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Taking Full Advantage of Roth Savings

February 11, 2014

Today we want to talk to you about Roth.  Not Philip, the author (although he is great), but William, the late senator from Delaware, whose name appears on a very attractive way to save for retirement.  We think many people may be unaware of just how useful the Roth way of saving has become.

By way of background, the traditional incentive the federal government has offered for retirement savings is through a pre-tax deferral of contributions, which looks like this: 

      1. deferral of taxation on contributions to a qualified plan or IRA,
      2. deferral of tax on the earnings, and
      3. taxation at ordinary income rates on the amounts distributed. 
In contrast, the tax savings in a Roth vehicle work as follows:
      1. taxation on contributions,
      2. exclusion from tax on the earnings, and
      3. exclusion from tax on the amounts distributed.  

The traditional incentive is a long-term deferral, while the Roth incentive is exclusion on all earnings while in the plan vehicle.  While there is a vast body of literature on which incentive is better, most experts think that for many individuals, Roth should at least be considered, and may be the better option depending on their particular situations.

From 1998, when Roth came into being, until 2007, contributing to a Roth IRA was not an option for high income individuals (for whom it might be most attractive), and contributions for others were quite limited.  During that time, only individuals with income under $90,000 (single) or $150,000 (married filing jointly), in both cases as adjusted for inflation, could make Roth contributions.  The annual amount that could be contributed was limited to the maximum for a traditional IRA - now $5,500.   In addition, a rollover from a traditional IRA to a Roth IRA was limited to individuals with income under $100,000.

But in 2007 things began to change.   In that year, 401(k) plans were permitted to add a Roth 401(k) feature.  Under this feature, any participant, without regard to income level, could elect to make  all or a portion of her elective deferral as a Roth deferral.  That means she can defer $17,500 into Roth in 2014, and an additional $5,500 if she is 50 or over.  That is more than triple the Roth IRA limit, and is available to every participant, without regard to income level, as long as the 401(k) plan provides for it.  In our experience, many 401(k) plans now include a Roth deferral option.

In 2009, the government loosened some more of the Roth restrictions, by eliminating the income restriction for an IRA to Roth IRA rollover. So any IRA owner could “convert” to a Roth by paying the tax on the amount converted.

In 2010, rollovers of non-Roth amounts to a Roth account within a 401(k) plan were permitted, also without any income limit. But the option was limited to amounts that could be currently distributed from the 401(k)  plan, which excluded an employee’s own deferrals if she was under 59 ½ and any other amounts as to which the plan restricted distribution.

Then, in 2013, the law was again changed to allow conversions of all pre tax amounts in a 401(k) plan to a Roth account at any time.  This includes not only traditional deferrals, but match amounts and employer contributions.  And if the plan is amended to permit these broader conversions, rollovers can be done at any time, at any age, and for any amounts.  In other words, a participant in a 401(k) plan can convert up to her entire account balance to Roth, all at once or over time, assuming the plan permits it.

In the aggregate, these changes are enormously important for long range tax planning.  A participant might, for example, have a long range goal of converting half of her 401(k) plan balance to Roth.  Of course, this is “expensive” because it generates current income tax.  A Roth contribution of $17,500 by a high income taxpayer will actually “cost” up to $35,000 once federal and state tax is factored in.   But that extra amount may be a very good investment if the payoff is to never be taxed on the long-term earnings in the plan or IRA.  A conversion of a large amount all at once may be impractical to a participant who does not have the extra amounts to pay the tax, but it can be done over a period of years if the 401(k) plan permits.  And again, it may be a very wise use of those funds.

One thing high income taxpayers should keep in mind is that Roth IRAs (into which Roth 401(k)s may be rolled) do not have required minimum distributions.  All of the funds can be accumulated until death.  This makes the Roth deal very attractive for taxpayers who expect not to have to use the Roth funds for a period of time after age 70 ½.  Compare a taxpayer at 70 1/2 with $1 million in a traditional rollover IRA to a taxpayer with $1 million in a rollover Roth IRA.  The additional tax-free buildup in the Roth IRA from 70 ½ until 87 (assuming current life expectancies), without diminution for required distributions, is very valuable.  A good financial planner can quantify that value.

We have focused on high income taxpayers, but many believe that Roth is also a better deal for many low income taxpayers.  We note that President Obama’s recent announcement of a “myRA” for lower income employees involves the use of a Roth IRA.   The reason is that if someone is paying no income tax, or paying only at a low level, then the current tax-hit of a Roth contribution has little or no current sting, making Roth a better choice in the long run.

So for all those plan sponsors, and high income executives, who have treated Roth as a technicality that was too much of a headache to learn about, think again.  We believe every employer with a 401(k) program should at least consider adding a Roth 401(k) and allowing broad “in plan” rollovers of pre tax amounts, and should talk to their third-party service providers about how those rollovers work, practically.  While there may be downsides in terms of increased administrative cost and additional participant education, there are also very real benefits for participants.  It has been our experience that many third-party administrators are now familiar with Roth and have the resources to make the transition easy for plan sponsors.

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