The Roth 401(k) Tax Trap

There’s a lot to love about the Roth 401(k). However, an interesting provision in the tax code is actually creating a stealth tax trap that hardly anyone knows about. We’ll tell you what it is and how to avoid it in this episode of Wise Money.
Season 4 Episode 41
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[@toystoryyeselliotmooseno7014]

Great information on the 5 yr rule. I have been contributing via Roth 401K since 2014 and wasn't aware of this cascading over to an additional 5 yr period after converting to a Roth IRA. After watching this I immediately called Fidelity and told them I needed to open a Roth IRA and explained why... 5yr rule. The guy that I talked to was blown away by this. He was totally unaware. They were very thankful for becoming aware of this situation. Thanks and keep up the good work.

[@genconex]

Don't entrust your money and financial future with these people who admit to not previously knowing this information. If they just stumbled upon this well known information, while working with a client, go with a different CFP and CPA worth their salt.

[@scottmghill]

Geez, was that the whole thing? You have to wait five years after opening the account? That's all this was? That's the big "tax trap"?

[@erikowren7894]

Yes, but there is more too it.

[@TheBobmarley3]

this doesnt take 45mins to explain. A roth 401k and a roth ira each have their own 5year clock. if you had your roth 401k for 10 years and you have a roth ira for 4years. When you roll over your 10yr roth 401k into your 4yr roth ira.. all the money is obviously stored in the 4yr roth ira. This means you have to wait 1 more year for all the money in the roth ira to fully mature. Simple answer: open both a roth 401k and roth ira so that you have a mature roth ira account to roll your money into. problem solved

[@austinnhernandezz6293]

Thank you for saving 45 minutes of my life.

[@jeffalex]

thank you. so even though the funds that were once in the roth 401k were contributions AND earnings, once it is rolled over into a 5 year old roth ira, it can all be withdrawn penalty free as it is ALL now considered contributions?

[@TheBobmarley3]

@@jeffalex when you roll over money into a roth ira it is considered a "contribution." If you roll over a mature roth 401k into a mature roth ira then you can withdraw that full contribution tax free.. If both are not mature, then refer to my original comment. below is for those rolling a 401k into a roth ira as it is different: rollovers are considered "contributions." The money has to follow the contribution rules. If you want to withdraw that money immediately you will be taxed 10%. Contributions must be in your roth ira for 5 years to withdraw contributions tax free. Answer: To get around this you can withdraw your already mature contributions first. Then withdraw the 401k "contribution" after 5 years. Also there is a method called the "roth ira conversion ladder" that solves this problem if you plan on retiring soon and need the money from your 401k before then. (if you want a more in-depth explanation look up the term I put in quotes) Basically this method is for someone who plans to retire (early) in five years. Each year before retirement you can roll over a portion of your 401k (amount would be how much you spend a year) then the next year roll over that portion again. then again next year and etc. five years later your first rollover will mature and you can withdraw it all tax free. Then next year the second rollover will mature and be tax free etc etc. moral of the story, plan ahead and know when you want to retire/need the money in your 401k and how much you spend a year so that you can utilize the roth ira conversion ladder properly as you can only rollover once a year.

[@jeffalex]

@@TheBobmarley3 i appreciate this. thank you very much

[@cathycathywhite8455]

Thanks for simplifying 👍

[@WiseMoneyShow]

Here is a shorter video we did covering the top 3 things you should know about saving with a roth 401(k)! kzbin.info/www/bejne/mX-5iZ2CrJt_j5Y

[@gkprivate433]

This is good to know because the IRS documentation is ambiguous on this 5 year as are every single chat I found on the internet. Open a ROTH IRA outside of WORK ASAP

[@adaytoremember225]

Hmm an awful long video to explain having to wait 5years to collect. Hate to say it, but with all the info on KZbin and the internet as a whole I feel like a lot of advisors are being faded out. I had a phone interview a famous KZbin advisor the other day. He told me naw man, you're doing very very well, it wouldn't be worth you paying my 1% fee. Your research and dedication has obviously paid off!

[@johnbrinker2559]

My son has offered to buy me a house and rent it to me. He would get depreciation and interest deduction. I would sell my house and invest it in S&P 500 fund. Use that to pay the rent. I think that would not have to pay any tax on the house because of the $250,000 exemption.

[@marktheshark7754]

Don’t put all your eggs in one basket. The S&P can go DOWN or SIDEWAYS for years. Research “the lost decade” before you execute your plan.

[@planetsaver]

I've always said this, though the 401k is one of the safest retirement plans, it is not a particularly a good option. Better strategy; Live below your means, Invest 20-30% of your income into the stock market but of course, be well informed about where you want to put your money... I made my first million earlier this year from stocks alone with about 550k after I dissolved my 401k and added little cash (through the help of a pro though). Greatest decision I ever made.

