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Retirement Perspectives

In part two of our two-part series, we explain the various rules for eligibility, contributions, rollovers, transfers, and distributions for Roth accounts.

When saving for retirement, you have a choice between saving on a pretax or aftertax basis via a Roth account. Traditional pretax retirement accounts [IRA, 401(k), 403(b)] are funded with pretax dollars, meaning the accounts are funded from your paycheck prior to paying taxes, thus reducing your current taxable income. However, when you withdraw funds from those accounts, you will have to pay taxes—most likely in the distant future when tax rates may be higher—based on your contributions plus earnings.

Roth accounts, on the other hand, are funded with aftertax dollars. When you contribute to a Roth, you pay taxes upfront at today’s rates. Therefore, funding a Roth account does not reduce your taxes today. Instead, Roth accounts pay you to wait—qualified distributions from a Roth account are tax free, including earnings.

How do you determine which account is most beneficial? The primary question to ask is, “Will I be in a higher or lower tax bracket during retirement versus today?” As covered in last week’s column, the Tax Cuts and Jobs Act (TCJA) lowered federal tax rates through 2025, after which they revert back to pre-2018 levels, which may make Roth contributions more attractive now. However everyone’s situation is different, so you should do your due diligence prior to opening a Roth account.

Let’s take a look at the myriad of rules for Roth IRAs and designated Roth accounts (e.g. 401(k), 403(b), 457(b) or TSP). Roth components do not apply to SEP or SIMPLE plans. Although both types of Roth accounts (IRA and employer plan) are funded with aftertax dollars while offering tax-free distributions—eligibility, contributions, rollovers, transfers, and distributions, including minimum distributions, differ.

Eligibility and Contribution limits

Anyone regardless of income is eligible to fund a designated Roth 401(k) account as long as the plan offers Roth as an option. In 2019, a plan participant can contribute up to $19,000 in a designated Roth 401(k) account. An additional $6,000 “catch-up” contribution (total of $25,000) is permitted for those participants that reach age 50 anytime during the year. Notably, the plan must include a “catch-up” provision and permit funds to be contributed to a Roth account.

Tip: Participation in a governmental 457(b) and 403(b) (assuming both plans offers a Roth option) offers the ability to double your Roth contributions in any single tax year. For example, Joe, a superintendent of WXYZ School district, enrolls in both 403(b) and 457(b). He can contribute the maximum ($19,000) amount to each plan for a total of $38,000 plus any applicable catch-up contributions

On the other hand, opening a Roth IRA requires an individual to satisfy two requirements: (1) they must have compensation (e.g. earned income) and (2) household income (MAGI) must be within government mandated limits. Roth IRA contributions for tax year 2019 are prohibited if the household income for married clients filing jointly is greater than $203,000 ($137,000 for single filers). Those high income earners who have been shut out of funding a Roth IRA have another option available: "backdoor Roth IRA.” 

Satisfying these requirements allows an investor to fund a maximum of $6,000 into a Roth IRA in 2019. Like an employer plan, Roth IRAs offer a “catch-up” contribution for those aged 50 and older, although it’s “only” $1,000.

The exception to the earned income requirement is a spousal IRA, whereby the working spouse funds an IRA on behalf of the spouse without compensation. See my column for more information.

Assuming you qualify, you can fund both Roth accounts (e.g. 401(k) and IRA), contributing a maximum of $25,000 ($19,000 + $6,000) plus available “catch-up” contributions.

Distributions

One, if not the most appealing feature of a Roth account is the ability to take distributions tax free. A lot of people assume—incorrectly—since funds are being distributed from a Roth account—“it’s always tax-free.” Like Roth IRAs, once a Roth 401(k) distribution is “qualified,”  all funds will be distributed tax and penalty free. However, you must jump through a few hoops prior to being entitled to tax-free treatment.

Like Roth IRA distributions, once a Roth 401(k) distribution is qualified (known as a “qualified distribution”), it will be withdrawn from the plan free of taxes and/or penalties. A Roth account must have been established for five years (“five-year holding” period) and the distribution must be made after age 59½ or the distribution is due to death of the plan participant. For example, suppose Tanya, 60,  funds her Roth IRA (first and only) on July 1, 2019. She will have satisfied her holding period on January 1, 2023. The holding period “clock” always starts January 1 of the tax year in which the initial contribution (or conversion) was made. Tanya is first eligible to take tax-free qualified distribution on January 1, 2023.

All subsequent Roth IRA contributions made to the original Roth IRA or a separate Roth IRA established at a later date would follow the same (original) clock. In other words, an investor would follow the timetable for a single Roth IRA contribution, regardless of the amount or location of accounts (i.e., different IRA custodians).

For tax purposes, all of your Roth IRAs, regardless of where they are held, are considered a single Roth. Therefore, there is no tax benefit gained by establishing a separate Roth IRA. In fact, it may cost you more because of multiple account fees.

Distribution timing rules differ, too. Roth IRA distribution rules are liberal, thus allowing an investor to access their contributions (principal), free of taxes and or penalties, regardless of age, reason, or holding period. For example, Tom, 30, has a Roth IRA currently valued at $100,000 of which $20,000 is basis (e.g. contributions). Tom can withdraw his entire basis, up to $20,000 tax and penalty free. The distribution, however, is reportable on Form 8606. Any amount distributed above the basis would be subject to tax and potential penalties.

Designated Roth 401(k) accounts differ; here, the participant must first be distribution eligible (e.g., retirement, separation from service, in-service, etc.), whereas Roth IRAs can be distributed at any time. Designated Roth 401(k) accounts (like Roth IRAs) require the distribution to be a qualified distribution in order to be tax free. A qualified distribution occurs upon the account owner reaching 59½ or dies or becomes disabled. In addition, the Roth account must have been in existence for five years.  

