money from their RMDs (not a bad problem to have) is that they journal the net distribution from their Traditional 401(k) or IRA to their brokerage investment account.  The brokerage investment account is non-qualified (no favorable tax treatment) that can be used for any purpose.

However, don’t let Lloyd Christmas have that chance at your estate. Make sure the brokerage investment account is titled properly – preferably in the name of your Living Trust.

Upon the elderly retired couples passing, the brokerage investment account would pass to their heirs (as dictated in the Trust), and they would receive a step-up in cost basis at death. For example, assume you put $100,000 into a brokerage investment account and it grows to $150,000 10 years later. If you close out the brokerage investment account, you would owe long-term capital gains taxes on the $50,000 gain and you would receive $150,000 minus what was paid in long-term capital gains taxes. If you instead leave the account open and pass away with the $150,000 brokerage investment account, your heirs would receive the account and can choose to take the $150,000 tax-free.

Conclusion:

Regardless of what demographic group you are a part of, there are investment accounts for you and a team of CERTIFIED FINANCIAL PLANNERS^TM at BFSG that can help you along your life journey.  Let us know what we can do to help. 

Sources:

1. https://www.bankrate.com/retirement/401-k-calculator/
2. https://www.fidelity.com/viewpoints/wealth-management/hsas-and-your-retirement
3. https://www.nerdwallet.com/article/investing/utma-ugma
4. https://www.bankrate.com/loans/student-loans/roth-ira-for-college/
5. https://www.savingforcollege.com/article/can-i-pay-my-mortgage-with-529-plan-money
6. https://www.irs.gov/newsroom/irs-announces-changes-to-retirement-plans-for-2022
7. https://www.courts.ca.gov/partners/documents/probguide-eng.pdf

Disclosure: BFSG does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to BFSG’s website or blog or incorporated herein and takes no responsibility for any such content. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Please remember that different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment or investment strategy (including those undertaken or recommended by Company), will be profitable or equal any historical performance level(s). Please see important disclosure information here.

Actually, there are three five-year rules you need to know about.

The first five-year rule determines when you can begin receiving tax-free qualified distributions from your Roth IRA.  Withdrawals from your Roth IRA — including both your contributions and any investment earnings — are completely tax- and penalty-free if you satisfy a five-year holding period and one of the following conditions also applies:

• You’ve reached age 59½ by the time of the withdrawal
• The withdrawal is made due to a qualifying disability
• The withdrawal is made for first-time homebuyer expenses ($10,000 lifetime limit)
• The withdrawal is made by your beneficiary or estate after your death

This five-year holding period begins on January 1 of the tax year for which you made your first contribution (regular or rollover) to any Roth IRA you own. For example, if you make your first Roth IRA contribution in March 2022 and designate it as a 2021 contribution, your five-year holding period begins on January 1, 2021 (and ends on December 31, 2025). You have only one five-year holding period for determining whether distributions from any Roth IRA you own are tax-free qualified distributions (Roth IRAs you inherit are subject to different rules).

The second five-year rule is a little more complicated. When you convert a traditional IRA to a Roth IRA, the amount you convert (except for any after-tax contributions you’ve made) is subject to income tax in the year of the conversion. However, your conversion isn’t subject to the 10% early distribution penalty, even if you haven’t yet reached age 59½.

But what the IRS giveth it can also taketh away. If you withdraw any portion of your taxable conversion within five years, you’ll have to pay the 10% early-distribution penalty on those funds that previously avoided the tax — unless you’ve reached age 59½ or qualify for another exemption from the penalty tax. This five-year holding period starts on January 1 of the year you convert your traditional IRA to a Roth IRA. And if you have more than one conversion, each will have its own separate five-year holding period for this purpose.

The third five-year rule applies to In-Plan Roth’s (i.e., Roth 401k or Roth 403b). While it’s similar to the five-year rule that applies to Roth IRAs, there are important differences. Learn more here about Roth’s in retirement plans.

Withdrawals from your Roth 401(k) plan account — including both your contributions and any investment earnings — are completely tax- and penalty-free if you satisfy a five-year holding period and one of the following conditions also applies:

• You’ve reached age 59½
• You have a qualifying disability
• The withdrawal is made by your beneficiary or estate after your death

(Note: There is no first-time home buyer exception for a Roth 401k).

The five-year holding period begins on the first day of the calendar year in which you make your first Roth 401(k) contribution (regular or rollover) to the plan. For example, if you make your first Roth contribution to your company’s 401(k) plan in December 2022, your five-year holding period begins on January 1, 2022, and ends on December 31, 2026.

