With a 401(k) plan, you can accumulate a tidy nest egg for retirement without any current tax erosion. Another retirement planning option, the Roth IRA, provides tax-free distributions in the future. But you can combine the best of both worlds.
Strategy: Switch your regular 401(k) account to a Roth 401(k). If your company doesn’t offer this option, ask them to get the ball rolling.
Assuming you meet all the tax law requirements, the distributions you receive in retirement will be completely exempt from tax.
This doesn’t have to be an all-or-nothing proposition. For instance, you can keep some of the funds in a regular 401(k) account. Alternatively, you might move all the funds to a Roth 401(k) over several years, thereby reducing the overall tax bite.
As with a regular 401(k) plan, contributions to a Roth 401(k) account grow on a tax-deferred basis. However, unlike a regular 401(k) elective deferrals aren’t made with a pre-tax dollars. The amounts contributed to the plan are subject to current tax.
With a Roth 401(k) plan, the tax-saving benefits come on the back end: Qualified distributions are 100% federal-income-tax-free. This includes distributions made five years after setting up the Roth 401(k) are taxable at ordinary income rates, now reaching as high as 37%.
The contribution limits for traditional 401(k) and Roth 401(k) plans are the same. For 2020, you can contribute up to $19,500 to either type of account ($26,000 if age 50 or over).
Note that Roth 401(k)s have an edge over Roth IRAs because there are no income limits on eligibility to make contributions. For 2020, availability to make Roth IRA contributions is phased out for single filers with modified adjusted gross income (MAGI) between $124,000 and $139,000 and between $196,000 to $206,000 of MAGI for joint filers. But you can contribute to a Roth 401(k) regardless of your income level!
Another point: Under a recent tax law change, you can convert 401(k) funds to a Roth 401(k) account at any time. Previously, you had to be eligible for a distribution, usually upon attaining a certain age or leaving the company. Thus, you have additional opportunities for inservice conversions.
Of course, you still must pay income tax in the year you convert, but it could be well worth it if you expect to be in a higher tax bracket in retirement. Factor in state income taxes, too.
Example: Suppose you are age 40, you’re in a combined 25% tax bracket and you have $200,000 in your regular 401(k). For simplicity, say you convert the entire $200,000to a Roth 401(k) in 2020 and you pay an effective tax rate of 28%. (The actual amount will depend on other variables.) Thus, you owe tax of $56,000 on the conversion. Assume that the Roth 401(k) grows to $1 million by the time you’re ready to retire in your sixties. No matter how much you withdraw from the Roth 401(k) during retirement, you’ll pay zero federal income tax on the distributions.
Now compare that to the outcome if you accumulate $1 million in regular 401(k) and you end up in a combined 35% tax bracket in retirement. In the unlikely event you pull out the entire amount in lifetime distributions, you would pay a whopping $350,000 in tax. A more likely scenario: You might withdraw half and pay tax of $175,000 – still $119,000 more than tax triggered by the conversion. Also, consider the possibility that tax rates will be even higher by the time you’re ready to start taking withdrawals in retirement.
On the flip side, switching to a Roth 401(k) may not make sense if you’ll be retiring soon and you expect to be in a lower tax bracket in the future.
You can avoid mandatory annual distributions after age 72 with a Roth 401(k), but not with a regular 401(k).
Small Business Tax Strategies