We recommend building your retirement assets by contributing to three separate “buckets” of money: 1) traditional retirement accounts; 2) Roth accounts; and 3) taxable accounts. Each of these buckets is affected by taxes in different ways. Since future tax laws are unknowable, it can be advantageous to hedge your bets by spreading your retirement assets across these three types of accounts. This is a means of reducing risk by diversifying your future tax liabilities.
While most investors can contribute to traditional retirement accounts, such as 401(k) accounts, 403(b) accounts, or Individual Retirement Accounts (IRAs), building your Roth assets can be more challenging due to income limits on direct Roth contributions. If your adjusted gross income is greater than $193,000 ($131,000 if single), you are prohibited from making direct contributions to a Roth IRA. Our previous newsletter (July 2015) discussed backdoor Roth contributions as an option for investors who are ineligible for direct Roth contributions. Designated Roth accounts and in-plan Roth rollovers are additional means for building Roth assets.
Since 2006, U.S. employers have been allowed by the IRS to offer designated Roth 401(k) or 403(b) accounts. These accounts allow employees to direct some or all of their salary deduction contributions to separate accounts within their retirement plan, called designated Roth accounts. Unfortunately, not all employers have implemented this change, so you may have to check with your benefits manager to see if designated Roth accounts are offered. As with Roth IRAs, contributions are made with after-tax dollars and then grow tax-free. Unlike traditional retirement accounts, Roth assets are typically tax-free when withdrawn during retirement. If your employer provides matching contributions, you will receive the employer match regardless of whether your personal contribution goes to a traditional retirement account or a designated Roth account, however, matching contributions must be allocated to a traditional account since they represent pre-tax dollars.
Designated Roth accounts are exempt from income limits and have higher contribution limits than Roth IRAs. If your employer offers a designated Roth account, you are eligible to participate regardless of your income. The combined annual contribution limit for designated Roth accounts and traditional pre-tax retirement accounts is $18,000 if you are under 50 years of age and $24,000 if you are over 50. If you leave your current job, you can roll your designated Roth account into a Roth IRA. Once converted to a Roth IRA there are no required minimum distributions throughout your lifetime.
A retirement plan with a designated Roth program can allow assets to be transferred in from another account in the same plan. This is referred to as an in-plan Roth rollover. In other words, eligible employees can transfer assets from their traditional 401(k) or 403(b) plan into their designated Roth account. These assets are taxed at your marginal income tax rate in the current year. Once the rollover is completed, the assets grow tax-free and are also tax-free when withdrawn during retirement provided that the usual Roth requirements are met. In-plan Roth rollovers often appeal to high net worth investors who don’t need all the money in their 401(k) for retirement and wish to pass along a tax-free inheritance to their spouse or kids. The greatest benefit may be to young investors since these assets can grow considerably over many years via tax-free compounding and provide substantial tax-free income during retirement.
One caveat about in-plan rollovers: The dollar amount converted to a Roth account is added to your taxable income. An in-plan rollover therefore has the potential to push you into a higher tax bracket. It may be prudent to consult your tax accountant to see how much you can convert without increasing your marginal tax rate. Of course, if you’re already in the top tax bracket, this is not a concern.
Any time we delve into the U.S. tax code, the details can be a bit mind-numbing. If you have any questions about designated Roth accounts or in-plan Roth rollovers, I would be happy to address them via telephone or email.
Jeffrey J. Brown, MD CFA Shearwater Capital