Roth 401k question

(this may belong in GQ?)

I understand the difference between Roths and traditional plans. What I’m unsure about is whether I should, at this late stage, bother switching part or all of my 401k contributions to Roths.

My retirement is around 4 years away. I’ve been steadily investing in my 401k for 30-ish years, but all if that was pre-tax.

At this late stage, does it make any sense at all to convert any or all my contributions into Roths?

If so, what percentage?

(I know there is no single answer for everyone, just looking for a rule of thumb).

Thanks!

(Side question: I don’t think you can convert existing accounts to Roths, only future contributions. Is this correct?)
mmm

I know that you can convert existing accounts to Roths, because that’s how a “backdoor” Roth contribution works. But you have to pay taxes on any gains your 401k earned from untaxed contributions.

I believe there is a waiting period between your last Roth contribution and the soonest you can withdraw. It might be five years?

The benefit of a Roth is that gains aren’t taxed like they are in a conventional 401k. At this late date you won’t have time to make many gains, therefore the benefit of a Roth will not be realized unless you can leave the money in for a long time. If you can do that you might show a benefit. Roth accounts are best invested in early in life when you need the tax relief less and the money has more of a chance to grow. Sorry about the advice that suggests you get a time machine and do something ten or twenty years ago, but there you have it.

Yeah, I suspected it was too late in the game for me to benefit.
mmm

On the other hand, there is no Required Minimum Distribution for Roths, so assuming you’re drawing down your IRAs and 401ks first, and assuming that you are still going to be alive for many more years, your Roth money would have a chance to grow for a significant time. And if you’re not going to be around for many more years, then it’s not your problem anyway.

By the way, my plan is to roll my 401k money into an IRA when I retire. Is that yours as well? Seems like I’ve heard that there are different or separate distribution rules for each.

Roth accounts are great, but it’s worth remembering that your employer’s contribution is always “pre-tax,” so if you’re getting a match, you’ll never be 100% “after-tax.”

Just a minor clarification might be helpful here.

A “backdoor” Roth conversion is typically done from an IRA that contains only post-tax contributions and no taxes are due. Typically this is done each year, starting with an empty IRA and converting the entire amount of the annual, post-tax contribution.

A “normal” Roth conversion is done from an IRA that contains pre-tax contributions. Taxes must be paid for that type of conversion.

Back to the original question, I did some late conversions from IRA->Roth (about 10%) starting at age 65. I won’t need the funds for a long time and have mentally tagged it as emergency/estate/grandkid education funds. Each year I converted enough to fill up to the next tax bracket.

Wouldn’t you have to pay the tax on the untaxed contribution not on the gain? Or do I not understand how this works?

You are correct - you would have to pay taxes on the entire untaxed portion (which would be all of, most likely).

The other benefit of the OP switching to Roth contributions now is that he can effectively increase his maximum contribution. Assuming he’s over the age of 50, you can put in $25,000/year. If that goes in pre-tax, the principal will at some point be reduced by the taxes paid on it. If it goes in post-tax, it won’t be.

OK, this may be relevant to my OP.

I didn’t realize that the Roth annual max is 25K. As it stands now, I hit my max some time in late November, so my final 2 or 3 paychecks of a calendar year contain no 401k deductions at all.

If I switched to Roth - all or partial - this would allow me to contribute more annually?

Am I interpreting this correctly?

If so, how would I approach deciding what percentage of my deduction should be Roth?

FWIW I am 61, planning on retiring at 65.
mmm

I believe that the $25K limit is a maximum in all accounts - regular and Roth. Here is the IRS doc on it.

I never had a Roth 401k option available so I was surprised to see that they require RMDs at 70 1/2. I consider that a big disadvantage compared to a regular Roth IRA which can remain unspent for life. Also, a Roth IRA would allow you to put away an additional $7K - but if you exceed the income limit, you have to play the “backdoor” game.

This is what I’m doing. One advantage is that you can control the amount of the move and thus move little enough to keep in a lower bracket for the money you’re moving. And yes you have to hold it for five years, so it depends on if you have enough other money to live on while it matures.

No, there is no such limit. You might be thinking about one of the limits for a “qualified distribution.” In order to take earnings out of a Roth 401k tax-free, they must be “qualified.” One of the conditions to be qualified is that you must have participated in the plan for at least 5 years.

Note that 401k distribution rules are not as liberal as IRA distribution rules which often confuses people. Generally, you cannot take distributions from 401k plans until you reach the designated retirement age, leave the employer, or the employer discontinues the plan. Compare this to an IRA where you can take a distribution (possibly with tax and penalty) at any time.

