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Roth 401(k) Conversions Explained

Image courtesy of Stuart Miles at FreeDigitalPhotos.net

Image courtesy of Stuart Miles at FreeDigitalPhotos.net

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.

When Rolling Over a 401(k) to an IRA Isn’t a No-Brainer

Stibnite-121128

Stibnite-121128 (Photo credit: Wikipedia)

Oftentimes when folks are considering leaving employment, the decision to rollover 401(k) to an IRA is a no-brainer.  After all, why would you leave your retirement funds at the mercy of the constricted, expensive investment choices and other restrictions of your old company’s 401(k) administrator, when you can be free to invest in any (well, most any) investment you choose, keeping costs down, and completely within your own control in an IRA?

Well, for some folks this decision isn’t the straightforward choice that it seems to be, for the very important reason of access to the funds before reaching age 59½ (see this article for more info about The Post-55 Exception to the 10% Penalty for Withdrawals from 401(k)).  Since only within a 401(k) (or other employer-sponsored plans) can you take advantage of this early withdrawal exception, it might be in your best interests to think about your rollover choice before automatically rolling over into an IRA.  This is only important if you are under age 59½, of course – and much more important if you’re under age 55 when you leave your old employer.

Why it’s important

If you are under age 59½ and you have a sudden need for the funds that you’ve saved over the years in your old 401(k), and you’ve rolled over the funds into an IRA, you will have to pay a 10% penalty in addition to the ordinary income tax on your withdrawal, unless you meet one of the other exceptions to the early withdrawal penalty.

However, if you rollover the old 401(k) into another 401(k) (or 403(b), et al), you will preserve your opportunity to withdraw those funds if you leave employment at the job associated with the new 401(k) plan after you’ve reached age 55.

How can this work in your favor?

If you start work with another employer, as long as the new employer offers a 401(k) plan that accepts “roll-in” of 401(k) plan money and IRAs, you can rollover those old plans into the new plan, which will keep your options for access open should you need them upon leaving employment after age 55.

That’s not really under your control so much, is it? How about this: as you’re leaving employment at the old employers, if you have the opportunity to start your own business – such as consulting, or perhaps some part-time business – you can start your own Solo 401(k) plan and rollover the funds from your old plan(s) and IRAs if you have them.  Then, on the chance that you’d need the money later on after you’re at least age 55 (but not yet 59½), assuming that you can end your employment in your consultancy or other self-employment activity, you can then have access to those funds in your Solo 401(k) plan without penalty.

Some Cautions

If you go the self-employment route, you need to make sure that the business that you’ve created is valid and legitimate.  The IRS doesn’t at all take this lightly – if your business isn’t making money (or at least validly attempting to make money), your actions in creating a 401(k) plan and everything else associated with the business can be considered fraud.

This also applies to the dissolution of the business in order to have access to the retirement funds.  If it’s deemed that the only reason you did this was simply to have access, this action could be considered fraud as well.  This could come about if you dissolved the original business and then shortly afterward started a similar business again, for example.

The Downside

Of course, as with attempts to “work the system” in your favor, there are usually downsides to the matters.  In addition to the concerns about fraud mentioned before, there is the matter of control.  If you roll-in your funds from the old employer to another 401(k) plan and you remain employed with that new job past age 59½ you will give up access to those funds unless the new plan allows in-service distributions.

Say for example you left an old company at age 50 and started work with a new company, rolling over your money from old employer’s 401(k) plan to the new plan.  Then you work until age 65 at the new employer.  Unless the new employer’s 401(k) plan allows in-service distributions, you can’t get to the funds until you retire at age 65.  Had you left the money at the old employer (or rolled it over to an IRA) you would have had access to the money from the old plan free of penalty or restriction once you reached age 59½.

What do you think?  Do you see any other downsides to this type of plan?  How about other ways to use these rules to your advantage? I’d love to see your thoughts on the subject – leave a comment below.

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Did the Advent of 401(k) Plans Hurt Americans?

The 87-vehicle pile up on September 3, 1999

The 87-vehicle pile up on September 3, 1999 (Photo credit: Wikipedia)

There’s been quite a bit of press lately about the recent Economic Policy Institute study (see this article “Rise of 401(k)s Hurt More Americans Than It Helped” for more), which indicates that the 401(k) plan itself is the cause of American’s lack of retirement resources.  I think it has more to do with the fact that the 401(k) plan (and other defined contribution plans) were expected to be a replacement for the old-style defined benefit pension plans, and the fact that those administering the retirement plans did little to ensure success for the employees.

Traditional defined benefit pension plans didn’t ask the employee to make a decision about how much to set aside – this was determined by actuaries.  Then the company made sure that the money was set aside (in most cases) so that the promised benefit would be there when the employee retires.  In the world of 401(k) plans, the employee has free choice to decide how much and whether or not to fund the retirement plan at all.  Human nature kicks in, and the nearer term needs of the employee win out over long term needs – of course the long-term requirements get short shrift!

It’s the same as when we turn over the car keys car to a 16-year-old.  Up to this point, the child has just ridden along, not having to know anything about rules of the road, car maintenance, or paying attention.  You wouldn’t just toss Johnny the keys and say “You know where you want to be. Do your best to get there!”  Of course you’re going to make sure that he has all the training necessary to operate the vehicle safely, and that he knows when to put fuel in the car, as well as that he knows how to navigate to his destination on time.

