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Thought Leadership

RetireSmart: How the Option to Pay Taxes Now Could Pay Off Later for Your 401(k)

January 21, 2016

How the Option to Pay Taxes Now
Could Pay Off Later for Your 401(k)

Of all the options for how to invest your 401(k) money, one of the most overlooked could be among the most valuable. It’s called a Roth 401(k) account. Technically, it’s not an investment choice like the rest. Rather, it offers a choice of when to pay income tax on your own money going into the plan – now or later.

In a regular 401(k) account, your own contributions are pre-tax. This money is not included in your currently taxable compensation, so 100% can go to work in plan investment. Income tax is deferred until you take distributions, perhaps decades from now. (That’s why these contributions are called “elective deferrals.”)

On any part of compensation that you choose to allocate to the Roth account, however, income tax is paid now. You invest after-tax money in the plan.

Roth Accounts Increase Tax Freedom

So, why might you want to pay taxes on your personal plan contributions now, rather than later? The best answer may be the freedom from worrying about future taxes. Once you’ve paid the IRS its share upfront, this money:

  • Can continue to grow over time on a tax-deferred basis 
  • May be distributed tax-free if you meet age and holding period requirements
  • Can be borrowed tax-free, on the same basis as regular 401(k) account money
  • Can be transferred tax-free to a Roth IRA at a distribution event
  • Need not ever be distributed during your lifetime, if that is your wish

In short, a Roth account creates new planning options that may not be available in your regular 401(k) account, thanks to its different tax treatment.

Here are the most important rules to know about a Roth 401(k) account:

  • If you plan offers a Roth account option, you may choose to allocate any part of your own contributions to the plan, from zero to 100%.

  • Employer contributions, including any matching, always go into the regular 401(k) account as pre-tax money. They never increase your Roth account, even if they match your own Roth account contributions. (Choosing a Roth account will not affect your eligibility for matching contributions.)

  • You have the same investment choices available in a Roth account as in the regular account. (The Roth account is just tax-related bookkeeping. It doesn’t impact how plan money is invested.) Investment earnings are tax-deferred.

  • Money in your Roth account is always 100% immediately vested. If your plan offers loans, you may borrow against up to 50% of this money, to a maximum of $50,000.

  • Distributions may be taken from the Roth account at the same “trigger events” that apply to the regular account – separation from service, retirement, disability or death.

  • Qualified distributions from the Roth account are totally tax-free. A distribution is qualified if it is taken after a five-year holding period and also after age 59 ½. If a distribution is not qualified: 1) the portion that represents your original post-tax contributions is tax-free; 2) the portion that represents investment earnings is taxable. A 10% penalty also may apply if the distribution is made before age 59 ½, unless an exception applies.

  • Roth account balances may be transferred tax-free, at a trigger event, to a Roth IRA or to the Roth account of a new employer’s plan.

How a Roth Account Adds Flexibility

To see how a Roth account’s flexibility can work over time, let’s consider a hypothetical example. A 401(k) participant named Mary begins saving in her plan at age 30. She puts $2,000 of her own money in the plan each year, allocating it 50-50 between the regular and Roth accounts. Her employer matches 50% of her contributions ($1,000) per year, and all of this goes into the regular account. At the end of 10 years, when she is age 40, her accounts are worth the following at a hypothetical average investment earnings rate of 6%:

Regular account          $26,362
Roth account               $13,181
Total 401(k)                 $39,543

At age 40, she decides to take a year off work and travel around the world. To do this, she will need to access $10,000 in cash from her plan, after paying any tax and penalty, and she prefers to take it as a distribution rather than a loan. She can instruct her plan administrator to distribute the money she needs from either, or both, of her accounts. (We will assume she pays income tax at a 28% marginal tax rate.)

If she takes the distribution from her regular account, all of the money will be subject to income tax plus a 10% penalty. However, by taking the distribution from her Roth, the portion representing her own contributions will be returned tax-free. Only the earning portion will be subject to tax + penalty. The table below summarizes the consequences.

 

Withdrawal from Regular Account

Withdrawal from
Roth Account

Withdrawal before tax and penalty

$16,129

$11,010

Taxable portion of withdrawal %

100%

24.13% (earnings only)

Taxable portion of withdrawal $

$16,129

$2,657

Income tax on withdrawal

$4,516 @ 28%

$744 @28%

10% penalty on withdrawal

$1,613 @ 10%

$266 @10%

Total tax + penalty

$6,129

$1,010

Cash remaining after tax on withdrawal

$10,000

$10,000


Summary: By having access to a Roth account and designating that 100% of the withdrawal be taken from it, Mary meets her need for $10,000 of after-tax cash by withdrawing just $11,010 from her plan. Her total tax and penalty on this withdrawal is $1,010.

If she had no Roth account, she would have had to withdraw $16,129 from her regular 401(k) account to have $10,000 left after-tax. She would have paid combined tax and penalty of $6,129 – more than five times as much than from the Roth account!

Retirement Advantages of Roth Accounts

If you keep your money in a Roth 401(k) account through retirement, there are other benefits. After you reach age 59 ½ and have held the account at least five years, distributions are 100% tax-free and penalty-free. That means you can use this money to fill retirement income gaps, without worrying about the tax impact on your budget.

Also, you can make a tax-free transfer to a Roth IRA. However, you are not allowed to transfer or roll over Roth account money to a Traditional IRA.

Finally, if you want to leave all of your Roth IRA to family or heirs, there are no minimum distribution requirements during your lifetime. In a regular 401(k) account, you are required to begin distribution no later than the year after you turn age 70 ½ or the year after you retire, whichever is later. When your beneficiary takes distributions from the Roth account, these, too, will be tax-free, provided the account has been held at least five years.

In summary: It’s a good idea to understand all options your 401(k) offers, and a Roth account is one of the most important. Even if you decide not to use it now, there may come a time when it meets your needs and tax circumstances for at least part of your contributions.  

The allocation of contributions to a Roth account is irrevocable. Once money goes into the Roth account, it can’t be moved back into the regular 401(k) account, so it may be advisable to seek personal tax advice before making this decision.

However, you probably can change the allocation of contributions between the two accounts periodically. Consult your Human Resource department for details. Also, you may find useful information from Shelton Capital at www.sheltoncap.com/rps .