Since the 1974 inception of the Individual Retirement Account, or IRA, this form of saving and investing has become ubiquitous in today’s financial world. In 1997, Congress authorized the Roth IRA, which added tax flexibility for account holders. Roth options have become an important part of many people’s retirement planning, and have expanded from the basic Roth IRA into ERISA-covered Plans, such as the Roth 401(k), and others. We will use the Roth 401(k) Plan to explain today’s concept.
Not all employers offer Roth 401(K) Plans, but more every day are adding the Roth option to their Traditional 401(k) offerings. Contributions to either, are made from after-tax income. Roth 401(k) Plan accounts can be rolled tax-free into Roth IRAs when service is terminated. No Required Minimum Distributions are required from a Roth IRA, and all withdrawals are tax-free to the original account owner. In other words, the tax treatment of the Roth 401(k) is identical to the tax treatment of a Roth IRA.
Why not simply contribute to a Roth IRA? Often, the potential Roth IRA account owner is precluded from contributing to a Roth IRA, as Congress imposes income limits on contributors. There are also other reasons to make after-tax contributions to a Traditional 401(k). Significantly higher contribution levels for ERISA Plans (such as all 401(k) Plans) attract serious savers. It is allowable to contribute to both, restricted only by eligibility rules.
Another option is the “Back-Door” Roth IRA. In this method, contributions are made to a Traditional IRA, but not deducted from the owner’s taxable income. Subsequently, those funds can be converted to a Roth IRA, through the so-called “Back Door” process.
Prioritizing Roth-style contributions should consider the long-term tax effects of the various account types. Easiest is the Roth IRA, which is tax-free forever and not subject to RMDs. Next is the Roth 401(k), which is likewise tax-free forever, but subject to RMD rules. Fortunately, Plan owners can avoid RMDs using a later tax-free rollover to a Roth IRA.
After-tax contributions to Traditional 401(k) Plans are treated differently. When eventually rolling the 401(k) funds into Individual Retirement Accounts, the only portion that can be split off into a Roth IRA is the after-tax contributions. Years of tax-deferred growth on those contributions become taxable at the time of withdrawal from the 401(k) or Traditional IRA. From the analysis, it is apparent that maximizing Roth contribution money into a pure Roth IRA or a pure Roth 401(k) has long-term benefits. Working with a qualified financial advisor is the best way to understand your options.
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