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Roth 401(k) Conversions Explained

Image courtesy of Stuart Miles at

Image courtesy of Stuart Miles at

Earlier in 2013, with the passage of ATRA (American Taxpayer Relief Act) there was a provision to loosen the rules for 401(k) plan participants to convert monies in those “regular” 401(k) accounts to the Roth 401(k) component of the account.  Prior to this, there were restrictions on the source of the funds that could be converted, among other restrictions.  These looser restrictions apply to 401(k), 403(b) and 457 plans, as well as the federal government Thrift Savings Plan (TSP).

Recently, the IRS announced that guidance was available to utilize the new conversion options.  As long as the 401(k) plan is amended to allow the conversions, all vested sources of funds can be converted, even if the participant is not otherwise eligible to make a distribution from the account.

This means that employee salary deferrals, employer matching funds, and non-elective payins to the 401(k) account can be converted to a Roth 401(k) account (as long as the plan allows it).  Previously, only employee deferrals were eligible to be converted, and then only if the participant was otherwise eligible to make distributions from the 401(k) account, such as being over age 59½ (if the plan allows) or having left employment.

The converted funds will remain under the purview of the 401(k) plan’s distribution restrictions.  Administrators of 401(k) plans can choose to amend their plan to allow these new conversion options or limit existing conversions as they see fit.

Any conversions will cause the converted funds to be included in your ordinary income for the tax year of the conversion, most likely triggering income tax on the additional ordinary income.  If you don’t have funds outside the 401(k) plan to pay the tax on the conversion, the whole operation becomes less attractive, since you’re having to take a (presumably) unqualified distribution of funds to pay the tax on the conversion.  In the future, qualified distributions from the Roth 401(k) account will be treated as tax-free (as with all Roth-type distributions).

For example, if you have a 401(k) account with $100,000 in it and you wish to convert the entire account to your company’s Roth 401(k) option.  If your marginal tax bracket for this additional income is 25%, this means that you would have a potential tax burden of $25,000 on this conversion.  If you have other sources to pull this $25k from, then you can convert the entire $100,000 over to your Roth 401(k) plan.

However (say it with me: “there’s always a however in life”), if you don’t have an extra $25,000 laying around to pay the taxes, you might need to withdraw the money from your 401(k) plan to pay the tax – which would also trigger a penalty on the withdrawal of an additional $10,000.  So now your conversion has cost 35% overall – and the chance of such a conversion paying off due to higher taxes later becomes less likely.

And then there’s the additional rub: most 401(k) plans have significant restrictions on taking an in-plan distribution such as the one mentioned above to pay the tax.  Your plan may allow the Roth 401(k) conversion distribution, but not the regular distribution while you’re participating in the plan, so you’re stuck – and will be stuck with a huge tax bill the following April.

NUA Allocation Twist – Not as Easy as it Looks



I’ve written much about the Net Unrealized Appreciation (NUA) treatment for company stock in a 401(k) plan – this is the provision that allows you to pull out company stock as part of a full distribution from the plan and get favorable tax treatment for the gain on the stock.  More about NUA can be found in this article about Net Unrealized Appreciation Treatment.

One of the factors in that article speaks to a special way to allocate the basis (original cost) of the stock.  Specifically, if handled correctly, the ordinary income tax on the NUA move can be minimized or eliminated, and the capital gains treatment maximized.

However. (As you know, there’s always a however in life!)

The problem with this move is that you absolutely must get the 401(k) administrator to go along with your plan – in order to make sure that the 1099R generated by your distribution correctly describes how you’ve allocated the basis.  If not, the strategy depends entirely on your own word and record-keeping, which I personally would not want to have as my only basis if the IRS disagrees with you on the applicability of the law to your actions.

I’ve spoken to quite a few folks who have looked into this, hoping to take advantage of the way I’ve described it and minimize or avoid tax altogether.  It seems that, at least among all those I’ve heard about, 401(k) administrators as a group don’t like to take direction from their participants.

Either that or they don’t want to do anything out of the ordinary (this is the more likely reason, in my opinion).  I can’t say that I blame them – there’s no benefit in it to them.  Even when confronted with the rules and the law that allow this move, I’ve not heard from any that have gone along with it yet.  (If you have gone down this path successfully, please let me know – leave a comment below! I’d love to hear of successes with this component of the law.)