There are 3 types of 401(k) contributions:

  1. The most common type people know about are the before-tax “elective deferals” to a traditional 401(k) account.

  2. The newer after-tax contributions to a designated Roth 401(k) account. Fewer employers offer this option.

  3. After-tax contributions to a traditional 401(k) account. Few people know about this option and very few employers offer it.
    The maximum combined total of options 1) and 2) is $19,000 plus an addtional $6000 “catch-up contribution” if you are over age 50. This limit is per-taxpayer, no matter how many employers you have.

The combined total of all three plus employer contributions is $56,000 plus a $6000 catch-up contribution PER PLAN or 100% of your compensation, whichever is less. If you have multiple employers during the year, this limit applies separately to each plan.

If your employer’s plan allows it, you can max out the $56,000 limit by making the third type of contribution and then convert your traditional 401(k) balance to a Roth 401(k) account. This is known as a mega-backdoor Roth contribution. There is no limit on how much you can convert from a traditional to a Roth account, if your employer’s plan allows it.

Both. When you convert from a traditional to a Roth (or for any other reason take money out of a traditional account) all of the money that is deemed to have come from before-tax contributions plus all of the money that is deemed to have come from earnings is taxable.

Once the money is in a Roth account, any further earnings from that point forward are not taxable if taken in a qualified distribution.

A number of things:

When you eventually retire, you should rollover all of your 401k assets from your employer’s plan into an/some IRA(s), so that you have complete control over the funds. If you have designated part of your salary deferrals as Roth contributions, then those assets would clearly be best rolled over into a Roth IRA, while everything else could go into a traditional IRA. You could rollover everything into the same IRA, but then you’d either have to pay lots of tax (if into a Roth) or keep track of your basis in your IRA (if into traditional) which I can tell you is absolutely no fun and is not as good tax-wise as keeping the Roth funds in a Roth account.

It’s probably too late for you to make very good use of a Roth 401k feature, since right before you retire from your main job is when you typically make the most money and you’ll typically be in the highest tax bracket you will ever be in. The main reason to designate some funds as Roth contributions is that you expect to pay less in taxes now than when you plan to take the funds out of the IRA, so all you really care about is relative tax rates between now and retirement. There also is the issue of tax rates possibly changing, but that’s hard to predict. Another possible use for Roth designated funds is to have a source of income in retirement that’s not taxable which allows you to take out extra funds as needed for things without incurring tax at a higher bracket than normal. But if you don’t have a decent chunk of change in there already, it’s probably not going to be too helpful.

In order for the earnings of your Roth designated funds to not be taxed on withdrawal, you have to wait 5 years after opening the account. You can always withdral your after-tax contributions in Roth IRAs with no tax or penalty, although I’m not so sure how it works with respect to Roth 401k that’s rolled over into a Roth IRA. I assume your 401k custodian keeps track of your basis in the Roth 401k, but I have no personal experience. This means that you can withdraw most of it basically as soon as your put it in, but if you were to make an awesome stock pick and have your account quintuple in value, you would only be able to withdraw one fifth of it tax-free until 5 years, regardless of how old you are. It’s never a good idea to take out your contributions from a Roth plan before retirement because you can’t put them back in later, but you can at least do it in a pinch and not technically pay taxes on it (you just lose the benefit of the tax-free earnings you would have gotten had you left it in). Once you hit 59.5 and five years of an active account, all your Roth distributions are tax-free. However, sometimes your custodian will not know for sure whether you meet the requirements, and code your 1099-R such that software will by default make it taxable; in such a case a good tax preparer/preparation software will ask you the necessary questions to determine whether it is taxable, but bad preparers who ignore their software’s diagnostics will just accept it’s taxable without further thought because they are pressed for time and care more about cranking out returns than getting them right.

Most people who will be withdrawing from Roth funds in the near future had those funds contributed directly into a Roth IRA in addition to maxing out their 401k, because as mentioned above it doesn’t make sense for people later in their career to be using the Roth 401k option. For a Roth IRA contribution to be made, you have to make under a certain amount of money in the tax year that the funds are contributed for. That’s currently around $133k for single and $200k for married filing jointly, but those are taken off the top of my head. This is a very good deal for those that would contribute more to their 401ks but can’t. You need earned income to make IRA contributions, but you can continue making Roth contributions your entire life so long as you have earned income, and you never need to make withdrawals during your lifetime (your heirs will though, assuming there’s something left). The limit for the 2019 tax year is $6,000 + $1,000 if over 50. This is up from 2018 and caused me some confusion during tax season this year since I contributed $6,000 to my Roth IRA fairly near the beginning of the year, but was seeing clients say they were making $5,500 contributions. It wasn’t until I realized that they were doing this for the previous tax year, not wanting to commit the funds until their accountant said it was OK, that it made sense. People make poor decisions when it comes to making IRA contributions all the time because they aren’t aware of the restrictions, so it makes sense for them to wait for their tax return to be finished before putting the money in.

