Tag Archives: 401(k)

Roth 401(k) vs Roth IRA

Many taxpayers ask the question: should I contribute to a Roth 401(k) or contribute to a Roth IRA? While there is no universal answer to this question, for many in the financial independence (FI/FIRE) community, I believe there is a clear answer. 

Roth Accounts

What is not to love about Roths? If withdrawn properly, they promise tax free growth and tax free withdrawals. Further, Roths (be them 401(k)s or IRAs) give taxpayers tax insurance: income tax increases in the future are not a problem with respect to money invested in a Roth account. Roths even provide some ancillary benefits during retirement if the United States ever adopts a value added tax (a “VAT”). 

Roth IRAs

Roth IRAs are an individual account and can be established at a plethora of financial institutions. Most working taxpayers qualify to make annual contributions to a Roth IRA. However, the ability to make an annual contribution to a Roth IRA phases out at certain income levels and is completely eliminated at $140,000 (single) or $208,000 (married filing joint) of modified adjusted gross income (2021 numbers). 

The maximum annual contribution to a Roth IRA is $6,000 (if under age 50) or $7,000 (if age 50 or older) (2021 and 2022 numbers). 

I have previously written about my fondness for Roth IRAs. One reason for my fondness is that annual contributions can be withdrawn from the Roth IRA at any time for any reason tax and penalty free. Thus, Roth IRAs can perform double duty as both a retirement savings vehicle and as an emergency fund. This is an advantage of Roth IRAs over Roth 401(k)s. 

Of course, considering their tax free growth, it is usually best to keep amounts in a Roth IRA for as long as possible. 

Roth 401(k)s

Roth 401(k)s are a workplace retirement plan. Contributions can be made through payroll withholding. Many employers offer a Roth 401(k), though they are far from universally adopted. 

The Roth 401(k) does enjoy some advantages when compared to its Roth IRA cousin. First, there is no income limit to worry about. Regardless of income level, an employee can contribute to a Roth 401(k). Second, the contribution limits are much higher than the contribution limits for Roth IRAs. As of 2021, the annual Roth 401(k) contribution limit is $19,500 (under age 50) or $26,000 (age 50 and older). 

The Roth 401(k) is not a good account for emergency withdrawals. Withdrawals occurring prior to both the account holder turning 59 ½ years old and the account turning 5 years old generally pull out a mixture of previous contributions and taxable earnings.

Roth 401(k) vs Roth IRA

So which one should members of the FI/FIRE community prioritize? Contributions to a Roth 401(k) or contributions to a Roth IRA?

To help us answer that question, let’s consider a young couple pursuing financial independence:

Stephen and Becky are both age 30, married (to each other), and pursuing financial independence. They both would like to retire at least somewhat early by conventional standards. They each have a W-2 salary of $90,000. They have approximately $2,000 of annual interest and dividend income. They claim the standard deduction. At this level of income, they have a 22 percent marginal federal income tax rate. Stephen and Becky each have access to a traditional 401(k) and a Roth 401(k) at work. They would like to maximize their retirement plan contributions. 

How should Stephen and Becky allocate their retirement plan contributions? Should they contribute to a Roth 401(k) and/or to a Roth IRA?

To my mind, the best play here is to contribute to a Roth IRA ($6,000 each) and contribute to a traditional 401(k) ($19,500 each). Stephen and Becky should not contribute to a Roth 401(k). 

There is a significant tax opportunity cost to making a Roth 401(k) contribution: the ability to deduct a traditional contribution to a 401(k). Remember, the Roth 401(k) shares the $19,500 annual contribution limit with the traditional 401(k). Every dollar contributed to a Roth 401(k) is a dollar that cannot be contributed to a traditional 401(k). 

For Stephen and Becky, the hope is that in early retirement tax laws either stay the same as they are today or at least keep today’s flavor. The idea is to take a deduction while working at a 22 percent marginal tax rate (by contributing to the traditional deductible 401(k)). Then, in early retirement, they convert amounts in the traditional 401(k) to a Roth. At that point, hopefully they have a marginal federal income tax rate of 10 percent or 12 percent. Many early retirees have an artificially low taxable income (and thus, a low marginal income tax rate) prior to collecting Social Security. 

Contrast the significant tax opportunity cost of making a Roth 401(k) contribution to the tax opportunity cost of making a Roth IRA contribution: practically nothing. 

Stephen and Becky have no ability to deduct a traditional IRA contribution because of their income level and the fact that they are covered by a workplace retirement plan. Thus, they aren’t losing much, from a tax perspective, by each making a $6,000 annual Roth IRA contribution. 

Situations Where the Roth 401(k) Contributions Make Sense

For those in the financial independence community, generally there are four situations where choosing to contribute to a Roth 401(k) makes sense. In three of these situations, the tax rate arbitrage play available to Stephen and Becky isn’t available. In the fourth situation (tax insurance), there is a separate consideration causing the taxpayer to forgo an initial tax deduction to get assurance as to the tax rate they will be subject to. 

In the situations below, a Roth 401(k) contribution is likely preferable to a traditional 401(k) contribution. As compared to a Roth IRA contribution, (a) the first contributions should generally be to the Roth 401(k) to secure the employer match, and then after that, (b) generally both the Roth 401(k) and the Roth IRA work well. To my mind, the emergency-type fund feature of the Roth IRA, which I’ve previously discussed, is probably the tiebreaker in favor of making the next contributions to a Roth IRA.

Transition Years

Think about a year one graduates college, graduate school, law school, or medical school. Usually, the person works for only the last half or last quarter of the year. Thus, they have an artificially low taxable income (since they only work for a small portion of the year). Why take a tax deduction for a contribution to a traditional 401(k) in such a year, when one’s marginal federal income tax rate might only be 10 percent or 12 percent?

Transition years are a great time to make Roth 401(k) contributions instead of traditional 401(k) contributions. 

Young Earners with Low Incomes

Many careers start with modest salaries early but have the potential to experience significant salary increases over time. My previous career in public accounting is one example. Medicine is another example. Young accountants and doctors, among others, making modest starting salaries should consider Roth 401(k) contributions at the beginning of their careers. As their salaries increase, they should consider shifting their contributions to a traditional 401(k). 

As a *very general* rule of thumb, those in the 10 percent or 12 percent marginal federal income tax rate (particularly those not subject to a state income tax) should consider prioritizing Roth 401(k) contributions (regardless of occupation).

