Roth 401k benefits

[sergio]

Is anyone aware of any benefits to a Roth 401k that are available after __ years? I know that in a Roth IRA there is a "5 year rule" which only checks when you opened the account. I max out my traditional 401k but was thinking about throwing $100/month into a Roth 401k just to have it be open starting in 2021.

FWIW we're in the 12% federal bracket and about 6% state. So maybe some Roth may not be a terrible idea either way?

Thanks!

 

[Lawrencewendall]

I recommend throwing $100 in a Roth just to start the timer.

 

[CSdot]

Sadly, not aware of a special 5 year rule similar to a Roth IRA. That said, in 2011 when my former Law Firm employer offered a Roth 401k option (the 401k provider suggested the idea of adding the option, and the employer went along), I was one of the very few who ever took advantage of the Roth option. My fellow 401k participants made compelling arguments against the Roth option saying my tax rate while contributing would surely be higher than my tax rate at retirement, and I would be missing the decrease in taxable income that comes with traditional 401k participation. I will admit that I questioned the logic of my decision.

I left that employer in early 2017, but left my 401(k) in place because I was happy with the fund choices. Now that 401(k) is worth 7 figures, with 25% of that amount being categorized as Roth 401(k).

I have given greater thought to the Roth 401(k) objections I heard from my former law partners, that my tax rate would be lower at retirement so I am unnecessarily paying extra tax, and now I 100% believe that I made the correct decision. Even if my post retirement tax rate is 10% lower than my working life tax rate, in looking at my most recent statement, the amount of growth exceeds the amount contributed. In another decade, the difference will be even more pronounced and magnified. Meaning the $10,000 in extra tax I paid (assuming my post-retirement tax rate will be 10% less than my working tax rate) will generate many hundreds of thousands in tax free money at retirement. In retrospect, it should have been a no brainer decision.

Point being, with or without the added benefit of the 5 year rule, I am now a true believer of benefit of the Roth 401(k).

 

[sergio]

Sadly, not aware of a special 5 year rule similar to a Roth IRA. That said, in 2011 when my former Law Firm employer offered a Roth 401k option (the 401k provider suggested the idea of adding the option, and the employer went along), I was one of the very few who ever took advantage of the Roth option. My fellow 401k participants made compelling arguments against the Roth option saying my tax rate while contributing would surely be higher than my tax rate at retirement, and I would be missing the decrease in taxable income that comes with traditional 401k participation. I will admit that I questioned the logic of my decision.

I left that employer in early 2017, but left my 401(k) in place because I was happy with the fund choices. Now that 401(k) is worth 7 figures, with 25% of that amount being categorized as Roth 401(k).

I have given greater thought to the Roth 401(k) objections I heard from my former law partners, that my tax rate would be lower at retirement so I am unnecessarily paying extra tax, and now I 100% believe that I made the correct decision. Even if my post retirement tax rate is 10% lower than my working life tax rate, in looking at my most recent statement, the amount of growth exceeds the amount contributed. In another decade, the difference will be even more pronounced and magnified. Meaning the $10,000 in extra tax I paid (assuming my post-retirement tax rate will be 10% less than my working tax rate) will generate many hundreds of thousands in tax free money at retirement. In retrospect, it should have been a no brainer decision.

Point being, with or without the added benefit of the 5 year rule, I am now a true believer of benefit of the Roth 401(k).

Thanks for the detailed reply. I've been torn on the Roth 401k, but ultimately decided against it because:

1. Right now our marginal state tax is 6.5%. We will absolutely not be living in this state in retirement. We'll likely move back to my home state next door which doesn't tax 401k distributions.

2. The traditional moves us out of the 22% federal bracket and into the 12% bracket. Also in 2021 this will open up $10k of tax gain harvesting, 0% dividend tax, 0% LTCG in case we need to sell in a pinch etc.

3. The $18k I put in my traditional 401k in 2019 made us eligible for full stimulus payments this year, since it bumped down our AGI below the threshold. Same thing with our state's 529 credit (not much, only $500). The stimulus was somewhat unexpected, but I've always always been a big proponent of keeping AGI as low as possible for these reasons.

4. Post retirement, we'll probably need about $50k in today's dollars per year, since the house will be paid off in a few years, no loans on cars, etc. Assuming a standard deduction of $25k, that leaves $25k of taxable income. I'm not too worried about explosive taxes on that amount of income.

