By Jim Terwilliger
In past columns, we have commented on the positive virtues of the Roth IRA and why it is one of the greatest gifts bestowed by Congress on the American taxpayer.
It allows one to save and invest over a working lifetime in an account where the income, appreciation and distributions are never taxed as long as certain rules are followed. What’s not to like about a retirement account where a dollar can grow tax-free from, say, a handful of pennies and command a full dollar’s worth of spending power?
Roth IRAs were introduced in 1997. Four years later, Congress added icing to the cake when it added the option of a tax-free Roth feature to employer retirement plans. Note that employers are not required to offer the Roth version. Because of that, some folks do not have access to a Roth 401(k). Every working person has access to a Roth IRA either via contribution or conversion.
Although both types of plans have been in place for several years, much confusion about the similarities and differences still exists. The purpose of this piece is to help reduce some of that confusion.
Maximum Annual Contribution. The Roth 401(k) is the clear winner here. Maximum annual contributions follow the same rules as the traditional 401(k). They are indexed for inflation and currently are $18,000 with an additional catch-up contribution of $6,000 allowed for those aged 50 and over. Annual limits for Roth IRA contributions are also inflation-adjusted and are capped at $5,500 and $1,000, respectively. Contributions to either cannot exceed annual earned income.
You can make contributions to both types of plans in any given year, subject to the limitations mentioned here. The Roth 401(k) is an employer-sponsored retirement plan. The Roth IRA is an individual retirement plan. The two operate independently.
Another route to adding money to a Roth-type account is through a conversion. This is generally a taxable event and is accomplished by transferring money from a traditional IRA to a Roth IRA or from a traditional 401(k) to a Roth 401(k). There is no ceiling on the amount that can be converted.
Income-Related Limitation. The Roth 401(k) again is the winner. There are no income ceilings that reduce or eliminate the ability to contribute. Not true for the Roth IRA. For 2017, the ability to contribute phases out to zero in the $186,000-$196,000 Adjusted Gross Income range for married-filing-joint taxpayers and in the $118,000-$133,000 range for single taxpayers.
There are no income-related limitations for conversions.
Required Minimum Distributions (RMDs). The Roth IRA is the winner here but just barely. RMDs are not required for Roth IRAs. Oddly enough, RMDs are required for Roth 401(k) plans starting at age 70-1/2, although if the participant is still working at the company holding the 401(k), distributions generally are not required until retirement.
The remedy for Roth 401(k) RMDs is simple. At retirement, just roll the Roth 401(k) over to a Roth IRA and the requirement for RMDs disappears. It is best to open a Roth IRA at least five years before such a rollover. This will ensure that all distributions from that account after age 59-1/2 are “qualified.” The “clock” for the rolled-over funds is set by when a Roth IRA was started.
The subject of qualified distributions and the Roth “clock” can get quite complicated. We’ll leave that conversation to another day.
RMDs for Beneficiaries. Non-spouse beneficiaries must start taking RMDs the year following the year of death. An inherited Roth IRA is established to receive a deceased owner’s Roth IRA or Roth 401(k) assets. A spouse can roll over a deceased spouse’s Roth IRA or Roth 401(k) into his/her own Roth IRA and not be faced with RMDs.
Contributions after Age 70-1/2. There is no winner or loser here. As long as you are receiving earned income, it is permissible to make contributions to both types of Roth accounts even if you are over age 70-1/2.
Who Can Contribute? Anyone who receives earned income can contribute to a Roth account as long as other limits are honored. This includes folks working for an employer and receiving W-2 wages as well as others who are self-employed. For the latter, a solo Roth 401(k) can be established, which follows all the other rules/limits as a typical employer Roth 401(k) plan.
Judicious use of these two Roth vehicles can make a marked difference in the success of one’s retirement-savings strategy. Understanding the similarities and differences between the two is key. Partner with a trusted financial planner to make them work best for you.
James Terwilliger, CFP®, is senior vice president, and financial planning officer, at Wealth Strategies Group, of Canandaigua National Bank & Trust Company. He can be reached at 585-419-0670 ext. 50630 or by email at firstname.lastname@example.org.