[@dannywalters958]

Now you have my attention sir How did you do this? Who's the knight in shinning armour? I am slowly giving up on all of these

[@planetsaver]

@@dannywalters958 Sir? It's funny cos I'm a lady or doesn't it suit the "narrative"? It takes quite some level of patience and "Nancy Lynn Lewis" is the "knight", she was in the news alot in 2018. You can check her out online for more.

[@dannywalters958]

@@planetsaver Low Blow right there ma'am. You didn't have to pull the gender card. Wasnt necessary. Thanks still. Ill check her out

[@lelaoliver521]

@@planetsaver Wow I know this little lady. Once attended a seminar she was also in attendance here in Texas,, Great speaker. I still think the 401k or putting it in a high yield savings account is the more reasonable option, given the economy,,

[@Mrcarlson_E]

@@lelaoliver521 This right here is the second time I am coming across this name in a week. Came across her podcast and it was lit

[@juztnlast953]

Are you sure a person only needs to have an open Roth account for five years? I think it has more to do with the yearly deposits having been in the account for five years and not being able to withdraw an amount greater than an amount in the Roth account that has sufficiently aged five years?

[@ehmiller61]

The Roth IRA five-year rule says you cannot withdraw earnings tax-free until it's been at least five years since you first contributed to a Roth IRA account. This rule applies to everyone who contributes to a Roth IRA, whether they're 59 ½ or 105 years old.

[@jo-annmacneill6454]

The issue is a lot of people don't have all this extra. You can put an extra 6000 all the stuff where are you supposed to get the money?

[@Ethernet480]

It feels like if you are starting a Roth at age 55 or greater…well that is good ( Bette late than never) but it seems like your bigger failure is not receiving any guidance by that age and especially if you are that behind.

[@hcrystalh]

But the 5 year rule applies just to earnings…so if you’re doing a rollover from a Roth 401k, I’d the entire rollover considered the principal? Or the portion that’s actually principal in the Roth 401k, will it still be considered the principal after the rollover and not subject to the 5 year rule? Or is everything subject to the rule?

[@ChrisSmith-ii7xu]

I've been informed that for a rollover from a Roth 401k to a Roth IRA before 59 1/2, it's split into contributions (basis) + earnings. For rollovers from a Roth 401k to a Roth IRA AFTER 59 1/2, the entire amount is considered basis, provided the Roth 401k has satisfied its own 5 year rule. Otherwise, it's split into earnings + contributions. It's also split into earnings + contributions if the Roth IRA it's being rolled into has not satisfied its own 5-year clock.

[@mjones9088]

Should my CFP be well versed in tax planning? Or do I need to talk to someone who specializes in tax planning for my estate, in addition to my CFP?

[@dougm1985]

you stated a 17k limit on earnings . for the couple in your example . the error was the limit is per person. so with 27k they are under the limit in your example

[@TravelingTheWorld1993]

Two individuals at full retirement age. They both apply for social security and Medicare benefits. One have 3 million in a traditional 401K and the other have 3 million in a Roth 401k. Would they be taxed the same on their social security and will their Medicare payments be the same? Thanks

[@johngill2853]

How much do they take out of the 401K is the information that we would need to answer your question. If you're planning on $3 million in the immediate future and not 30 years from now or something you better put some in a Roth. 3 million is it the top tier of retirement savings in this country. You need help with that much money if you don't know the answer

[@charleslemaire8137]

I dont understand the name of this episode! It seems like this episode's name should be related to IRA or Roth Roll-over rather than "The Roth 401(k) Tax Trap" as the so called tax trap relates to rolling over Roth funds into an IRA, not being in a 401K. The big problems is not knowing in time. As mentioned, start a Roth IRA asap! If you find out as you are retiring, leave some money in the 401K for the 5 years as the IRA seasons. If you already rolled, pull from your trad IRA, it is taxed, but it would be taxed anyway.

[@mapmanlxii1715]

Thanks guys I recently started contributing to my employers Roth 401k I envisioned rolling these funds into my own Roth IRA and having the 5 year rule satisfied via the 401K, guess I was wrong??? I am a high income wage earner any solutions for getting a Roth IRA open to eventually receive these funds?

[@WiseMoneyShow]

Great question. If you're unable to contribute directly to a Roth IRA due to the income limits, then possibly consider funding a backdoor Roth IRA. If that's not a good solution because you already have pre-tax money in a Roth IRA, then another option could be to convert a very small amount of money from your IRA to a Roth, even something as small as $100. Sure you'd have to pay tax on this small amount of conversion, but it would start your 5-year countdown.