Also, if your tax is 10% lower in retirement, shouldn't you be deferring taxes, instead of paying them upfront? If the tax rate is the same pre/post-retirement then Roth/Trad 401k is mathematically an even steven.

Having said all that, we also fully fund our two Roth IRA's every year to the absolute max, since I also believe in being diversified.

 

[CSdot]

Thanks for the detailed reply.

Also, if your tax is 10% lower in retirement, shouldn't you be deferring taxes, instead of paying them upfront? If the tax rate is the same pre/post-retirement then Roth/Trad 401k is mathematically an even steven.

Having said all that, we also fully fund our two Roth IRA's every year to the absolute max, since I also believe in being diversified.

Sounds like the right decision for you.

For me, I calculate the Roth 401(k) decision will result in me paying approximately $100,000 less in taxes compared to an equivalent six years of contributions to a Traditional 401(k) me over the life of the transaction. My tax savings will just come during retirement.

 

[Dash man]

Something to consider, converting from your traditional 401k to a Roth later triggers another five year clock for each of those conversions.

 

[Out-to-Lunch]

Sounds like the right decision for you.

For me, I calculate the Roth 401(k) decision will result in me paying approximately $100,000 less in taxes compared to an equivalent six years of contributions to a Traditional 401(k) me over the life of the transaction. My tax savings will just come during retirement. (emphasis added)

I think this comes down to what you mean by "equivalent." If you are comparing a contribution of, say, $10k to a Roth to $10k to Traditional, I do not think that those are equivalent situations.

IMHO, the appropriate comparison would be: Contributing $10k to a Traditional vs. contributing $10k*(1-taxrate) to a Roth. As @sergio points out, this comparison makes it clear that your marginal rate when withdrawing vs. your marginal rate when contributing is the important consideration.

What @sergio said for his case is also true in my case: I also fully funded a Roth IRA, even at a higher (i.e., while working) tax rate, due to a desire for tax diversification.

 

[MarieIG]

Interesting. My Roth 401k - which I carried from my last firm to this firm, recorded the "start date" from my last firm (IIRC 2012). I had to nag the partners in charge of the retirement plan for about two years before they set it up - and then I was the only one who used it.

I really see no downfall to tossing $100 into the 401k Roth to start the clock ticking. (I did very small conversions w/n one of DH's 401k to start the clock on that one.)

And doesn't the "clock" only apply to gains, not to the original non-deductible contributions?

 

[CSdot]

I think this comes down to what you mean by "equivalent." If you are comparing a contribution of, say, $10k to a Roth to $10k to Traditional, I do not think that those are equivalent situations.

IMHO, the appropriate comparison would be: Contributing $10k to a Traditional vs. contributing $10k*(1-taxrate) to a Roth. As @sergio points out, this comparison makes it clear that your marginal rate when withdrawing vs. your marginal rate when contributing is the important consideration.

What @sergio said for his case is also true in my case: I also fully funded a Roth IRA, even at a higher (i.e., while working) tax rate, due to a desire for tax diversification.

I was paying an effective 25% rate during the 2011-2016 time frame when I contributed to the Roth 401(k). Over those 6 years I contributed around $100,000, meaning I paid $25,000 in taxes I otherwise would not have paid if I elected to participate in the traditional 401(k). At the end of 2020, the Roth 401(k) alone showed a balance of $250,000, meaning $150,000 in growth over the last decade.* That growth along with your contributions are taxed at distribution in a traditional 401(k), yet none of it is taxed at distribution in a Roth 401(k). I just turned 51, so I cannot take a distribution for another 8.5 technically, but using today for example purposes only, compared to a traditional 401(k) I am saving at the very least my 25% tax rate on that $150,000 growth difference, or $37,500 in taxes. Meaning I am already ahead. Now if I was in the 12% tax category (which I don’t envision I will ever be considering my Traditional retirement accounts are already over $1M), that figure is halved, or $18,000 compared to the $25,000 tax paid to date.

However, I have at least 8.5 more years (until 59.5) before I can even touch the Roth 401(k) money, so if it doubles (10% annually has been my experience in my 25 years investing in the stock market), I will be at $500,000, or $400,000 growth. 25% of $400,000 is $100,000.00 (plus the $25,000 already paid = $125,000). Since I will be taking that Roth money out over time, and probably not all at once, I estimate that $100,000 saved is a floor, not a ceiling, on the tax savings.

That said, the tax savings is wholly dependent on each participant’s specific situation (tax rates, amount saved, how much growth risk you are willing to take, and what other investments you have). Sounds like you and OP made the correct decisions for you, and I am happy with the decision I made.

