Rolling a Roth 401(k)

Thanks to my friend Jim Blankenship, CFP, for his thoughts:

Roth 401(k)s are great retirement savings tools for many individuals. However, there are a couple of rules you may not be aware of concerning these investment vehicles.

When you leave your employer, generally speaking, you should always rollover your Roth 401(k) to a Roth IRA. This is because minimum distributions (RMD) are required from Roth 401(k)s beginning at age 70.5, while RMDs are not required from Roth IRAs.

A Word of Caution

Generally, both Roth 401(k)s and Roth IRAs require you to be 59.5 and have held the account for five years before the distribution is qualified, and therefore, tax-free. However, if you have owned the account for less than five years, the time in the Roth 401(k) doesn’t count toward time held in a Roth IRA.

For example, if you rollover the Roth 401(k) account before you’ve met the five year requirement, all the time you’ve held that account is wiped out, and the five-year holding period starts anew. If you put the funds into a new Roth IRA, you will have to wait another five years before you can take the money out in a qualified fashion.

Meanwhile, if you’ve held the Roth 401(k) for five years or longer and you reach age 59.5, rolling the funds over to a Roth IRA allows you to withdraw the funds at any time, for any purpose, without tax.

Diversify Your Diversification Strategy

Diversification is one of the most commonly used terms in financial planning. Most people know they should invest in both stocks and bonds, own U.S. and international securities, and buy large cap and small cap stocks. However, there is another way to diversify your portfolio that could produce significant savings: tax diversification.

Diversification is important because we can’t predict the future. Will value stocks outperform growth stocks next year? Since we don’t know, it is wise to invest in both so part of our portfolio is likely to benefit regardless of what happens.

Will your earned income cause you to be in a higher or lower tax bracket when you retire? Even more abstract is the question of whether income tax rates as a whole will be higher or lower in the future. Further, how will the capital gains tax rate compare to the ordinary income tax rate 10, 20, or 40 years from now? Again, because we can’t predict the future, tax diversification may be useful.

Tax-deferred accounts such as 401(k)s or traditional IRAs enable you to delay paying taxes on today’s income until you withdraw it during retirement. These accounts are useful if you will be in a lower tax bracket during retirement. Contributions to tax-free accounts such as Roth 401(k)s or Roth IRAs do not allow a tax deduction now, but all growth on your investments can be withdrawn tax free during retirement. Tax-free accounts are valuable if you will be in a higher tax bracket after you retire. Finally, growth on investments in a taxable brokerage account is subject to capital gains tax, which is currently favorable compared to the ordinary income rate.

If you don’t know your future tax bracket, you can hedge your bets by investing in both tax-deferred and tax-free accounts. Further, since we are unclear how the capital gains rate will compare to the ordinary income rate in the future, investing in a taxable account may also have a purpose.

Tax diversification offers other benefits. Both tax-deferred and tax-free accounts can’t typically be accessed before age 59.5 without a 10 percent penalty. However, early retirees could draw from a taxable account in years before they are allowed to take penalty-free withdrawals from their retirement accounts. Further, required minimum distributions (RMDs) from tax-deferred accounts must begin at age 70.5. Meanwhile, RMDs aren’t required from taxable and tax-free accounts. Thus, having part of your portfolio in these accounts can prevent you from having to withdraw more than you want, which can lower your tax bill and allow for more tax-free growth.

Having various investment accounts can also lower your marginal tax rate. Someone withdrawing $100,000 a year from a tax-deferred account would fall into the 25 percent federal tax bracket. On the other hand, if the individual withdrew $50,000 from a tax deferred account and $50,000 from a tax-free or fully taxable account, which doesn’t count as earned income, the investor would be in the 15 percent tax bracket.

Speak to a fee-only financial planner to learn if you could benefit from this strategy.

Happy Talk

Jeff Thredgold publishes a weekly blog concerning economic updates. This week he listed the following positive statistics:

• Economic output of the average American worker is 10 times that in China. Americans won 30 Nobel prizes in science and economics during the past five years. China?…just one

• The value of a university education for American men and women in terms of future earnings power is nearly twice that of those in the average rich nation

• Violent crime in the U.S. declined during 2009 for the third consecutive year. Reported property crime is at a 20-year low

• Roughly half of the 50 states have added jobs during the most recent 12-month period. Formerly, every state had dealt with recession at some point during the past three years

• Even as U.S. economic output (GDP) has climbed by more than 210% since 1970, aggregate emission of six principal air pollutants has plunged by 60%

• The number of people who have quit smoking (46 million) now exceeds the number who still smoke (45 million). Less than 21% of adults smoke today, versus nearly half in the early 1950s

