Most employees who utilize a 401(k) plan to stash part of their salary away for the future are probably aware that there are limits on how much they can contribute. In 2017, that limit is $18,000 for those under age 50, and $24,000 for those age 50 and above.3 Of course, the primary motivation for most people who use a 401(k) plan to begin with for such savings (besides accessing company matching contributions) is the tax deduction. Effectively, getting a tax deduction means that for every two dollars the typical employee contributes, the government ponies up a third.2 That kind of assistance, coupled with time, compound interest, and tax-deferred growth, is what has made 401k plans so popular to begin with. But what if you could use a little known option in some 401(k) plans to contribute on an after tax basis to your 401(k), and then convert those funds to a Roth IRA at retirement?
Well, thanks to a recent IRS rule change, now you can.
What Are “After-Tax” 401k Contributions?
While the regular “pre tax” contribution amounts are larger than most other retirement plan options available, there are still some employees that want to do more. In these cases, a small minority of plans offer the ability to put more away, but with the important caveat that you don’t get a tax deduction. These are called “after-tax” contributions, and in some cases they can increase the total contribution limit by tens of thousands of dollars.1
But since these contributions do not get a tax deduction, why do them? While some have argued the tax-deferral alone (the ability to avoid taxation on the gains in the account from year to year) is attractive, most investors haven’t been persuaded. Thus, after-tax contribution features have been relatively unused until this important shift in policy came down from the IRS, which allows job changers to convert their after tax 401(k) accounts to Roth IRAs.
Rolling After-Tax Dollars into a Roth IRA
Before the rule change, some taxpayers had argued that they should be able to roll over after-tax contributions into a Roth IRA when they leave employment, just as before-tax contributions can be rolled into a Traditional IRA. The rules were not entirely clear, so some plan participants had even been going forward with the idea, presumably thinking it better to “ask for forgiveness than permission.” And for their part, the IRS had taken every opportunity to express their disagreement with this interpretation, but there lacked a definitive decision on the matter in the tax courts. However, in 2014, the IRS released Notice 2014-54 which essentially reversed their position and sanctioned the practice. What this means is that those with this unique opportunity can now contribute up to $36,000 per year (in the best cases) into the after-tax portion of their 401(k), and then rollover the entire after-tax account into a Roth IRA at retirement.
This is incredibly attractive to aggressive savers, because the limit on Roth IRA contributions is only $5,500 per year, and even that is limited to taxpayers under certain income limits. Of course, many of the people that would be interested in socking away extra money tax-free are also the highest earners, and therefore aren’t able to access the Roth IRA at all. Now, however, if they have access to the after-tax contribution option in their 401k, they can sidestep the contribution and income limits altogether.
Earnings on After-Tax Contributions are Pre-Tax
One important caveat on this strategy is to realize that earnings on any after-tax contributions are considered part of the pre-tax portion of the total 401(k) balance, and therefore would have to be rolled over into an IRA at retirement. Only the actual after-tax contributions themselves can be rolled over into the Roth IRA. However, once in the Roth IRA, both the contributions and any earnings remain tax-free forever.4
I should also point out that very few people stay in the same job for their entire careers. So, each time you switch jobs, you can rollover the after-tax contributions into a Roth IRA, and have plenty of time for earnings to accumulate tax-free. In the meantime, earnings on after-tax contributions within the 401(k) will eventually end up in a tax-deferred IRA, and thus still avoid taxation for many years, even decades.
After-Tax 401k to Roth IRA Example
Assume that you work for ten years at a job with a 401k allowing after-tax contributions. During this period, you max out the regular 401k contributions at $18,000 per year, and receive a company match worth $5,000. In addition, you contribute another $25,000 in after-tax contributions per year. Assuming an 8% compounded return over that period, you would end up with a total 401k balance of about $750,000.
Of that total balance, $250,000 would consist of your after-tax contributions (not earnings) and the rest would be the pre-tax portion. So after you leave the company, you would simply request to rollover the $250k into a Roth IRA and the approximately $500k+ of pre-tax money into a traditional IRA.
There are more aspects to consider when deciding whether or not this strategy is for you. However, those with 401(k) plans that allow this and who want to save additional amounts for retirement may want to at least consider the option. As always, I highly recommend working with an objective, unbiased CFP professional to help you think through the important factors in this decision, and to help determine if this is a good fit for you. But for those that have the opportunity, after-tax 401k to Roth IRA rollovers can be a tremendously profitable strategy over the long term.
1) The amount of after-tax contributions is limited based on the IRS’s limit on the total amount of employee and employer contributions to the plan in any given year (section 415(c)). The total contribution limit for 2017 is $54,000; therefore, the maximum one could contribute would be $54,000 less $18,000 of pre-tax (or Roth) contributions, or $36,000. This amount would also be reduced by any employer contributions (matching or otherwise) to the account as well, and could also be reduced by the individual plan rules as well. Every plan is unique, so check with your HR department to learn more. 2) While the government doesn’t literally write a check to your 401k, the tax deduction allows you to put more money into the account, which accomplishes the same thing. Take this example: let’s say you want to put $10,000 into your 401k account. Without the tax deduction, that $10,000 would first be taxed before you even receive it, and therefore you would probably lose about $3,500 to taxes (depending on your tax bracket, of course). Since that didn’t go to the IRS because you put it directly into your 401k and received a tax deduction, it’s like the government is matching your contributions. 3) Additionally, some highly-compensated employees are also limited based on non-discrimination rules, but this situation is rare. 4) Forever meaning for the rest of the Roth IRA owner’s life. Roth IRA beneficiaries eventually do have to withdraw the funds during their lifetimes.