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Join the Roth 401(k) revolution

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in Small Business Tax,Small Business Tax Deduction Strategies

A little-noticed tax break in the new “fiscal cliff” tax law—the American Taxpayer Relief Act of 2012 (ATRA)—could provide a big boost for upper-income retirement-savers. It makes it easier to take advantage of a Roth 401(k)—the 401(k) version of the Roth IRA—when an employer provides this option.  

Strategy: Switch money from your regular 401(k) account into the Roth 401(k) account. Assuming you meet all the tax law requirements, the distributions you receive in retirement will be completely exempt from federal income tax.

This doesn’t have to be an all-or-nothing proposition. For instance, you can keep some of the funds in a regular 401(k) account. Alternatively, you might move all the funds to a Roth 401(k) account over several years, thereby reducing the overall tax bite.  

Here’s the whole story: As with a regular 401(k) plan, contributions to a Roth 401(k) account grow on a tax-deferred basis. However, unlike a regular 401(k), elective deferrals aren’t made with pretax dollars. The amounts contributed to the plan are subject to current tax.

With a Roth 401(k) plan, the benefits come on the back end: Qualified distributions are 100% federal-income tax free and usually state-income tax-free, too. This includes distributions made five years after setting up the Roth 401(k) if you’re older than age 59½ at that time. In comparison, distributions from a regular 401(k) are taxable at ordinary income rates, now reaching as high as 39.6% under ATRA.

The contribution limits for traditional 401(k) and Roth 401(k) plans are the same. For 2013, you can contribute up to $17,500 to either type of account ($23,000 if age 50 or older).

Note that Roth 401(k)s have an edge over Roth IRAs because there are no income limits on your eligibility to make contributions. For 2013, eligibility to make Roth IRA contributions phases out for single filers with modified adjusted gross income (MAGI) between $112,000 and $127,000 for single filers and $178,000 to $188,000 of MAGI for joint filers. But you can contribute to a Roth 401(k) regardless of your income level.

New tax break: Under a “hidden” ATRA provision, you can convert regular 401(k) funds to a Roth 401(k) account at any time. Previously, you had to be eligible for a distribution, usually upon attaining a certain age or leaving the ­company. Thus, the new law creates more opportunities for conversions while you are still working.

Of course, you still must pay tax in the year you convert, but it could be well worth it if you expect to be in a higher tax bracket in retirement.

Example: Suppose you are age 40, you’re in the 25% tax bracket and you have $200,000 in your regular 401(k). For simplicity, let’s say you convert the entire $200,000 to a Roth 401(k)

in 2013 and you pay an effective tax rate of 28%. (The actual amount will depend on all the other variables that affect your taxable income level.) Thus, you must pay tax of $56,000 on the conversion.

Assume that the Roth 401(k) grows to $1 million by the time you’re ready to retire in your 60s. No matter how much you withdraw from the Roth 401(k) during retirement, you’ll pay zero federal income tax on the distributions.

Now compare that to the outcome if you accumulate $1 million in a regular 401(k) and you end up in the 35% tax bracket in retirement. In the unlikely event you pull out the entire amount in lifetime distributions, you would pay a whopping $350,000 in federal income tax and maybe state income tax, too.

A more likely scenario: You might withdraw half and pay tax of $175,000—still $119,000 more than the tax currently owed on the conversion. Also, consider the possibility that tax rates will be even higher by the time you’re ready to retire.

On the flip side, switching to a Roth 401(k) may not make sense if you’ll be retiring soon and you expect to be in a lower tax bracket in the future.

Tip: The required minimum distribution (RMD) rules also apply to Roth 401(k)s, but amounts can be rolled over tax-free into a Roth IRA where there are no RMDs.

Online resource: For more information on Roth 401(k)s, see Retirement Plans FAQs on Designated Roth Accounts.

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{ 1 comment… read it below or add one }

Robert Henderson May 3, 2013 at 5:21 pm



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