By making Roth designated contributions, you effectively get to put more into your retirement plan than making all traditional contributions, since the dollar amount is the same but it’s made with post-tax money, which is worth more than pre-tax money. So despite what I said above about it being better tax-wise to do all traditional contributions if your tax rate is going to be lower in retirement, that assumes that you actually contribute less to the Roth account with the difference going to pay the taxes on the funds used to make Roth contributions. So it can make sense to switch to all Roth contributions so long as you’re willing to take a reduced paycheck because the federal income tax withheld will go up, and are willing to wait long enough to withdraw the funds such that the additional tax paid on putting them into the Roth account is outweighed by the additional tax-free earnings the account generates. What that time frame is depends on how the market does and what the difference in tax rates is. It’s impossible to say in general. So going to Roth contributions does effectively get more money into retirement accounts when you’re up against the limit, but might not be worth the extra tax you pay upfront.

A backdoor Roth conversion is where you make too much money to make a Roth IRA contribution. Instead, you make a nondeductible traditional IRA contribution, which can always be made, and then roll over the funds over into a Roth immediately. The only hoop you have to jump through in order to do this is have absolutely no other money in a traditional IRA. For people that have changed employers and rolled the 401k funds into IRAs so they could get the funds out of the previous employer’s control, they basically can’t do this. What happens is that Roth rollovers from traditional plans are taxable distributions, but the taxable amount is reduced by an amount of your “basis” in your traditional IRA that is allocable to the amount you rolled over. People generally don’t have any basis in IRAs rolled over from 401k plans; the only way you get basis is by making nondeductible traditional IRA contributions*. If you have multiple traditional IRAs and have some basis in them, when you rollover part of your IRA into a Roth (or simply withdraw it normally), the percentage that is tax free is the same as the percentage your basis is as a whole of all your IRAs. If you have a $50,000 IRA and make a $5,000 “backdoor” contribution and Roth rollover, you actually only get to use $500 of your basis, and leave $4500 in basis for later withdrawals and being taxed now on $4500 of the rollover. There is actually a client of ours who is doing something like this. We’re not their financial planner, we just do their tax return, and their decisions on how to fund their retirement plan are their own. If they were my direct client I would advise them to stop, but I’m just the peon who enters data for that particular person. There are multiple other clients who are doing it the “right” way - they have no other money in an IRA.

*On general accounting principles, it may be that you can rollover a Roth IRA into a traditional IRA and then you’d have basis in your rollover IRA. But this is absolutely a terrible idea, and it’s possible that you’re not even allowed to do it because of how colossally stupid it would be. It’s so stupid that I haven’t even entertained the idea before and would have no reason to look up if it’s actually possible. The only reason people make nondeductible contributions to traditional IRAs is because they want money in a retirement account and have no other way of getting it there. Nondeductible traditional IRA contributions are better than leaving the money in a taxable account, but just barely compared to deductible traditional contributions or Roth contributions, which are effectively the same if your marginal tax rate doesn’t change. The only thing that would make it a good idea is if you expect the market value of your account to go down due to market fluctuations and you have other traditional IRAs, but if that were the case, you could just put the funds into cash and let them sit there while the market falls. Since markets tend to go up, and that’s why you invest, making nondeductible traditional IRA contributions or rollovers should be a last resort.

You can get basis in your IRA by rolling over an after-tax contribution from a traditional 401(k). Few 401(k) plans allow after-tax contributions to traditional plans.

The available remedy for this is to roll the before-tax money in their IRA into their new employer’s 401(k) (or their old employer’s 401(k), if allowed). Since you are not allowed to roll after-tax money to a 401(k), there is an exception to the usual pro-rata rule that allows you to roll just the before-tax money.

Rolling money from a Roth IRA or a Roth 401(k) to a traditional IRA or a traditional 401(k) is not allowed. To make matters worse, I have talked to a few people who accidentally managed to roll a Roth 401(k) to a traditional IRA and the TCJA took away the option to do a recharacterization of a rollover from a 401(k), so they got royally screwed.

Tons of excellent advice, I appreciate everyone taking the time to answer.

I do have more questions.

But first, to review…

I am 61, retiring in a little less than 4 years.

I have maxed out my contribution limits in November for the past few years. My final 2 or 3 paychecks at the end of each year indicate zero 401k contributions.

Reading through this thread I have determined that a Roth would not make sense for me at this stage.

So… what should I do with that extra money I am getting at the end of the year? I have a few traditional IRAs (mutual funds); I’m thinking I should direct it toward one of them?

I am in a position where I can give a good percentage of my pay to my retirement portfolio, it seems unwise to not invest the extra net pay of those last few paychecks.

Thanks,
mmm

Does that mean that you miss out on your employer’s matching contributions for those last two or three paychecks? My employer matches per-paycheck, so if I max out the 401k early, I miss out on free money. My income varies substantially, so I plan late in the year to make sure that I contribute enough to max out my employer’s match, but not so much that I hit the ceiling before the end of the year.