March 29, 2018
Roth IRA/401(k)s and the New Tax Law
With the passing of the new tax law in 2017 many investors will experience lower tax rates potentially affecting retirement saving strategies. Getting out your crystal ball, if you believe that when your client starts to draw down on the retirement account taxes will be lower then choose the traditional deferral approach. If you think rates will be greater choose the Roth. If you are not sure well, you can always hedge your bets and go 50/50.
As in the past, if investment returns are achieved mostly through long-term capital gain returns then the after-tax savings approach might be more advantageous than pre-tax savings which is subject to potentially higher tax rates.
Recharacterization of the Roth – with the new tax bill, the ability to convert a traditional 401(k) or IRA into its parallel Roth version is still available allowing the investor to avoid the anticipated higher tax rates in the future. However, the ability to undo a conversion is no longer permitted.
Backdoor Roth – Regardless of income level an investor can convert pre-tax money in either a pre-tax 401(k)/IRA account to a Roth 401(k)/IRA account. In 401(k) Plans this is called an In-service Roth Conversion and this feature must be written into the document. The participant would pay the applicable taxes on the money converted, usually outside the plan and the account would grow tax-free. This approach has been available for several years.
However, many of our solo clients who utilize a combination of 401(k)/Profit Sharing and Defined Benefit Plans take advantage of the ability to put after-tax money into their 401(k)/Profit Sharing Plan. After-tax money is different than Roth money since it is technically considered an employer contribution and the investment gain, when distributed, is subject to ordinary taxes. So why use it? See the example below:
Jody James (age 50) is a solo practitioner. She makes $500K and is maxing out her retirement program. She defers $24.5K into her 401(k) Plan, $16.5K as the maximum profit sharing contribution allowed, and $194K into the defined benefit plan. For a total of $235K pre-tax contributions. In addition, she can contribute up to $20K in after-tax monies into the 401(k)/profit sharing plan. She can then “backdoor” this $20K contribution and convert it to a Roth IRA where it will grow tax-free. Jody has just saved $75K ($235K x 32% tax rate) in taxes plus has $20K growing tax free in a Roth IRA.
To learn how the Recharacterization of the Roth or the Backdoor Roth is appropriate for your client please contact your Retirement Sales Director at The Benefit Practice or call (203) 517-3502.
