Using a 401(k) to Boost Roth IRA Assets

The Roth IRA appeals to many people because of its long-term advantages. Sure, there are no tax breaks when you make contributions. You must contribute after-tax dollars. After that, though, the tax breaks multiply. Income and gains compound tax free within the IRA. You can take tax-free distributions of income and gains at any time and of contributions after five years. There are no required minimum distributions on the original owner. Beneficiaries who inherit a Roth IRA also receive distributions tax free. They are required to take minimum distributions, but the RMDs are taken over their life expectancies.

The package of benefits is so powerful that Congress doesn’t allow upper-income taxpayers to contribute to Roth IRAs. Your ability to make a Roth IRA contribution is phased out beginning when your adjusted gross income reaches $116,000 for a single person and $183,000. The contribution is eliminated when your AGI is $10,000 higher than those levels.

Fortunately, there are a couple of ways you might be able to use a 401(k) to effectively begin funding a Roth IRA for your retirement years.

The first way is to make salary deferrals to a Roth 401(k) instead of a traditional 401(k). The deferrals (or contributions, as most people think of them) are included in your gross income just as though they were paid to you. So, you’ll pay taxes on income you aren’t receiving in cash. In return you receive the many long-term benefits of a Roth account. Eventually, you can roll over this account to a Roth IRA or leave it in the Roth 401(k) if you think that’s a better deal.

The Roth 401(k) plan has the same contributions limit and general rules as the traditional 401(k). The differences are those we discussed: deferrals are after-tax, and distributions are tax free in most cases.

The Roth 401(k) has been allowed for only a relatively few years. Not every employer offers one as part of its plan. But many do, especially larger employers, and more are offering the plans every year. If your employer doesn’t yet offer one, consider asking for one.

The other method, and one that’s potentially more rewarding, is to make after-tax contributions to a traditional 401(k) plan. You’re aware that pre-tax contributions can be made to a 401(k) up to $18,000 in 2015 (and an additional $6,000 if you’re age 50 or older).

Most people aren’t aware they can make additional deferrals or contributions. The limit on total 401(k) contributions is $53,000 in 2015, or $59,000 for those make catch up contributions at age 50 or older. That means if you’re 50 or older and maximize pre-tax contributions at $24,000, you can make additional after-tax contributions up to $35,000.

That’s the catch. Only the first $24,000 of contributions has up-front tax benefits. The additional contributions up to $35,000 will be included in your gross income and subject to taxes. But once in the 401(k), the income and gains on the contributions compound tax deferred. When you take the contributions out of the 401(k), the after-tax contributions aren’t taxed. Only the income and gains on the after-tax contributions are taxes.

Plus, the IRS issued regulations in 2014 that provide an added benefit to making after-tax 401(k) contributions.

For years it wasn’t clear how to rollover after-tax 401(k) contributions to a Roth IRA. Under the latest regulations, when you’re ready to rollover the 401(k) to an IRA, you can separate the after-tax contributions and roll them directly to a Roth IRA. You can do this even if the after-tax contributions weren’t in a separate 401(k) account. At the same time, you move the pre-tax contributions and all the accumulated income and gains to a traditional IRA.

It can be even better if your 401(k) plan allows in-service withdrawals. These are distributions that the tax code allows after age 59½. Even if you continue to work for the employer, you can roll over the account tax-free to an IRA. If you have both pre-tax and after-tax contributions, you can roll the after-tax contributions to a Roth IRA and the pre-tax contributions and accumulated returns to a traditional IRA. You then have the 401(k) money in IRAs, giving you complete flexibility in managing them. Yet, you can continue to contribute to the 401(k), to both pre-tax and after-tax contributions.

Some employers restrict how often in-service withdrawals can be taken, but others allow them as often as you want once you are qualified. In these cases, you can make simple online orders to move your after-tax 401(k) money to a Roth IRA on a regular basis, if you want. To keep things simple, if you’re going to make frequent in-service withdrawals have the 401(k) invested only in a money market fund so there won’t be much income and gains in the 401(k) to complicate things.

Some people ask why they should put after-tax money in a Roth IRA or in one of these 401(k) strategies. There are two good reasons.

One reason is to achieve tax diversification. None of us knows what will happen with the tax law in the future. It is risky to arrange our assets solely to achieve short-term tax breaks or to bet that the tax law won’t change in the future. Tax diversification means having money in each of the different types of accounts. That way, you won’t be hurt badly by major tax law changes, and some of your accounts are likely to benefit from changes while others might be hurt.

Tax diversification also increases control of your tax rate in retirement. You’ll have income you can’t control, such as Social Security benefits and interest income in taxable accounts. But you’ll have some control over recognition of capital gains from sales of assets in taxable accounts, and distributions from both traditional IRAs and Roth IRAs. By coordinating these different ways of generating cash to pay expenses, you can keep your tax rate low, often as low as 20%.

Another reason to have some assets in a Roth account is to avoid the senior stealth taxes and the RMD waterfall. As people age, especially in their late 70s and beyond, the required minimum distributions from traditional retirement accounts increase. Whether you need the money or not you have to take distributions and include them in gross income. I call this the RMD waterfall.

The RMD waterfall can trigger more than income taxes. The higher income from the RMDs might trigger a range of additional taxes or the loss of tax breaks. Social Security benefits might become taxable. You could lose itemized deductions and personal exemptions. The Medicare premium surtax could be triggered. The list of these stealth taxes goes on.

The senior stealth taxes can be reduced or avoided if you have money in a Roth account instead of a traditional IRA account. The Roth accounts don’t have RMDs to the original owner. Also, distributions from them are tax-free and don’t trigger the stealth taxes.

If the tax law stymied your ability to add Roth accounts to your portfolio, help might be available. Consider the strategies described here to enhance your retirement assets.

RW September 2015.