How High Income Earners Can Contribute to a Roth and Other Differences Between Roth 401K and Roth IRA

Although there are a lot of differences between a Roth IRA and a Roth 401k, I wanted to highlight what I believe are some of the more significant ones. Individuals utilizing a Roth IRA and Roth 401(k) have the same objective, to qualify for tax free distributions. In both situations, the individual contributes after-tax dollars to the accounts, and while the Roth IRA and Roth 401(k) have a lot of the same rules, there are some important differences.

1. Contribution limits

Roth 401(k)

For 2018, if you are under age 50, the annual contribution limit to 401(k) plans is $18,500.If you are age 50 or older, you can contribute an additional $6,000 in catch-up contributions, for a total of $24,500.

These contributions apply on an individual basis, and are aggregated with contributions to traditional 401(k) plans. As a result, the limit of $18,500 plus $6,000 catch-up can be contributed to one Roth 401(k); or split among more than one Roth 401(k) and traditional 401(k) Plans.

Roth IRA

For 2018, your total contributions to all of your traditional and Roth IRAs cannot be more than $5,500 ($6,500 if you’re age 50 or older), or your taxable compensation for the year, if your compensation was less than the dollar limit noted above.

Roth IRA contributions are aggregated with contributions to traditional IRAs. This means that an individual’s total regular contribution to both a traditional and a Roth IRA cannot exceed $5,500 for the year, plus the additional catch-up contribution of $1,000.

Contributions to a Roth 401(k) and a Roth IRA in the same calendar year

An individual can make the maximum contribution amount to both types of accounts without limitations, if eligible. As an example, if a married individual, age 35, has $75,000 in wages for the year this employee could contribute $18,500 to their Roth 401(k) retirement plan, but they could also contribute $5,500 to their personal Roth IRA. Additionally, they may be able to contribute another $5,500 for their spouse's Roth IRA.

2. Income Limitations

Roth 401(k) contributions are not restricted by your personal income. Whereas an individual is eligible to make a contribution to a Roth IRA only if their modified adjusted gross income (MAGI) is below certain levels. The following table illustrates the MAGI Limits for 2018:

MAGI Limits

If your filing status is:

And your 2018 MAGI is:

Then you can contribute:

Single

< $120,000

100%

 

> $120,000 but < $135,000

Reduced

 

> $135,000

Zero

Married filing jointly

> $189,000

100%

 

  > $189,000 but < $199,000

Reduced

 

 > $199,000

Zero

Married filing separately

< $10,000

Reduced

 

> $10,000

Zero

Source: www.irs.gov/retirement-plans/plan-participant-employee/amount-of-roth-ir...

For individuals whose MAGI falls within the phase-out range, calculations must be completed to determine the specific amount of contribution for which they are eligible.

3. Opening a Roth IRA and/or a Roth 401(k)

Anyone can establish a Roth IRA; and regular Roth IRA contributions can be made to the account as long as the income eligibility is met.

In contrast, the ability to participate in a Roth 401(k) is dependent on your employer's retirement plan. A recent study reported only 47% of employer plans offer the Roth 401(k) benefit. If your plan does not offer this feature, consider following up with your employer, as the cost could be nominal to incorporate into the existing plan. fact it may not be offered because the plan has not been updated in recent years. It should also be noted that employers who want to offer a Roth 401(k) benefit must first have a traditional 401(k) plan in order to add the Roth as an additional choice.

4. Required Minimum Distribution

When you start to move into the required minimum distribution phase of your life, you want to be able to control this area as much as possible, since the IRS is now forcing you to withdraw funds. You generally do not have to take required minimum distributions from either a traditional 401(k) or a Roth 401(k) if you are still working for the employer that sponsors the plan. If, however, you are retired, you do need to take RMD’s from either kind of 401(k) account after you turn age 70½, although your Roth 401(k) withdrawals will be tax-free. The required withdrawals are based on the balance in your account at the end of the previous year and the IRS’ life-expectancy figure for your age. If you have Roth 401(k) accounts with several former employers, the RMD is calculated separately for each one. In fact, 401(k) RMDs cannot be aggregated, therefore you are required to take distributions from each account. Another important fact is that Roth 401(k) beneficiaries are subject to the RMD rules.