No Hope

Picture a charismatic franchise NFL quarterback. He’s got a $40M plus annual NFL contact, endorsement deals, business ventures, and likely a long TV career after his playing days are done. For him, there is no hope ( 😉 ). He will probably be in the top federal income tax bracket the rest of his life. He might be well advised to “lock-in” today’s low (by historical standards) 37% federal income tax marginal tax rate by choosing to contribute to a Roth 401(k) instead of to a traditional 401(k).

Tax Insurance

We really do not know what the future holds. That includes future federal and state income tax rates. 

Thus, some workers may want to buy tax insurance. Roth 401(k) contributions are a way to do that. The extra tax paid (because the taxpayer did not deduct traditional 401(k) contributions) is an insurance premium. That insurance premium ensures that the taxpayer won’t be subject to future income tax (including potential tax rate increases) on amounts inside the Roth 401(k) and the growth thereon. 

Remember, none of this is “all or nothing” planning. Some may want to allocate a piece of their workplace retirement plan contributions to the Roth 401(k) to get some insurance coverage against future tax rate increases. 

Conclusion

In the FI community, a maxed out traditional 401(k) and a maxed out Roth IRA (whether through a regular annual contribution or through a Backdoor Roth IRA) can be the dynamic duo of retirement savings. This combination can provide tax flexibility while maximizing current tax deductions. Roth 401(k) contributions often have a significantly greater tax opportunity cost as compared to the tax opportunity cost of Roth IRA contributions. In such situations, the Roth IRA is preferable to my mind. 

Of course, each individual is unique and has different financial and tax goals and priorities. The above isn’t advice for any particular individual, but hopefully provides some educational insight regarding the issues to consider when allocating employee retirement account contributions. 

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter: @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here. 

Sean Presentation at CampFI

My presentation to CampFI Southwest in October 2021.

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter: @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here. 

The Backdoor Roth IRA and December 31st

New Year’s Eve is an important day if you do a Backdoor Roth IRA. Read below to find out why.

The Backdoor Roth IRA

I’ve written before about the Backdoor Roth IRA. It is a two step process whereby those not qualifying for a regular Roth IRA contribution can qualify to get money into a Roth IRA. Done over several years, it can help taxpayers grow significant amounts of tax free wealth.

One of the best aspects of the Backdoor Roth IRA is that it does not forego a tax deduction. Most taxpayers ineligible to make a regular Roth IRA contribution are also ineligible to make a deductible traditional IRA contribution. In the vast majority of cases, the choice is between investing money in a taxable account versus investing in a Roth account. For most, a Roth is preferable, since Roths do not attract income taxes on the interest, dividends, and capital gains investments generate. 

The Basic Backdoor Roth IRA and the Form 8606

Let’s start with a fairly basic example. 

Example 1

Betsy, age 40, earns $300,000 from her W-2 job in 2021, is covered by a workplace 401(k) plan, and has some investment income. Betsy has no balance in a traditional IRA, SEP IRA, or SIMPLE IRA.

At this level of income, Betsy does not qualify for a regular Roth IRA contribution, and she does not qualify to deduct a traditional IRA contribution. 

Betsy contributes $6,000 to a traditional IRA on May 20, 2021. The contribution is nondeductible. Because the contribution is nondeductible, Betsy gets a $6,000 basis in her traditional IRA. Betsy must file a Form 8606 with her 2021 tax return to report the nondeductible contribution.

On June 5, 2021, Betsy converts the entire balance in the traditional IRA, $6,003, to a Roth IRA. As of December 31, 2021, Betsy has no balance in a traditional IRA, SEP IRA, or SIMPLE IRA.

Betsy has successfully executed a Backdoor Roth IRA. Here is what page 1 of the Form 8606 Betsy should file with her 2021 income tax return should look like. 

Notice here that I am using the 2020 version of the Form 8606 for this and all examples. The 2021 Form 8606 is not yet available as of this writing. 

The most important line of page 1 of the Form 8606 is line 6. Line 6 reports the fair market value of all traditional IRAs, SEP IRAs, and SIMPLE IRAs Betsy owns as of year-end. Because Betsy had no traditional IRAs, SEP IRAs, and SIMPLE IRAs as of December 31, 2021, her Backdoor Roth IRA works and is tax efficient. This important number ($0) on line 6 of the Form 8606 is what ensures Betsy’s Backdoor Roth IRA is tax efficient. 

Note that Betsy’s Backdoor Roth IRA creates an innocuous $3 of taxable income, which is reported on the top of part 2 of the Form 8606. 

The Pro-Rata Rule and December 31st

But what if Betsy did have a balance inside a traditional IRA, SEP IRA, or SIMPLE IRA on December 31, 2021? Would her Backdoor Roth IRA still be tax efficient? Probably not, due to the Pro-Rata Rule.

The Pro-Rata Rule tells us just how much of the basis in her traditional IRA Betsy can recover when she does the Roth conversion step of the Backdoor Roth IRA. Betsy’s $6,000 nondeductible traditional IRA creates $6,000 of basis. As we saw above, Betsy was able to recover 100 percent of her $6,000 of basis against her Roth conversion. 

But the Pro-Rata Rule says “not so fast” if Betsy has another traditional IRA, SEP IRA, or SIMPLE IRA on December 31st of the year of any Roth conversion. The Pro-Rata Rule allocates IRA Basis between converted amounts (in Betsy’s case, $6,003) and amounts in traditional IRAs, SEP IRAs, and SIMPLE IRAs on December 31st. Here’s an example. 

Example 2

Betsy, age 40, earns $300,000 from her W-2 job in 2021, is covered by a workplace 401(k) plan, and has some investment income. Betsy has no balance in a traditional IRA, SEP IRA, or SIMPLE IRA.

Betsy contributes $6,000 to a traditional IRA on May 20, 2021. The contribution is nondeductible. Because the contribution is nondeductible, Betsy gets a $6,000 basis in her traditional IRA. Betsy must file a Form 8606 with her 2021 tax return to report the nondeductible contribution.

On June 5, 2021, Betsy converts the entire balance in the traditional IRA, $6,003, to a Roth IRA. 

On September 1, 2021, Betsy transfers an old 401(k) from a previous employer 401(k) plan to a traditional IRA. On December 31st, that traditional IRA is worth $100,000. The old 401(k) had no after-tax contributions. 