If the playing field had been level – that is, if when 401(k)-type plans were introduced as replacements for pension plans that there was no choice regarding participation and funding level, we’d see a much different picture.  I don’t think education alone is the answer, because the importance of continual funding is so difficult to comprehend.  Forced participation runs counter to the “American Way”, but that would have changed our outlook dramatically.

The problem isn’t the 401(k) plan itself – it’s that when companies dropped pension plans in favor of 401(k) plans they didn’t provide employees with the correct message about the importance of participation.  Free will is a good thing, don’t get me wrong.  But I think employers could have done much, much more to emphasize the importance of participation, of making long-term investment decisions, and of providing for your future with today’s earnings.

It wasn’t the account that is the problem, it’s in the implementation.

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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.

Join in the Movement – Add 1% to Your Savings This Year!

Retirement

Over the past several weeks we’ve been writing articles to encourage all Americans to add at least 1% more to savings in the coming year. More than 20 of my fellow bloggers have submitted articles, and these articles include many great ideas that you can apply in order to increase your savings rate in the coming year.

Since many employees are going through annual benefit elections right about now, it’s a very good time to increase your annual contributions to your retirement savings plans. Big changes are easiest to undertake with incremental steps – starting with adding 1% can have a great impact and get the momentum going!

Listed below are all of the articles that I’ve been notified about so far – 22 23 in all! These folks are very smart, and have shared some great ideas. You owe it to yourself to check it out, and then take action!  Add that 1% to your 401(k) or IRA!  If you’re a blogger, see the original post for details on how to join the action: Calling All Bloggers!

Listed below are the articles in our movement so far (newest are at the top):

A video tv segment from Laura Scharr: Preparing for Retirement

From Paula Hogan: 6 Ways to Add Another 1% of Income to Retirement Savings in 2013

From Kevin O’Reilly: From TwentySomething to Millionaire

From Tom Batterman: Take the 1% Challenge in 2013!!!

From Dana Anspach: Can You Spare A Penny?

From Steve Doster: The Easy Way to Become a Millionaire

From Nancy Anderson: Save 1% More for Retirement in 2013

From Kathy Stearns: Do the 1% in 2013!

From Ken Weingarten: The 1% Challenge (Should you dare to accept)

From Richard Feight: The 1% Challenge!

From John Hunter: Save What You Can, Increase Savings as You Can Do So

From Emily Guy Birken: Increase your savings rate by 1%

From Jonathan White: Ways to increase your retirement contributions 1% in 2013

From Alan Moore: Financial Challenge – Should You Choose To Accept It

From Ann Minnium: Gifts That Matter

From Laura Scharr: In Crisis: Personal Savings- Here Are Six Steps to Improve Your Retirement Security

From yours truly: Add Your First 1% to Your 401(k)

From Steve Stewart: Seriously. What’s 1 percent gonna do?

From Theresa Chen Wan: Saving for Retirement: The 1% Challenge for 2013

From Mike Piper: Investing Blog Roundup: Saving 1% More

From Robert Wasilewski: Increase Savings Rate By 1%

From Sterling Raskie: A Nifty Little Trick to Increase Savings

From Roger Wohlner: Need Post-Election Financial Advice? Try the 1% Solution

From Michele Clark: Employer Retirement Accounts: 2013 Contribution Limits

Thanks to all who have participated so far – and keep those links coming!

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Increase Your Retirement Savings by At Least 1% in the Coming Year

ceramic piggy bank

Several financial bloggers (20 at last count!) have been diligently writing articles of encouragement for people to consider increasing their savings rates by at least 1% in the coming year. Since many employees are going through annual benefit elections right about now, it’s also a very good time to put in an increase to your annual contributions to your retirement savings plans. Small steps are the easiest to take, and the least painful – so why not set aside an additional 1% in your retirement plan in the coming year?

The list below includes a boatload of ideas that you can use to help you with this increase to savings. I’ve heard from several more bloggers who are going to put their posts up soon. If you’re a blogger, see the original post for details on how to join the action: Calling All Bloggers!

Listed below are the articles in our movement so far (newest are at the top):

From Dana Anspach: Can You Spare A Penny?

From Steve Doster: The Easy Way to Become a Millionaire

From Nancy Anderson: Save 1% More for Retirement in 2013

From Kathy Stearns: Do the 1% in 2013!

From Ken Weingarten: The 1% Challenge (Should you dare to accept)

From Richard Feight: The 1% Challenge!

From John Hunter: Save What You Can, Increase Savings as You Can Do So

From Emily Guy Birken: Increase your savings rate by 1%

From Jonathan White: Ways to increase your retirement contributions 1% in 2013

From Alan Moore: Financial Challenge – Should You Choose To Accept It

From Ann Minnium: Gifts That Matter

From Laura Scharr: In Crisis: Personal Savings- Here Are Six Steps to Improve Your Retirement Security

From yours truly: Add Your First 1% to Your 401(k)

From Steve Stewart: Seriously. What’s 1 percent gonna do?

From Theresa Chen Wan: Saving for Retirement: The 1% Challenge for 2013

From Mike Piper: Investing Blog Roundup: Saving 1% More

From Robert Wasilewski: Increase Savings Rate By 1%

From Sterling Raskie: A Nifty Little Trick to Increase Savings

From Roger Wohlner: Need Post-Election Financial Advice? Try the 1% Solution

From Michele Clark: Employer Retirement Accounts: 2013 Contribution Limits

Thanks to all who have participated so far – and keep those links coming!

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