I’m a big fan of 401(k) plans that allow Roth contributions, especially for employees who are in low income tax brackets. You can contribute up to $18,000 of after-tax salary in 2016 to a designated Roth account for 401(k) plans that allow such contributions. The limit is increased to $24,000 if you’re 50 and older. These are the same limits as traditional 401(k) plan contributions.
Although you won’t reduce your taxable salary when you have Roth 401(k) contributions withheld from your paychecks, your Roth 401(k) account and employer matching contributions will grow tax-deferred. In addition, withdrawals will never be taxed provided that they’re taken after age 59-1/2 or in the event of death or disability and the first contribution to the Roth 401(k) account was made at least five years ago.
The Roth 401(k) Trap
There’s one advantage of Roth IRAs that you won’t find with designated Roth 401(k) accounts that needs to be kept in mind. Roth IRAs are exempt from the required minimum distribution rules that kick in at age 70-1/2 for qualified retirement plans and traditional IRAs. You can let your Roth IRA accounts grow without ever taking any distributions from them during your lifetime. It’s not until you die that your beneficiaries must take required minimum distributions (“RMDs”) over their lifetime.
Unlike Roth IRAs, designated Roth 401(k) accounts aren’t exempt from the RMD rules. RMDs must be taken annually from Roth 401(k) accounts beginning at age 70-1/2 unless you continue to work for the employer who sponsors your 401(k) plan and you’re not a five percent owner. Like all RMDs, they’re calculated using a life expectancy factor from an IRS table and the value of the account as of December 31st of the previous year.
Roth 401(k) RMDs are nontaxable provided that the first contribution to the Roth 401(k) account was made at least five years ago. Like all RMDs, you don’t have to spend them; they just need to be withdrawn from the account in which they’re held.
Avoiding the Trap
If you have a designated Roth 401(k) account and you want to avoid being subject to IRS’ RMD rules, there’s an easy solution: roll your Roth 401(k) account into a Roth IRA account before January 1st of the year that you turn 70-1/2.
You can roll your Roth 401(k) account into a Roth IRA account if you’ve left your employer or when you meet the in-service withdrawal provisions of your 401(k) plan assuming your plan contains these stipulations. Plans that allow you to take withdrawals while still working for the employer who sponsors the plan specify a minimum age for doing so, e.g., 60.
Not all assets in 401(k) plans may be eligible for in-service withdrawals. Plans typically specify assets by their origin, including after-tax contributions, rollover amounts, company match contributions, and pre-tax contributions. All types of assets that can be used for in-service withdrawals typically include earnings on those assets.
Designated Roth 401(k) accounts are a great option for diversifying retirement assets. Assuming that your goal is to avoid the required minimum distribution rules, subject to other considerations, you should roll your Roth 401(k) plan to a Roth IRA using your plan’s in-service withdrawal provisions, after you leave your employer, and, in any event, no later than December 31st of the year before the year that you will turn 70-1/2.
Robert Klein, CPA, PFS, CFP®, RICP®, CLTC® is the founder and president of Retirement Income Center in Newport Beach, California. Bob is also the sole proprietor of Robert Klein, CPA. Bob applies his unique background, experience, expertise, and specialization in tax-sensitive retirement income planning strategies to optimize the longevity of his clients’ after-tax retirement income and assets. He does this as an independent financial advisor using customized holistic planning solutions based on each client’s needs and personality.