As my colleague mentioned last week, the income limitations on Roth IRA conversions (moving qualified retirement plan or traditional IRA assets into a Roth IRA) were removed beginning in 2010. That change opens the door for all taxpayers to take advantage of the Roth IRA – specifically the tax-free growth (as opposed to tax-deferred in a 401(k) or traditional IRA) and the lack of required minimum distributions (RMDs). You pay the tax once on conversion to move those pre-tax assets into post-tax assets, and then (after meeting the age and time requirement) any future distributions are 100% tax free, including all future earnings as long as you live.
Current Roth Contributions
Even though the income limitations on Roth conversions were lifted, the income limit on annual Roth contributions is still in place ($105,000-$120,000 for single taxpayers, $167,000-$177,000 for married taxpayers). That keeps annual Roth contributions out of reach for higher-income individuals.
There is another option, however: starting in 2006, employers were allowed the option of including a Roth component of their 401(k) plan – called a Roth 401(k). The contribution limits are the same as a regular 401(k) ($16,500 in 2010), but instead of getting a tax deferral on the amount (the contribution is excluded from your pay and taxed later during your retirement); the amounts are taxed currently and can be distributed tax-free in the future, just like a Roth IRA. This is a great option for a taxpayer who earns too much to be eligible for Roth IRA contributions, but wants to take advantage of the tax-free growth. One other note: employer contributions cannot be allocated to the Roth account – those are still taxable on withdrawal.
The catch is that the Roth 401(k) is not exactly like a Roth IRA. We already know the annual contribution limits are higher, which is an advantage. And the Roth 401(k) is not restricted by income limitations—another advantage.
Disadvantages of the Roth 401(k)
The disadvantages, however, stem from the fact that the Roth 401(k) is really a child of the 401(k) rules more than the IRA rules. For example, Roth 401(k) accounts are subject to the RMD rules, just like your regular 401(k). That means upon reaching age 70 ½, you have to start withdrawing annual amounts to gradually deplete the account.
Another example: regular Roth IRA contributions (but not earnings) can be withdrawn at any time, tax free (since you never deducted the contribution)—even before reaching age 59 ½ and satisfying the 5 year holding requirement. This is due to the way in which distributions from a Roth IRA are ordered, leaving the earnings (which would be taxable if distributed early) to come out last. A Roth 401(k) doesn’t share that attribute; all distributions are as restricted as your regular 401(k). Any early distribution is prorated to determine the portion related to earnings vs. contributions, and the earnings portion is taxed and subject to the 10% early-withdrawal penalty. Also, you lose the ability to take early distributions for a first-time home purchase (which you can do with a Roth IRA).
The Rollover Solution
So, Roth 401(k)s have their advantages and disadvantages before you even get into the tax bracket game (better to pay tax now with a Roth or later with a regular 401(k) or traditional IRA?). However, there is a way to avoid some of the disadvantages of a Roth 401(k), but this too has its catches.
You can rollover your Roth 401(k) directly into a Roth IRA. You have to wait until you leave your job or retire (unless your employer offers in-service 401(k) withdrawals), just like a regular 401(k) to traditional IRA rollover. But, by rolling the assets into a Roth IRA you can avoid the RMD rules. The catch is that each rollover from a Roth 401(k) to a Roth IRA has its own 5 year waiting period, and the tax treatment changes based on whether you would have been allowed to take a penalty-free distribution from the Roth 401(k) in the first place. If you would have met the 5 year requirement (and attained age 59 ½), the rollover to the Roth IRA gets very favorable treatment (all of the rollover amount is considered basis and can never be penalized on distribution). If you would not have met the age or holding period requirements, you still don’t have to pay tax on the rollover, but the earnings in the Roth 401(k) have to stay in the Roth IRA for 5 years to avoid any penalties on withdrawal. There are a lot of different scenarios here, and I recommend consulting your tax advisor to fully explain the tax attributes of any potential transaction.
A Roth 401(k) is a pretty good alternative to the venerable Roth IRA, but it is not without its restrictions. However, the higher contribution limits and the ability to roll it into a Roth IRA later in life may offset some of its disadvantages. As always, you should consider the tax vehicle for your retirement assets in the context of your overall retirement & estate plan, but it is nice to see more options becoming available. If you have further questions, consult your tax advisor or give us a call – we’d be happy to help with all of your tax planning and/or compliance needs.