Nowadays, many employer retirement plans give employees the option of contributing to designated Roth accounts (DRAs). According to a 2020 survey, 75% of employer plans now offer DRAs, which are also known as Roth 401(k) accounts.
If your employer offers this option and your income is too high to make annual Roth IRA contributions, contributing to a DRA is worth considering. This option also may be worthwhile if you expect to pay higher federal income tax rates during your retirement years than you’re currently paying. Here’s more information about DRAs.
Nuts and Bolts
If your company’s qualified retirement plan allows you to make contributions out of your salary to a regular 401(k) account, the plan may also include the DRA option.
Important: 403(b) and 457(b) plans can also offer DRAs. Contact your tax advisor for more details on DRA offerings through these plans.
When you contribute to a regular 401(k) account, the contribution reduces your taxable salary. This reduces your federal income tax bill and your state income tax bill, too, if applicable.
In contrast, when you contribute to a DRA, you’re taxed on the contribution as if it’s part of your salary. The payoff is that earnings in your DRA can accumulate free of federal income tax, and you can eventually take federal-income-tax-free qualified withdrawals from the account.
In general, a qualified withdrawal means one taken after your DRA has been open for more than five years and you’re at least 59½. Qualified withdrawals can also include withdrawals after becoming disabled or withdrawals taken by an account beneficiary after the original account owner has died.
Your employer must keep your DRA funds in a separate account that can be rolled over into either your own Roth IRA or into another qualified plan that permits DRAs.
There are no income limits on the DRA contribution privilege. For 2021, you can contribute up to $19,500 ($26,000 if you’ll be age 50 or older as of December 31, 2021). These are the same as the contribution limits for regular 401(k) plan contributions. (See “DRA Contributions vs. Annual Roth IRA Contributions” at right.)
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. That said, employer matching contributions are always good because they’re “free money.”
2 Key Factors to Consider with DRAs
The two most important factors to consider when evaluating this option are:
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 can be appealing 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, suppose your DRA contributions would be taxed at a 24% federal rate for 2021, and you expect to be in the 32% tax bracket in retirement. In this situation, the privilege of taking future tax-free DRA withdrawals is worth more than the current tax cost of making DRA contributions.
In-Plan Rollovers into DRAs
If your company 401(k) plan allows DRAs, it may also allow you to roll over funds from your regular 401(k) account into a DRA. A so-called “in-plan rollover” is the quickest 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 treated the same as a Roth IRA conversion transaction.
Important: 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 unless an exception applies.
DRA Rollovers into Roth IRAs
When you leave the company, you can roll over your DRA balance into a Roth IRA. Then you won’t have to take any annual required minimum distributions (RMDs) from the Roth IRA for as long as you live. So, you can keep earning 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 die, whoever inherits the account can take tax-free withdrawals after meeting the rules for qualified withdrawals.
DRA Contributions vs. Annual Roth IRA Contributions
There are no income limits on contributions to a designated Roth account (DRA) if one is offered by your employer. For 2021, you can contribute up to $19,500 ($26,000 if you’ll be age 50 or older as of year-end).
In contrast, there are income limits on contributions to a Roth IRA. 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 ($198,000 if you’re married and file a joint return). Your ability to contribute is completely phased once AGI reaches $140,000 if you’re unmarried ($208,000 if you’re married and file a joint return).
In addition, the limits on annual Roth IRA contributions are lower than the limits on DRAs. For 2021, the maximum contribution to a Roth IRA is only $6,000 ($7,000 if you’ll be 50 or older as of December 31, 2021).
So, the DRA contribution privilege is potentially much more beneficial than the annual Roth IRA contribution privilege. However, 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.
Contact your tax advisor to discuss which DRA options might make sense for your situation.
If your company plan includes the DRA option, give it a hard look. This option may be especially beneficial if your employer would match your DRA contributions, your income is too high to make annual Roth IRA contributions, and/or 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 your company plan includes that option. But you must understand that there’s a tax cost for making an in-plan rollover. We can help you evaluate your DRA options.