Setting Up a 401(k) to Take Advantage of the 'Mega' Back Door Roth Conversion

Setting Up a 401(k) to Take Advantage of the ‘Mega’ Back Door Roth Conversion

If you’re a personal finance nut you may have heard of a strategy called the “back door Roth IRA conversion.”  This maneuver essentially allows you to contribute money to a Roth IRA, even if your income is otherwise to high to make a direct contribution.  You make a non-deductible contribution to a traditional IRA, convert those funds to a Roth IRA, and presto!  You have cash in the Roth that won’t ever be taxed again.  While it seems like this is a glaring loophole in the tax code, Congress has endorsed the strategy in a conference committee report from the Tax Cut & Jobs Act.

But as great as it is to take advantage of Roth IRAs while you’re in high tax brackets, you’re still limited to the annual IRA contribution maximums of $6,000 per year (or $7,000 if you’re 50 or older).  The “Mega” back door Roth conversion is a similar strategy, but allows for up to $37,000 per year in additional Roth contributions using a 401(k) plan.

 

Why the “Mega” Back Door Roth Conversion Strategy Works

 

The Three Types of 401(k) Contributions

To start, let’s review the three types of contributions you could make to a 401(k) plan.  The first is the most common: your employee deferrals.  You can instruct your employee to defer funds from your paycheck and deposit them on your behalf into the company’s 401(k) plan.  Some plans allow you to make these deferrals on a Roth basis, and the limit in 2019 is $19,000 per year.

The second type of contribution is an employer contribution.  This is anything your employer puts into the plan on your behalf, and includes matching contributions, or contributions based on a percentage of your compensation or company profitability.  It may be subject to a vesting schedule, and is always made on a pre-tax basis.

The third, and widely unknown type of contribution is an after-tax deferral.  Some 401(k) plans allow you to make additional contributions beyond your employee deferral on an after-tax basis, once you’ve reached the $19,000 annual limit.  Note here that 401(k) plans are not required to allow this feature, and not all do.

There are two limitations to annual 401(k) contributions.  The first is the $19,000 limit on employee contributions ($25,000 if you’re over 50 years old).  The second is on the total amount contributed to the plan on your behalf.  This limit is $56,000 in 2019, and consists of the three contribution types listed above.

So, to determine how much you could contribute in after-tax deferrals, you’d need to subtract $19,000 (again, $25,000 if you’re over 50) and the total amount of your employer contributions from $56,000.

Theoretically you could make up $37,000 per year in additional Roth IRA contributions using this maneuver ($56,000 – $19,000).  You’d need to be under 50 though, and you couldn’t receive any contributions from your employer.

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A Review of Providence's 457(b) Plan

A Review of Providence’s 457(b) Plan

In my financial planning firm I work mostly with business owners and medical professionals.  A good number of my clients are employees of Providence, which is one of the major medical providers in the Pacific northwest.  Providence offers its employees a very strong benefits & retirement package.  Employees can contribute to a 403(b) plan on a tax-deferred or Roth basis and Providence contributes to a 401(a) plan on their behalf, depending on compensation and years of service.

Providence also offers a 457(b) plan to its employees.  While it’s convenient to have another tax-deferred savings vehicle available, 457 plans come with some quirks – especially surrounding distribution options once you separate from service.

Recently, one my of my clients and I discussed the possibility of them leaving to take another job.  So to wrap our heads around the ins and outs of the 457 plans, we jumped on the phone with one of Providence’s retirement plan administrators.  The administrator helped to explain the unique features of the plan, which I’ll explain in this post.  Hopefully this review is helpful to anyone thinking about participating in Providence’s 457 plan.

 

A Quick Primer on 457(b) Plans

457(b) plans are sometimes mistakenly considered an alternative to a 403(b) plan.  There is actually some nuance to 457(b) plans, and much of it depends on whether the plan is sponsored by a governmental entity.

457(b) plans sponsored by governments have nearly identical rules to 403(b) plans.  The contribution limits are the same, the distribution options & limitations are the same, and by and large the plans operate in the same way.