In glaring contrast, Roth IRA owners are not subject to RMD rules, but once again the beneficiaries for this type of account are subject to RMD rules. However, an exception applies to spousal beneficiaries who transfer the inherited assets into their personal Roth IRAS. Since Roth IRA owners are not subject to the RMD rules, it is another good reason to transfer the Roth 401(k) to your personal Roth IRA. Note that if any RMD is due for the year in which the rollover occurs, that RMD must be taken before the account is transferred.

5. Implications of a Non-Qualified Distribution

Qualified distributions from a Roth 401(k) or a Roth IRA are tax-free and penalty-free. Non-qualified distributions may be subject to income taxes, and a 10% early distribution penalty on any taxable amount. The 10% early distribution penalty does not apply if the distribution occurs on or after the date on which the account owner reaches age 59½, or if an exception to the penalty applies.

In the event you need to make a non-qualified distribution from your Roth IRA, the IRS states that any earnings on the principal will leave the Roth IRA last. This means that the only funds that would be taxed will come out after your Roth IRA contributions have been completely distributed.

In contrast, your Roth 401(k) non-qualified distribution is subject to the more punitive pro-rata rule. This means that a portion of each distribution that is not qualified will be taxed and the 10% penalty could apply.

6. Five Year Rule Distinctions

In order for a distribution to be qualified, an individual must have had their Roth IRA/401k for five years. regard to the Roth IRA, the clock starts on January 1st of the year you make your first contribution. Because you can make a Roth IRA contribution up to April 15th of the next year, your five years technically would not have to be five calendar years. regard to distributions, the five year rule is also considered on an aggregate basis. Therefore the five year period generously applies to all of the Roth IRA as of the date of the individual's first Roth IRA.

In regard to Roth 401(k) accounts when determining whether or not the five-year period has been met, each of that individual’s 401(k) accounts must independently meet this requirement. An exception applies when two Roth 401(k) accounts under different employer plans are combined. Under this exception, if one Roth 401(k) is moved to another using the direct rollover method, then the five-year period starts with the Roth 401(k) that was first established and funded. Another nuanced rule, is that the age of your Roth 401(k) doesn’t transfer to a Roth IRA when you do a rollover. This peculiar rule can work to your advantage or disadvantage.

  • If you owned a Roth 401k for just a few years, but the Roth IRA for more than five, then you can satisfy the five-year test, by rolling the Roth 401k to your Roth IRA.

  • The reverse situation is less appealing. You might have held your Roth 401k account several years without having opened a Roth IRA. Therefore when you create a Roth IRA to receive the rollover from the Roth 401k, you’ll be forced to start a new five-year waiting period before you can take qualified distributions.

Roth IRAS and Roth 401ks have created great opportunities in the retirement planning process. If you want to explore the value of a Roth account for you, and address all of the relevant rules to your situation, then contact your HFG Trust advisor. If your employer does not offer the Roth 401(k) as an option, let us know and we would be happy to reach out to them and assist them with their Qualified Retirement Planning needs.

Bob Lagonegro, CFP ®

Financial Advisor

 

Legal Information and Disclosures

 

This memorandum expresses the views of the author as of the date indicated and such views are subject to change without notice. HFG Trust has no duty or obligation to update the information contained herein. Further, HFG Trust makes no representation, and it should not be assumed that past investment performance is an indication of future results. Moreover, wherever there is potential profit there is the possibility of loss. This memorandum is being made available for educational purposes only and should not be used for any other purpose. The information contained herein does not constitute and should not be construed as an offering of advisory services or an offer to sell or solicit and securities or related financial instruments in any jurisdiction. Certain information contained herein concerning economic trends and performance is based on or derived from information provided by independent third-party sources. HFG Trust believes that the sources from which such information has be obtained are reliable; however, it cannot guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based. This memorandum, included the information contained herein, may not be copied, reproduced, republished, or posted in any form without the prior written consent of HFG Trust.

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