Using a 401(k) to Supercharge a Roth

Let’s talk this time about a tax trick that may be available to you if you participate in a 401(k). The reason for the “may” is that – while the tax Code permits it – your individual plan may not. You have to inquire.

Let’s set it up.

How much money can you put into your 401(k) for 2015?

The answer is $18,000. If you are age 50 or over you can contribute an additional $6,000, meaning that you can put away up to $24,000.

Most 401(k)’s are tax-deductible. There are also Roth 401(k)’s. You do not get a tax break like you would with a regular 401(k), but you are putting away considerably more than you could with just a Roth IRA contribution.

Did you know that you might be able to put away more than $18,000 into your 401(k)?

How?

It has to do with tax arcana. A 401(k) is a type of “defined contribution” (DC) plan under the tax Code. One is allowed to contribute up to $53,000 to a DC plan for 2015. 

What happens to the difference between the $18,000 and the $53,000?

It depends. While the IRS says that one can go up to $53,000, your particular plan may not allow it. Your plan may cut you off at $18,000.

But there are many plans that will allow.  

Now we have something - if you can free-up the money.

Let’s say you max-out your 401(k). Your company also contributes $3,000. Combine the two and you have $21,000 ($18,000 plus $3,000) going to your 401(k) account. Subtract $21,000 from $53,000, leaving $32,000 that can you put in as a “post-tax” contribution. 

Did you notice that I said “post-tax” and not “Roth?” The reason is that a Roth 401(k) is limited to $18,000 just like a regular 401(k). While the money is after-tax, it is not yet “Roth.”

How do you make it Roth?

Prior to 2015, there had been much debate on how to do this and whether it could even be done. The issue was the interaction of the standard pro-rata rules for plan distributions with the unique ordering rule of Code Section 402(c)(2).

In general, the pro-rata rule requires you to calculate a pre- and post-tax percentage and then multiply that percentage times any distribution from a plan.

EXAMPLE: You have $100,000 in your 401(k). $80,000 is from deductible contributions, and $20,000 is from nondeductible. You want to roll $20,000 into a Roth account. You request the plan trustee to write you a $20,000 check, which you promptly deposit in a newly-opened Roth IRA account. 

           Will this work?

Through 2014 there was considerable doubt. It appeared that you were to calculate the following percentage: $20,000/$100,000 = 20%. This meant that only 20% of the $20,000 was sourced to nondeductible contributions. The remaining $16,000 was from deductible contributions, meaning that you had $16,000 of taxable income when you transferred the $20,000 to the Roth IRA. 

I admit, this is an esoteric tax trap.

But a trap it was. 

There were advisors who argued that there were ways to avoid this result. The problem was that no one was sure, and the IRS appeared to disagree with these advisors in Notice 2009-68. Most tax planners like to keep their tires on the pavement (so as not to get sued), so there was a big chill on what to do.

The IRS then issued Notice 2014-54 last September.

The IRS has clarified that the 401(k) can make two trustee-to-trustee disbursements: one for $80,000 (for the deductible part) and another of $20,000 (for the nondeductible). No more of that pro-rata percentage stuff.

There is one caveat: you have to zero-out the account if you want this result.

Starting in 2015, tax planners now have an answer.

Let’s loop back to where we started this discussion.

Let’s say that you make pretty good money. You are age 55. You sock away $59,000 in your 401(k) for five years. Wait, how did we get from $53,000 to $59,000? You are over age 50, so your DC limit is $59,000 (that is, $53,000 plus the $6,000 catch-up). Your first $24,000 is garden-variety deductible, as you do not have a Roth option. The remaining $35,000 is nondeductible. After 5 years you have $175,000 (that is, $35,000 times 5) you can potentially move to a Roth IRA. You may have to leave the company to do it, but that is another discussion.

Not a bad tax trick, though.

Do You Earn Too Much For An IRA?

I have received several questions about IRAs recently.  They can roughly be divided into two categories:

(1) Do I qualify?

(2) I converted to a Roth and it is worth less than what I paid tax on.

I wondered whether there is some way to blog about this without our eyes glazing over. IRAs are a thicket of seemingly arbitrary rules.

