Better Than Shark Week: Capturing the Mega Roth in Your 401(k) Plan
The 401(k) retirement plan has become a household name to most working Americans. In case you’re unfamiliar, a 401(k) is an employer-sponsored retirement plan to which employees can make retirement savings contributions to help prepare themselves for retirement.
Given the 401(k)’s rise in prevalence since its debut in the early 80’s and our familiarity with them, it is easy to think that all 401(k) plans are the same. But this is simply not true! You might be surprised by the diversity among 401(k) plans, and it is in your best interest to understand the features specific to your plan. The goal of this article is to inform you of a lesser-known but “fan-favorite” feature that might allow you to contribute significantly more into your 401(k) in a tax-advantaged manner. Please welcome the eloquently named “mega back-door Roth”.
Do you know how much you can contribute to a 401(k)?
In 2020, 401(k) plans have a contribution limit of $19,500 for an employee under the age of 50 and $26,000 for those age 50 and above (this article assumes the employee is under the age of 50). Setting aside $19,500 per year for your retirement is an impressive feat by itself. But what if you want to contribute more than $19,500 in a given year, or if your goals require that you do so? Where should you save those additional dollars?
Some 401(k) plans allow for after-tax contributions into the plan. Unlike the typical pre-tax contributions that reduce the amount of ordinary income that you report on your income tax return, after-tax contributions do not provide a tax-deduction and any gains are taxable when you withdraw the money. You’re probably thinking that sounds like the worst of both pre-tax and Roth contributions, and you’re wondering why you decided to read this article. But this is where it gets good because you can contribute more than you think. If your plan allows after-tax contributions, you may contribute an additional $37,500 to the after-tax portion of your plan for a total of $57,000 in 2020! If left alone, any growth on those excess contributions would be taxable upon withdrawal. And if you stopped here, it would be like preparing a Thanksgiving Day feast and not eating any of it.
Now it’s time for the “mega back-door Roth”.
Your after-tax contributions can and should be converted to Roth and there is no tax liability for doing so. Roth assets grow tax-free for the life of the account, making them the most attractive type of retirement asset to own. By contributing to the after-tax component of your 401(k), and then converting those contributions, you are taking dollars that would ordinarily have been taxable and making the growth and earnings tax-free for the rest of your life.
Read that again.
Had you invested these funds in a non-retirement investment account, you would pay taxes on dividends and interest each year as well as any growth in the account when you sold the investment. This strategy helps you build tax-free assets in your retirement plan and removes the income and contribution limitations that exist in Roth IRA accounts. That’s right, you can take advantage of this strategy regardless of your income as long as it is offered in your 401(k) plan. Furthermore, your contribution limit goes from $6,000 in a Roth IRA to $57,000 in a 401(k).
We realize that you might not be able to save that much right now and your normal $19,500 401(k) contribution limit will suffice for your goals. If you are reaching that and you are on track to hit your goals, well done! But we want you to know that this “mega back-door Roth” may be an available option for you. Chances are, if you’re spending the time reading this article, you are motivated to build a strong financial plan and you will exceed the $19,500 contribution limit eventually.
So keep this in your back pocket, and if you need help understanding the options available to you in your retirement plan, consult your benefits department because the mechanics of this process vary slightly per plan.
Our goal is to empower purpose-filled lives and we find great joy in helping people navigate the complexities of personal finance. Give us a call if you think we can help you and we’re happy to spend the time with you.