Q: My company recently added a Roth option to our 401k plan. We can now choose to contribute to the Roth or the traditional 401k. Some of my coworkers say the Roth is better, but I’m not sure. What do you think?
A: Not every 401k plan offers a Roth option, but if yours does, you should take a close look at it. Roth 401k plans are similar to Roth IRAs. Contributions are made with after-tax money and all future gains and withdrawals are tax-free. Roth 401k plans have several attractive benefits.
First, you can contribute up to $18,000 each year into a Roth 401k plan, or $24,000 if you are over 50. Roth IRA contributions, on the other hand, are limited to $5,500 per year, or $6,500 if you are over 50.
Second, anybody at any income level can contribute to a Roth 401k. A Roth IRA, on the other hand, is unavailable for a married filing jointly tax-payer with income greater than $196,000.
Third, like traditional 401k plans, Roth 401ks have required minimum distributions (RMDs) beginning the year you turn 70 ½. However, when you retire you can roll your Roth 401k into a Roth IRA and avoid the RMD problem. No RMD means you have more control over your retirement income planning.
Finally, your heirs can inherit your Roth 401k and receive tax-free payments for the rest of their lives. As with an inherited Roth IRA, they will be subject to RMDs, but those RMDs will not be taxable.
The idea of never having to pay taxes on your portfolio’s future gains or distributions is enticing. However, this benefit comes at a cost. To gain the benefit of the Roth 401k, you must be willing to live with less take home than you would have by contributing to a traditional 401k.
How much take home pay will you need to give up? The answer depends on several factors, but typically it works out to be somewhere between 5 and 10 percent. Another rule of thumb is that your Roth 401k contribution should be at least 80 percent of what you would otherwise contribute to a traditional 401k plan. If you contribute more, your Roth 401k will do better than a traditional 401k.
Q: I converted a large part of my IRA to a Roth earlier this year. With all the talk of tax reform, I am wondering if maybe I should have waited. Is there anything I can do?
A: If you already did a conversion this year and feel like you want to undo it, you can reverse the conversion by doing something called a “recharacterization.” Doing a recharacterization is like pressing the reset button on your Roth conversion.
The trustee of the financial institution holding your Roth IRA should be able to help you. Simply tell them what you want to do and they will transfer the funds into a traditional IRA. The recharacterization must be complete by October 15 of the year following the year in which the original transaction occurred.
The instructions must also include a calculation of the gains and losses that have accrued on the amount you want to recharacterize. Gains and losses include any income and change in value that occurred in the interval between immediately before the conversion and immediately before the recharacterization.
Steven C. MerrellMBA, CFP®, AIF® is a Partner at Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey. He welcomes questions that you may have concerning investments, taxes, retirement, or estate planning. Send your questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA93940 or email them to firstname.lastname@example.org.