Let’s give it a try by discussing a couple of situations (names and numbers changed, at least a smidge) that came across my desk this year.     

Our first example:

Matt is single and makes around $200,000 annually. He is over age 50 and maxes-out his 401(k). He heard that he can put away an additional $1,000 in an IRA for being over age 50. He puts $6,500 into a Roth, and then he calls his tax advisor to be sure he was OK.

He is not.

His 401(k) is fine. There generally are no problems with a 401(k), unless you are one of the highly-compensated and the plan administrator sends money back to you because the plan went “top heavy.” 

It is the IRA that is causing headaches.

He has a plan at work (the 401(k)) AND he made an IRA contribution. The tax rules can get wonky with this combination.

You see, having a plan at work can impact his ability to make an IRA contribution. If there is enough impact, He cannot make either a traditional (which means “deductible”) or Roth IRA contribution.

 Is it fair? It’s debatable, but those are the rules.

What is too much?

(1) A single person cannot make a traditional IRA contribution if his/her income exceeds $71,000. 

CONCLUSION: He makes $200,000. He does not qualify for a traditional (that is, deductible) IRA.

(2) A single person cannot make a Roth contribution if his/her income is over $131,000.

CONCLUSION: He makes too much money to make a Roth contribution. 

Did you notice the two different income limits for a regular and Roth IRA? It is an example of the landmines that are scattered in this area.

What should Matt do?

Let’s go through example (2) and come back to that question.

Sam and Diane are married. They are both in their 50s and make approximately $180,000 combined. They did well in the stock market this past year, picking up another $15,000 from capital gains as well as dividends, mostly from their mutual funds. Diane and Sam were a bit surprised about this at tax time.

Diane has a 401(k) at work. Sam does not. Diane contributes $6,500 to her traditional (i.e., deductible) IRA, and Sam contributes $6,500 to his Roth.

There is a problem.

The 401(k) is fine. The 401(k) is almost always fine.

Again it is those IRAs. The income limits this time are different, because we are talking about a married couple and not a single person. The limits are also different because Sam does not have a retirement plan at work.

A reasonable person would think that Sam should be allowed to fully fund an IRA. To require otherwise appears to penalize him as he has no other retirement plan. Many would agree with you, but Congress saw things differently. Congress said that there was a retirement plan at work for one of the two spouses, and that was enough to impose income limits on both spouses. Seems inane to me and more appropriate for the Gilligan’s Island era, but – again – those are the rules.

(1) Since Diane has a plan at work, neither can make a traditional/deductible) IRA contribution if their combined income exceeds $193,000. 

Note that she would have had a deductible IRA (at least partially deductible) except for the dividends and capital gains. Their combined income is $195,000 ($180,000 + $15,000), which is too high. No traditional/deductible IRA for Diane.

(2) Roth contributions are not allowed for marrieds with income over $193,000.

OBSERVATION: Hey, that is the same limit as for a traditional/deductible IRA. Single people had different income limits for a traditional/deductible and Roth IRA. 

Q: Why is that? 

A: Who knows. 

Q: How does a tax person remember this stuff?

A: We look it up.

They went over $193,000. Sam cannot make a Roth contribution. 

Diane and Sam did their tax planning off their salaries of $180,000, which was below the income limit. They did not anticipate the mutual funds. What should Diane and Sam (and Matt) do now?

First, you have to do something, otherwise a penalty will apply for over-funding an IRA. Granted the penalty is only 6%, but it will be 6% every year until you resolve the problem.

Second, you can contact the IRA custodian and have them send the money back to you. They will also send back whatever earnings it made while in the IRA, so there will be a little bit of tax on the earnings. Not a worst case scenario.

Third, you can have the IRA custodian apply the contributions to the following year. Maybe they will, maybe they won’t.  It would be a waste of time, however, if your income situation is expected to remain the same.

Fourth, you can move the money to a nondeductible IRA.

Huh?

Bet you did not realize that there are THREE types of IRAs. We know about the traditional IRA, which means that contributions are deductible. We also know about Roth IRAs, meaning that contributions are not deductible. But there is a third - and much less common – IRA.

The nondeductible IRA. 

