A Super-Charged Roth IRA

Question:
What if you could have a Roth account that had higher annual contributions and no income limits?
Answer:
If you have a 401(k), you can! (Keep reading.)

Dear Friends,

Remember the hoopla and excitement when the Roth IRA was introduced in 1997? The thought of being able to put money into an account where the growth would forever escape federal tax had everyone salivating. Even non-financial publications ran stories about how much money you’d end up with after years of tax-free compounding. The government was doing something that actually encouraged us to save — it seemed too good to be true!

“Indeed,” sniffed the doomsayers, who started predicting that the tax-free status of Roth withdrawals would be repealed almost before the ink had dried on the legislation creating the new IRA.

Huh. Here it is 8 years later and the Roth IRA is still alive and well. According to the Investment Company Institute, Americans have squirreled away about $120 billion in Roth IRAs so far. Of course, the doomsayers are still claiming they’ll be proven right… one of these days.

To be fair, there are a few drawbacks to the Roth IRA. First, the amount you can contribute is limited by the IRA rules. Thankfully, the annual contribution has been increasing ever since passage of the Economic Growth and Tax Relief Reconciliation Act of 2001, or 2001 Tax Act. As a result, this year you can contribute up to $4,000 to an IRA, plus another $500 as a “catch-up” contribution if you’re age 50 or more. (Next year the base contribution stays the same, but the catch-up amount increases to $1,000.)

In addition, even though contributions to a Roth IRA can only be made with after-tax dollars — meaning you don’t get any tax deduction at the time you make your contribution — not everyone is eligible for one of these accounts. There are income limits.

If you’re single, you can only contribute to a Roth IRA if your modified adjusted gross income (MAGI) doesn’t exceed $95,000. Between $95,000 and $110,000 you can make a partial contribution. Once your income is over $110,000, you’re no longer eligible.

If you’re married and file [jointly], the magic number is $150,000. If your MAGI is higher than this but below $160,000, each spouse can make a partial contribution. If it’s more than $160,000, neither spouse can contribute to a Roth.

By the way, if you’re married and file separately, you lose your eligibility for a Roth IRA when your MAGI exceeds $10,000. (That’s “ten thousand dollars.” I did not leave out a zero. Please contact the IRS, not me, if you have a problem with this!)

Last but not least, these are the same income brackets we were given eight years ago when the Roth was introduced. Unlike the traditional IRA, the Roth IRA income limits are not adjusted for inflation.

So in a way I suppose the doomsayers are right: Congress won’t have to do anything to eliminate the Roth IRA; as salaries increase due to inflation, this will ensure that fewer and fewer Americans are eligible for it.

Just when you’re ready to throw up your hands and write off politicians as idiots who, on the one hand, chastise us for not being better savers while on the other they eliminate the incentives for doing so, the clouds part and a brilliant ray of sunshine bursts through the gloom. I won’t claim to have read the entire 2001 Tax Act, but there’s a gem inside it that is in danger of being overlooked:

The Roth 401(k)

As you may know, although this massive piece of legislation was passed in 2001, many of its provisions are phased in — and out — over several years. The lower tax rates for qualified dividends and capital gains are one example. These disappear at the end of 2008.

Starting January 2006, the Tax Act gives 401(k) plans the ability to offer participants a “Roth” option. Like its IRA cousin, contributions would be made from after-tax dollars, so you wouldn’t get a tax deduction for contributing to this part of your 401(k). But this might not be a big deal. It all depends on what you expect your tax bracket to be in retirement compared to what it is today.

Lori Lucas, Director of Participant Research at the benefits consulting firm Hewitt Associates points out that “if you’re a younger worker just starting in your career and expect to be in a higher tax bracket when you retire, you’d be better off paying the taxes now.” By biting the bullet sooner rather than later, you eliminate the tax on all of the growth your contributions will earn over your working life and ensure you have a source of tax-free income for your later years.

But it doesn’t have to be an “all or nothing” proposition. If you aren’t sure what income tax brackets will look like in the future (who is?), you can simply hedge your bet and put, say, half of your 401(k) contribution into the Roth side of your plan.

The most important thing, according to Martin Nissenbaum, National Director of Personal Income Tax Planning for Ernst and Young, is that you activate your Roth account. That’s because, like the Roth IRA, in order for earnings on your Roth 401(k) to come out tax-free, a key condition is that the account must be at least five years old. “The five-year clock starts running the day you make your first contribution,” says Nissenbaum.

Even if you’re not certain you should participate, he recommends making a minimal contribution in order to establish the opening date. You can always decide later whether to fully participate or not.

Aside from the tax-free growth and five-year rule, there are some distinct differences between a Roth 401(k) and a Roth IRA. First of all, the contribution amounts are governed by the 401(k) rules, meaning next year you could put as much as $15,000 into the Roth portion of your company retirement plan. Tack on another $5,000 if you’re at least age 50. That’s potentially $20,000 that can grow federally tax-free.

Perhaps best of all, there are no income restrictions on who can put money into the Roth part of their 401(k) plan. Anyone eligible to contribute to the 401(k) can choose to direct his/her money into either the traditional or the Roth accounts. For this reason, Hewett’s Lucas predicts “people above the Roth IRA limits could find it very attractive.”

According to Nissenbaum, any profit-sharing or matching contributions your company makes would be unaffected. These would continue to go into the regular (pre-tax) side of your 401(k). To reduce confusion, Hewitt is recommending that 401(k)s offer the same investments in both regular and Roth accounts.

The rules that govern getting your money out of a Roth 401(k) will be similar to those for your regular 401(k) plan — not a Roth IRA. For instance, you couldn’t withdraw money from your Roth 401(k) to use toward the purchase of a first-time home. A “hardship” withdrawal would only be possible if your 401(k) plan had a provision for this.

When you leave your company or retire, the Roth portion of your 401(k) could be rolled over to a Roth IRA where it would continue to grow tax-free.

But before you get all excited about a Roth 401(k), ask yourself if you’ve heard anything about this from your company human resources department. Chances are you haven’t. That’s because most companies don’t plan to offer these accounts. At least not right away.

A survey of major employers by Hewitt Associates found that only 6 percent are “very likely” to add a Roth option to their existing 401(k) plans next year. According to Lucas, a number of companies are concerned that it could actually reduce employee participation rates by making the plan seem more complicated.

But both she and Nissenbaum agree that a significant factor is the lack of demand from employees. In other words, H.R. folks are just like the rest of us: busy. However, when there are a lot of people clamoring for something, that’s the issue that usually gets their attention.

The point is if you and your fellow employees want a Roth 401(k) on January 1, you’ve got to ask for it. Be a pest. Badger your H.R. department with emails. Circulate a petition. Buttonhole the CEO in the elevator.

This isn’t something that can be turned on overnight. The 401(k) plan document has to be amended, employees have to be educated about the new option, they have to be given time to enroll, etc. It takes months.

By delaying the implementation of this account, a company isn’t “just pushing off the Roth 401(k),” says Nissenbaum. “It’s delaying the start of the five-year clock.”

It’s more critical than that. Your company might completely miss the opportunity to offer a Roth 401(k) at all. Unless Congress acts to change things, the Roth 401(k) is slated to “sunset” at the end of 2010 along with the rest of the provisions of the 2001 Tax Act.

From my perspective, if a Roth 401(k) makes sense for you, the fact that there is such a narrow window of opportunity makes a stronger argument for contributing as much as you can to these accounts as soon as possible. Even if you’re not allowed to add new money after 2010, whatever you’ve contributed up to that point could continue to grow tax-free in this account.

Hope this helps,

Gail

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