Roth 401ks?

labro

I saw @hoffse mention Roth 401ks in another thread (I think anyway?) and it jogged my memory that I wanted to poll everyone here about them. Last week I learned that H has the option to contribute to a Roth 401k in addition to his regular pre-tax 401k. I don't have this option through my employer unfortunately, but it seems like it could be worthwhile?

We're both contributing up to the federal limt ($18k) into our pre-tax 401ks. H now makes enough of a salary that he'll hit that $18k before the end of the year leaving him with a few paychecks where he won't be able to contribute any further money to his pre-tax 401k. Would it be worthwhile to go ahead and open a Roth 401k? I don't see any special advantages other than that we'd obviously be able to put more money into retirement, and that that money wouldn't be taxed (unlike any distributions from our pre-tax 401ks).

Is it better to focus on larger contributions to a Roth 401k instead of the pre-tax? My original thought had been to open one up just to take in excess contributions above and beyond what he's allowed to contribute to his pre-tax 401k but now I'm wondering if it's actually better to focus on a Roth instead.

hoffse

Unfortunately the 18K limit is for 401(k)s generally - both Roth and regular combined.  Once he hits $18K in one he won't be able to contribute to the other for the rest of the year.

Any employer matches don't count toward this limit - there is a separate ceiling for those.

If you guys can afford to do Roth 401(k)s as part of your retirement plan, you might want to think about it.  You don't get the deduction of course, but the funds grow tax-free like a Roth IRA, and there are no required minimum distributions on the back end since taxes are paid upfront.  That gives you a ton of flexibility once you hit the age where you can withdraw.

Roth 401(k)s are also eligible for employer matches (if any), though the match money will go into a regular 401(k), not the Roth account.  That makes sense because nobody has paid taxes on it yet, given that it's "free" money.

FWIW H and I are only using Roth accounts right now because we expect our marginal rates to go up in the future. 

EDIT: Just to be clear, a married couple can contribute up to $11K/year (combined) in Roth IRAs PLUS $36K/year in Roth 401(k)s, which results in $47K/year total in Roth accounts that grow tax-free between them.

labro

@hoffse Ah bummer! I definitely misunderstood that when I was looking at the table on the federal website comparing Roth 401ks vs pre-tax 401ks vs IRAs. I thought it was $18k and then another $18k and I thought it sounded pretty awesome!

I think for right now what that tells me is we need to keep our pre-tax 401ks. It helps us too much with our tax burden. Maybe at the end of the year it's something we can discuss with our accountant since we could try and find a balance between half Roth and half pre-tax or something so we don't end up with a massive federal refund.

hoffse

Also, I will add that the lack of required minimum distributions (RMDs) is hugely appealing to me.  I mentioned in another post that my parents are about to hit the RMD age where they have to pull money out of their regular 401(k)s and pay taxes on it even though they don't need it.  

If there is any chance that you might not need that money - either because of a pension, or an inclination to keep working, or an inheritance or whatever, you might want to think about sending at least some of that money to an account that does not have an RMD requirement. 

The way the RMD formula works is once you hit RMD age you have to withdraw a percentage of the account that is partially based on how much is in the account and your age/life expectancy, and you have to do it every year.  They make sure that the percentage is low enough that the account won't be drained before you die, but you can't opt out from it without incurring a penalty.  And the IRS will know if you didn't take your RMD - the banks that run retirement accounts have to report it to the IRS.  The only way to get around paying those taxes (that I know of) is to donate the RMD amount to a charity instead of taking it for yourself - this avoids the taxes, but then you no longer have the money for yourself or your heirs either.  

Basically RMDs ensure that the taxes are paid at some point. You can't get the deduction in your contribution year and then just hoard the money in the account and never withdraw it.  The reason Roth 401(k)s don't have RMD requirements is because the taxes are paid upfront, so the government no longer cares whether you hoard the money or not.

hoffse

@labro, yeah I hear you.  Honestly, H and I have talked about doing a 50-50 split to hedge more, but we always end up sticking with what we are doing.  Our tax bracket is likely to go up SO much in the next 10 years that we can't really justify the regular 401(k) when we have a Roth option.

Despite the RMD thing, I do think we will shift to regular 401(k)s when we think we are peaking in our careers because then the deduction is worth more than the tax savings (and in theory I don't mind donating my RMD to charity... yet).  It's just a really hard call from year to year, but we are pretty sure we haven't peaked yet.

FWIW almost nobody uses Roth 401(k)s.  The IRS estimates that about half of all plans have that option, but very very few people take it.  I think most people don't even know what it is.

labro

@hoffse Are you sure about the RMD rule? The table I saw on the IRS website and this link say otherwise.

"What types of retirement plans require minimum distributions?