This one 401(k)-to-IRA rollover transaction dramatically changes both the taxation of Betsy’s Backdoor Roth IRA and her 2021 Form 8606. Here’s page 1 of the Form 8606.

Line 6 of the Form 8606 now has $100,000 on it instead of $0. That $100,000 causes Betsy to recover only 5.67 percent of the $6,000 of basis she created by making a nondeductible contribution to the traditional IRA. As a result, $5,663 of the $6,003 transferred to the Roth IRA in the Roth conversion step is taxable to Betsy as ordinary income. At a 35% tax rate, the 401(k) to IRA rollover (a nontaxable transaction) cost Betsy $1,982 in federal income tax on her Backdoor Roth IRA. Ouch!

Quick Lesson: The lesson here is that prior to rolling over a 401(k) or other workplace plan to an IRA, taxpayers should consider the impact on any Backdoor Roth IRA planning already done and/or planned for the future. One possible planning alternative is to transfer old employer 401(k) accounts to current employer 401(k) plans.

There is an antidote to the Pro-Rata Rule when one has amounts in traditional IRAs, SEP IRAs, and SIMPLE IRAs. It is transferring the traditional IRA, SEP IRA, or SIMPLE IRA to a qualified plan (such as a 401(k) plan) before December 31st. Here is what that might look like in Betsy’s example. 

Example 3

Betsy, age 40, earns $300,000 from her W-2 job in 2021, is covered by a workplace 401(k) plan, and has some investment income. Betsy has no balance in a traditional IRA, SEP IRA, or SIMPLE IRA.

Betsy contributes $6,000 to a traditional IRA on May 20, 2021. The contribution is nondeductible. Because the contribution is nondeductible, Betsy gets a $6,000 basis in her traditional IRA. Betsy must file a Form 8606 with her 2021 tax return to report the nondeductible contribution.

On June 5, 2021, Betsy converts the entire balance in the traditional IRA, $6,003, to a Roth IRA. 

On September 1, 2021, Betsy transfers an old 401(k) from a previous employer to a traditional IRA. The old 401(k) had no after-tax contributions. 

On November 16, 2021, Betsy transfers the entire balance in this new traditional IRA to her current employer’s 401(k) plan in a direct trustee-to-trustee transfer. 

Here is Betsy’s 2021 Form 8606 (page 1) after all of these events:

Betsy got clean by December 31st, so her Backdoor Roth IRA now reverts to the optimized result (just $3 of taxable income) she obtained in Example 1. 

Pro-Rata Rule Clean Up

Implementation 

From a planning perspective, it is best to clean up old traditional IRAs/SEP IRAs/SIMPLE IRAs prior to, not after, executing the Roth conversion step of a Backdoor Roth IRA. I say that because things happen in life. There is absolutely no guarantee that those intending to roll amounts from IRAs to workplace qualified plans will get that accomplished by December 31st. 

Further, transfers from one retirement account to another are usually best done through a direct “trustee-to-trustee” transfer to minimize the risk that the money in the retirement account accidentally is distributed to the individual, causing potential tax and penalties. 

Before cleaning up old traditional IRAs, SEP IRAs, and SIMPLE IRAs, one should consider the investment choices and fees inside their employer retirement plan (such as a 401(k)). If the investment options are not good, and/or the fees are high, perhaps cleaning up an IRA to move money into less desirable investments is not worth it. This is a subjective judgment that must weigh the potential tax and investment benefits and drawbacks. 

Tax Issues

Amazingly enough, the Pro-Rata Rule is concerned with only one day: December 31st. A taxpayer can have a balance in a traditional IRA, SEP IRA, or SIMPLE IRA on any day other than December 31st, and it does not count for purposes of the Pro-Rata Rule. Perhaps December 31st should be called Pro-Rata Rule Day instead of New Year’s Eve. 😉

Betsy’s November 16th distribution from her traditional IRA to the 401(k) plan does not attract any of the basis created by the nondeductible traditional IRA contribution earlier in the year. This document provides a brief technical explanation of why rollovers to qualified plans do not reduce IRA basis. 

Extra care should be taken when cleaning up (a) large amounts in any type of IRA and (b) any SIMPLE IRA. While it is fairly obvious that significant sums should be moved only after considering all the relevant investment, tax, and execution issues, the SIMPLE IRA provides its own nuances. Any SIMPLE IRA cannot be rolled to an account other than a SIMPLE IRA within the SIMPLE IRA’s first two years of existence. Thus, SIMPLE IRAs must be appropriately aged before doing any sort of Backdoor Roth IRA clean up planning. 

Spouses are entirely separate for Pro-Rata Rule purposes, even in community property states. Cleaning up one spouse, or failing to clean up one spouse, has absolutely no impact on the taxation of the other spouse’s Backdoor Roth IRA.

Lastly, non spousal inherited IRAs do not factor into a taxpayer’s application of the Pro-Rata Rule. Each non spousal inherited IRA has its own separate, hermetically sealed Pro-Rata Rule calculation. The inheriting beneficiary does a Pro-Rata Rule calculation on all IRAs he/she owns as the original owner, separate from any inherited IRAs. In addition, non spousal inherited IRAs cannot be rolled into a 401(k).

Mega Backdoor Roth

Good news: the concerns addressed in this blog post generally do not apply with respect to the Mega Backdoor Roth (sometimes referred to as a Mega Backdoor Roth IRA, though a Roth IRA does not necessarily have to be involved). Qualified plans such as 401(k)s are not subject to the Pro-Rata Rule. 

While 401(k)s are not subject to the Pro-Rata Rule, amounts within a particular 401(k) plan’s after-tax 401(k) are subject to the “cream-in-the-coffee” rule I previously wrote about here. Thus, if there is growth on Mega Backdoor Roth contributions before they are moved out of the after-tax 401(k), generally speaking either the taxpayer must pay income tax on the growth (if moved to a Roth account) or the taxpayer can separately roll the growth to a traditional IRA (which could then create a rather small Pro-Rata Rule issue with future Backdoor Roth IRAs). Fortunately, the cream-in-the-coffee rule has a much narrower reach than the Pro-Rata Rule.

Backdoor Roth IRA Tax Return Reporting

Watch me discuss Backdoor Roth IRA tax return reporting.

Conclusion

Get your IRAs in order so you can enjoy New Year’s Eve! 

December 31st is an important date when it comes to Backdoor Roth IRA planning. It is important to plan to have no (or at a minimum, very small) balances in traditional IRAs, SEP IRAs, and SIMPLE IRAs on December 31st when planning Backdoor Roth IRAs. 