If you participate in 401(k) plans maintained by different employers, your five-year holding period is determined separately for each plan. But there’s an important exception. If you make a direct rollover of Roth dollars from your prior employer’s plan to your new employer’s plan, your five-year holding period for the new plan will be deemed to start with the year you made your first Roth contribution to the prior plan.

For example, Beth made Roth contributions to the Acme 401(k) plan beginning in 2018. In 2022, she changed jobs and began making Roth contributions to the Beacon 401(k) plan. Her five-year holding period for the Acme plan began on January 1, 2018, and ends on December 31, 2022. Her five-year holding period for the Beacon plan began on January 1, 2022, and ends on December 31, 2026. In 2022, Beth decides to make a direct rollover of her Acme Roth account to Beacon’s 401(k) plan. Because of the rollover, Beth’s January 1, 2018, starting date at Acme will carry over to the Beacon plan, and any distributions she receives from her Beacon Roth account after 2022 (rather than after 2026) will be tax free (assuming she’s at least age 59½ or disabled at the time of distribution).

There are many rules you must be aware of when establishing a Roth, completing a rollover, or when doing a Roth conversion. If you’d like to learn more about retirement planning strategies using Roth retirement accounts, feel free to Talk With Us!

Prepared by Broadridge Advisor Solutions. Edited by BFSG. Copyright 2022.

Disclosure: BFSG does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to BFSG’s website or blog or incorporated herein and takes no responsibility for any such content. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Please remember that different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment or investment strategy (including those undertaken or recommended by Company), will be profitable or equal any historical performance level(s). Please see important disclosure information here.

By:  Crystal Kessler, CFP®, Wealth Advisor/Financial Planner

There is a lot of confusion when it comes to In-Plan Roth’s (i.e., Roth 401k or Roth 403b) and a Roth IRA. Throughout this article we will refer to just Roth 401ks but know the rules we refer to for Roth 401ks apply to other In-Plan Roth’s like 403bs. It is important to realize that these are two completely different investment vehicles, and they both have very different rules when it comes to eligibility and contributions.

First off, it helps to know the difference between Traditional vs. Roth. It mostly boils down to when you pay your taxes -now or later. With a Traditional Retirement Plan (i.e., 401k or 403b) or Traditional IRA (Individual Retirement Account), you make contributions with pre-tax dollars, and you get a tax break up front, thus helping to lower your current taxable income. Both contributions and earnings grow tax-deferred, meaning you do not pay taxes on it, until you withdraw it. With a Roth 401k or Roth IRA, it’s basically the reverse. You make your contributions with after-tax dollars, meaning there’s no upfront tax deduction and your income taxes are paid on that money before it goes into the account. Due to this, both the contributions and earnings grow tax free, and any withdrawals are tax free after you reach age 59 ½ (*withdrawals are tax free provided they are made at least 5 years after the first Roth contribution was made).

A Roth 401k is an employer sponsored retirement plan where an individual makes contributions directly from their paycheck to their company sponsored retirement account. Most employer plans give you the option to make your employee contributions to a Traditional 401k or a Roth 401k.

A Roth IRA is an account one can open at any investment firm and contribute to as long as they have earned income. However, there are income limitations to Roth IRAs when it comes to being able to contribute. To make a full contribution to a Roth IRA, as a single filer you must make less than $125,000 for 2021 ($129,000 for 2022). For married filing jointly, the combined income must be less than $198,000 for 2021 ($204,000 in 2022). The maximum contribution limit is $6,000 a year. However, there is a $1,000 catch-up contribution if you are over the age of 50. This allows an individual to contribute up to $7,000 if he or she is over the age of 50. If you are married and make less than the income limit, each spouse can make a full contribution to each of their Roth IRAs.

Example: If Jack (age 53) and Jill (age 54) file married, jointly and make less than $198,000 combined income in 2021 then Jack can contribute $7,000 to his Roth IRA and Jill can contribute $7,000 to her Roth IRA by April 18th, 2022, since they are both over age 50 and made less than the income limit set for 2021.

Most of the confusion with Roth 401k’s centers around if individuals can contribute to them because they see “Roth” and assume that if they make too much money then they can’t contribute to it. That is very wrong when it comes to Roth’s in retirement plans. Most employees are eligible for a Roth 401k and can contribute to it as long as their employer offers it in their retirement plan. A Roth 401k has no income limit whatsoever. The only limitation a Roth 401k has, is the plan’s contribution limit. For 2022 employees can contribute up to $20,500, and anyone over the age of 50 can make an additional catch-up contribution of $6,500. What is important to consider when contributing to a Roth 401k is the fact that you will be taxed on your income before you contribute to the Roth 401k, but the contributions and earnings grow tax free within the Roth 401k.