Non-governmental 457(b) plans are different, in several ways.  Whereas the contribution limits are the same, the distribution options are not.  For non-governmental 457(b) plans, you are not allowed to roll your balances into an IRA.  Yes, you read that correctly.  Whereas participants in government sponsored 457(b) plans may roll their balances into IRAs after separating from service without triggering a taxable event, participants in non-governmental plans may not.

Instead, as a participant in such a plan you’re limited to the unique distribution options of the plan.  This is worth some investigation, as some plans require full distribution shortly after separating from service.  There isn’t an early distribution penalty for withdrawals prior to age 59 1/2, but withdrawals are still taxed as income.  Think about that for a moment.  You participate in a non-governmental 457(b) plan for years, accumulating potentially hundreds of thousands of dollars in the plan.  Then when you separate from service you’re forced to take everything out, and be taxed on it, in one year.

Another unique difference is creditor protection.  Whereas 403(b) and 403(k) plans are held in trust, 457(b) plans are held in the name of the organization sponsoring the plan.  This seems like a subtle difference, but can be impactful in the event of liquidation.  If the sponsoring organization falls into bankruptcy, your assets in the plan would be exposed to creditors.  The chances of this happening are probably quite small (especially for an organization like Providence), but I’m sure that’s what everyone at WorldCom and Enron thought as well.

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Defined Benefits Pension Plan: Helping Business Owners Shelter Thousands from Income Tax

The Defined Benefits Pension Plan: Helping Business Owners Shelter Thousands from Income Tax

Taxes are frustrating to nearly every small business owner I speak with.  Most people agree that we should all pay our fair share.  But after working countless thousands of hours to build a viable business, it’s easy to feel like Uncle Sam’s reaching into our pockets too far.  That’s why I focus on helping my clients who own businesses make sure they’re not paying more in taxes than they need to.  One great tool we can use in this endeavor is a defined benefit retirement plan.  Whatever you want to call it, DB plan, defined benefits pension plan, etc., it can be a killer way to defer a huge portion of your income from taxation.

I realize you might cringe when you read the words “pension” or “defined benefit”.  The idea of promising employees a monthly check throughout their retirement may not foster warm and fuzzies.  But if you don’t have employees, or only have a few, a defined benefit plan can offer some pretty major tax advantages.

Read on to learn how you might take advantage of them.

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Top Strategies for Managing Incentive Stock Options

Top Strategies for Managing Incentive Stock Options

Incentive stock options, or ISOs, are a pretty common way for companies to compensate management and key employees.  Otherwise known as “statutory” or “qualified” options, ISOs are a way to give management a stake in the company’s performance without doling out a bunch of cash.

While they can have wonderful tax benefits, far too many people who own ISOs fail to exercise them wisely.  Some estimates even claim that up to 10% of in the money ISOs expire worthless every single year.  If you own incentive stock options but aren’t sure how to manage them, read on.  This post will cover a few of the top management strategies at your disposal.

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ERISA Section 404(c): Another Way for Plan Sponsors to Limit Legal Risk

ERISA Section 404(c): Another Way for Plan Sponsors to Limit Legal Risk

Sponsoring a qualified retirement plan is a pretty convenient way to defer taxes AND offer your employees a valuable benefit.  It comes with some hefty responsibilities, too.  Among other things, you’re obligated to act in the best interests of your participants, monitor expenses & performance, and make sure everyone’s getting the proper disclosures.

However, to make your life easier ERISA includes six nifty safe harbor provisions.  By following a few additional guidelines your plan can qualify for these safe harbors, which relieves you of certain fiduciary responsibilities.

We covered one of the six safe harbors a few weeks back: auto-rollovers.  Today we’ll cover another safe harbor: section 404(c).  This section has to do with who is responsible for the investment performance in your participants’ accounts.

If you’re responsible for a qualified plan and are curious about how you can limit risk, read on.  You’re in the right place.

