Options to Choose, Not Choose, or Defer to a Later Date
Not all plans include the so-called “In plan conversions” detailed below, which allow existing pre-tax 401K dollars to be converted to after-tax ROTH 401k dollars. They can be a good way to build tax-free income in retirement, in addition to the other benefits cited below. If you aren’t sure if your plan allows it ask your administrator or human resource department. The only reason it may not be part of your current plan is because no one suggested it as an option, or there wasn’t interest when the plan was implemented. Employee demographics and savings goals change over time.
ROTH 401k Contributions as a Standalone Option
The ROTH allows employees to put away after-tax dollars: no tax deduction today in exchange for lifetime tax free growth & income. This has several real and potential benefits:
1. Tax rates today are near historic lows. This could mean rates may go higher in the future.
• Even if one’s income is lower in retirement, they could potentially be in a higher tax bracket
• Good option for young people at low tax rates who will likely move up in tax brackets
2. Higher savings rate (i.e. a dollar in after-tax ROTH savings is much more money than a dollar in pre-tax savings)
3. Tax-free income in retirement. And ROTH income doesn’t count as income for calculating taxes on Social Security or Medicare premiums – which can save money in retirement.
4. Distribution flexibility – traditional 401Ks and IRAs require distributions at age 70 ½, whereas ROTH IRAs don’t force one to take distributions ever. However, distributions are required from a ROTH 401k but if you roll the money into a ROTH IRA before age 70 ½ – distributions can still be avoided.
5. ROTH’s transfer to heirs tax-free; whereas pre-tax money requires heirs to pay taxes
ROTH In Plan Conversion Options
In Plan ROTH Rollover (IPRR) vs. In Plan ROTH Transfer (IPRT) – both allow existing pre-tax contributions to be converted to after-tax money. The tax must be paid on the amount converted.
1. IPRR is more restrictive. Only money eligible for distribution can be converted (i.e. age 59 ½, disability, etc.)
2. IPRTs are for any one at any age and only on their vested amount
Conversions can be beneficial for any of the following:
1. Those who have time (10 years or more is ideal)
2. Those with plenty of discretionary income
3. Those who can pay the tax from sources outside the Plan
4. Those with tax rates may be lower or about the same as in the future (which is of course hard to predict but with low historic tax rates and government debt rising it’s a reasonable bet that rates may be higher in the future).
After-Tax Contributions and Mega Backdoor ROTH
After-tax contributions are separate from salary deferrals and a company match. They are used often to do large (i.e. mega backdoor) ROTH IRA conversions. After-tax contributions allow people to put away total maximum contributions of close to $60,000. The after-tax contributions can then be converted into a ROTH IRA. It’s a good idea in the right situation. However, discrimination testing could prevent this from being viable. But you should ask about it if you have the capacity to save extra money. The adminstrator can make a preliminary estimate to see if it could work for your plan.
HR and Paperwork
A couple administrative details that often confuse employees, so it’s important the adviser educates employees at enrollment and that HR or the company’s signatory to the request form remind employees of the following:
• Conversions can only be done on vested account balances.
• Make sure to educate employees on that tax is due in the year you make a conversion. Rollover requests go through HR and require a signature, which is a good time to remind employees of the taxes. It often happens that employees weren’t aware taxes are due at year-end. You want to be sure they undertand that conversions are taxed at their ordinary income tax rates, so they aren’t surprised and angry when the tax bill comes due!
Jerry Matecun helps business owners to understand and manage retirement plan risks and responsibilities, as well as help participants understand saving, investment, and distribution strategies vital to retirement readiness. For a no cost, confidential conversation regarding your retirement plan call or email Jerry at 949-273-4200, 616-499-2000, or email@example.com.
PLEASE NOTE: Nothing herein or elsewhere on this site constitutes investment, legal, or tax advice. For details please see Disclosure.