None of what is discussed in this blog post is advice for any particular taxpayer. Those working through Backdoor Roth IRA planning issues are often well advised to reach out to professional advisors regarding their own tax situation.

Further Reading

I did a blog post about Backdoor Roth IRA tax return reporting here.

I did a deep dive on the taxation of Roth IRA withdrawals here.

I did a deep dive on the Pro-Rata Rule here.

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter: @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.

The End of the Backdoor Roth IRA?

Is the backdoor closing? If a recently released proposal from the House Ways & Means Committee is enacted, then yes it is.

My analysis and commentary below is just my initial take on the proposed new laws: it is subject to revision.

UPDATE December 18, 2021

The update as of December 18, 2021 can be read here. Turns out that as of now (December 18th) my predictive analysis offered in November appears rather spot on. But remember, things can change.

Here’s what I wrote in November: On November 19, 2021, the House of Representatives passed the proposals discussed below. To my mind, the passage of this legislation is a 26.2 mile marathon: Passage in the House is the first mile, and passage in the Senate is the next 25.2 miles. There are absolutely no guarantees as to whether the proposals ultimately become law. My view is that passage in the Senate is going to be much more difficult than passage in the House.

Backdoor Roths

The Backdoor Roth IRA has been a popular transaction for over a decade. It allows those unable to make a direct Roth IRA contribution to get an annual contribution into a Roth IRA through a two-step process. There is a 401(k) version popularly referred to as the Mega Backdoor Roth IRA, which allows taxpayers to move significant amounts into Roth accounts using after-tax 401(k) contributions.

House Ways & Means Proposal

On September 13, 2021, the House Ways and Means committee released legislative text and an explanation of proposed new rules that would change the Roth landscape.

Elimination of Backdoor Roth IRAs and Mega Backdoor Roth IRAs

Effective in 2022, after-tax amounts in IRAs could not be converted to Roth IRAs. This rule would apply to all taxpayers regardless of their level of adjusted gross income. This rule would eliminate the Backdoor Roth IRA, as amounts contributed to a nondeductible traditional IRA (the first step of a Backdoor Roth IRA) could not be converted to a Roth IRA.

The bill would also eliminate after-tax contributions to qualified plans. As a result, workplace plans such as 401(k)s could no longer offer the Mega Backdoor Roth.

Effect on 2021 Backdoor Roth IRAs

In a twist, the new rule would effectively impose a deadline on all 2021 Backdoor Roth IRA planning: December 31, 2021. If the new law is passed, both the nondeductible traditional IRA contribution step and the Roth conversion step for a Backdoor Roth IRA would need to be completed by 2021 in order to do a 2021 Backdoor Roth IRA.

Usually, the deadline to worry about from a Backdoor Roth IRA perspective is the deadline to make the nondeductible traditional IRA contribution, usually April 15th of the following year. There is no particular deadline to complete the Roth conversion step. By prohibiting Roth conversions of after-tax money in traditional IRAs beginning January 1, 2022, Congress effectively makes December 31, 2021 the deadline to execute the Roth conversion step of a 2021 Backdoor Roth IRA.

I wrote about how the legislative proposal impacts the approach to 2021 Backdoor Roth IRA planning and deadlines here.

I have previously written about late or “split-year” Backdoor Roth IRAs under current law here.

Update on Legislative Proposals (As of November 4, 2021)

On October 28th, a new tax proposal came out which did not have the Backdoor elimination proposals. However, a second new tax proposal issued on November 3rd did contain the Backdoor Roth elimination proposals. Based on the current political landscape, there is significant doubt as to whether any tax proposal is enacted during this Congress. However, there is at least some chance the Backdoor Roth proposals are enacted.

Elimination of Roth Conversions for High Income Taxpayers Beginning in 2032

The legislative proposal also eliminates Roth conversions in any year a taxpayer’s adjusted taxable income is $400K (single filers) or $450K (married filing joint) starting in the year 2032.

A couple of observations about this rule. First, this rule would have no practical effect on the FI community. Usually, those in the FI community avoid taxable Roth conversions during high income years. Taxable Roth conversions (such as the so-called Roth Conversion Ladder strategy) are usually executed during early retirement before collecting Social Security. Those years often have artificially low taxable income, so a high income cap on the ability to do a Roth conversion is a rule without consequence for the FI community.

Second, you might be wondering: why the heck are they changing the tax law 10 years in the future? Why not now? The answer lies in how Congress “scores” tax bills. Taxable Roth conversions, particularly in the near term, increase tax revenue. An immediate repeal of Roth conversions would “cost” the government money in the new few years. But by delaying implementation for 10 years, Congress is able to predict that taxpayers, facing a future with no Roth conversions, will increase Roth conversions in 2030 and 2031, increasing tax revenues in those years.

Outlook

Congress is closely divided. There is absolutely no guarantee this bill will pass both houses of Congress and be signed by the President. That said, these proposed rules are now “out there” and being “out there” is the first step towards a tax rule becoming law.

I will Tweet and blog about any future developments in this regard.

FI Tax Guy can be your financial advisor! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter: @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here. 

Tax Deductions for Individuals

Tax deductions can be a confusing topic considering the many types of tax deductions and the terminology for them. Below I explain the different types of tax deductions you can claim on your tax return. You may be taking several of these types without even knowing it.

Types of Individual Tax Deductions

Exclusions

Many things we think of tax deductions are not treated as tax deductions on a tax return. Instead, they are excluded from taxable income. An exclusion from taxable income has the exact same effect as a tax deduction.

The most common exclusion is the exclusion for employer provided benefits, including health insurance, retirement plan contributions, and health savings accounts contributions. Here is an example:

Example: Mark has a salary of $100,000. He contributes ten percent ($10,000) of his salary to his employer’s 401(k) plan. His W-2 for the year will report wages of $90,000, not $100,000, and he will enter $90,000 as wages on his Form 1040. The $10,000 Mark contributed to his 401(k) is excluded from his gross income. This exclusion has the same income tax effect as a deduction.

Exclusions are a great form of deduction in that they are generally unlimited on your tax return, though they may have their own limitations. For example, in 2021 the most an employee under age 50 can exclude for contributions to a 401(k), 403(b), or a 457 is $19,500.

For those at least 70 1/2 years old, the qualified charitable distribution (“QCD”), which I wrote about here, can be a great tax planning technique. 

