The latest innovation in retirement planning is the Roth 401(k). Not all employers offer them, but more are including them in their plans. Like Roth IRAs, the tax benefits are back-ended. No deduction or exclusion is available for contributions, but distributions are tax-free. Here’s a guide with nine frequently-asked questions about the plans.
Q: Can I convert money in a traditional 401(k) into a Roth 401(k)? Is there an income limit on who can do this conversion? Will I owe tax when I convert?
A: You can convert money in a traditional 401(k) into a Roth 401(k). There is no income limit to do this conversion, but it is a taxable transaction.
As the debt limit debate drags on in Washington, many investors and their advisors are preparing for a future when higher taxes on their returns are likely. A range of strategies need to be considered, and the ones to use depend on the individual’s financial situation. Investment News recently surveyed a few advisors for ideas they are recommending to their clients. Strategies recommended are tax-exempt bonds (after appropriate research on credit-worthiness), short-term bonds, conversions of traditional IRAs to Roth IRAs, being sure investments are held in the most tax-efficient accounts, and harvesting tax losses periodically to shelter gains from other investments. We’ve discussed these and other strategies in our monthly Retirement Watch visits, and we’ll keep presenting ideas that will increase after-tax wealth.
The last-minute tax changes Congress made in 2010 make one decision easier.
Taxpayers who converted a traditional IRA or employer plan into a Roth IRA in 2010 have a choice. They can include the converted amount in gross income in 2010 and pay taxes at their 2010 rate, or they can defer recognition of the gross income. The deferral allows the converters to include half the income in 2011 gross income and half in 2012. But Congress extended the 2010 tax rates for the next two years. For most people that means there isn’t much of a decision. You’ll face the same tax brackets in all three years, so for most people there isn’t the potential you’ll pay higher taxes by deferring. You might as well choose deferral and hold onto the money for a while. Maybe you’ll earn a little income on it.
People who should consider paying the taxes in 2010 are those who expect to have lower tax rates in 2010. They might have a large amount of deductions for the year or a shortfall in income. Or perhaps you expect to have higher income in the next couple of years from the sale of a business, collection of deferred income, or some other action. Another reason not to defer is that you expect to have significantly fewer deductions after 2010. Maybe you paid off your mortgage or soon will.
I suspect for most people it will be an easy decision and they’ll defer the income.
I continue to receive a lot of questions about the five-year waiting period for taking distributions after Roth IRA contributions and conversions. There’s a lot of confusion about the rules. It is slightly different for conversions and for contributions. It also is different for income taxation of distributions and the 10% early distribution penalty on distributions. Here’s how I described the rules in the May 2010 issue of Retirement Watch.
The five-year waiting period also generates many questions.
Only qualified distributions from a Roth IRA are tax-free. For a distribution to be qualified, the Roth IRA must be open at least five years. For regular Roth IRA contributions, the five-year rule is met if any Roth IRA owned by the taxpayer is at least five years old. If you opened a Roth IRA in 2000, for example, any distributions you take out of any regular Roth IRA now are tax-free.
The rule is different for converted Roth IRA amounts. A new five-year waiting period starts for each conversion. That means income and gains from the converted amount are taxable if withdrawn within five years of the conversion.
For most people, however, the five-year waiting period doesn’t matter. The rules for taxing Roth IRA distributions are that distributions are first considered to be of after-tax contributions. Distributions of after-tax contributions (such as converted amounts on which you paid the conversion tax) are tax-free. Only after all after-tax contributions (whether regular contributions or converted amounts) are withdraw are you withdrawing potentially taxable income and gains. So, the five-year rule doesn’t matter, unless you withdraw all or most of the IRA within five years. Even then, you’ll pay taxes only on the accumulated income and gains distributed not on the after-tax contributions.
The five-year period for either type of contribution begins on Jan. 1 of the year of the contribution or conversion, not on the date of the contribution or conversion.
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