You hardly hear about them, as the Roth does a much better job. No one would fund a nondeductible if they also qualified for a Roth. 

There is no deduction for money going into a Roth IRA, but likewise there is no tax on monies distributed from a Roth. Let that money compound for 30 or 35 years, and a Roth is a serious tax-advantaged machine.

There is no deduction for money going into a nondeductible IRA, but monies distributed will be partially taxed. You will get your contributions back tax-free, but the IRS will want tax on the earnings.  The nondeductible IRA requires a schedule to your tax return to keep track of the math. 

The Roth is always better: 0% being taxed is always better than some-% being taxed. 

Until you cannot contribute to a Roth.

You point out that Matt, Diane and Sam are over the income limits. Won’t the nondeductible IRA run into the same wall?

No, it won’t. A nondeductible IRA has no income limit. 

And that gives the tax advisor something to work with when one makes too much money for either a traditional/deductible or Roth IRA.

Let’s advise Matt, Diane and Sam to move their contributions to a nondeductible IRA.  That way, they still make a contribution for the year, and they preserve their ability to make a contribution for the following year. Some retirement contribution is better than no retirement contribution.

BTW, what we have described – moving one “type” of IRA to another “type” – is sometimes called “recharacterization.” More commonly, it refers to moving monies from a Roth IRA to a traditional/deductible IRA. 

For example, if you made a Roth “conversion” (meaning that you transferred from a traditional/deductible IRA to a Roth) in 2014, you might be dismayed to see the stock market tanking in 2015. After all, you paid tax when you moved the money into a Roth, and the account is now worth less. You paid tax on that money!

There is an option: you can “recharacterize” the Roth back to a traditional IRA in 2015. You would then amend your 2014 tax return and get a tax refund. You have to recharacterize by October 15, 2015, however, as that is the extended due date for your 2014 tax return.  Does it matter that you did not extend your 2014 return? No, not for this purpose. The tax Code just assumes that you extended. 

You can recharacterize some or all of the Roth, and there are some rules on when you can move the monies back into a Roth.

The nondeductible IRA is also involved in a technique sometimes called a “backdoor” Roth. This is used when one makes too much money for a Roth contribution but nonetheless really wants to fund a Roth. The idea is to fund a nondeductible IRA and then convert it to a Roth. This works best with an IRA contribution made after December 31^st but before the tax return is due.

EXAMPLE:  You make a $5,500 nondeductible IRA contribution on February 21, 2016 for your 2015 tax year. You convert it to a Roth the next day. Think about the dates for a moment. You made a 2015 IRA contribution (albeit in 2016). You converted in 2016. Even though this happened over two days, the two parts of the transaction are reported in different tax years.

BTW, converting to a Roth means that you literally move the money from one account to a different account. It is not enough to just change the name of the account. Formality matters in this area. 

There are rules that make the backdoor all-but-impossible if you have other IRA accounts. It is one of those eye-glazing moments in this area, so we won’t go into the details. Just be aware that there may be an issue if you are thinking about a backdoor Roth.

The President’s myRA

The President introduced something called a “myRA” at the State of the Union speech. He explained…

… while the stock market has doubled over the last five years, that doesn’t help folks who don’t have 401(k) s. That’s why, tomorrow, I will direct the Treasury to create a new way for working Americans to start their own retirement savings: myRA. It’s a savings bond that encourages folks to build a nest egg. myRA guarantees a decent return with no risk of losing what you put in.”

The idea here is to encourage small retirement savers. The concern is that routine bank or investment fees (for example, the annual “maintenance” fee for an IRA) may discourage some (or many) from saving for retirement. Under the myRA, the government picks up that tab. The concept makes sense.

The myRA would function as a Roth-type account. Monies going in would not be deductible for income taxes.

Contributions will be automatic, voluntary and small. Initial investments could be as low as $25 and ongoing contributions as low as $5. Contributions would be made through “automatic” payroll deductions.

COMMENT: “Automatic” meaning actual employers who pay people in actual payroll department to process these transactions. Automatic seems to mean “magical” inside the Washington beltway. 

The myRA big deal will be the savers account balance “will never go down.”

COMMENT: Somewhat like a savings account or certificate of deposit. There are – by the way – no annual fees for those accounts either. They are “magical.”