The RMD rules apply to all employer sponsored retirement plans, including
profit-sharing plans, 401(k) plans, 403(b) plans, and 457(b) plans. The RMD rules also apply to traditional IRAs and IRA-based plans such as SEPs, SARSEPs, and SIMPLE IRAs.

The RMD rules also apply to Roth 401(k) accounts. However, the RMD rules do not apply to Roth IRAs while the owner is alive."

I expect we'll receive some sort of inheritance from my parents...hopefully not until a long long time in the future, but I don't have any idea as to the amount so it's not something we're planning on in our later years. I suppose the only way to get away from this is to roll Roth 401ks into Roth IRAs which seems to be allowable based on this article. http://www.investopedia.com/articles/retirement/09/roth-401k-rollover.asp

hoffse

labro said:

@hoffse Are you sure about the RMD rule? The table I saw on the IRS website and this link say otherwise.

"What types of retirement plans require minimum distributions?

The RMD rules apply to all employer sponsored retirement plans, including
profit-sharing plans, 401(k) plans, 403(b) plans, and 457(b) plans. The RMD rules also apply to traditional IRAs and IRA-based plans such as SEPs, SARSEPs, and SIMPLE IRAs.

The RMD rules also apply to Roth 401(k) accounts. However, the RMD rules do not apply to Roth IRAs while the owner is alive."

I expect we'll receive some sort of inheritance from my parents...hopefully not until a long long time in the future, but I don't have any idea as to the amount so it's not something we're planning on in our later years. I suppose the only way to get away from this is to roll Roth 401ks into Roth IRAs which seems to be allowable based on this article. http://www.investopedia.com/articles/retirement/09/roth-401k-rollover.asp

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Well there are no taxes to pay on the Roth 401(k).... sorry, that's what I meant by no RMD rules.  You take it out, but it's a net 0 to you, so it can be reinvested in something else. 

EDIT: And yes, that money can be rolled into a Roth IRA when you leave employment, and that also doesn't cost you anything.

Functionally, there is no RMD for a Roth 401(k) because you don't have a tax consequence for it.

labro

@hoffse Gotcha! That makes a ton more sense to me - and also why H's grandpa was complaining when he turned 70 1/2 about being forced to take money out of his retirement account. He still works full time so that probably hurts quite a bit for him.

hoffse

Yeah, sorry for using the wrong terminology.  You're right that all 401(k)s technically have RMD's. I just think of Roths as being outside of the RMD rules because it has none of the problems you get with a regular 401(k).   I didn't slow down long enough to clarify that - sorry!

For the record, notice how this is like the "income limits" on Roth IRAs?  Because that's a totally pointless rule too.  Your Congress at work!

The real problem your H's grandpa has is his RMD is included as part of his gross income when it comes to calculating his marginal tax rate.  So not only is he paying taxes on that money, he is probably paying at a higher rate than he otherwise would pay since he has income from a regular job AND income from the retirement account.

This is the dark underbelly of retirement planning that your HR people don't tell you, lol.

jtmh2012

hoffse said:

FWIW almost nobody uses Roth 401(k)s.  The IRS estimates that about half of all plans have that option, but very very few people take it.  I think most people don't even know what it is.

I've had a normal Roth IRA setup for ages and between that and my 401k we're kinda at our limit for the time being.  Aside from the increased contribution limit, not sure I really see an advantage, but I could be missing something.

hoffse

jtmh2012 said:

hoffse said:

FWIW almost nobody uses Roth 401(k)s.  The IRS estimates that about half of all plans have that option, but very very few people take it.  I think most people don't even know what it is.

I've had a normal Roth IRA setup for ages and between that and my 401k we're kinda at our limit for the time being.  Aside from the increased contribution limit, not sure I really see an advantage, but I could be missing something.

The Roth 401(k) simply allows you to increase the amount of money going into a Roth designated account.  Virtually the same rules as a Roth IRA in terms of tax-free growth.  The difference is a Roth IRA has a $5500/year limit per person, and a Roth 401(k) has an 18K/year limit per person.

jtmh2012

hoffse said:

jtmh2012 said:

hoffse said:

FWIW almost nobody uses Roth 401(k)s.  The IRS estimates that about half of all plans have that option, but very very few people take it.  I think most people don't even know what it is.

I've had a normal Roth IRA setup for ages and between that and my 401k we're kinda at our limit for the time being.  Aside from the increased contribution limit, not sure I really see an advantage, but I could be missing something.

The Roth 401(k) simply allows you to increase the amount of money going into a Roth designated account.  Virtually the same rules as a Roth IRA in terms of tax-free growth.  The difference is a Roth IRA has a $5500/year limit per person, and a Roth 401(k) has an 18K/year limit per person.