Exclusions also reduce adjusted gross income (“AGI”). Items that reduce AGI are great because AGI (or modified AGI, “MAGI”) is usually the measuring stick for whether a taxpayer qualifies for many tax benefits (such as eligibility for making a deductible contribution to an IRA or making a contribution to a Roth IRA). Lowering AGI is an important tax planning objective, since lower AGI opens the door to several tax benefits. 

Business Deductions

Business deductions include trade or business deductions generated from self-employment and investments in partnerships and rental property. On a Form 1040, these deductions are reported on Schedule C or Schedule E. Business deductions include salaries, rent, depreciation (deducting the cost of a business asset over a useful life), and other ordinary and necessary expenses.

Business deductions are generally great tax deductions because they are subject to relatively few limitations on your tax return. That said, limitations such as the passive activity loss rules and the at-risk limitations can limit a taxpayer’s ability to claim some business losses. Further, business deductions reduce not only income tax but also self-employment income, and thus, self-employment tax.

Business deductions are also valuable because they reduce AGI.

“For AGI” or “Above the Line” Deductions

On your Form 1040 you deduct certain expenses from your gross income to determine your AGI. Prior to tax returns filed for 2018 and later, these deductions were at the bottom of page 1 of the Form 1040. Starting with tax returns for 2018, these deductions are presented on Schedule 1 which accompanies Form 1040.

Examples of these deductions include one-half of self-employment tax paid by self-employed individuals, deductible contributions to IRAs, and contributions to certain self-employed retirement plans.  

Capital losses, generally up to $3,000 on any one tax return, can be deducted for computing AGI. Capital losses in excess of $3,000 are carried over to future tax years to be deducted against capital gains and against up to $3,000 per year of ordinary income. 

Health Savings Accounts (“HSAs”) are their own special breed. If contributions to an HSA are made through workplace payroll withholding, they are excluded from taxable income. If contributions to an HSA are made through another means (such as a check or wire transfer to the HSA), the contributions are for AGI deductions reported on Schedule 1. Which is better? From an income tax perspective, there is no difference. But from a payroll tax perspective, using payroll withholding is the clear winner. Amounts contributed to an HSA through payroll withholding are not subject to the FICA tax, creating another HSA tax win!

Standard Deduction or Itemized Deductions

Tax reform changed the landscape of itemized deductions. As a result of the tax reform bill enacted in December 2017, far fewer taxpayers will claim itemized deductions, and will instead claim the standard deduction.

The most common itemized deductions are state and local taxes (income, property, and in some cases, sales taxes), charitable contributions, and mortgage interest.

Taxpayers generally itemize if the sum total of itemized deductions (reported on Schedule A) exceed the standard deduction. Tax reform did two things to increase the chance that the standard deduction will exceed a taxpayer’s itemized deductions. First, the amount of the standard deduction increased. It went from $6,350 for single taxpayers in 2017 to $12,000 for single taxpayers in 2018. For married filing joint taxpayers, the standard deduction went from $12,700 in 2017 to $24,000 in 2018.

The standard deduction for 2021 is $12,550 (single) and $25,100 (MFJ) for most taxpayers. 

In addition, several itemized deductions were significantly reduced. For example, starting in 2018 there is a deduction cap of $10,000 per tax return ($5,000 for married filing separate tax returns) for state and local taxes. This hits married taxpayers particularly hard and increases the chance that if you are married filing joint you will claim the standard deduction, since you will need over $15,100 in other itemized deductions to itemize (using the 2021 numbers).

In addition, miscellaneous deductions, such as unreimbursed employee expenses and tax return preparation fees, were eliminated as part of tax reform.

Thus, many taxpayers will find that they will often claim the standard deduction. As discussed below, there will be planning opportunities for taxpayers to essentially push many itemized deductions (such as charitable contributions) into one particular tax year, itemize for that year, and then claim the standard deduction for the next several years.

Neither the standard deduction nor itemized deductions reduce AGI.

Special Deductions

In a relatively new development in tax law, there are now deductions that apply only after AGI has been determined and separate and apart from the standard deduction or itemized deductions. 

QBI Deduction

Tax reform created an entirely new tax deduction: the qualified business income deduction (also known as the QBI deduction or the Section 199A deduction). I have written about the QBI deduction here and here. Subject to certain limitations, taxpayers can claim, as a deduction, 20 percent of qualified business income, which is generally income from domestic business activities (not wage income), income from publicly-traded partnerships, and qualified REIT (real estate investment trust) dividends.

The QBI deduction does not reduce AGI.

Taxpayers can claim the QBI deduction regardless of whether they elect itemized deductions or the standard deduction.

Special Deduction for Charitable Contributions

For the 2021 tax year, taxpayers who do not claim itemized deductions are eligible for a special deduction for charitable contributions. The deduction is limited to $300 for single filers and $600 for MFJ filers.

As discussed by Jeffrey Levine, this deduction, like the QBI deduction, neither reduces AGI nor is an itemized deduction. 

The statutory language for this new deduction is found at Section 170(p). I believe that there is a very good chance that this deduction is extended to years beyond 2021, though as of now, it is only applicable to the 2021 tax year. 

Planning

Tax deductions provide a great opportunity for impactful tax planning. Here are some examples.

Timing

If your marginal income tax rate is the same every year, then you generally want to accelerate deductions. Thus, if you have a sole proprietorship and are a cash basis taxpayer, you are generally better off paying rent due on January 1, 2022 on December 31, 2021 instead of January 1, 2022 since the deduction saves the same amount of tax regardless of which tax year you pay it, but you’ll get the cash tax benefit sooner – on your 2021 income tax return instead of on your 2022 income tax return.

But there can be situations where you anticipate that your marginal tax rate will be greater next year than this year. In those cases, it makes sense to delay deductions. For example, perhaps you would make a large charitable contribution next year instead of before the end of the current year. Or, in the above example, you would pay the rent on January 1, 2022 to ensure the deduction is in 2022 instead of 2021.

Bunching

For some taxpayers, it may make sense to bunch deductions to maximize the total benefit of itemizing deductions versus claiming the standard deduction over several years. My favorite example of this is the donor advised fund. I’m not alone in my fondness of the donor advised fund. It allows you to contribute to a fund in one year, claim a charitable deduction for the entire amount of the contribution, and then donate from that fund to charities in subsequent years. The big advantage is that you get an enhanced upfront deduction in the first year and then claim the standard deduction in several subsequent years. This strategy only works if the amount of the deduction for the contribution to the donor advised fund is sufficient such that your itemized deductions in the year of the contribution exceed the standard deduction by a healthy amount.