So, unfortunately if you’re hoping to use the special allocation of basis option, I’m in your court, but expect to run into some push-back.  Although the option seems to be completely valid, don’t count on getting to use it.

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Why Diversify?


Diversity (Photo credit: Wikipedia)

Remember Enron? I think we all do. Enron was once a powerhouse company that saw its empire crumble and took the wealth of many of its employees with it. Why was that the case? Many of Enron’s employees had their 401(k) retirement savings in Enron stock. This was the classic example of having all of your eggs in one basket and zero diversification.

Let’s say that the employees had half of their retirement in Enron stock and half in a mutual fund. Enron tanks but their mutual fund stays afloat. This means that they lost, but only lost half of their retirement, all else being equal.

Imagine if they had only a quarter of their retirement in Enron and the remaining 75% in three separate mutual funds. Enron’s demise is only responsible for a fourth of their retirement evaporating. This could go on and on.

The point is that when you choose to diversify you’re spreading your risk among a number of different companies. That way if one goes belly-up you’re not left with nothing.

Mutual funds are an excellent way to diversify among an asset class. For example, if you purchased a total stock market index fund you’d have nearly the entire US Stock Market in your portfolio which amounts to approximately 4,100 different stocks.

That’s great diversification but we can do better. The US equity market is only one area. We can diversify into domestic bonds, international stocks, international bonds, real estate, and so on. This is called diversifying among asset class. The point is that you want to spread your risk and diversify as much as possible so one market or asset class doesn’t ruin your entire portfolio.

A term we use often in the industry is correlation. This simply means how one particular security moves in relation to another. If I own two large cap growth funds they’re pretty closely correlated; meaning that if large cap companies fall both of these funds are going to fall very similarly.

If I own a large cap fund and a bond fund, then if large cap stocks fall, the bonds may rise or may stay the same or even fall slightly. This is because they are a different asset class and move differently than equities. Keep adding different assets to the mix and you have a potential portfolio that can withstand the dip and turns of the market.

Even the Oracle of Omaha, Warren Buffett diversifies. Granted he may have all of his eggs in one basket, Berkshire Hathaway, but own Berkshire Hathaway stock and you’ll get exposure to insurance, bricks, candy, cutlery and underwear to name a few. Admittedly, not many people have $175,000 to buy just one share of BRK stock, but the point is that even Mr. Buffett diversifies.

Diversify. It works.

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Don’t Just Walk by That Dime on the Ground!

The Government Dime

The Government Dime (Photo credit: scismgenie)

Have you ever been walking along the street and saw a dime on the ground?  Did you just walk right by, or did you stop to pick it up?  Heck, it’s only a dime, it’s not hardly worth the effort to bend over, right?  But what if it was a dollar?  Or a hundred dollars?  You wouldn’t just walk by that, would you?  What about $1,200?

Unfortunately, many folks do this very thing with their 401(k) plan employer matching funds.  Most employers that sponsor 401(k) plans provide a matching contribution when you defer money into the plan.  Often this is expressed as a certain percentage of your own contribution, such as 50% of your first 6% of contributions to the plan.

So if you make $40,000 a year and you contribute 6% to the 401(k) plan, that means you’ll be contributing $2,400 to the plan from your own funds, pre-tax.  Since your employer contributes 50% of your first 6%, you’ll have an additional $1,200 added to the account for the year.

If you can only afford to contribute 2% (or $800) to the plan, you’re still getting an additional 50% of your contribution added by your employer for a total of $1,200 for the year.  It still makes sense to participate even if you can’t maximize the employer contributions.

However, if you choose not to participate at all, you are giving up the extra money from your employer – forever.  You can’t go back and get this money later when you think you can afford to.  You’re essentially walking by that $1,200 that’s just sitting there on the ground waiting for you to pick it up.

Arguments against

After having this conversation with several folks, I’ve heard many different excuses to not take advantage of a 401(k) plan.  The excuses usually fall into a few limited camps, which I have listed a below.

It’s my money! You’re darn right it is!  And if you don’t participate in your 401(k) plan you’re throwing some of *your* money away.  Many times people believe that when they put money into a 401(k) plan, it’s gone for good.  Nothing could be more untrue!  The 401(k) plan is your property. All of your contributions and (as long as you’re vested in the plan) the employer contributions are yours to keep.  Granted, it’s locked up behind some significant fees and penalties until you reach retirement age (59½ in most cases) – but it’s still yours.