[@mapmanlxii1715]

Wise Money Show excellent thank you for the tip! I’ll research this further! Stumbled onto your show regarding this issue!!!

[@mavissmith3]

Wise Money Show - how can pre-tax money be in a Roth IRA? Did you perhaps mean a Traditional IRA?

[@ThomasBomb45]

@@mavissmith3 Yeah they meant pre tax money in an IRA

[@hcrystalh]

I’m not sure but you might be able to open a Roth IRA but just not fund it. But if you have to fund it, you might be able to contribute like $50 to it even though you’re not technically allowed to and then just pay the taxes and penalties on that $50. But if neither of these work, then yes, back door.

[@ameroamigo1]

Good stuff.

[@cathycathywhite8455]

How can start it ?

[@pfan12000]

Is it possible to open a Roth IRA (new single account) and take portions of a traditional IRA (1 single account) to convert those portions over several years into the Roth IRA while paying the tax for converting each portion during those years? Say $100,000 in Traditional IRA converted into Roth IRA over 5 years by converting $20,000 each year from the same IRA account?

[@WiseMoneyShow]

Absolutely! Worth considering given the right planning circumstances.

[@sams4169]

Backdoor Roth conversion. Not so simple.

[@annieluish]

Is it worth transferring traditional IRA to Roth IRA if the age is 72 ?

[@alrocky]

If your plan is to spend it, then likely not.

[@newmoneyange2265]

The 5 year rule relates to distributions not conversions correct? I'm looking to convert from roth 401k to roth ira due to change of employer. I do not and will not need to take any distributions for years. I just want to make sure I'm not taking a penalty after already contributing taxed income. Also, I cannot open a Roth IRA due to income limits. I can't open a Roth IRA now and hold it for 5 years. What are my options?

[@neutralsportsfan17]

The 5 year rule applies to BOTH distributions and roth 401k conversions. I would suggest the "backdoor" Roth IRA method to get the account open and start the clock.

[@jasonzelic9030]

Good video. Thanks.

[@amerlin388]

Those who retire early may have a golden opportunity to fund their Roth via conversions, however they may want to limit income to qualify for ACA Obama-don't-care insurance subsidies before Medicare (which may require after tax monies to carry them through).

[@escargot8854]

click bait

[@rajbeekie7124]

Click bait. Waste of time.

[@Chris..440]

Contribute to both Roth IRA and Roth 401k

[@manchesterunitedakamrtread8317]

Real Estate is the only way very simple and reall

[@charlesbyrneShowComments4all]

This video doesn't make any sense about the Roth 401K tax trap. I'd be more concerned if my financial advisor wasn't aware that Roth IRAs and 401K, Roth and pretax are under different tax codes and are not the same investment instrument. Even then I would still consult with a tax attorney or CPA before doing a transfer because of the constant changes in the Federal Register, IRS rulings and tax law interpretation for something so important (my retirement portfolio). If a person already had a personal Roth IRA setup for a decade or longer and they have been contributing to their Roth IRA and then they start a Roth 401K they can rollover the Roth 401K when they retire or leave their work and can withdraw after 59.5 without worrying about the 5 year rule. If a person has only The Roth 401K they can withdraw funds at the appropriate age without consequence. If they decide that they want better investment options they can setup a private Roth IRA, keep 5 or more years of expected withdrawal funds in the Roth 401K and transfer the balance to their new Roth IRA and use those Roth 401K funds. Heck they can put any amount ($1.00) in the new Roth and just keep most of their money in the Roth 401K if they're concerned about a future financial emergency in the upcoming 5 tax years. Then later transfer the Roth 401K balance to their private Roth after the 5 year period. The only issue I can see is that they would need to have wages when they setup their new personal Roth IRA. That or have a spousal Roth account. In most cases that would be unnecessary unless the worker retires on December and then tries to setup a personal Roth IRA after April 15 the next year. Even if they missed the opportunity to setup a Roth IRA from previous year's income they could apply for a minimum wage job, work for a day, then quit or put a two week notice and put $1 in a new Roth IRA once you get your first/one-time check. So I guess it might be an issue if you aren't aware of the tax law, but there are plenty of workarounds. If you fail to prepare then prepare to fail.

[@georgewashington938]

thanks for the info great content for an 8 minute video

[@ehmiller61]

Not sure how you consider the 5 year rule as a tax trap. I was aware of that when I opened mine back in 2019. The important thing is that the earnings are still tax free. If you stay on top of your investment and watch the returns you can adjust your investment to get the maximum returns.

[@jonathanbrutt]

Thank you for allowing me to skip the whole video.