Deadlines, Deadlines, Deadlines!!!

Different deductions have different deadlines. Many deductions have December 31st deadlines, so it is important to make the contribution by year-end. For charitable contributions, it is best to make the contribution online with a credit or debit card before January 1st if you are running really late, though if you place the contribution in a U.S. Postal Service mailbox prior to January 1st that counts as prior to the near year (though it makes it harder to prove you beat the deadline if you drop it in the mailbox on December 31st).

For employee contributions to a 401(k), the deadline is December 31st. Thus, if you are reading this on December 5th and you want to significantly increase your 401(k) contribution for 2021, you ought to get in touch with your payroll administrator and increase your contribution rate for your last paycheck ASAP.

By contrast, the deadline for a 2021 contribution to a deductible IRA or a non-payroll 2021 contribution to a HSA is April 15, 2022 (the date tax returns are due).

Self-employed retirement plans have their own sets of deadlines that should be considered.

Conclusion

Tax deductions present several important tax planning considerations. These considerations should include the taxpayer’s current marginal tax rate and future marginal tax rate. They should also include consideration of maximizing the combination of itemized deductions and the standard deduction over multiple taxable years.

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter: @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.

Roth IRAs and the VAT Boogeyman

The Roth IRA: tax free retirement income. What’s not to love? 

But wait a minute. What Congress gives Congress can take away, right? Might Congress, looking for tax revenues to pay off the debt, simply make Roth distributions in retirement taxable? Not very likely. 

While I have no evidence to support this proposition, my guess is that Roth account owners vote at very high rates. Voting to tax Roth withdrawals in retirement seems to be a good way to create a motivated constituency to deny members of Congress re-election. I’m hardly the first person to argue that it is very unlikely that Congress will ever subject Roth withdrawals to income taxation.

The Value Added Tax

There are indirect ways for Congress to attack Roths and tax some of that otherwise tax free account value. One way some worry about is the value-added tax, otherwise known as the VAT. The VAT is a consumption tax on goods and services. The EU has a website here describing the VAT in the European Union. A VAT functions like a sales tax and can be added at any or all levels of production. Many developed countries have a VAT, but the United States does not. 

Roths and the VAT

A VAT has the potential to increase the price of goods and/or services, and thus, to potentially eat away at value inside Roth accounts. 

Here is a simplified example of how that would work. 

Maria is retired. Her annual consumption is approximately $95,000, $5,000 of which is property taxes. She lives off $25,000 a year in Social Security income and $70,000 a year in withdrawals from her Roth IRA. She pays no income taxes on those withdrawals. If a 10 percent VAT were enacted on retail sales, she would need to withdraw approximately $9,000 (10 percent of her current $90,000 non-property tax annual consumption) more from her Roth IRA to pay for her current level of consumption. Instead of using an income tax, the government collects $9,000 from her Roth IRA annually by imposing a VAT.

The VAT functions as a tax on a Roth IRA. As Maria has to withdraw more from her Roth to maintain the same level of consumption, the VAT also reduces the value of amounts inside a Roth IRA. Does this mean a Roth IRA is less desirable?

For the reasons argued below, I believe that the answer is No. First, it should be remembered that were a VAT to be implemented, is almost certain to be implemented in addition to the current federal income tax. Sure, if the United States were to switch from an income tax to a VAT traditional IRA owners would win big (having previously received an income tax deduction without a later income tax charge) and Roth IRA owners would lose big. But a switch from an income tax to a VAT is almost certainly not happening. 

Second, when assessing the value of Roth accounts in a United States with a VAT, one must compare them to the alternatives: traditional retirement accounts and taxable accounts. 

Traditional Versus Roth with a VAT

Let’s start out by examining the difference between a Roth IRA and a traditional IRA if there is a federal VAT. Here is an example. 

Joe is 65 years old and retired. He is a lifelong New York Jets fan, and decides he wants to go Super Bowl LVI, to see his Jets, presumably the AFC representatives in the game. One ticket costs $10,000 and Joe’s only source of funds for the purchase is his retirement account. Joe’s marginal federal income tax rate is 22 percent. Here are the results if Joe has a traditional IRA and a Roth IRA both without a federal VAT on the ticket and with a 5 percent federal VAT on the ticket:

No VATNo VAT5% VAT5% VAT
IRA TypeAmount NeededIncome Tax DueAmount NeededIncome Tax Due
Traditional$12,821$2,821$13,462$2,962
Roth$10,000$0$10,500$0

Hopefully you can see what is going on in the table. With a traditional IRA, one cannot simply withdraw $10,000 to pay for a $10,000 expense. There will be income tax due on the withdrawal. In order to net out $10,000 to pay for the ticket, Joe must withdraw $12,821, which covers the cost of the ticket and the 22 percent federal income tax (assume Joe lives in Florida so there’s no state income tax). This is computed as the amount needed ($10,000) divided by 1 minus the tax rate (1 minus .22), which equals $12,821. 

With a 5 percent VAT, Joe must pay $10,500 for the Super Bowl ticket. From his traditional IRA, he must withdraw $13,462, computed as the amount needed ($10,500) divided by 1 minus the tax rate (1 minus .22). 

As we are about to learn, paying a VAT with a traditional IRA creates a new tax: income tax on the VAT. Paying a VAT with a Roth IRA avoids this new tax.

If Joe pays for his Super Bowl ticket with a traditional IRA, he needs $641 more from his traditional IRA in a VAT environment to pay for the Super Bowl ticket. He must pay $141 in additional income tax to cover this additional withdrawal. The income tax on the VAT is $110 (22 percent of $500), the income tax on the income tax on the VAT is $24 (22 percent of $110), and there is approximately $7 of income tax on the remainder of the income tax required. 

See this spreadsheet for the income tax calculation. Incredibly, it is possible to pay income tax on the income tax on the income tax on the income tax on the VAT if you pay the VAT from a traditional IRA. It will get much worse as expenses increase beyond the $10,000 tackled in this example. 

The first lesson: a VAT hurts those with traditional IRAs, since they will have to increase their taxable withdrawals to pay for goods and services subject to the VAT. When paid with a traditional retirement account, VAT creates several new taxes: the VAT itself, the income tax on the VAT, the income tax on the income tax on the VAT, etc.