I don’t trust my company – they’ll go bankrupt and lose my money! As noted above, the 401(k) account is yours, not the company’s.  Even if the company goes bankrupt completely, as long as you haven’t invested your entire 401(k) plan in company stock (a la Enron), you still have your 401(k) plan intact.  They can’t lose your money, in other words!  It’s not theirs to lose.

I can’t afford to put money in the plan!  These days, money can be pretty tight (but when isn’t it?).  Unfortunately, regardless of how much money you make, it’s always possible to spend up to and more than what you bring home each payday.  The reverse of this is also true.  Within limits, it’s usually possible to make do with less.  If your paycheck was a dollar less every payday you’d figure out how to get by, right?  How about $78 less?

Using our example from above, for a single person with an annual income of $40,000 per year, before you participate in the 401(k) plan, your total income tax would be approximately $4,054.  If you chose to put 6% or $2,400 in your company 401(k) plan, your income tax would work out to $3,694 – $360 less.  So your take home pay would only reduce by about $78 per paycheck (if you’re paid every other week).  In return for this annual reduction of $2,040 in take-home pay, you’d now have a 401(k) account with $3,600 in it when counting the employer contributions.

Pretty sweet deal, if you asked me (but you didn’t, I just threw this in your face!).  For a total “cost” of $78 per paycheck, you get lower taxes PLUS a retirement savings account worth 75% more than what you had to give up.  Not too shabby.

One great benefit of participating in a 401(k) plan is that once you’ve made the decision to participate, you are deferring this income before it makes it into your hands. You don’t have to (or get to) make a decision about saving, it’s done automatically.  This helps you to get past one of the real difficulties that many folks face with saving: the money always seems to find another place.  This way it automatically goes into savings, before it can find another place.

The bottom line

The best and most important way to assure success in retirement savings is to put away more money over time.  Of course your investment returns will help, but if you don’t save the money, it can’t produce returns, right?  So do yourself a favor and don’t walk past that $1,200 that’s just lying on the ground!

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Exceptions to the 10% Early Withdrawal Penalty from IRAs and 401(k)s

English: A clock made in Revolutionary France,...

English: A clock made in Revolutionary France, showing the 10-hour metric clock. (Photo credit: Wikipedia)

When you take money out of your IRA or 401(k) plan (or other qualified retirement plan, such as a 403(b) plan), if you’re under age 59½ in most cases your withdrawal will be subject to a penalty of 10%, in addition to any taxes owed on the distribution.  There are many exceptions to this rule though, and the exceptions are not the same for all types of plans.  IRAs have one set of rules, and 401(k)s have another set of rules.

The exceptions are always related to the purpose for which the money was withdrawn.  The exact same dollars withdrawn do not have to be used for the excepted purpose, just that the excepted expense was incurred.

IRA Exceptions

It is important to know that all distributions from your traditional IRA are subject to ordinary income tax, but some distributions are not subject to the early withdrawal penalty.  The list of exceptions for early withdrawals from IRAs is as follows:

Death of the owner of the IRA – if the owner of the IRA dies, the beneficiaries of the IRA can (in fact, must) take withdrawals from the plan without paying the 10% penalty.

Total and permanent disability of the owner of the IRA – if the owner of the IRA is deemed to be totally and permanently disabled.   You are considered disabled if you can furnish proof that you cannot do any substantial gainful activity because of your physical or mental condition. A physician must determine that your condition can be expected to result in death or to be of long, continued, and indefinite duration.

SOSEPP – With a Series of Substantially Equal Periodic Payments, lasting at least five years or until age 59½ (whichever is longer), there is no 10% penalty applied.

Medical Expenses – if you have medical expenses greater than 7.5% of your Adjusted Gross Income, a distribution from your IRA to cover these expenses (the excess above 7.5% of AGI) will not be subject to the penalty.  Any amounts paid by insurance toward the medical expenses reduces the overall expense counted toward the excepted expenses.

Health Insurance Premiums – if you’re unemployed, you can take a distribution from your IRA to cover your health insurance premiums without paying the penalty.