Furthermore, designated non-qualified Roth accounts are distributed from an employer plan “pro-rata”—not basis first, as with a Roth IRA. Let’s continue with the previous example, except Tom has a Roth 401(k). Tom recently left his employer for a new opportunity. Any distribution Tom takes will not be qualified because he is not 59½. Tom has $70,000 in Roth deferrals and $30,000 in earnings, totaling $100,000. Tom has time before starting his new role, so he takes a partial distribution of $10,000 from his Roth account to cover bills until he receives his initial paycheck. Seventy percent or $7,000  (of $10,000) distribution will be tax free, whereas the remaining $3,000 will be subject to income taxes, plus he’ll have a 10% early distribution penalty and mandatory 20% federal tax withholding.

The Intersection of Multiple Plans and the five-year clock

What “clock” applies when a participant rolls over a Roth 401(k) account to a new employer’s plan?

A participant that has multiple Roth 401(k) accounts (across multiple employers) means he/she also has multiple five-year hold periods. Each plan will have its own five-year hold period. This is different from a Roth IRA, where the owner has one five-year hold period regardless of the amount or location of established accounts. It’s straightforward when rolling assets over from one employer to another using a direct “trustee to trustee” transfer. Here, the existing holding period can be absorbed by the new plan as long as the funds are moved via a direct rollover. However, things get messy when a participant elects an indirect (60-day rollover). First, only the growth (e.g. earnings) from the former employer plan can be rolled over to the new employer’s Roth 401(k). In addition, the earnings portion will be subject to a mandatory 20% federal tax withholding. The third item is a real doozy. Here again, if you do a 60-day rollover (qualified or non-qualified) to a new employer’s Roth 401(k), the “clock” of the new plan will apply even if the funds had been in the former employer’s Roth 401(k) for a longer period of time.

Example: Scott’s Roth 401(k) account is valued at $20,000, of which $5,000 is earnings. Scott elects to roll his 401(k) to his new employer’s Roth 401(k) plan.

If Scott doesn’t move (rollover) the account via a direct trustee transfer, the consequences are significant—he will be permitted to rollover only $5,000 (earnings) into the new plan. Scott will receive a check for $19,000, which represents his basis of $15,000 plus $5,000 earnings (minus 20% tax withholding). Scott’s basis cannot be rolled into the new plan, although it can be moved into a Roth IRA. If Scott moved the assets via a trustee transfer, the full $20,000 would be eligible for a rollover. Avoid an indirect 60-day rollover when possible.

How is the five-year hold period determined upon rollover from a Roth 401(k) to a Roth IRA?

Things here are somewhat simplified. You always use the five-year holding period associated with the Roth IRA. This is the case regardless of  how (trustee transfer or 60-day rollover) or when (qualified or non-qualified distribution). In other words, the holding period associated with the employer plan is always forfeited. Suggestion: Everyone establish a Roth IRA (contribution, conversion, back-door Roth) immediately, thus starting the five-year hold period.

Example: Lisa worked at Life's a Dream Inc. for 20 plus years. In 2019, at age 66, Lisa decides to retire. Lisa began making Roth 401(k) contributions in 2006, the first year Roth was permitted in her plan. Lisa can take a qualified distribution since she has reached 59½ and met the five-year hold period. Lisa decides to roll her Roth account to a newly established Roth IRA (this is Lisa’s first Roth IRA). All Roth assets will move over as basis. However, Lisa must satisfy a new five-year hold period before being able to take a qualified distribution. In other words, the previously satisfied hold period has been lost.

Take caution in those rollover situations where Roth 401(k) assets are being rolled to a Roth IRA as a non-qualified distribution. Here the funds retain their original characterization prior to the rollover—a portion is basis and a portion is earnings and thus taxable until qualified.

Under current law, you're not permitted to move Roth IRA assets into a Roth 401(k), 403(b), 457(b) or TSP.

Required minimum distributions (RMDs)

Roth IRAs are never subject to lifetime RMDs for the account owner and the surviving spouse. In other words, the account is first subject to required distributions upon an inheritance by a nonspouse beneficiary.

However, designated Roth 401(k) accounts are subject to lifetime RMDs. So, being proactive can help avoid RMDs. How? By rolling over Roth 401(k) funds to a Roth IRA prior to age 70½.

 

To comply with Treasury Department regulations, we inform you that, unless otherwise expressly indicated, any tax information contained herein is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties that may be imposed under the Internal Revenue Code or any other applicable tax law, or (ii) promoting, marketing, or recommending to another party any transaction, arrangement, or other matter.

The information is being provided for general educational purposes only and is not intended to provide legal or tax advice. You should consult your own legal or tax advisor for guidance on regulatory compliance matters. Any examples provided are for informational purposes only and are not intended to be reflective of actual results and are not indicative of any particular client situation.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett's products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

Traditional IRA contributions plus earnings, interest, dividends, and capital gains may compound tax-deferred until you withdraw them as retirement income. Amounts withdrawn from traditional IRA plans are generally included as taxable income in the year received and may be subject to 10% federal tax penalties if withdrawn prior to age 59½, unless an exception applies.

A Roth IRA is a tax-deferred and potentially tax-free savings plan available to all working individuals and their spouses who meet the IRS income requirements. Distributions, including accumulated earnings, may be made tax-free if the account has been held at least five years and the individual is at least 59½, or if any of the IRS exceptions apply. Contributions to a Roth IRA are not tax deductible, but withdrawals during retirement are generally tax-free.

Modified adjusted gross income (MAGI) includes wages, interest, capital gains, income from retirement accounts and alimony paid received by the taxpayer adjusted downward by specific deductions, including contributions to deductible retirement accounts and alimony paid by the taxpayer; but not including standard and itemized deductions.

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