The second lesson: if a VAT is enacted, the Roth protects retirees from the income tax payable on the VAT. The 5 percent VAT increases the total tax cost of the $10,000 ticket by $641 if one uses a traditional IRA but only by $500 if one uses a Roth IRA. Having a Roth protects against income tax on the VAT itself. This makes a Roth an even more desirable planning alternative if there is a VAT than if there is no VAT. 

The income tax on the VAT is another tax villain the Roth can successfully defeat.

Roth Versus Taxable with a VAT

I believe the logic applied in the Roth versus Traditional VAT environment applies in assessing Roths versus taxable accounts in a VAT environment. To fund consumption, retirees will have to sell more of their taxable brokerage accounts to pay for the now increased price of goods and services, resulting in higher capital gains (and thus, more capital gains taxes) in many cases. Using a Roth withdrawal to pay a VAT protects against those additional capital gains taxes. 

Planning

If one believes that a VAT is coming, there is not much, to my mind, to be done from a financial planning perspective, other than increasing amounts in Roth accounts. One might purchase durable goods in advance of the enactment of a VAT, but that sort of planning is of limited value. How many refrigerators can you stockpile for your future use? For those worried about a VAT, the tactics that appear effective are to increase Roth contributions and/or conversions.

While a VAT would not be good news, it makes the Roth planning decision more likely to be the advantageous planning decision.

Paying a VAT out of a Roth avoids the income tax on the VAT (and the resulting additional income taxes) retirees incur when paying the VAT out of a traditional IRA. A Roth also avoids increased capital gains taxes resulting from using taxable brokerage accounts to pay a VAT. 

Conclusion

A VAT is not good news for Roth IRA owners, but it is worse news for traditional IRA owners. Roths limit the tax damage of a VAT to the VAT itself in a way neither traditional retirement accounts nor taxable accounts are capable of. In the age-old traditional versus Roth debate, the possibility of a future VAT moves the needle (if ever so slightly) in the direction of the Roth. 

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter: @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.

Sean on The Struggle is Real Podcast

I chatted with Justin Peters on The Struggle is Real Podcast regarding tax issues for those in their 20s to consider. You can access the episode here: https://justinleepeters.podbean.com/e/what-you-need-to-know-about-taxes-in-your-20s-e39-sean-mullaney/

As always, the discussion is general and educational in nature and does not constitute tax, investment, legal, or financial advice with respect to any particular individual or taxpayer. Please consult your own advisors regarding your own unique situation.

FI Tax Guy can be your financial advisor! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter: @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here. 

QCDs and the FI Community

Qualified charitable distributions (“QCDs”) are an exciting tax planning opportunity, particularly for the FI community. Below I describe what a qualified charitable distribution is and how members of the FI community should think about them when tax planning.

Of course, this post is educational in nature. Nothing in this blog post is tax advice for any particular taxpayer. Please consult your own tax advisor regarding your unique circumstances. 

Qualified Charitable Distributions

QCDs are transfers from a traditional IRA directly to a charity. Up to $100K annually, they are (a) not included in the taxpayer’s taxable income, (b) not deductible as charitable contributions, and (c) qualify as “required minimum distributions” (“RMDs”) (to the lesser of the taxpayer’s required minimum distribution or the actual distribution to the charity). Here is an example:

Example 1: Jack and Jill are 75 years old and file their tax return married filing joint. Jack has a RMD from his traditional IRA of $40,000 in 2021. Jack directs his traditional IRA institution to transfer $40,000 during 2021 to a section 501(c)(3) charity. Jack and Jill recognize no taxable income on the transfer, and Jack does not have to take his 2021 RMD (the $40K QCD having covered it). Further, Jack and Jill receive no charitable contribution deduction for the transfer.

Considering that Jack & Jill (both age 75) enjoy a standard deduction of $27,800 in 2021, they get both the standard deduction and a $40K deduction for the charitable contribution from the traditional IRA (since they do not have to include the $40K in their taxable income). This is the best of both worlds. Further, excluding the $40K from “adjusted gross income” (“AGI”) is actually better than taking the $40K as an itemized deduction, since many tests for tax benefits are keyed off of AGI instead of taxable income. 

Important QCD Considerations

Take QCDs Early

Generally speaking, it is best that QCDs come out of the traditional IRA early in the year. Why? Because under the tax rules, RMDs come out of a traditional IRA first. So it is usually optimal to take the QCD early in the year so it can fulfill all or part of the required minimum distribution for the year. Then you can do Roth conversion planning (if desired), so long as the full RMD has already been withdrawn (either or both through a QCD and a regular distribution) from the traditional IRA first. 

No Trinkets

I don’t care how much you love your PBS tote bag: do not accept any gift or token of appreciation from the charity. The receipt of anything (other than satisfaction) from the charity blows the QCD treatment. So be sure not to accept anything from the charity in exchange for your QCD.

QCDs Available Only from Traditional IRAs

In order to take advantage of QCD treatment, the account must be a traditional IRA. 401(k)s and other workplace plans do not qualify for QCDs. Further, SIMPLE IRAs and SEP IRAs do not qualify for QCD treatment. 

As a practical matter, this is not much of an issue. If you want to do a QCD out of a 401(k) or other tax advantaged account, generally all you need to do is rollover the account to a traditional IRA. 

QCD Age Requirement

In order to take advantage of the QCD opportunity, the traditional IRA owner must be aged 70 ½ or older. 

Inherited IRAs

QCDs are available to the beneficiary of an inherited IRA so long as the beneficiary is age 70 ½ or older. 

QCDs For Those Age 70 ½ and Older

If you are aged 70 ½ or older and charitably inclined, the QCD often is the go-to technique for charitable giving. In most cases, it makes sense to make your charitable contributions directly from your traditional IRA, up to $100,000 per year. QCDs help shield RMDs from taxation and help keep AGI low. 

QCDs and the Pro-Rata Rule

If you have made previous non-deductible contributions to your traditional IRA, distributions are generally subject to the pro-rata rule (i.e., the old contributions are recovered ratably as distributions come out of the traditional IRA). 