Qualified higher education expenses – amounts withdrawn from your IRA to pay for tuition, fees, books, supplies, and equipment needed for enrollment or attendance of a student at an eligible higher education institution are not subjected to the penalty.  In addition, if the student is at least a half-time student, room and board expenses paid for with an IRA distribution would not be subject to the penalty.  The amount of education expenses is reduced by any scholarships, grants, and qualified 529 plan distributions; any amount applied to an IRA penalty exception is also not eligible to be used toward education credits, such as the American Opportunity Credit or the Lifetime Learning Credit.

First-time home purchase – amounts withdrawn from your IRA up to $10,000 that are used toward a qualified first-time home purchase are an exception to the penalty.

Qualified reservist distributions – if a reservist who is called to active duty after September 11, 2001 for a period of 179 days or more takes a distribution from an IRA (after the start of active duty and before the end of active duty) the distribution will not be subject to the 10% penalty.

Rollovers – both direct, trustee-to-trustee transfers and 60-day indirect transfers are exempted from the penalty.

Excess contributions – if you have contributed too much to your IRA, you can take out the excess contribution without penalty.  However, any growth that is attributed to the amount that you over-contributed will be subject to the 10% penalty and taxes when withdrawn.

401(k) Exceptions

As with the IRA, most withdrawals from a 401(k) or other qualified retirement plan are subject to taxation.  Early withdrawals before age 59½ are also subject to a 10% penalty, with some exceptions.  The exceptions are as follows:

Death of the participant – this is the same as the exception for an IRA above.

Total and permanent disability of the participant – same as with an IRA.

SOSEPP – same as with an IRA.

Medical Expenses – same as with an IRA.

Qualified reservist distributions – same as with an IRA.

Rollovers – same as with an IRA.  However, an indirect 60-day rollover (not a trustee-to-trustee transfer) is subject to mandatory 20% withholding.  If the withheld 20% is not transferred within 60 days, this amount may be subject to both taxation and the 20% early withdrawal penalty.

Corrective distributions – just like with an IRA, if you have contributed too much to your 401(k), you can take out the excess contribution without penalty. However, any growth that is attributed to the amount that you over-contributed will be subject to the 10% penalty and taxes when withdrawn.

Separation from service after age 55 – if you leave employment after the age of 55, you are eligible to take distributions from your 401(k) or other QRP without penalty.  This is only valid while the funds are still in the 401(k) – if you rollover the funds to an IRA, this option is no longer available.  If the participant is a public safety employee (police, fire, or emergency medical technicians), the age is 50 or older.

Qualified Domestic Relations Order (QDRO) – in the event of a divorce, if the 401(k) is to be divided or distributed to the ex-spouse of the participant, withdrawals from the plan by the ex-spouse are not subject to the 10% penalty.

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Avoid Awkwardness in the Afterlife–Confirm Your Beneficiary Designations

Withholding Water

This is a topic that I cover with all clients, and one that I recommend you for everyone with retirement plans and other accounts with beneficiary designations.  Too often we think we have the beneficiary designation form filled out just the way we want it, and then (once it’s too late) it is discovered that the form hadn’t been updated recently – and the designation is not what we hoped for.

I made this recommendation to a client not long ago.  He assured me that he had all of his designations set up just the way he wanted.  His wife, sitting next to him in our meeting, asked him to make sure – talk to the IRA custodian and get a copy of the designation as it stands today.  A bit miffed about it all, he agreed to do so, and did the next day.  Guess what he found – as it stood on that day, his IRA beneficiary designation form indicated 100% of his IRA would pass to his ex-wife from 15 years ago!  Plus, he had no secondary beneficiaries named, which meant that if the ex predeceased him, HER heirs would be the primaries.  Thankfully he had checked on this to avoid this awkward and possibly devastating situation.

Know what was fixed pretty much immediately?

Take the time

You owe it to yourself and your heirs to take the time to review your beneficiary designations and keep copies of them in your “dead file”.  This includes IRAs, Roth IRAs, 401(k)/403(b)/457 plans, and other pensions or retirement plans.  You also may have POD or TOD (Pay on Death or Transfer on Death) designations on non-retirement accounts – confirm these and keep copies as well.

For your standard retirement accounts, such as IRAs, 401(k)s and the like, you typically have the option of naming a primary beneficiary (or beneficiaries) and a secondary or contingent beneficiary or beneficiaries.  It makes a huge difference on these accounts that you name a specific person (or persons) as the primary beneficiary, and a specific person (or persons) as the contingent beneficiary.  With IRAs, if you leave the designation blank, you may be taking away important options for your heirs.

