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Tax Guy: What is a designated Roth account? Here are two important factors to weigh when considering one

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Many company retirement plans now give employees the option of contributing to designated Roth accounts (DRAs). According to a 2020 survey, 75% of employer plans now offer DRAs. DRAs are often called Roth 401(k) accounts, but we will stick with the acronym.

If your company offers the DRA option, and your income is too high to make annual Roth IRA contributions, contributing to a DRA is worth considering. Ditto if you expect to pay higher federal income tax rates during retirement. Here’s what you need to know about DRAs.

How do designated Roth accounts (DRAs) work?

If your company qualified retirement plan allows you to make elective contributions out of your salary to a 401(k) account, the plan can also include the DRA option. DRAs can also be offered by 403(b) and 457(b) plans, but the focus of this column is on 401(k) plans that offer DRAs.

When you make an elective contribution to a regular 401(k) account, the contribution reduces your taxable salary. So, your federal income tax bill is reduced, and your state income tax bill too, if applicable.

In contrast, when you contribute to a DRA, your taxable salary is not reduced. You are taxed on the contribution as if it was included in your salary. The payoff is that earnings in your DRA are allowed to accumulate federal-income-tax-free and you can eventually take federal-income-tax-free qualified withdrawals from the account. You can take a qualified withdrawal after your DRA has been open for more than five years and you are age 59½ or older.

Your employer must keep your DRA funds in a separate account that can be rolled over to either your own Roth IRA or another company qualified plan that permits DRAs.

How much can I contribute to a DRA?

There are no income limits on your ability to contribute to a DRA. For 2021, you can contribute up to $19,500 or up to $26,000 if you’ll be age 50 or older as of 12/31/21.

Your employer can make matching contributions, but any matching contributions must go into your regular 401(k) account, and later withdrawals from that account will be taxable. See here. That said, employer matching contributions are always good because they are “free money.” You should not turn down free money.

The two most important factors when evaluating the DRA option
  1. The longer you hold funds in a DRA, the better, because you can build up a bigger federal-income-tax-free retirement fund. So DRAs should be especially attractive to younger retirement savers.
  2. The higher the tax rate you expect to pay during your retirement years, the bigger the DRA advantage. For instance, say your DRA contributions are taxed at a 24% federal rate, and you expect to be in the 32% tax bracket in retirement. The privilege of taking future tax-free DRA withdrawals is worth more than the current tax cost of making DRA contributions. Now, if you are someone who believes you won’t pay higher tax rates in retirement, I applaud your optimism and wish you the very best of luck. Go buy some lottery tickets.
DRA contributions versus annual Roth IRA contributions

There are limitations on your ability to make annual Roth IRA contributions. For 2021, the maximum contribution is $6,000, or $7,000 if you’ll be 50 or older as of 12/31/21. For 2021, your ability to make a Roth IRA contribution is phased out once your adjusted gross income (AGI) exceeds $125,000 if you’re unmarried or $198,000 if you’re a married joint-filer. Your ability to contribute is completely phased once AGI reaches $140,000 if you’re unmarried or $208,000 if you’re a married joint-filer.

In contrast, there are no income limits on your ability to make DRA contributions. And, for 2021, you can contribute up to $19,500 or $26,000 if you’ll be age 50 or older as of yearend. So, the DRA contribution deal is potentially much more beneficial than the annual Roth IRA contribution deal.
On the other hand, you have complete control over your own Roth IRA. You don’t have complete control over a DRA. Your company plan will have limited investment options, and you generally can’t take money out of a DRA until you leave the company.

In-plan DRA rollovers

If you company 401(k) plan allows DRAs, it may also allow you to roll over funds from your regular 401(k) account into a DRA. This is a so-called in-plan rollover and is a quick way to get more money into a DRA. But you must understand that the amount you roll over will be taxed, because it’s effectively the same as a Roth IRA conversion transaction.

Warning: If you withdraw rolled over DRA funds within the five-year period starting on the first day of the year in which you did the rollover, you can get hit with a 10% early withdrawal penalty tax. So, don’t do that!

Rolling over your DRA balance into a Roth IRA

When you leave the company, you can roll over your DRA balance into a Roth IRA. Do that, because you won’t have to take any annual required minimum withdrawals from the Roth IRA for as long as you live. You can keep earning that nice tax-free income and line yourself up for tax-free withdrawals after reaching age 59½. If you still have a balance in your Roth IRA when you depart this cruel orb, whoever inherits the account can take tax-free withdrawals after meeting the rules for qualified withdrawals.

The bottom line

If your company plan offers the DRA option, give it a hard look. This is especially good advice if: (1) the company plan matches DRA contributions, and/or (2) your income is too high to make annual Roth IRA contributions, and/or (3) you expect to pay higher tax rates in retirement than you’re paying now.

You should also consider making an in-plan rollover into a DRA if the company plan gives you that option. But remember that there’s a tax cost for making an in-plan rollover. I recommend consulting a tax pro before rolling over a significant amount to ensure that you fully understand the tax consequences.

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