* to the extent that there was an assumption that the tax paid would have gone into a traditional 401(k) -meaning a larger 401(k) investment- I was already maxing out, so sadly the 401(k) company would have gotten the same IRS capped amount from me whether a Roth or a Traditional 401(k). Anything more went to supporting my wife and three kids. Assume the smile face emoji here.

 

[ut2sua]

Something to consider, converting from your traditional 401k to a Roth later triggers another five year clock for each of those conversions.

Can one avoid this issue if the 401k $ is first moved to a tIRA account, then the Roth conversion is done from the tIRA? Or is there a catch somewhere? Thanks.

 

[Dash man]

Can one avoid this issue if the 401k $ is first moved to a tIRA account, then the Roth conversion is done from the tIRA? Or is there a catch somewhere? Thanks.

No, it works the same.

 

[bada bing]

Sounds like the right decision for you.

For me, I calculate the Roth 401(k) decision will result in me paying approximately $100,000 less in taxes compared to an equivalent six years of contributions to a Traditional 401(k) me over the life of the transaction. My tax savings will just come during retirement.

You are making a common error in conflating the amount of taxes paid with the amount of benefit to you. Roth contributions will usually result in less taxes paid, assuming you had a positive return for the years in the account. The correct way to model it is to maximize the eventual post-tax balance that you will have. When you model it that way, it becomes a simple arbitrage between tax rate at time of contribution and tax rate at time of withdrawal.

One complicating factor is Roth IRAs don't have an RMD requirement and Roth 401k's are eligible for direct roll over. Another complication is strategically doing Roth conversions at advantageous times.

 

[CSdot]

One complicating factor is Roth IRAs don't have an RMD requirement and Roth 401k's are eligible for direct roll over. Another complication is strategically doing Roth conversions at advantageous times.

Please elaborate further on these two items.

(1) One complicating factor is Roth IRAs don't have an RMD requirement and Roth 401k's are eligible for direct roll over.

So the Roth 401(k) DOES have a RMD requirement, but seems you are saying Roth 401(k) holders wishing to avoid the RMD requirement can simply do a direct roll over to a Roth IRA prior to the RMD date (age 72)?

(2) Another complication is strategically doing Roth conversions at advantageous times.

When would be a disadvantageous time to do a Roth conversion (assume we are still talking about the Roth 401(k) direct roll over to a Roth IRA)?

Other than after the age 72 RMD where there may be tax entanglements, it would seem a Roth to Roth rollover should never be a taxable event, unlike a rollover from a Traditional 401(k) or Traditional IRA to a Roth IRA which would result in a taxable event.

 

[Out-to-Lunch]

* to the extent that there was an assumption that the tax paid would have gone into a traditional 401(k) -meaning a larger 401(k) investment- I was already maxing out, so sadly the 401(k) company would have gotten the same IRS capped amount from me whether a Roth or a Traditional 401(k).

I am glad that you were happy with your choices. My interest is in providing information for others.

Part of your message is that circumstances may constrain your choices: you state that you were maxing out your 401(k), and thus were unable to contribute more to a traditional plan.

Over those 6 years I contributed around $100,000, meaning I paid $25,000 in taxes I otherwise would not have paid if I elected to participate in the traditional 401(k). At the end of 2020, the Roth 401(k) alone showed a balance of $250,000, meaning $150,000 in growth over the last decade.* That growth along with your contributions are taxed at distribution in a traditional 401(k), yet none of it is taxed at distribution in a Roth 401(k).

Imagine if you had been able to contribute $100,000 + $25,000/(1-0.25) = $133.33K to a traditional plan. (This would be the same out-of-pocket as what you spent.) It would have grown (with the same investments) to $333.3k. True, the whole balance would have been taxed upon distribution. Let's assume it was taxed at 25%. You would then have $333.3*(1-0.25) = $250K to spend. Which is the same as what you have in the Roth scenario.

Mathematicians call this "the commutative law of multiplication."

Again, I understand that you are happy with your choice, and you were constrained in your choices, and that you bristle at revisiting it. I am speaking more to people yet contemplating Roth vs. traditional, and trying to disabuse them of the notion that a Roth has some magical tax-savings properties that a traditional account lacks. They each have their place, and a wise user considers tax-rate arbitrage (which is perhaps the principal driver) along with other constraints (such as the contribution limits you mentioned).