If you leave the primary beneficiary designation blank you are leaving the transfer of your IRA up to the custodian’s default designation.  Quick! What’s your IRA custodian’s default beneficiary designation??  I didn’t think you’d know.

Often this default is your spouse first, and then your “issue” – meaning your children and other descendants.  Other times, the default beneficiary is your estate.  In the event that the estate is the default beneficiary, any beneficiaries of the estate will receive the IRA, but they will not be able to utilize the “stretch” option of receiving payout of the account over their remaining lifetimes.  This is because the IRS rules state that a “named beneficiary” must be in place in order to use the stretch provision.  If no “named beneficiary” exists, the stretch option is not allowed.  If the default is your spouse and your issue, these can be treated as “named beneficiary” if they are alive.

Discuss with your heirs

At face value, even though you think your intent for your beneficiary designations is clear, it might not be clear to your heirs.  For example, you may have chosen to pass along half of your IRA to your youngest child and only a quarter to the older two children because you believe the youngest child can use the money more than the other two.  Or maybe you decided to leave the entire IRA to your oldest daughter, and you want to designate your three sons to split up the farmland – which you believe is an equitable division.

Whatever you’ve decided, especially if there are perceived inequities in your division plan, you should take the time to review your plan with your heirs.  If that makes you uncomfortable, there are a couple of things to consider: First, if you’re uncomfortable discussing it with them, imagine how uncomfortable your heirs may be when the time comes to distribute your estate.  Maybe it’s not such a good idea after all if it could cause contention among your heirs.  Second, if you still believe your split is the right way to go, you should explain your plan to someone – your designated executor would be a good choice. And the designated executor should be a disinterested separate party, someone who isn’t receiving benefit from your estate plan, in order to keep the process “clean”.  Otherwise, if one of the heirs is your executor and the executor is perceived to receive preferential treatment, again you’ll have some contention among your heirs.

If there are complex instructions involved, consider making an addendum to your will.  Instructions in your will would have no impact on the beneficiary designations on your IRAs and other plans (these pass outside of your estate as long as you’ve made specific designations) but other asset divisions aside from retirement accounts may require explanation for your heirs to understand your intent.  Don’t expect that everyone will understand or agree with your thought process when you’re gone.  Explaining your thought process in advance will likely help to ensure that your division plan doesn’t result in a family rift.

Take the time to review your beneficiary designations.  Make sure that you have the primary beneficiary or beneficiaries that you want, and the percentages that you’d like each to have.  Also make sure that you have named contingent beneficiary or beneficiaries in the event that your primaries have predeceased you.  Lastly, make sure that you note how division is done after the death of the beneficiaries: per stirpes or per capita.

Your Employer’s Retirement Plan

Backcountry Provisions

Whether you work as a doctor, teacher, office administrator, attorney, or government employee chances are you have access to your employer’s retirement plan such as a 401(k), 403(b), 457, SEP, or SIMPLE. These plans are a great resource to save money into, and some employers will even pay you to participate!

Let’s start with the 401(k). A 401(k) is a savings plan that is started by your employer to encourage both owners of the business and employees to save for retirement. Depending on how much you want to save, you can choose to have a specific dollar amount or percentage of your gross pay directed to your 401(k) account. Your money in your account can be invested tax-deferred in stock or bond mutual funds, company stock (if you work for a publicly traded company), or even a money market account. Your choice of funds will depend on the company that offers the 401(k) through your employer. Generally, you’re going to want to choose funds with low fees and expenses. As of 2013, the maximum amount you can put into your 401(k) is $17,500 annually and another $5,500 “catch-up” contribution if you’re age 50 or older. At age 59 ½ qualified withdrawals are now taxed as ordinary income. Withdrawals before age 59 ½ are subject to penalties with some exceptions.

A cousin to the 401(k) is the 403(b). The 403(b) is very similar to the 401(k) in that you’re allowed to allocate a certain amount or percentage of your gross pay to your account, tax-deferred. Where the 403(b) differs is that it’s only allowed for non-profits such as school districts, hospitals, municipalities, and qualified charitable organizations. Another difference is by law the money in your 403(b) can only be invested in mutual funds or annuity contracts. You’re not allowed to own individual stocks or bonds in it. Like the 401(k), you’re allowed to save (as of 2013) $17,500 annually and another $5,500 “catch-up” contribution if you’re age 50 or older. At age 59 ½ qualified withdrawals are now taxed as ordinary income. Withdrawals before age 59 ½ are subject to penalties with some exceptions.

