While Roth IRAs have been around for over a decade, the Roth 401(k) is a more recent addition to the lineup of retirement savings plans. While many high-income taxpayers are unable to directly fund a Roth IRA due to adjusted gross income (AGI) limits, any taxpayer, regardless of their income, can contribute to a Roth 401(k) assuming their employer offers this retirement plan option. If the Roth 401(k) is offered by one’s employer, you’ll also see the pre-tax 401(k) option as well.
The main difference with the pre-tax and Roth 401(k) plans is the taxation of contributions and withdrawals. Dollars deposited into the pre-tax 401(k) are just that – before-tax contributions. After-tax dollars are contributed to the Roth 401(k). However with the Roth 401(k), assuming it’s a qualified distribution (i.e. the five year and post-age 59½ rules are met), all future withdrawals are income-tax free. Having a source of income in retirement that is tax free can be very appealing to investors, particularly those in a high tax bracket as they look to diversify their retirement income sources.
While the tax-free nature of the Roth 401(k) plan option can be appealing, there are some differences investors need to understand before jumping in. First, unlike Roth IRAs, if you convert your pre-tax 401(k) to a Roth 401(k), you can not later change your mind and recharacterize the conversion. There is no “do-over” with a Roth 401(k) conversion like there is with a Roth IRA conversion, where you otherwise have until October 15th of the year following the year of conversion to recharacterize. This can be a costly and difficult rule to miss. If the investor finds they are unable to pay the tax bill due on the converted amounts, they can’t unwind the conversion and put the dollars back in the pre-tax 401(k) plan. Instead, they are stuck with the tax bill. Or consider the situation where the market value in the Roth 401(k) declines after the conversion, and the investor would otherwise benefit from recharacterizing and re-doing the conversion at a later date, and at a lower tax cost. That’s not an option when you convert a pre-tax 401(k) to a Roth 401(k).
Another nuance with a Roth 401(k) is that lifetime required minimum distributions (RMDs) do apply to Roth 401(k) plans, but they do not apply to Roth IRAs (until they are inherited). When the investor reaches age 70½, they must take an RMD from the Roth 401(k) plan each year. Roth 401(k) plans behave like pre-tax 401(k) plans when it comes to RMDs; you must satisfy the RMD from each qualified plan and can not elect to take your total RMDs from just one plan. As Roth accounts become more powerful as time goes on due to the tax-deferred and tax-free withdrawal nature, having to spend down a Roth 401(k) during life, or at a time when the money is not needed, can curtail an investor’s cash flow, tax and estate planning. RMDs can be avoided from Roth 401(k) plans by simply rolling the Roth 401(k) plan to a Roth IRA before the investor reaches their required beginning date. This may seem like a “no-brainer,” but there are some considerations. Creditor protection is not as strong in an IRA as in a 401(k) plan. If the investor has creditor issues, they may want to think twice before rolling their Roth 401(k) into a Roth IRA. Next, if you roll over your Roth 401(k) plan to a Roth IRA, the five-year rule starts all over again. The clock starts ticking from Day 1 that the rollover funds hit the Roth IRA for purposes of meeting the five-year rule. Your time in the Roth 401(k) plan does not count here. However, if you had contributed to any Roth IRA in a prior year, the five -ear period for determining qualified distributions from a Roth IRA takes into account the date you first contributed to any Roth IRA.
Roth 401(k)s are not Roth IRAs. They are similar in many regards, but under certain circumstances, as we’ve discussed, investors can be caught seriously off guard if they don’t realize that a Roth 401(k) may look like a Roth IRA, but it doesn’t always play by the same rules, for better or for worse.
Lisa Brown, CFP, CIMA, is a wealth advisor and partner at Brightworth, an Atlanta-based and nationally recognized independent, fee-only private wealth counsel firm that serves high-net-worth families and individuals.