 

[monte1022]

Something to consider, converting from your traditional 401k to a Roth later triggers another five year clock for each of those conversions.

It's kind of sad that Uncle Sam still wants to control "your" money even after the age of 59.5. How does one keep track of the various converted amounts?

 

[RxMan]

I’m contributing 8% into the traditional 401k and 14% into the Roth 401k plan currently. This puts me right at the maximum 401k individual contributions limit for the year. I’m also maxing out my Roth IRA separately. This way I’m contributing to both types of accounts and I’m less concerned with whatever direction tax rates will go in the future.

 

[bada bing]

For those still working and funding retirement accounts that are constrained by qualified contribution limits, one thing worth checking into is if your employer's retirement savings plan 401K happens to allow non-Roth after-tax contributions. Most plans don't, but many of the largest employer plans do. If your plan does and also allows either in-plan rollovers or in-plan recharacterizations, then you can do what is popularly called a mega-backdoor Roth. That allows up to ~$30K per year of additional Roth savings contributions.

My employer had the features that allowed the mega-backdoor Roth and I maxed it out the last 7 years I worked. I put away ~$200K into a Roth as well as continuing to max out my regular 401k limits as pre-tax. It was a great help in catching up, savings wise and eventually retiring. My personal experience was my company's HR rep didn't understand or know much about the 401K details. The best place to ask is the account custodian (brokerage).

 

[MarieIG]

For those still working and funding retirement accounts that are constrained by qualified contribution limits, one thing worth checking into is if your employer's retirement savings plan 401K happens to allow non-Roth after-tax contributions. Most plans don't, but many of the largest employer plans do. If your plan does and also allows either in-plan rollovers or in-plan recharacterizations, then you can do what is popularly called a mega-backdoor Roth. That allows up to ~$30K per year of additional Roth savings contributions.

My employer had the features that allowed the mega-backdoor Roth and I maxed it out the last 7 years I worked. I put away ~$200K into a Roth as well as continuine to max out my regular 401k limits as pre-tax. It was a great help in catching up, savings wise and eventually retiring. My personal experience was my company's HR rep didn't understand or know much about the 401K details. The best place to ask is the account custodian (brokerage).

My employer's plan did not do in service conversions (DH's employer did) but did accept rollovers from IRAs. Curtesy of PB4uski, I rolled out all my pre-tax money into the 401k, and converted my non-deductible contributions to a Roth, which was a non-taxable event. (As an aside, I already had a very small Roth which was over five years old.) The following year, I did an in-service rollover of the Roth to the IRA (a lot of fees on the 401k) and contributed my last non-deductible 7k and immediately converted.

This year I rolled out the pre-tax money into a traditional - and henceforth any converstions will be taxable.

I do not have a crystal ball as to what tax rates will be when we are subject to the RMDs, but I don't anticipate them going down.

 

[CRLLS]

It's kind of sad that Uncle Sam still wants to control "your" money even after the age of 59.5. How does one keep track of the various converted amounts?

As I understand it, after a person reaches the age of 59.5, there is only one 5- year clock with "Roth converted amounts". That is the start date of the Roth IRA or any of his/her Roth IRA accounts for that matter. The separate 5-year clock(s) on each conversion does not apply once a person reaches 59.5. I may be wrong on this detail. Someone will comment for sure if I am.

 

[monte1022]

As I understand it, after a person reaches the age of 59.5, there is only one 5- year clock with "Roth converted amounts". That is the start date of the Roth IRA or any of his/her Roth IRA accounts for that matter. The separate 5-year clock(s) on each conversion does not apply once a person reaches 59.5. I may be wrong on this detail. Someone will comment for sure if I am.

I thought this to be true as well until reading the business insider write-up on the five year rule. It states that the rule applies regardless of age when considering converted amounts. However, another piece by Kitces seemed to agree with what you said.

 

[MarieIG]

As I understand it, after a person reaches the age of 59.5, there is only one 5- year clock with "Roth converted amounts". That is the start date of the Roth IRA or any of his/her Roth IRA accounts for that matter. The separate 5-year clock(s) on each conversion does not apply once a person reaches 59.5. I may be wrong on this detail. Someone will comment for sure if I am.

That was my understanding - but I am no tax expert. (My Roth 401k was over five years old; my Roth IRA was over five years old; and I started making minute converstions on DHs second 401k - which we don't intend to tap prior to his reaching age 70 in any event, to start the clock.) I expect this year will be our biggest conversion, as I will not be working the entire year and it is the last year that IRMMA will not be a factor. In any event, I will be printing out Gumby's Important Trigger Income Levels list, and discuss the converstion plan with my accountant.