However, QCDs are not subject to the pro-rata rule! This has a positive effect on future taxable distributions from the traditional IRA. Here is an example of how this works:

Example 2: Mike is age 75. On January 1, 2021, he had a traditional IRA worth $500,000 to which he previously made $50,000 of nondeductible contributions. If Mike makes a $10,000 QCD to his favorite charity, his traditional IRA goes down in value to $490,000. However, his QCD does not take out any of his $50,000 of basis from nondeductible contributions. This has the nice effect of reducing the tax on future taxable distributions to Mike from the traditional IRA, since the QCD reduces denominator (by $10K) for determining how much basis is recovered, while the numerator ($50K) is unaffected. 

QCDs for Those Under Age 70 ½

Those in the FI community considering early retirement need to strongly consider Roth conversions. The general idea is that if you can retire early with sufficient wealth to support your lifestyle, you can have several years before age 70 during which your taxable income is artificially low. During those years, you can convert old traditional retirement accounts Roth accounts while you are taxed at very low federal income tax brackets.

For the charitably inclined, the planning should account for the QCD opportunity. There is no reason to convert almost every dime to Roth accounts if you plan on giving significant sums to charity during your retirement. Why pay any federal or state income tax on amounts that you ultimately will give to charity?

If you are under the age of 70 ½ and are charitably inclined, QCDs should be part of your long term financial independence gameplan. You should leave enough in your traditional retirement accounts to support your charitable giving at age 70 ½ and beyond (up to $100K annually). These amounts can come out as tax-free QCDs at that point, so why pay any tax on these amounts in your 50s or 60s? Generally speaking, a Roth conversion strategy should account for QCDs for the charitably inclined. 

Conclusion

For the charitably inclined, QCDs can be a great way to manage taxable income and qualify for tax benefits in retirement. QCDs also reduce the pressure on Roth conversion planning prior to age 72, since it provides a way to keep money in traditional accounts without having to pay tax on that money. 

FI Tax Guy can be your financial advisor! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter: @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.

Sean on the Earn & Invest Podcast

Really enjoyed this year-end tax planning conversation with Doc G on the Earn & Invest podcast. Stay tuned to the end for some candid behind the scenes podcast recording.

https://www.earnandinvest.com/episodes-2/year-end-tax-moves-that-count

FI Tax Guy can be your financial advisor! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter: @SeanMoneyandTax

This post (and this podcast episode) is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here. 

Roth 401(k)s for Beginners

Roth 401(k)s are gaining prominence as a tax-advantaged workplace retirement account. This post provides introductory information regarding Roth 401(k)s and their potential benefits as a retirement savings account.

Two important introductory notes. First, not all 401(k) plans offer a Roth option, so for some employees, a Roth 401(k) contribution is not an option. Second, this post is for educational purposes only and is not advice for any particular taxpayer. 

Traditional 401(k) versus Roth 401(k)

In an ideal world, contributions by an employee to a traditional 401(k) result in a tax deduction when contributed, and taxable income when withdrawn.

Example 1: Tony makes $100,000 from his employer in W-2 wages in 2021. Tony contributes $15,000 during the course of 2021 to his employer’s traditional 401(k). Tony will receive a W-2 from his employer reporting $85,000 of taxable W-2 wages for 2021.

In an ideal world, contributions by an employee to a Roth 401(k) result in no tax deduction when contributed, and no taxable income when withdrawn.

Example 2: Rudy makes $100,000 from his employer in W-2 wages in 2021. Rudy contributes $15,000 during the course of 2021 to his employer’s Roth 401(k). Rudy will receive a W-2 from his employer reporting $100,000 of taxable W-2 wages for 2021.

Roth 401(k) Contributions

Employees can contribute the lesser of their earned income or $19,500 (2021 limit) to a Roth 401(k) in “employee deferrals.” For those 50 years old or older, the 2021 limit is the lesser of earned income or $26,000.

The employee deferral limit factors in both traditional 401(k) employee contributions and Roth 401(k) employee contributions. Here’s an illustrative example.

Example 3: Sarah, age 35, earns $100,000 in W-2 income in 2021 at Acme Industries, Inc. Sarah contributes the maximum to her 401(k) plan. Assuming Acme offers both a traditional 401(k) and a Roth 401(k), that maximum $19,500 contribution can be split up however Sarah chooses ($13,000 to the traditional 401(k) and $6,500 to the Roth 401(k), $5,000 to the traditional 401(k) and $14,500 to the Roth 401(k), etc.). 

Any combination (including all in the traditional or all in the Roth) is permissible as long as the total does not exceed $19,500 (using 2021’s limits).

Roth 401(k) Contributions: Income Limits

There’s good news here. Unlike their Roth IRA cousins, Roth 401(k) contributions have no income limits. In theory, one could make $1 billion annually in W-2 income and still contribute $19,500 to a Roth 401(k). 

Matching Contributions

Employer matching contributions are one of the best benefits of 401(k) plans. 

It is important to keep in mind that matching contributions, profit sharing contributions, and forfeitures must go into employee accounts as traditional contributions. This is true regardless of whether the employee’s own contributions are traditional, Roth, or both. 

Example 4: Elaine, age 35, works at Perry Publishing. She earns a salary of $50,000. Perry matches 50% of the first 6% of salary that Elaine contributes to her 401(k). Elaine decides to contribute $3,000 (6 percent) of her salary to the 401(k) as a Roth contribution. Perry contributes $1,500 as a matching contribution. The $1,500 employer match goes into the 401(k) as a traditional contribution. The $3,000 and its growth are treated as a Roth 401(k), and the $1,500 and its growth are treated as a traditional 401(k). 

Matching contributions may be subject to vesting requirements, as described in this post. Employee contributions to a 401(k) (whether traditional or Roth) are always 100% vested. 

Roth 401(k) Withdrawals

The greatest benefits of a Roth 401(k) are tax-free growth and tax-free withdrawals. Tax-free withdrawals are generally the goal, but they are not automatic. Recently, I wrote a post on Roth 401(k) withdrawals. 

One important consideration regarding Roth 401(k) withdrawals: Roth 401(k)s are subject to the required minimum distribution rules starting at age 72. Thus, you must start withdrawing money from a Roth 401(k) at age 72. As a result, you will have less wealth growing tax-free. For this reason, many consider rolling Roth 401(k)s to Roth IRAs prior to age 72. 

Conclusion

Roth 401(k)s provide a great opportunity to save and invest for retirement. Taxpayers should consider their own circumstances, and often consult with tax professionals, in deciding their own investment program. 

Further Reading

For more information about 401(k) plans, please read this post. 

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter: @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.