Cool.  I'll keep that in mind if I ever see a raise.  So is that $18k + the $5500 ?

hoffse

The Roth 401(k) simply allows you to increase the amount of money going into a Roth designated account.  Virtually the same rules as a Roth IRA in terms of tax-free growth.  The difference is a Roth IRA has a $5500/year limit per person, and a Roth 401(k) has an 18K/year limit per person.

Cool.  I'll keep that in mind if I ever see a raise.  So is that $18k + the $5500 ?

Yep, it sure is.  Combining the $18K limit on the 401k and the $5500 limit on the IRA lets you do up to $23,500/year per person in Roth-designated accounts.  

jtmh2012

hoffse said:

The Roth 401(k) simply allows you to increase the amount of money going into a Roth designated account.  Virtually the same rules as a Roth IRA in terms of tax-free growth.  The difference is a Roth IRA has a $5500/year limit per person, and a Roth 401(k) has an 18K/year limit per person.

Cool.  I'll keep that in mind if I ever see a raise.  So is that $18k + the $5500 ?

Yep, it sure is.  Combining the $18K limit on the 401k and the $5500 limit on the IRA lets you do up to $23,500/year per person in Roth-designated accounts.  

Yeah, won't be doing that anytime soon.   Currently doing 6% to each of our 401ks for the match and then a full $5500 to each IRA.  Although, should my wife ever change jobs, I may need to find a way to backdoor our Roths.  Never thought I'd find myself saying that.

kmurphy2131

hoffse said:

The Roth 401(k) simply allows you to increase the amount of money going into a Roth designated account.  Virtually the same rules as a Roth IRA in terms of tax-free growth.  The difference is a Roth IRA has a $5500/year limit per person, and a Roth 401(k) has an 18K/year limit per person.

Cool.  I'll keep that in mind if I ever see a raise.  So is that $18k + the $5500 ?

Yep, it sure is.  Combining the $18K limit on the 401k and the $5500 limit on the IRA lets you do up to $23,500/year per person in Roth-designated accounts.  

It's so aggravating to me that if you work somewhere with a 401K or roth 401K you can contribute $23,500 to retirement but if (like me) your work offers no retirement you are limited to only $5500. I know this sounds whiny but it's so unfair...it also makes no sense!  I feel like the IRA/roth IRA limits should be different if you have no other retirement options. I read these posts about upping retirement contributions and I feel so stuck. An IRA is just over 5% of my income but I cant up my contributions.I could go somewhere with more benefits but I would lose ~$10K of my income.

AprilZ81

kmurphy2131 said:

hoffse said:

The Roth 401(k) simply allows you to increase the amount of money going into a Roth designated account.  Virtually the same rules as a Roth IRA in terms of tax-free growth.  The difference is a Roth IRA has a $5500/year limit per person, and a Roth 401(k) has an 18K/year limit per person.

Cool.  I'll keep that in mind if I ever see a raise.  So is that $18k + the $5500 ?

Yep, it sure is.  Combining the $18K limit on the 401k and the $5500 limit on the IRA lets you do up to $23,500/year per person in Roth-designated accounts.  

It's so aggravating to me that if you work somewhere with a 401K or roth 401K you can contribute $23,500 to retirement but if (like me) your work offers no retirement you are limited to only $5500. I know this sounds whiny but it's so unfair...it also makes no sense!  I feel like the IRA/roth IRA limits should be different if you have no other retirement options. I read these posts about upping retirement contributions and I feel so stuck. An IRA is just over 5% of my income but I cant up my contributions.I could go somewhere with more benefits but I would lose ~$10K of my income.

I think it is silly that the government puts limits on what you can save in a tax advantaged account.  One way or another they will get their money so let people who want to save to it as much as they want to.

And don't forget you can put as much money as you want into mutual funds and other stock investments.  Even though they aren't "retirement" accounts it would be to your advantage to open one (or more) up and treat them as if they are.  You won't get any tax savings but you will have a bigger next egg when you want to retire.  Not to mention the added perk of being able to withdraw the funds at any time penalty free... You would just have to pay regular taxes on what you take out.

hoffse

@April, the limits are so the benefit is focused on building a secure retirement, instead of giving wealthy people a way to defer or even 0-out their taxes.  If you had no limits, you would have highly compensated people deferring tens or even hundreds of thousands of dollars a year and taking the deduction for it.

Even with the RMD rules, you could seriously whipsaw the government if you had the ability to do that.  Besides, a tax-deferred or tax-advantaged plan is an exception to the general rule that you have to pay taxes on income you earn in the current year or generate through investments in future years.  It's a lot like getting a deduction for health insurance or mortgage interest.  These are all tax breaks given to us by the grace of Congress, and in a perfect tax world none of them would exist. In order to provide these tax breaks to millions of people, the government often has to set ceilings or risk running out of money.  

I personally wish the limits were higher, but there are a lot of policy reasons for why they exist.