Example: Let’s look at Jack (age 53) and Jill (age 54) who file married, jointly and make $325,000 combined taxable income in 2022. Although they make too much to contribute to a Roth IRA, they can still contribute to a Roth 401k. Let’s say Jack maxes out his Roth 401k for the year, and because he is over age 50, he can make a maximum contribution, due to the catch up, of $27,000. He will be taxed on that $27,000 at their marginal tax bracket of 24%, but that full $27,000 will be contributed to the Roth 401k and grow tax free. Come retirement when Jack and Jill take distributions from the account it will all be income tax free. Another big difference between a Roth 401k and Roth IRA, is that Roth 401k accounts are subject to required minimum distributions. You are required to start taking tax-free withdrawals at age 72 from an Roth 401k. Roth IRA’s do not have this required minimum distribution requirement. However, you can rollover your Roth 401k account to a Roth IRA before age 72 and avoid the required minimum distributions.

* Withdrawals are tax free provided they are made at least 5 years after the first Roth contribution was made.

Disclosure: BFSG does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to BFSG’s website or blog or incorporated herein and takes no responsibility for any such content. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Please remember that different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment or investment strategy (including those undertaken or recommended by Company), will be profitable or equal any historical performance level(s). Please see important disclosure information here.

There may be potentially a way for you to put up to $37,500 in a Roth IRA or Roth 401(k) this year. The goal here is to put as much money as possible into a Roth account to take full advantage of the tax-free growth. This is a wonderful strategy for the lucky few who qualify and can take advantage of it. The reality is that your employer-sponsored plan may not allow it. Let us take a closer look at this little-known strategy and how it works.

Understand the Basics

A backdoor Roth conversion is an excellent strategy for the high wage earner to make Roth contributions if they are above the income limitations of a Roth IRA. With this strategy, someone can contribute a max of $6,000 ($7,000 if 50 or older) into a Traditional IRA as a non-deductible contribution and then convert this amount directly into a Roth IRA. There are some additional qualifiers like the pro-rata rule, so discuss this with a tax advisor before completing a backdoor Roth conversion.

The mega backdoor Roth takes this concept to a whole new level. This strategy can allow for an additional $37,500 Roth contribution by taking advantage of the rules with your employer-sponsored plan.

The Factors to Make a Mega Backdoor Roth Conversion Work

There are many moving parts with this strategy as you will see below so consult with a financial planner and tax professional before trying this on your own. Here are the factors to make a mega backdoor Roth conversion work:

1. An employer-sponsored plan (either a 401(k), 403(b) or 457) that allows after-tax contributions. After-tax contributions are generally done after you have maxed out your normal $19,500 ($26,000 if 50 or older for “catch-up” contributions) per year contributions into the plan. The after-tax contributions are separate from your Traditional or Roth buckets. Note special catch-up limits apply to certain participants in 403(b) and 457(b) plans.

2. Your employer allows you to move the after-tax money into the Roth bucket in the plan. The alternative is that the plan allows for in-service rollovers, which would allow you to move money out of the employer-sponsored plan while you are still working. It is best to check with your plan administrator or HR to see if your plan allows either option.

3. You can make large contributions to the retirement account and still have other savings. Remember, these after-tax contributions are above the normal limit to max out your 401(k) contributions of $19,500 or $26,000 if 50 or older.  You will also need to have sufficient cash flow to meet your other expenses and have enough savings that are not in the retirement account.

If you have met these three requirements, then you may want to consider using the mega backdoor Roth strategy.

How to Calculate How Much You Can Contribute   

For 2020, the plan contribution limit is $57,000, or $63,500 if you’re age 50 or older. For example, assume a worker over the age of 50 maxes out the Roth contributions to the plan for $26,000 and the employer offers a 5% match on contributions based on a $100,000 salary, so they contribute $5,000 as well. This means that the max this person is eligible to contribute for mega backdoor Roth contributions is $32,500 ($63,500 plan max  – $26,000 max Roth contributions – $5,000 employer contributions). For a small number of individuals contributing to 401(k) plans, the amount may be less based on non-discrimination tests.

Alternatives to Consider

Before making a mega backdoor Roth conversion or if you are not eligible you may want to explore simpler options first:

1. Make Roth contributions to your employer-sponsored plan (there are no income limits).

2. If this is not possible, or you want to make further Roth contributions use a Roth IRA if your Modified Adjusted Gross Income (MAGI) is under $124,000 (single) or $196,000 (married filing jointly).

3. If you are over the Roth IRA income contribution limits then consider a backdoor Roth contribution. This is where you make after-tax contributions into a Traditional IRA and then convert the contributions into a Roth IRA.

There are some rules about pro-rata so make sure to speak with a financial planner or tax advisor before completing a backdoor Roth conversion.