Branching out in our retirement plan family tree we come to the 457 plan. 457 plans are reserved for certain non-profits such as hospitals, government entities, school districts and colleges and universities. As you may have guessed, 457 plans are similar to their 401(k) and 403(b) counterparts in that money from your gross pay goes into your account tax-deferred. Like the 403(b) the 457 only allows investments in mutual funds or annuity contracts.

Similar to the 401(k) and 403(b), you’re allowed to save up to $17,500 annually and another $5,500 “catch-up” contribution if you’re age 50 or older (for 2013). Unlike the 401(k) and 403(b) the 457 allows you access to your money at any age, as long as you’re separated from service from your employer. For example, if you were 40 years old and have been saving into a 457 since you were age 25 and you saved $50,000 and you were fired, laid off or resigned, you’d have access to your 457 money without penalty; you’d simply pay ordinary income tax on any withdrawals.

Another key point to make is in regards to the aggregation rule. What this means is that you’re only allowed to invest $17,500 (along with the “catch-up” if you qualify) total between a 401(k) and a 403(b). For example, you work as a professor for nine months of the year and save $14,000 in your college’s 403(b). Over the summer, you work part time for a company that offers a 401(k) plan and you want to save money there. Assuming you’re age 40, you’d only be able to save an additional $3,500 to your summer company’s 401(k) – for a total of $17,500.

There is one exception to the aggregation rule. If you have access to a 401(k) or 403(b) and a 457, you are allowed to contribute the maximum to the 401(k) or 403(b) – for a total of $17,500 and then contribute the maximum to the 457 for an annual total of $35,000. The 457 trumps the aggregation rule. Few people may be able to actually sock away $35,000 per year, but it is available to those that work for employers offering both plans or if you work for two or more employers and they offer one or the other.

SEPs and SIMPLEs work a bit different. Typically these plans are available to smaller employers and SEPs are common for those that are self-employed. Both SEPs and SIMPLEs use IRAs as the funding vehicle to place retirement money, but each has different requirements as to contribution limits and participation requirements.

SEPs (Simplified Employee Pensions) can be funded to a maximum of $51,000 annually (for 2013) or 25% of the employee’s salary – whichever is smaller. There can be corresponding tax deductions involved that may be beneficial for solo businesses or businesses with a small number of employees as there are requirements that all employees must participate.

SIMPLEs (Savings Incentive Match PLan for Employees) are another option for smaller businesses looking to start a retirement plan and looking for a cost effective way to start (a 401(k) can be administratively expensive). Essentially, both employer and employees are allowed to participate and certain rules dictate that the employer must make a matching contribution (hence the Match in the name) to participating employees. As of 2013 you can contribute a maximum of $12,000 annually to a SIMPLE plan with an additional “catch-up” contribution of $2,500 if you’re age 50 or older.

The aggregation rule that applies to the 401(k) and 403(b) also applies to SEPs and SIMPLEs. This means that of the four plans for 2013, you’re still only allowed a total contribution of $17,500 annually ($23,000 if you’re age 50 or over). Having a 457 would be the only way to increase this amount.

Like SEPs and SIMPLEs, some 401(k) and 403(b) plans also have the company match. This means that in addition to your contributions, your employer will also make a contribution or “match” to the amount you’re contributing up to a certain percent. Consider taking full advantage of this. It’s free money! There are several reasons why an employer would do this ranging from plan compliance to helping ensure employee satisfaction and loyalty.

Finally, participating in your employer’s plan does not prohibit you from participating in a Traditional or Roth IRA. You are allowed to contribute the maximum allowed by law to both your employer’s plan and your own IRA.

It goes without saying that before you decide to participate, talk with your human resources department (not your cubicle buddy) or a financial professional regarding your options and which option or combination is right for you.

Pros and Cons of the Roth 401(k)

Christine Roth

The Roth 401(k) first became available in January 2006, is an option available for employers to provide as a part of “normal” 401(k) plans, either existing or new.  The Roth provision allows the employee to choose to direct all or part of his or her salary deferrals into the 401(k) plan to a separate account, called a Designated Roth Account, or DRAC.