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401(k) Auto Rollovers: A Convenient Safe Harbor for Small Business Retirement Plans

401(k) Auto Rollovers: A Convenient Safe Harbor for Small Business Retirement Plans

OK – with a new year upon us it’s time to clean up that rusty old 401(k) plan at your small business….right?  Let’s say that you work in or own a small business, and are responsible for operating the company’s 401(k) plan.  To put it lightly, it’s probably a massive nuisance.

401(k) plans can be a wonderful benefit to your employees AND a great opportunity for you to put more money away for retirement in a tax deferred account.  But as you may now, operating a plan can be a real bear.

I’ll be covering the finer points of operating small business retirement plans throughout the year.  Today’s post will focus on what to do with departed employees.  Employees will come and go to and from your business over time (hopefully not too often), and it’s not uncommon for them to leave money they’ve accumulated in your company’s qualified retirement plan.

 

ERISA & Fiduciary Responsibility

As you probably know, departed employees always have the opportunity to pull their money from your plan after they leave, either directly or via a trustee to trustee rollover.  But many employees neglect to do so.  Whether it’s because they don’t know how, don’t care, or are simply lazy, it’s very common for departed employees to “accumulate” in your 401(k) plan, long after leaving the company for greener pastures.

As you also know, as the sponsor of a qualified retirement plan you have certain fiduciary responsibilities when it comes to managing the plan on behalf of your participants.  It’s for this reason – fear of repercussion – that many sponsors feel stuck when it comes to managing assets of employees who long ago left the company.

Fortunately for you, ERISA was not written with the sole intention of making your life hell.  There are six safe harbors written into the law that free you from fiduciary responsibility if you follow a few step by step instructions.  And one of them conveniently covers departed employees.

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401k RMD Rules

401k RMD Rules: A Comprehensive Guide

You’re probably familiar with the term “required minimum distributions” (or RMDs for short).  They’re the systematic withdrawals that the IRS makes you take out of an IRA after you turn 70 1/2.  But what about for 401k and other qualified retirement plans?  What are the 401k RMD rules?

While they largely resemble IRA RMD rules, 401k plans have a few subtle but important differences.  And since many people these days are staying at their jobs beyond 70 1/2, it’s a situation that more and more people find themselves in.

To help you navigate the waters, here’s a comprehensive guide to 401k RMD rules, which also applies to 403b, 457, and other qualified plans.

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5 Times a Roth 401k Conversion is a Good Idea

5 Times a Roth 401k Conversion is a Good Idea

Roth IRAs have become one of the most popular ways to build retirement savings over the years.  In fact, they’re so popular that thousands of people clamor every tax season to convert their traditional IRAs to Roth IRAs.

This conversion is one of the most popular financial planning moves, since it can reduce your tax burden and eliminates required minimum distributions (RMDs).

More recently, a new form of Roth account has emerged: Roth 401k plans.  Roth 401k plans are essentially the same alternative to traditional 401k plans that Roth IRAs are to traditional IRAs.  Contributions are made after tax, and gains and withdrawals are tax free.

And with Roth 401k plans on the scene, many sponsors are starting to allow their participants to convert their traditional, pretax 401k balances into Roth, after tax balances.  This transition is known as a Roth 401k conversion.

Roth 401k conversions are not unlike Roth IRA conversions.  The transition will create taxable income, but your assets will never leave your employer’s 401k plan.

Here’s how one might work:

  • Johnny has a $100,000 saved up in his employer’s 401k plan.  He didn’t pay any income tax on his contributions, and they will continue to grow tax free until he starts taking withdrawals.
  • When he starts taking withdrawals after age 59 1/2, he’ll owe income tax on every dollar he takes out of his account.
  • If Johnny were to convert his 401k contribution to Roth contributions, he would owe income tax on the entire $100,000 this year.  His account would continue to grow tax free as it would have otherwise.
  • But, when he begins taking withdrawals down the road, they won’t be taxable income to Johnny.  Essentially, he would be paying his tax burden now instead of later.

Conversions can be appealing.  You pay taxes on the account now, rather than in the future when you might be in a higher bracket.  But the decision is not always so cut and dry.  And since this is a question I get in my practice from time to time, I thought it’d help to share 5 circumstances where a Roth 401k conversion is a good idea.

