22 Feb Tax-free retirement income? Maybe

Q. My employer just started offering a Roth 401(k). I have always saved the max to my traditional 401(k), worth $220,000, and I have no Roth accounts. I’m afraid a Roth 401(k) will hurt my tax situation too much. How can I decide?
— Investor

A.  You’re correct that switching to a Roth 401(k) could change your tax situation, but it’s not necessarily a bad thing.
Some background, first.

A Roth 401(k) also known as a DRAC (Designated Roth Account) has been a popular addition to many employer sponsored retirement plans, said Bellaria Jimenez, a certified financial planner with MassMutual Tri State in Iselin.

The popularity of this option is driven by a few factors.

Unlike a traditional 401(k), qualified withdrawals from either a Roth IRA or DRAC are income tax free to both the account holder and their spouse (if the accounts are inherited) as long as the withdrawal is made after the DRAC has been in existence for at least five years and the account holder is over age 59 ½, Jimenez said.

Also, she said, there is no mandatory Required Minimum Distribution (RMD) at age 70½ for either the account owner or their spouse (again, if the account is inherited), as long as it’s rolled over to a Roth IRA prior to the age of 70 ½.

Assets held in either of these accounts can be inherited without the imbedded income tax of a traditional IRA or 401(k) by non-spousal beneficiaries, although a non-spouse beneficiary will have RMD requirements once inherited, she said.

“While RMD withdrawals will be necessary for non-spouse beneficiaries, the withdrawals will not be taxed if the account has been in existence for at least five years,” Jimenez said.

All of the benefits of a DRAC are on the “back-end.”

There is no tax deduction when the contributions are made as with a traditional 401(k), Jimenez said, so there will be no reduction in taxable income.

“It is possible that changing from a deductible 401(k) to a DRAC will cost them more in income taxes while earning the same salary,” she said. “But this is where the most difficult aspect of the decision making process comes to light. Is losing a current tax deduction worth tax-free withdrawals years or decades later in retirement?”

Most advisors will begin this “cost benefit analysis” by comparing the net tax savings, Jimenez said.

For example, if you’re in the 28 percent federal tax bracket while working and making a pre-tax contribution but you will move down to the 25 percent bracket in retirement because you’ll have less income, then the math doesn’t favor the Roth 401(k), she said.

“Remember, both traditional 401(k) plans and DRAC plans enjoy tax-deferred growth, so the assumption is the `nest egg’ will be equal in either plan when retirement arrives, assuming the same contribution is made each year,” Jimenez said. “Since most people will likely have a lower tax bracket in retirement, the traditional 401(k) appears to still be the better alternative.”

Still, there are many scenarios where switching to a DRAC may be the prudent choice.

There’s no guarantee what your retirement tax bracket will be, and it could actually go up.

“While this may not seem too common, the one wild card is the tax code and the administration in power at any point in time,” Jimenez said. “Specifically, if the current administration lowers income tax brackets for the next four years but years later during retirement, taxes are raised across the board, tax-free withdrawals will be quite attractive.”

Next, consider “tax control,” a rapidly developing strategy for many advisors and their retired clients.

“Tax control is about mitigating tax liabilities by withdrawing retirement income from multiple sources, some taxable — traditional 401(k) — and some tax-free to keep the clients tax burden lower and more manageable throughout retirement,” she said.

Then there’s legacy planning, or what you plan to leave to your heirs.

This involves tax strategies, and one of those is to pass on tax-free assets (DRAC assets) to the next generation instead of a taxable asset (traditional 401(k)), she said.

Jimenez said the decision pivots on when you want the tax advantages.

If you’re in a high tax bracket, but switching to a DRAC and losing the 401(k) contribution tax deduction will keep you in the same bracket, then a DRAC could make sense, Jimenez said.

But if the switch to the DRAC would move you to a higher bracket, then the math doesn’t work, but tax-free is still tax-free, she said.

“Finally we, as advisors, see significant merit in the tax control strategy in retirement because it gives the client flexibility and tax efficiency,” she said. “Too often we see clients retire with all of their retirement assets tied up in 401(k) plans and that means every dollar they pull for income will be taxable. This could also force more of their Social Security to be taxed, further reducing their spendable income.”

Good luck making your decision!

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This post was first published in February 2017.