Matt Nelson discusses using a Roth 401k in your company plan

>> Matt Nelson: You've heard about Roth IRAs, but is a Roth 401k for you? In this show, I'm going to hit on the highlights about using Roth 401k contribution feature in your company plan, how to know if it makes any tax sense, and then review an easy trick to make sure you can withdraw your money tax free later. M welcome back to the show. I'm, uh, Matt Nelson and my team at perspective6 group has been helping people retire for over 25. We talk about what works in tax planning, investments and more. So let's just hop right into it.


Roth 401ks differ from traditional pre tax 401ks

All right, first let's talk about how Roth 401ks differ from pre tax. Now, a lot of you've probably heard about both Roth IRAs and Roth 401s. The main difference is the contributions go in pre tax or after tax. So with pre tax contributions, obviously it reduces your taxable income, but later you're gonna take that money out and it's gonna be taxable. Another big difference between the traditional pre tax 401k and the Roth would be that there's RMD's required minimum distributions at age 73. With pre tax, those aren't there for the Roth 401k feature. The biggest one though is you can take the withdrawals tax free later, even for your heirs. So this is a huge benefit not only during your retirement, but also with estate planning and uh, passing it on to people you care about.


You need to consider your current and your future tax brackets

All right, so this, this all sounds pretty good. Why doesn't everybody use the Roth 401K? Well, the first thing is you need to consider your current and your future tax brackets. So let's think about this way. If you're in a low tax bracket, it's probably better for you to just forego a tax deduction today, meaning skip the pre tax option and use all after tax or Roth 401k. Now don't confuse the two. After tax and Roth are similar, but they're not the same. So we're going to only focus on Roth 401 contributions. Now, if your income bracket is at, uh, let's say 22% and below, I'd steer you toward all Roth 401 contributions. This is incomes for, let's say if you're married, finally jointly, that'd be income's around 200,000. If you're single, it's around 100,000. But if you're in a middle to high income bracket, then it's pretty common to be using all traditional pre tax option. So you save the taxes today. You know, it's sort of that bird in the hand, two in the bush, however that phrase goes. So let's say that the 24% bracket, which starts about 200,000 for merely filing jointly with this level, you're probably going to want to do a mix. You might do all Roth, you might do all pre tax. Kind of depends. We'll talk about that in a minute. Once you get to that 32% level, though, which is around 400,000 for married filing jointly, you're most likely going to want to take the tax deduction up front for various reasons. The main idea is that you need to consider your lifetime income bracket. So will you always be at the income level you are today? For instance, you know, let's say your early career versus late career. Well, maybe in this case, if your early career, you might be more apt to use Roth 401 contributions and forego that deduction because later in your career you maybe will be higher income or plan to be. And then you'd want to be using the pre tax contribution. And consider, are you going to retire early? So let's say you retire early and you're going to have a gap between when you're going to collect Social Security, when your RMDs kick on, when your pensions start, you might actually want to contribute mostly to the pre tax side so that during that gap period, you can make use of a low income period, low taxable income period. I should say pull money out of the 401 and pay a lower tax bracket. You also should consider if you'll remain in a high bracket forever, maybe you've accumulated a lot of assets, you're going to continue to make high income, and you'll just never really get out of that high bracket. Well, in this case, now you need to be thinking of who's going to get the money later. Okay, so many of our clients might be at this situation and they're thinking about how their kids are going to receive the money. Think about their tax brackets, what will be most advantageous for them. Also, if the money's going to go to charity versus your kids, that's a whole different decision of what type of money is best to pass on. And then the final, uh, idea you want to think about is some tax diversification. So just like you think of your asset allocation with stocks and bonds and cash, you need to be thinking about, do you have some tax free money? Do you, do you have some tax deferred money? Is it taxable? That gives you choices as you get to Withdraw money out of your accounts. The final part on this section is I'd uh, say consider the possibility, probably even the likelihood that tax brackets are going to increase in the future. We've been at a historical low in tax brackets, believe it or not. If you look back over history and so it may make some sense, even if you're in a higher income bracket today, to be using the Roth 401k feature to pay your tax and get it out of the way. Okay, so here's how you should be thinking about this from a tax planning perspective on an ongoing basis. Number three, you need to adjust your mix of pre tax to Roth based on fluctuations in your income. So for instance, let's say you're on the bubble of income limit to qualify for a Roth IRA. And that's for instance starting at around 236,000 of income for married and it's about 150 for single. So let's say that you are getting close to or you're just over those levels. I should say you may want to just use pre tax money to get you down below those levels so you can qualify to contribute to a Roth IRA and then go back and fill up the Roth 401 side of things. This brings me back to one of the prior points where we talked about in that kind of low to just starting middle tax brackets, you may prefer Roth after tax contributions anyway. And so managing your money in this way when you're kind of near those Roth IRA levels allows you to have a little bit of the best of both worlds. Bring your income down enough to then qualify for the ira. Another idea to manage on an ongoing basis is if you're on the bubble of a higher income bracket due to, let's say a higher equity compensation year, maybe a large bonus year that you had, this would be a great opportunity if you're in those low to middle brackets, to use more of the pre tax side, maybe all pre tax side, to bring that income down and eliminate the possibility of pushing up into those higher brackets. You'd also want to consider what happens if you're going to have a lower income year due to, let's say a partial income from a job change, or maybe, you know, you have a job change coming up and you can plan ahead for this. You're going to have a gap in income. Consider that type of approach. You might want to use more Roth 401k at that time because your, your tax bracket is going to be lower for the year. So basically switch to more Roth when You have lower income for the year, switch to more pre tax when you're going to have higher income for the year.