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Does the 4% Rule Still Work

Does the 4% Rule Still Work?

Recently I had a client come into my office who was concerned about his and wife’s and his retirement.

This client works at a company that sponsors a 401(k), but his wife works for the state and will receive a pension after retiring.  My client was concerned that his 401(k) savings wouldn’t be enough to cover their annual living expenses, after accounting for their pension and social security benefits.

“Do we need to save more?  I’m not sure we could.  We’ve got Danny in college now and our daughter right behind him.  I’m just worried we’ll zero out our savings and have to cut back on spending.”

We talked about how much he was saving in his 401(k), and how much that might amount to in 15 years when they planned to retire.  But really, the crux of my client’s concern was that he’d spend through his savings too fast after they stopped working.

In his financial plan, we’d originally planned for withdrawals of 3.5% of his nest egg per year.  Whatever was left over after he and his wife passed would go to the kids.

“I just think that 3.5% might be too much.  I’ve been reading some pretty negative things about the 4% rule recently.  3.5% just seems too close for comfort.  What’s your take on it?”

 

 

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The Ultimate 7 Step Checklist for Hiring a Financial Advisor

The Ultimate 7 Step Checklist For Hiring a Financial Advisor

A few years back, I had a friend approach me at a BBQ.  He had some questions about how his financial advisor was managing his accounts.

 

Friend: “Yeah, I just don’t know if this guy is doing the right thing for me.  We talk every now and then, he seems like a nice guy, but my portfolio hasn’t really gone anywhere.

Plus, every time we chat he has some brand new investment idea he tries to sell me on.  And every single time, he talks up his new idea like it’s the Michael Jordan of portfolio management.  (My friend is a big NBA fan).  His ideas sound good….I’m just not sure I’m in the right situation.  I feel like there’s more going on behind the scenes that I don’t see, but I don’t know what questions to ask.”

Me: “Well how did you find him?”

Friend: “A coworker recommended him.  Said the guy made him a ton of money a few years ago.”

Me: “How are you paying him?”

Friend: “Well, I’m not really sure.  Everything gets wrapped through the account somehow.”

Me: “OK.  Let’s take a step back.  Maybe it’d help to identify what you’re looking for in an advisor.  If you were starting fresh, what would you like an advisor to help you with?”

Friend:  “Hmmm.  I guess manage my money and help it grow, make sure I’m on track for retirement, and make sure I don’t run out of money after I stop working.”

Me: “So if you were starting from scratch, what qualities would you look for in an advisor?  What criteria would you use?”

Friend:  “I really have no idea.  I’ve never thought of it that way.  Plus there’s about a million financial advisors around here, I get information overload.  I guess I’d go with someone I know and like, and seems to have a good reputation.  What should I be looking for?”

I had to think about my friend’s question for 10 seconds or so.  At the time, I was working at Charles Schwab, but strongly considering starting my own firm.

Me: “I think if I were looking for an advisor, I’d try to find someone who’s competent, trustworthy, unbiased, enjoyable, and looks after for my finances for a fair and transparent price.”

Friend: “Whoa whoa whoa.  Slow down with the laundry list.  That’s a whole lot of stuff I don’t understand.  It sounds GOOD though.  I need to tend the grill, but let’s reconvene in a few minutes.”

Coincidentally, this was one of the very reasons I was considering starting my own firm.  There are about 300,000 professionals in the U.S. today who call themselves “financial advisors” or “financial planners.”  But in my opinion, only a small portion of them have the qualities and service model I’d look for in an advisor.

I’ve had this question come up many times in the years since, and my friend isn’t the only one who’s not sure how to evaluate a potential advisor.  And without knowing what questions to ask, how can you be sure you’re finding someone trustworthy and competent?

Because of this, I thought it’d be helpful to build a checklist you can use to evaluate financial advisors & planners.  If I were looking to hire someone for help with my finances, these are the exact qualities I’d look for and the exact criteria I’d use.  And at the very least, hopefully you’ll be armed with a few good questions to ask.

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