By Andy Ives, CFP®, AIF®
A time machine would be cool to have. Even if it only worked on financial assets, it sure would come in handy. One might jump into the future and see if an investment paid off, or you could look around to see where the smart money succeeded. And if the original investment turned out to be a loser, you could go back in time and sell it – or never even buy it in the first place.
Too bad financial time machines don’t exist. Bummer.
While literal time machines have yet to be invented and we can’t quantum leap, there is a way for some of us to figuratively “fast-forward” time. While only Marty McFly can climb into a DeLorean customized with a flux capacitor, a lucky few may be able to at least send some of their money into the future.
How, you ask? Take, for example, co-workers Albert and Biff. Both are age 62. Albert has a Roth IRA, which he started way back in 1998 when the Roth IRA was first created. Albert understood that it was important to get his 5-year clock moving. Even though he only funded his original Roth with $20 bucks, his clock still began to tick in 1998. Albert knew that once the 5-years were up and he was age 59 1/2, his Roth IRA earnings would be tax free. He also knew his 5-year holding period began when his first Roth IRA was established and would not re-start for each subsequent Roth IRA contribution or conversion.
The administration at Albert and Biff’s place of work has been less proactive. The company started a 401(k) just two years ago and had the foresight to include a percentage match. Albert was pleased to see the plan also included a designated Roth account, to which he deferred the maximum.
Just like Albert, co-worker Biff also made salary deferrals to the 401(k) designated Roth for the past two years. However, Biff does not have a Roth IRA outside of the plan. He only has a traditional IRA because he never saw the value of getting his 5-year clock started.
Albert and Biff retire on the same day in 2019. They roll their 401(k) dollars – the money that has only been in the company plan for two years – to their IRAs. These rollovers consist of three things: pre-tax employer match dollars; employee contributions to the designated Roth account (after-tax); and earnings. Biff’s pre-tax money rolls to his traditional IRA. He also opens a Roth IRA as a destination for his designated Roth 401(k) dollars and the earnings on those Roth dollars. Biff’s designated Roth 401(k) earnings climb into a time machine and go BACKWARDS. Even though he funded the designated Roth 401(k) for two years, Biff must wait another five years before his earnings are tax free. Why? His Roth 401(k) earnings assume the 5-year clock of his new Roth IRA. Poor Biff. He received some bad advice. He should have left his designated Roth money in the plan for a few more years and never climbed into the time machine.
Albert completes a similar rollover. He opens a new traditional IRA to accept the pre-tax 401(k) employer match, and he directs the designated Roth 401(k) dollars and earnings into his existing Roth IRA. Albert’s designated Roth 401(k) earnings ZOOM FORWARD in time by three years and assume the clock within his existing Roth IRA. Even though he only participated in the 401(k) plan for two years, and even though the designated Roth rollover was “non-qualified” (because it had only been held for two years in the plan), Albert took advantage of the rule allowing his Roth IRA clock to supersede the 401(k) clock. All his Roth earnings are immediately tax-free.
Getting his Roth IRA clock ticking was a smart move by Albert. Those $20 bucks back in 1998 were dollars well invested. Marty McFly would be proud.