The DRAC account is segregated from the regular 401(k) account, because of the way the funds are treated.  When you direct a portion of your salary into a DRAC, you pay tax on the deferred salary just the same as if you had received it in cash.  This deferred salary is subject to ordinary income tax, Medicare withholding, and Social Security withholding if applicable.

The unique thing about your DRAC funds is that, upon withdrawal for a qualified purpose (e.g., after you have reached age 59½, among other purposes) the growth that has occurred in the account is not subject to tax.  If this sounds familiar, it’s because this is the same type of tax treatment that is applied to a Roth IRA.  Conversely, the regular 401(k) growth and contributions are subject to ordinary income tax upon withdrawal – just the same as a regular (non-Roth) IRA.

Pros of a Roth 401(k)

Among the positive aspects of a Roth 401(k) versus a regular 401(k) are:

  • Future taxation is eliminated (for qualified purposes).  Growth and contributions are tax-free when withdrawn after age 59½.
  • Concerns over future tax rates are eliminated since you’ve already paid the tax on your contributions. If the future tax rates are greater you’d pay the higher rates on regular 401(k) distributions – no tax is due on qualified Roth 401(k) distributions.
  • Contributions could be withdrawn tax-free, with restrictions, prior to age 59½ – after you have left the employer.
  • Early distribution options for education, home down payment, or medical expenses are not available for a DRAC as they are from a regular 401(k).

Benefits of a Roth 401(k) versus a Roth IRA:

  • Higher contribution amounts for the Roth 401(k) – up to $23,000 in 2013, versus $6,500 for a Roth IRA (catch-up contributions have been included, the maximums are $17,500 and $5,500 if under age 50).
  • Employer matching contributions are available, although these must be directed to a “regular” 401(k) account, not the DRAC.
  • Income restrictions that are applied to Roth IRA contributions are more-or-less eliminated with the DRAC.
  • Contributions can be made to the account after reaching age 70½ if still employed and not a 5% or greater owner of the employer.
  • Loans may be available against the balance in the Roth 401(k) account while still employed, if allowed by the plan administrator.

Cons of a Roth 401(k)

Negative aspects of a Roth 401(k) compared to a regular 401(k):

  • You must pay tax on the salary deferred into the DRAC, whereas deferrals to a regular 401(k) are not subject to ordinary income tax.
  • If tax rates are lower for you in retirement, you have paid a higher rate on the contributions to the account, although the growth is still tax free for qualified withdrawals.

When comparing a Roth 401(k) to a Roth IRA, the following downsides are evident:

  • Upon reaching age 70½ your DRAC account will be subject to Required Minimum Distributions, just like a regular 401(k) or IRA.  This can be mitigated by rolling over the Roth 401(k) to a Roth IRA upon leaving the employer.
  • You can’t access the contributions to the DRAC before you leave employment, while you can always have access to the contributions to a Roth IRA account.


The decision of whether to participate in a Roth 401(k) if your employer provides one is primarily the same as the decision-point of contributing to a Roth IRA versus a regular IRA.  Actually, the decision between the two types of IRA is a bit more complicated due to restrictions on income levels and deductibility, which don’t apply here.  The primary questions that need to be asked are:

  1. Can you afford the tax on the maximum contribution to a Roth 401(k) account?
  2. Do you think the tax rates will be higher or lower when you reach retirement age?


If you can’t afford to pay the additional tax on the deferred salary (as compared to when you place the money in a regular 401(k)), then it would probably be better to choose the regular 401(k).

For example, if you’re in the 25% tax bracket deferring the maximum $23,000 into a regular 401(k) will reduce your taxes by $5,750 – and so if you chose the DRAC instead, you’d have to pay that much more in tax.  If this kind of additional tax will have a negative impact on being able to pay your day-to-day expenses, the Roth 401(k) is probably not a good option for you.

Keep in mind that the decision isn’t all-or-nothing: you could choose to direct a portion of your deferral to Roth 401(k) and the remainder to the regular 401(k), which would allow you to manage the amount of extra tax that you pay.

Future Tax Rates

If you believe that the future tax rates will be greater than they are for you now, it will be to your advantage to use the Roth 401(k) – so that you pay tax at the lower rate now and avoid the future higher rate.  On the other hand, if you believe that the rates will be lower for you in the future, deferring tax on regular (non-Roth) 401(k) contributions will be more to your advantage.

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