[@Je.rone_]

I second Jonathan's comment

[@michelletucker2842]

Me too! Glad you save my valuable time.

[@rayanderson3164]

Kudos on not wasting my time as well. Thank you!

[@JeanieFemia]

It's your life itself. You know, I want to check out. You know what the 11 days are lying? No sleep, I don't eat 1 day. Fine. Woke my happy a** up and yo cause I got all my knees surrendered when I knew my kids were in the mix too. How bad can it get? I never had a friend. You'll really have a family no one chose me. Knowing loved me, I was a vessel yellow for their desires. They're manifestations and they've everybody who they're dead and how it's kind of like me, Jack, it's nobody else makes me. I just want to blanket. That's right under the boardwalk. Gotta get a candle.

[@cathycathywhite8455]

So I can open a Roth IRA and a Roth 401k I'm 53

[@WiseMoneyShow]

You sure can, as long as you qualify from an income standpoint. Login to your 401(k) and shift your contributions to Roth, and work with your CFP to set up and fund a Roth IRA. Just make sure those are the best accounts to fund for your specific situation by confirming with your CFP who is doing comprehensive financial planning for you.

[@mrbigpundaddy]

You guys said that you can only open a Roth IRA if you are within the income limits...That is not true. You can “open” a Roth IRA no matter what, you just can’t “contribute” to it if you are over the income limits. That is very important to state.

[@amerlin388]

Plenty of explanations out there showing IRA vs. Roth IRA is a wash provided comparable tax rates then/now. It's all about the tax rates, at least the one guy pointed this out halfway through the show. If young people can spare the cash for IRA or Roth IRA (or 401k) and they are also not yet earning enough to be in a relatively high tax bracket, definitely should choose Roth option. Love the idea of giving the gift of funding an IRA for your children who are just starting to earn a paycheck and either can't or don't won't to sacrifice to fund it themselves. Did this for my kids. P.S. Funny seeing them mocking those who predict interest rates will go up - four years ago.

[@steves3234]

The IRS says they look at withdrawals as contributions first, than conversions, than earning. So it should not be that huge an issue

[@markh9129]

If you retire before 59 1/2 and you have a 5 year old Roth IRA, and you roll over a Roth 403b into you Roth IRA. When can you withdraw the rolled over contributions and also earning that were rolled in?

[@WiseMoneyShow]

Yep! The key is already having a Roth IRA open for 5 years.

[@markh9129]

@@WiseMoneyShow just to clarify. I could draw out those rolled over funds tax/penalty free at age 48?

[@mikesherrard8871]

@@markh9129 if you’re under 59 1/2 your contributions (which come out first in withdrawals) are tax and penalty free any earnings are still subject to taxation and penalty until you reach retirement age. They’re are some exceptions to this for qualified Roth IRA distributions.

[@splashmt99]

So you need to move a roth 401k to a roth ira, in order to access the funds in your roth 401k? Why can’t you just wd straight from your roth 401 k?

[@July.4.1776]

If you have a Roth 401k can you withdrawal from that at 59.5 without any five year look back? I am not talking converting it to an IRA.

[@WiseMoneyShow]

Great question, Tim! You must have had a Roth IRA open for at least 5 years total in order to draw the money out tax-free at age 59.5. Unlike the 5 year rule for Roth Conversions, this doesn't mean every dollar needs to stay in there for 5 years, but rather that you have to have had a Roth IRA, any Roth with any size balance, for at least 5 years.

[@dec1slh]

@@WiseMoneyShow that is not what Tim asked

[@dozendozen1238]

Click bait...Is that a tax trap??? Guys do better with your time. Simple 5 years rule not a trap.

[@dozendozen1238]

Could never subscribe to these people

[@legacyorliabilitywithsammy7261]

So how much can you safely pull from these annually in retirement?

[@whyyeseyec]

Remember, the federal taxes you paid today were spent 10 years ago.

[@kimmungkim]

So if you switch from a pre-tax to roth, how would paying tax work? Would you still pay tax ok the amount that you transfer at the time?

[@damondiehl5637]

You have to report the money you had in the traditional account plus the gains on that money, when you do your taxes. That money counts as income, and increases your Adjusted Gross Income. Depending on how much you ear, this additional money can push you into a higher tax bracket. In really rough numbers, each bracket is about $40,000 if you file single, double that if you file jointly. If you rollover, say $60,000, you are certainly going to jump into the next higher bracket if you are single, and maybe if you file jointly. You can set aside some of the money for taxes as you do the rollover. The IRS doesn't like it if you underpay your taxes, and will add a penalty if it crosses a threshhold. I've actually had that happen to me. I thought I set enough aside, but I didn't, so I had to write a check at tax time for the rollover, plus the penalty.