The myRA will earn the same interest rate as the federal employees Thrift Savings Plan Government Securities Investment Fund.

NOTE: Which returned 1.47% in 2012. Unfortunately, inflation for 2012 was 1.8%. The G Plan pays investors the investor the average return on long-term Treasury bonds.  

It will be available to households earning up to $191,000 annually.

Participants will be able to save up to $15,000, or for a maximum of 30 years. 

            COMMENT: Remember: this is a “starter” savings plan.

There would be a provision to transfer the account to a Roth IRA.

COMMENT: That part makes sense, as these accounts can be described as “Roth-lite.”

The President created this by executive action this past Wednesday.

            COMMENT: Really? 

Reflecting the crowd currently occupying it, this White House also wants to compel employers that do not offer myRA’s to offer automatic enrollment IRAs.

OBSERVATION: Approximately half of American workers are not covered by a retirement plan at work, propelling policy mandarins to talk about “mandatory” solutions to the retirement “problem.” I acknowledge the problem - two problems, in fact. First, that many people do not save enough. It might help if they had a job, though. Second, that these hacks and their “mandatory” solutions are themselves a problem.  

Call me completely underwhelmed. 

Obama’s $3 Million IRA Cap

We have received several calls on the proposed $3 million cap on 401(k)s and IRAs. Some of those discussions have been spirited.

What is it? Equally important, what is it not?

The proposal comes from the White House budget. Here is some text:

The budget will also show how we can provide targeted tax relief to strengthen the economy, help middle class families and small business and pay for it by eliminating tax loopholes and make the tax system more fair. The budget will include a new proposal that prohibits individuals from accumulating over $3 million in IRAs and other tax-preferred retirement accounts. Under current rules, some wealthy individuals are able to accumulate many millions of dollars in these accounts, substantially more than is needed to fund reasonable levels of retirement saving. The budget would limit an individual’s total balance across tax-preferred accounts to an amount sufficient to finance an annuity of not more than $205,000 per person per year in retirement, or about $3 million in 2013."

Let us point out several things:

(1)    The proposal would not force monies out of an existing retirement plan. It would instead prevent new monies going into a plan.

This raises a question: should one draw enough to reduce the balance below $3 million, would one be able to again contribute to the plan?

(2)    The proposal uses the term tax “preferred” rather than tax “deferred.”  This indicates that the proposal would reach Roth IRAs. Roth IRAs are not tax deferred, as there is no tax when the funds come out. They instead are tax “preferred.”

There is some rhyme or reason to this proposal. $205,000 is the current IRC Section 415 limit on funding defined benefit (think pension) plans. The idea here is that the maximum tax deduction the IRS will allow is an amount actuarially necessary to fund today a pension of $205,000 sometime down the road. The closer one is to retirement, the higher the Section 415 amount. The farther one is, the lower the Section 415 amount. This proposal is somewhat aligning limits on contribution plans with existing limits on benefit plans.

(3)    The $3 million is an arbitrary number, and presumably it would change as interest rates and actuarial life expectancies change over time. If longevity continues to increase, for example, the $3 million may be woefully inadequate. Some planners consider it inadequate right now, at least if one is trying to secure that $205,000 annual annuity.

(4)    Would the annuity amount increase with inflation? Assuming an average inflation rate of 4.5 percent, one would lose almost three-quarters of a fixed annuity’s purchasing power over 30 years.

The frustrating thing about the proposal is that it affects very few people. The Employee Benefit Research Institute estimates that only 1% of investors have enough to be subject to this rule. This of course feeds into the perceived anti-success, anti-wealth meme of this White House.

(5)    The amount of money to be raised over a decade is also chump change for  the federal government: less than $10 billion.

Something to remember is that account balances in 401(k), SEP, SIMPLE and regular IRA accounts will be taxable eventually. IRAs are subject to minimum distribution rules, for example. The larger the balances, the more the government will take in taxes. Dying will not make the tax go away. In fact, it may serve to accelerate required distributions to a beneficiary and taxes to the government.

The budget was dead on arrival at Capitol Hill. Let us hope that less ideologically rigid minds on the Hill keep it so.