• The U.S. Justice Department said the number of juvenile offenders declined 26% between 2000 and 2008

• During the early 1960s, the five-year survival rate from cancer for Americans was one in three. Today it is two in three…continuing to climb…and the highest in the world

• A recent poll of more than 12,000 global business figures conducted by the World Economic Forum ranked the U.S. as the world’s most competitive economy

• The earnings gap between men and women has shrunk to a record low. Women on average earn 83% of what men earn, versus 76% a decade ago. Women with comparable education and experience earn comparable incomes

• Conventional thirty-year fixed-rate mortgages have averaged 4.35% in recent weeks, the lowest level in nearly 50 years

• For every dollar of U.S. economic output generated today, we burn less than half as much oil as 30 years ago

• Women have drawn even with men in holding advanced degrees in the U.S.

• Men’s contribution to housework has doubled over the past 40 years, while their time spent on child care has tripled

• U.S. traffic deaths per 100 million miles traveled during 2009 were the lowest on record

• Roughly 47% of science and engineering degrees of those ages 25 to 39 are held by women, compared with 21% among those 65 and older

• America produces more steel today than 30 years ago, despite the shuttered plants and slimmed-down work force

• Energy-efficient appliances, cars, buildings, and other technologies that already exist could lower U.S. energy usage 30% by 2030

• The worldwide income of women is expected to rise by nearly half during the next three years

• An estimated 925 million people worldwide are undernourished, down from slightly more than one billion in 2009. Obviously, more needs to be done

• The U.S. accounted for nearly one-third of the $1.1 trillion spent globally on research & development in the latest data available

• Total U.S. workplace fatalities declined to their lowest point on record last year

• Donations to charity were near the all-time high in 2009, with nearly $304 billion donated by individuals, foundations, and corporations. As a percentage of GDP, Americans gave twice as much as the next most charitable nation…England. In 1964, there were 15,000 U.S. foundations. By 2001, there were 61,000

• Smoke-free laws in restaurants, bars, the workplace, etc. reduced the rate of heart attacks by an average of 17% after one year in those communities where the bans had been adopted

• The Dow average has rebounded 64% since its low in early March 2009, with even larger gains by other measures

• Roughly 80% of companies that suspended or reduced their 401(k) matches during the past 2-3 years plan to reinstate them this year or in 2011

• The divorce rate dropped by one-third between 1981 and 2008, and is at its lowest level since 1970

• U.S. exports to China have risen roughly 24% per year since 2001, making China the fastest growing market for U.S. goods

• The number of American volunteers rose 2.0% to 61.8 million in 2008. Among young adults, the number of volunteers rose 5.7%

• Women now make up a record 46% of global MBA candidates. More than 70% of students surveyed name the U.S. as the top MBA study destination

• The Consumer Price Index (CPI) is up a modest 1.1% during the most recent 12-month period

• The number of people using public transportation hit a 52-year high during 2008

• Alcohol-related traffic fatalities in the most recently reported year dropped by more than half versus 20 years ago

• Average U.S. life expectancy has reached 78 years (men 75, women 80), the highest ever. This compares to 76 years in 1995, 68 years in 1950, and 47 years in 1900

• Children’s deaths from unintentional injury have dropped by almost 40% since 1987. Bicycle deaths fell 60%, while firearms-related deaths fell 72%

• Roughly 30% of trash was recycled or composted in the latest year, versus 16% in 1990

• A record 50.5 million foreigners visited the U.S. during 2008

• Seat belt usage by Americans was at 82% in 2007, versus 49% in 1990 and 14% in 1983

• A record 30% of men have earned a bachelor’s degree or higher, versus 29% of women, also a record. This compares to a combined 7.7% in 1960. A record 85% of adults over age 25 now have at least a high school diploma, versus 24% in 1940

• Substantiated cases of childhood sexual abuse have fallen 49% since 1990. Physical abuse of children is down by 43%

• U.S. teen pregnancy and birth rates plummeted to all-time lows in recent years, before a slight rise. The reasons? More widespread use of birth control, more work opportunities, and more girls who “just say no”

• Flexible work schedules are now the norm for 43% of workers, up from 29% in 1992 and 13% in 1985. This allows greater flexibility for more people, especially those with children

• Productivity of U.S. workers rose an average of 2.6% annually during the past 10 years, the largest gains in 40 years. Rising productivity is a long-term key to higher standards of living

• The upward “mobility” of the typical American remains the greatest in the world. Why? The U.S. economy “rewards” the combination of hard work and educational achievement more than ever before…and more than any other country in the world

• The U.S. role of dominance in the global economy during the past decade was as clear-cut as at any time since the 1950s

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