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“Keene on Your Finances” – Roth 401k and Roth IRA, a lifetime of tax free earnings

By   /  January 31, 2014  /  8 Comments

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Brad KeeneA well-respected tax and estate planning attorney recently told me he had no idea he could contribute to a Roth 401k. He was sure there was an income limit. He and many others are missing a great investment opportunity.

For years we have been wired to defer taxes and pay only when it is absolutely necessary.  Roth 401k and IRA accounts turn that logic on its head, encouraging taxes to be paid today in exchange for tax free benefits later.

Created by Congress on Jan. 1, 1998 as part of the Taxpayer Relief Act, the Roth IRA is still a youngster from an historical investment perspective. For example, the traditional IRA was created in 1974 and the New York Stock Exchange was formed in 1792. The Roth 401k, created in 2006, is newer still.

The Roth accounts offer several unique benefits.  One very attractive advantage  is that the investment earnings are tax free, with the exception of early withdrawals. Earning must remain in a Roth account for at least five years and until you have reached at 59 1/2.

There are also no required minimum distributions at age 70 1/2. The Roth IRA can build until death and be passed to your kids or grandkids, who must take distributions over their life expectancy. And if you need the money before you retire, you can always withdraw your contributions — but not earnings — without penalty or taxes.

In 2014, the contribution limit for Roth IRAs is $5,500 ($6,500 if you are over age 50). There are income limits, however. To contribute to a Roth IRA, a single taxpayer’s income cannot exceed $112,000, or $178,000 if filing jointly.

Roth 401k

If a person wants to contribute more than $5,500, or makes too much money to qualify for a Roth IRA, an employer’s Roth 401k feature may be an option. There are no income limits and the contribution limit is $17,500 ($23,000 if you are over age 50).

A recent survey by Aon Hewitt revealed that just 51 percent of companies had a Roth 401k feature in their plan.  If your employer doesn’t offer one, ask if they will add it to the plan.  Several of my clients have been successful in their efforts to get this accomplished.

Potential Strategies

There are many ways a person can take advantage of the potential of Roth accounts. One is to split your savings between pre-tax investments and a Roth account – or accounts – to get the best of both worlds.

If you are over the income threshold, you can take the backdoor into a Roth IRA. Contribute to a non-deductible IRA and then immediately convert it to a Roth IRA. You will have the benefits of a Roth and no taxes due.

Roth IRAs can be set up for a minor if the child has earned income from babysitting, cutting grass, etc.  If a 15 year-old deposits $500 into a Roth IRA and earns eight percent annually, that initial investment would grow to more than $23,000 by the time he or she reached age 65.

Look for opportunities to convert your existing IRA to a Roth IRA in years where you have very low taxable income from a job loss, recent retirement, business losses, etc. You will pay taxes on any amount not previously taxed, but the low income will lower the tax burden.

There are many individual factors to consider with Roth accounts. It is best to consult a tax advisor before making any decisions.  Ideally, your financial advisor and tax advisor have a good working relationship.

 

Brad Keene is a Wealth Management Advisor, Portfolio Manager at Visionary Wealth Advisors.  He is a CERTIFIED FINANCIAL PLANNER (TM), holds an MBA from St. Louis University and a B.S. in Finance from Eastern Illinois University. He has been advising clients since 1996 and is a lifelong Collinsville resident. Contact Brad at brad.keene@vwa-llc.com

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About the author

Brad Keene is a Wealth Management Advisor, Portfolio Manager at Visionary Wealth Advisors. He is a CERTIFIED FINANCIAL PLANNER (TM), holds an MBA from St. Louis University and a B.S. in Finance from Eastern Illinois University. He has been advising clients since 1996 and is a lifelong Collinsville resident. Contact Brad at brad.keene@vwa-llc.com

8 Comments

  1. David says:

    Hello, I’ve read many articles about Roth 401ks but I’m not seeing a clear answer about the 17500 contribution limit. For the Roth 401k, is this 17500 limit before or after taxes. Meaning if I want to max out will it be 17500 pre taxed dollars or will it be 13125 max assuming 25% tax bracket. In other words is the 17500 limit before or after taxes for the roth?

    Thank you.

    • Brad Keene says:

      David,

      You can contribute a total of $17,500 to the Roth 401k.

      Here is an example: Investor A has a salary of $50,000 and contributes $17,500 to a traditional 401k plan. His W-2 for tax purposes will show taxable income of $32,500. Investor B has a salary of $50,000 but contributes $17,500 to a Roth 401k. His taxable income will still be $50,000. His tax bill next April will likely be higher than Investor A but he still is able to get the full $17,500 into the Roth 401k.

      I hope this helps, thanks for reading.

  2. Hiral says:

    Ok — here is another question … Simply put what happens of I max out my traditional 401k at $17,500…Can I still contribute to a Roth 401k? If so, how much, $5500? I don’t qualify for a Roth IRA because my income exceeds the allowable limit. My employer offers a Roth 401k and I feel it’s a lot easier than having to do a Roth conversion.

    • Brad Keene says:

      The total combined amount you can contribute to all of your 401k plans is $17,500 annually. In theory, you could have 3 different jobs, and contribute to each of their 401k plans, use a traditional 401k and Roth 401k, yet you would still be subject to the combined limit of $17,500.

      If your income is too high to contribute directly to a Roth IRA, you may want to consider contributing to a non-deductible IRA and then converting it to a Roth IRA. This is the “backdoor” Roth IRA I briefly discussed. If you have other IRA assets this technique may not work for you. There are some great articles you can find which discuss the “backdoor” Roth IRA. As always, check with your tax adviser before taking action.

      • Patrick says:

        Hi there. Is it possible to save in both a Roth 401k and a Roth IRA in the same year? If so, what is the total contribution limit between the two accounts? Is it 17,500 combined? The IRS website verbiage leaves much to be desired (as always!).

        Thanks,
        Patricks

        • Brad Keene says:

          Patrick,

          The contribution limits to a 401k plan and an IRA are independent of one another. In other words, you can defer the maximum amount to your 401k and also contribute the maximum amount to an IRA. If you are over age 50 the maximum amounts are increased. Remember to keep an eye on the income limitations for contributing to a Roth IRA or a deductible traditional IRA.

  3. John Root says:

    If I contribute to a Roth 401k and then roll it over to a Roth IRA when I leave my employer, does the rollover amount count toward the $5500 annual contribution limit to a Roth IRA?

    • Brad Keene says:

      Great question John. No, the rollover from your Roth 401(k) to a Roth IRA does not affect your ability to contribute to a Roth IRA. Please make sure your modified adjusted gross income is below the threshold to make a Roth IRA contribution.

      Below is a link to IRS Publication 590 which is a great resource investors can use for information. This is a very complex area and I always encourage folks to involve their tax preparer when it comes to these decisions.

      http://www.irs.gov/publications/p590/ch02.html#en_US_2013_publink1000231013

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