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One of the possible outcomes of this election is the prospect of higher future income taxes. Not just because of the promise of the President-elect, but out of necessity due to the massive increase of the national debt caused, in part, by the COVID-19 pandemic relief measures. We are currently enjoying some of the lowest personal income tax rates in recent history, with the top rate of 37 percent for those making over $622,500, and down to 22 percent for joint income of $80,250-$171,050. Does it make sense now to reduce current taxable income by contributing to a traditional IRA or 401(k) when rates are this low? Or would it be better to draw future income provided by a Roth IRA or Roth 401(k) tax free? We cannot be sure what the future will look like, but it may be wise today to start creating a bucket of tax-free future income by opening a Roth IRA or switching your 401(k) contributions to the Roth option, if available. Here is more information on the Roth 401(k) that many retirement plans offer.
What is a Roth 401(k)?
A Roth 401(k) is simply a traditional 401(k) plan that accepts Roth 401(k) contributions. Roth 401(k) contributions are made on an after-tax basis, just like Roth IRA contributions. This means there’s no up-front tax benefit, but if certain conditions are met, your Roth 401(k) contributions and all accumulated investment earnings on those contributions are free from federal income tax when distributed from the plan.
Who can contribute?
Unlike Roth IRAs, where you can’t contribute if you earn more than a certain dollar amount, you can make Roth contributions, regardless of your salary level, as soon as you are eligible to participate in the 401(k) plan. And while a 401(k) plan can require employees to wait up to one year before they become eligible to contribute, many plans allow you to contribute beginning with your first paycheck.
How much can I contribute?
There’s an overall cap on your combined pre-tax and Roth 401(k) contributions. In 2020, you can contribute up to $19,500 ($26,000 if you’re age 50 or older) to a 401(k) plan. You can split your contribution between Roth and pre-tax contributions any way you wish. For example, you can make $10,000 of Roth contributions and $9,500 of pre-tax 401(k) contributions. It’s up to you.
Can I also contribute to an IRA?
Yes. Your participation in a 401(k) plan has no impact on your ability to contribute to an IRA (Roth or traditional). You can contribute up to $6,000 to an IRA in 2020 ($7,000 if you’re age 50 or older). Your ability to contribute to a Roth IRA may be limited if your “modified adjusted gross income” (MAGI) exceeds certain levels. Similarly, your ability to make deductible contributions to a traditional IRA may be limited if your MAGI exceeds certain levels and you (or your spouse) participate in a 401(k) plan.
Are distributions really tax free?
Because your Roth 401(k) contributions are made on an after-tax basis, they’re always free from federal income tax when distributed from the plan. Investment earnings on your Roth contributions are tax free if you meet the requirements for a “qualified distribution.”
In general, a distribution from your Roth 401(k) account is qualified if it satisfies both of the following requirements:
- It’s made after the end of a five-year waiting period
- The payment is made after you turn 59½, become disabled or die
What about employer contributions?
Employers don’t have to contribute to 401(k) plans, but many will match all or part of your contributions. Your employer can match your Roth contributions, your pre-tax contributions or both. But your employer’s contributions are always made on a pre-tax basis, even if they match your Roth contributions. That is, your employer’s contributions, and investment earnings on those contributions, are not taxed until you receive a distribution from the plan
Should I make pre-tax or Roth 401(k) contributions?
When you make pre-tax 401(k) contributions, you don’t pay current income taxes on those dollars (which means more take-home pay compared to an after-tax Roth contribution of the same amount). But your contributions and investment earnings are fully taxable when you receive a distribution from the plan. In contrast, Roth 401(k) contributions are subject to income taxes up front, but qualified distributions of your contributions and earnings are entirely free from federal income tax.
Which is the better option depends upon your personal situation. If you think you’ll be in a similar or higher tax bracket when you retire, Roth 401(k) contributions may be more appealing, since you’ll effectively lock in today’s lower tax rates. However, if you think you’ll be in a lower tax bracket when you retire, pre-tax 401(k) contributions may be more appropriate. Your investment horizon and projected investment results are also important factors. A financial professional can help you determine which course is best for you.
Whichever you choose — Roth or pre-tax — make sure you contribute as much as necessary to get the maximum matching contribution from your employer. This is essentially free money that can help you pursue your retirement goals.
What happens when I terminate employment?
When you terminate employment, you generally forfeit all employer contributions (and earnings on them) that haven’t vested. “Vesting” means that you own the contributions and any associated earnings. Your contributions, Roth and pre-tax, are always 100 percent vested. But your 401(k) plan may require up to six years of service before you fully vest in employer matching contributions (although some plans have a much faster vesting schedule).
When you terminate employment, you can generally leave your money in your 401(k) plan, although some plans require that you withdraw your funds when you reach the plan’s normal retirement age (typically age 65). (You generally must begin taking distributions after you reach age 72.1) Your plan may also “cash you out” if your vested balance is $5,000 or less, but if your payment is more than $1,000, the plan must generally roll your funds into an IRA established on your behalf, unless you elect to receive your payment in cash. [This $1,000 limit is determined separately for your Roth 401(k) account and the rest of your funds in the 401(k) plan.]
You can also roll all or part of your Roth 401(k) dollars over to a Roth IRA, and your non-Roth dollars to a traditional IRA. You may also be able to convert your non-Roth dollars to a Roth IRA, but income taxes will apply to any tax-deferred amounts in the year of conversion. You may also be able to roll your funds into another employer’s plan that accepts rollovers.
Finally, you may also be able to take a cash distribution of your contributions and earnings, as well as any vested employer amounts. However, keep in mind that any tax-deferred funds will be subject to income taxes and a possible ten percent penalty tax if you’re under age 59½ and an exception does not apply. (As noted above, an exception to the penalty tax may be allowed in 2020 for qualified participants affected by the coronavirus for distributions up to $100,000.)
Employers aren’t required to make Roth contributions available in their 401(k) plans. So be sure to ask your employer if they are considering adding this exciting new feature to your 401(k) plan.
Provided by Ed Wettig, CFP, Wettig Capital Management, which offers investment management, financial planning and retirement income strategies. Securities, insurance and investment advisory services offered through Royal Alliance Associates, Inc. Member FINRA/SIPC. Wettig Capital Management is a marketing designation.
