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Using a Roth 401k Even With Higher Income

| April 08, 2017
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Many traditional 401k's in recent years have started to add another option: the Roth 401k.  Did you know that there is no income limit on contributions or conversions to Roth 401k's?

 

Some plans now offer an automated Roth Conversion for any after tax contributions made to your 401k.  This could be a very valuable feature?

 

Explanation:

When you participate in your 401k plan, you elect a percentage of your income to be deposited into the 401k.  When the percentage you have elected to contribute exceeds $18,000 per year (or $24,000 if you are over age 50), remaining deposits are made after tax.  After tax contributions can be moved into the Roth 401k with "minimal or no tax consequences"***.  Further, there is no income limit to making contributions or conversions to a Roth 401k.  The advantage of the Roth 401k is that it grows tax free, whereas the traditional 401k grows tax deferred.

 

Here is an example:

Let’s say that your annual income is $150,000 and you have elected to contribute 15% of your pay to the traditional 401k.  There are several advantages of this:

  1. You are saving money for retirement
  2. Your employer might match a portion of your contribution (the match is not included in the $18,000/$24,000 limit)
  3. You have reduced your taxable compensation by the amount of your contribution up to the $18,000/$24,000 limit

 

So in our example:

$150,000 in annual pay x 15% contribution = $22,500 deposited and potentially matched into the 401k

 

However, if you are under age 50, the IRS limits 401k deposits that reduce your taxable income to $18,000 per year.

 

This means that your remaining contribution of $22,500 - $18,000 = $4,500 is made after tax.  Said differently, you only get to reduce your taxable income by up to $18,000 by making 401k contributions (not including match) according to current IRS rules if you are under age 50.  So the $4,500 over the contribution limit is still considered taxable income even though you are depositing these dollars in your 401k.

 

Because this $4,500 deposit is after tax money, it can be moved to the Roth 401k if your employer offers one with no transaction costs and “minimal to no tax consequences”***.  Again, there is no income limit to making Roth 401k contributions or conversions.  So even if you have a very high income, you can still contribute or convert to a Roth 401k.  This is a huge advantage to you because the money in your Roth 401k is never taxed under current tax rules.

 

Fast forward to retirement, let’s say that you have managed to save:

$500,000 in your traditional 401k, plus an additional $100,000 in your Roth 401k.  As you withdraw money from the traditional 401k for income in retirement, the entire $500,000 pretax balance is taxable as income.  However, the entire Roth 401k balance of $100,000 is completely tax free under current IRS rules as long as it is a qualified withdrawal (over age 59 ½ and held for at least 5 years).

 

***I’ve mentioned a couple of times that converting after tax deposits from your traditional 401k to your Roth 401k means “minimal to no taxes” on the converted amount. Why the words “minimal to no taxes”?  In the example above, we see a $22,500 deposit into the 401k throughout the year with a pretax limit of $18,000 per year.  This means $4,500 is after tax dollars that could be converted to the Roth 401k.  Let’s say that in our example the $4,500 sits in the traditional 401k for a year, this money grows to $5,000 during that year, and then the entire $5,000 gets converted to the Roth 401k.  Please note that the growth, in this case $500, is considered taxable income ($5,000 conversion amount - $4,500 after tax contribution = $500 growth).  So by converting after tax dollars to Roth 401k quickly, any taxable growth may be minimized. 

 

Another way of handling this would be to adjust your contribution percentage.  For example, contributing 12% of the $150,000 salary to traditional 401k = $18,000 and then contributing the remaining 3% directly to Roth 401k accomplishes the same thing as before without having to worry about a small tax consequence.

 

If you have questions about whether you are making the most of your 401k contribution strategy, please contact me and we can review your situation specifically.

 

Here is a handy chart from the IRS web site that compares Roth 401k’s, Roth IRA’s, and Traditional 401k’s.

 

 All investing involves risk, including the possible loss of principal. There is no assurance that any investment strategy will be successful. Past performance is not an indication or guarantee of future results. For a comprehensive review of your personal situation, always consult with a tax or legal advisor.  Neither Cetera Advisor Networks LLC nor any of its representatives may give legal or tax advice.

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