 

[Dash man]

That was my understanding - but I am no tax expert. (My Roth 401k was over five years old; my Roth IRA was over five years old; and I started making minute converstions on DHs second 401k - which we don't intend to tap prior to his reaching age 70 in any event, to start the clock.) I expect this year will be our biggest conversion, as I will not be working the entire year and it is the last year that IRMMA will not be a factor. In any event, I will be printing out Gumby's Important Trigger Income Levels list, and discuss the converstion plan with my accountant.

The IRS pamphlets are pretty confusing. But there are a number of articles explaining it. Here’s one:

https://www.businessinsider.com/roth-ira-5-year-rule

 

[MarieIG]

The IRS pamphlets are pretty confusing. But there are a number of articles explaining it. Here’s one:

https://www.businessinsider.com/roth-ira-5-year-rule

Thank you. Looks like I'll have to plan a time-frame to stop my conversions five years before I want to take withdrawals to be on the safe side. I started "conversions" last year, so those onward will be traceable. This year should be my biggest conversion, barring any tax surprises. I was really surprised that the conversions were taxable, since you've just paid taxes on them.

It may be that I convert 2021-2025; and start SS and taking withdrawals from my traditional IRA starting 2026; five years earlier than I intended to, to get RDMs down that way . . .

 

[Dash man]

We plan to keep converting, figuring we’d never take out so much to reach funds within the five year window. Note that a conversion in December is counted as a conversion in January of the same calendar year. So it may not have to be a full five years.

 

[CRLLS]

Whenever I get conflicting answers, I try to go to the source. While it is not excerpts from the actual law, the following is from the IRS. I believe it says that at age 59.5+ we are free and clear of any penalty from conversions done within the last 5 years. Bold and underlined parts are my accents and some parts are clipped out. You can read the whole publications here:

https://www.irs.gov/publications/p590b#en_US_2019_publink1000231064

if you satisfy the requirements, qualified distributions (discussed later) are tax free.

What Are Qualified Distributions?
A qualified distribution is any payment or distribution from your Roth IRA that meets the following requirements.
1. It is made after the 5-year period beginning with the first taxable year for which a contribution was made to a Roth IRA set up for your benefit, and
2. The payment or distribution is:
a. Made on or after the date you reach age 59½,
b. Made because you are disabled (defined earlier),
c. Made to a beneficiary or to your estate after your death, or
d. One that meets the requirements listed under First home under Exceptions in chapter 1 (up to a $10,000 lifetime limit).



If you receive a distribution that isn't a qualified distribution, you may have to pay the 10% additional tax on early distributions as explained in the following paragraphs.




Distributions of conversion and certain rollover contributions within 5-year period.

If, within the 5-year period starting with the first day of your tax year in which you convert an amount from a traditional IRA or roll over an amount from a qualified retirement plan to a Roth IRA, you take a distribution from a Roth IRA, you may have to pay the 10% additional tax on early distributions. You must generally pay the 10% additional tax on any amount attributable to the part of the amount converted or rolled over (the conversion or rollover contribution) that you had to include in income (recapture amount). A separate 5-year period applies to each conversion and rollover. See Ordering Rules for Distributions , later, to determine the recapture amount, if any.

Unless one of the exceptions listed later applies, you must pay the additional tax on the portion of the distribution attributable to the part of the conversion or rollover contribution that you had to include in income because of the conversion or rollover.

Exceptions.

You may not have to pay the 10% additional tax in the following situations.
• You have reached age 59½.
• You are totally and permanently disabled.
• You are the beneficiary of a deceased IRA owner.
• You use the distribution to buy, build, or rebuild a first home.
• The distributions are part of a series of substantially equal payments.
• You have unreimbursed medical expenses that are more than 7.5% of your adjusted gross income (defined earlier) for the year.
• You are paying medical insurance premiums during a period of unemployment.
• The distributions aren't more than your qualified higher education expenses.
• The distribution is due to an IRS levy of the qualified plan.
• The distribution is a qualified reservist distribution.

I read that as any withdrawal from a Roth IRA are "qualified" once the recipient is over 59.5 and their 1st Roth IRA opened and contributed to was over 5 tax years ago. Meeting that requirement, any withdrawal is not taxed. Further, even if the withdrawal was not "qualified" since the recipient is over 59.5 the "additional 10% tax" does not apply either.