One Question to Ask HR if You Are Already Maxing Out Your 401k Contributions

I recently spoke with a client interested in additional tax-saving options for retirement. She works for a large corporation and is currently contributing the IRS maximum amounts into her traditional 401(k) plan and Roth IRA. Since she is already maxing out her 401(k) plan and Roth IRA, she wanted to find out whether any additional tax saving options were available. Once I gained a full understanding of her financial picture, I was able to point her towards a Mega Back Door Roth Strategy. For this strategy to work, there is one question that she had to ask her human resources department.

Does the 401(k) plan allow after-tax contributions in addition to pre-tax 401(k) or Roth 401(k) contributions? If the answer is “Yes,” this strategy will work. If the answer is “No,” we, unfortunately, will have to look for other ways to save.

This strategy is preferred over other investment options because it essentially allows individuals to make extra Roth IRA contributions by making use of after-tax contributions allowed by their 401(k) plan.

Let’s look at an example to see how the strategy works:

Jane is 45 years old, earning $150,000 per year. She is already contributing the maximum amounts into her 401(k), Roth IRA, and HSA in the amounts of $19,000, $6,000, and $3,500, respectively. Jane has additional cash flow available, and she is looking for ways to save this money in the most tax-advantaged way. When Jane asks her HR department whether after-tax contributions are allowed in her 401(k) plan at work, she is told that they allow up to 10% of her annual salary to be contributed to an after-tax account. Given this information, Jane decided to contribute the maximum allowed of $15,000 into the after-tax account each year.

Jane will now have three separate buckets of money within her employer 401(k) plan: pre-tax contributions, employer matching contributions, and after-tax contributions. Each of these buckets is a combination of the money that Jane or the employer contributed and the amount that those contributions grew over time.

Once Jane leaves her employer, she will have the opportunity to rollover her funds from the 401(k) plan to an outside investment company. This is where the advantage of this strategy becomes apparent. Jane will rollover her pre-tax contributions and her employer matching contributions into an IRA, but the after-tax contributions are treated differently. Jane’s contributions into the after-tax bucket are rolled over into her Roth IRA, while the growth of those contributions is rolled into her IRA. This means that Jane could make annual Roth IRA contributions of $21,000 ($15,000 in after-tax contributions plus $6,000 into her Roth IRA) while making her pre-tax 401(k) contribution of $19,000 per year.

Can we increase the tax advantages of this strategy even further?

If Jane’s 401(k) plan allows in-service distributions in addition to after-tax contributions, the advantage of this strategy is further enhanced. Here is how it works:

In our example, Jane made her after-tax contributions of $15,000 into her 401(k) account, which grew tax-deferred until Jane left the company. To further enhance this strategy, we will have Jane make her after-tax contributions of $15,000 into her 401(k) account and immediately request an in-service distribution of her $15,000 to roll it over into her Roth IRA. This allows the $15,000 to start growing tax-free instead of tax-deferred, which can have a significant effect on her retirement balances.

How much of a difference does it make?

If Jane makes a $15,000 after-tax contribution into her 401(k) account every year from age 45 to age 65 and it grows an average of 8% per year, her after-tax account will be worth approx. $686,430. Her contributions over those 20 years are $300,000 and the growth in the account is $386,430 over 20 years.

If the plan does not allow for in-service distributions, then Jane will rollover her $300,000 in contributions to her Roth IRA upon retirement and she will rollover her $386,430 of growth to her IRA upon retirement. When she later takes the $386,430 out of her IRA for retirement, it will be counted as taxable income so she will owe approx. $85,000 in Federal taxes (22% tax rate).

If on the other hand, the plan does allow for in-service distributions, then Jane will be taking her $15,000 out of the 401(k) every year and rolling that into her Roth IRA so all the growth will occur inside the Roth IRA tax free. This means that she will not owe any taxes on the full account balance of $686,430 upon retirement.

Mega Back Door Roth Flowchart:

If you are currently maxing out your 401(k) and Roth IRA contributions and are looking for additional ways to save, please feel free to contact me to develop your customized plan.