You can convert pre tax money to the Roth if your plan offers it

All right, so what if you have really big income fluctuations in a year? Well, this is where you might want to consider in plan Roth conversions. So we've maybe heard about Roth IRA conversions. Well, you can do this in your 401k as well, as long as the plan offers it and most plans do. So if you're going to have a really large income change in the year, you might want to actually convert some of your pre tax money to the Roth. So what's going to happen is you'll take the money out of the pre tax side, pay tax on it for the year and then place it back in the Roth side. Let's just give some examples. Let's say, um, back to the prior. You know you're going to be changing jobs or maybe you lose your job early in the year due due to a layoff and it takes you most of the year to find another job. Great opportunity to maybe take some pre tax money out at what will be a lower income bracket, put it into a Roth 401K. Also, what if you have a major promotion coming up? So you know, you're, you're at, you know, a certain level today, you've got this promotion coming up, it's going to start in a certain point in the future. Maybe you go ahead and convert some now while you're at a lower income. You need to pay attention though to your specific plan rules. So for instance, in Medtronic's plan they only allow one conversion per year. This isn't necessarily an IRS limit, it's just the plan limit. So you need to actually read that plan document so you can plan ahead. If you only get one per year, you need to make sure it counts. Um, in other situations you might be able to have a couple of bites at the apple. Also be very careful if you have company stock in the plan. So Medtronic's plan document for instance, specifically calls out, if you have Medtronic stock and you convert that in an in plan conversion, you're going to lose your net unrealized appreciation option, the NUA option. And this would be a huge deal. So be very careful. So that brings me to the final point and uh, the piece that's important to think about. To make sure you set yourself up for options in the future, you need to start the five year clock. And what this means is if you draw money out before you've met this five year rule, you're going to pay a 10% penalty. So all those benefits I talked about with the money coming out tax free, they uh, go out the window. You need to participate for five years before distributions will qualify as tax free after age 59 and a half. And this is, this is even if you're disabled or for death. Roth IRAs have a similar five year rule, but it's a single holding period that applies across all your accounts. So basically you could have multiple Roth IRAs. Uh, you started one of them five years ago. Three others you just started, you know, a year ago. It doesn't matter. You meet the five year rule with Roth 401ks though, there's a separate holding period for each plan. So you need to pay attention. If you've changed jobs and you had a Roth 401k at your prior job doesn't count for your current position. So the thing is, if contributing even a small amount gets that five year clock started, what you could do. And uh, here's the tip, just make one contribution, one payroll period, just that one contribution, uh, gets that clock started and then you're good to go and you have options for the future. The information about this 5 year rule and the differences between the 401k and the IRA are actually enough for an entire video. But I have summarized that here in just a quick table for reference, so take a look at it. All right, to wrap it up, the decision to use a Roth 401 comes down to your current and your future tax situation. And you need to be thinking about managing your contributions and whether to make an in plan. Roth conversion as an ongoing set of annual decisions. Don't just set it and forget it. Pay attention to what's happening throughout the year so you don't miss opportunities. And also be sure to start that five year clock so you give yourself some options later. If you found this video helpful just like and subscribe for more of our content. You can also download a paper I wrote on maximizing youg 401k in the comments section below. Or, uh, check out our other videos on the channel on retirement planning and tax savings opportunities. Thanks for watching. Remember, financial freedom takes more than money, so make a plan to live your life well. If you need any guidance, we're here for you.

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