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Supercharge Your Retirement Savings with Mega Backdoor Roth Contributions

Roth 401(k)'s are steadily gaining acceptance from employers.  If the retirement plans that Vanguard administers are any guide, more than two-thirds of employers now allow Roth 401(k) contributions.  Unfortunately, however, plan participants have been much slower to take advantage of their ability to make Roth 401(k) contributions. Among the same Vanguard retirement plans with this feature, only about 11% of employees are choosing to make Roth contributions.  (For a primer on Roth 401(k) retirement plans, please click on The ABC's of the Roth 401(k) Plan.)

This is a shame.  Roth 401(k) contributions are especially advantageous to younger workers still looking forward to their peak earning years.  And for higher-paid employees, Roth 401(k)'s may be the only way to contribute to Roth-style accounts.  (For a more detailed discussion of whether you should contribute to a Roth 401(k) plan, please click on Are Roth 401(k)'s Right For You?)

Now here's a way - courtesy of some fairly recent clarification from the IRS - to potentially supercharge the pace of your contributions to Roth-style accounts at the workplace, regardless of whether or not your employer offers a Roth 401(k) feature.  Many of you 401(k) and 403(b) participants will be aware of the current annual limit on your elective salary deferrals of $19000, or $25000 if you're age 50 or older.  These can be pre-tax contributions, Roth contributions, or a combination of both, if your employer offers a Roth feature on your plan.

Unknown to a lot of corporate employees, on the other hand, is that there is another limit relevant to their 401(k) accounts.  This so-called Section 415 limit regulates the total amount of contributions, regardless of source, that may be added to an employee's account in a given year.  It's this limit that typically puts a cap on employer additions, i.e. matches, profit-sharing contributions and the like.  This year, the Section 415 limit is $56000, or $62000 with the catch-up provision.

So if your employer and the plan administrator allow it, there is actually nothing to stop you from topping up your annual contribution to your 401(k) or 403(b) account with after-tax dollars.  These don't count towards the $19000 (or $25000 with catch-up) "elective deferral" limit.

An example might help.  Let's say you are 45 years old, you max out your 401(k) account with $19000 of pre-tax contributions, and your employer matches 50 cents on the dollar for another $9500 into your account.  You could then potentially contribute another $27500 after-tax into your account for a total of $56000.

It should be carefully noted that these after-tax contributions are not Roth contributions.  After-tax contributions can be made regardless of whether or not your 401(k) plan has a Roth feature.  In addition, earnings on Roth balances are tax-free when eventually withdrawn, whereas earnings on after-tax contributions are taxable when withdrawn.

This being the case, why make after-tax contributions to a 403(b) or 401(k) account?  Well, the IRS guidance mentioned above made it clear that when you eventually separate from service with this employer (or possibly even sooner), you will be able to rollover the total after-tax contributions you have made through time to your 401(k) account directly into a Roth IRA tax-free.  The remainder of your 401(k) account balance, including any earnings made on your after-tax contributions, may be rolled over into a regular IRA tax-free.

So going back to our example, you faithfully continue contributing $27500 after-tax to your 401(k) or 403(b) every year for 20 years until age 65.  You retire and end up with a $550,000 Roth IRA tax-free in addition to the Rollover IRA you would have received anyway, but now the latter also contains earnings accumulated on all those after-tax contributions and these earnings also remain tax-deferred until withdrawn.  And again, this is possible regardless of whether or not your employer offers a Roth 401(k) and regardless of whether your income precludes you from making Roth IRA contributions directly.

So should you make after-tax contributions to your retirement plan in addition to making the maximum pre-tax or Roth contributions?  Assuming you have the excess cash flow to do so and assuming that the investment options within the plan are relatively attractive, the answer to this question will also depend on: (a) the rules governing the plan that have been established by your employer, and (b) the capabilities of the plan's service provider.  

There are 3 possible ways that your after-tax contributions may be converted to a Roth account:

1.    Your retirement plan may allow, and its service provider may be capable of executing, “in-plan conversions”. This means your after-tax 401k contributions would be converted into a Roth 401(k) account within the plan tax-free.

2.    Your retirement plan and its service provider may allow “in-service distributions”.   If option 1 is not permitted, you may be able to rollover your after-tax balance within the plan to a Roth IRA outside the plan tax-free while you’re still employed there.

3.    Your plan allows neither option 1 nor 2.  However, when you separate from service with this employer, you will then be able to rollover your after-tax balance (but not the earnings thereon) into a Roth IRA tax-free.

The bottom line is that the sooner your after-tax contributions will be converted into a Roth account of some type, whether a Roth 401(k) account within the plan or a Roth IRA account outside the plan, the more attractive making these contributions becomes.  The reason for this comes back to the difference in how earnings on Roth balances are treated vs. how earnings on after-tax balances are treated.  

Recall from above that earnings on Roth balances are themselves tax-free if qualified, whereas earnings on after-tax contributions are added to your pre-tax plan account balance, and remain to be taxed as ordinary income when eventually distributed to you.  The ideal situation, then, is for your after-tax contributions to be converted to Roth balances before they have a chance to generate earnings.  In contrast, if it will be years before you can rollover your after-tax balance into a Roth IRA, i.e. only after you separate from service, then after-tax contributions to your retirement account become a less attractive proposition.

About the Author

Paul Winter, MBA, CFA, CFP® is a Fee-Only financial advisor and fiduciary in Salt Lake City, UT. His independent wealth management firm, Five Seasons Financial Planning, provides professional portfolio management and objective financial planning services to individuals and families, and to their related entities including trusts, estates, charitable organizations, and small businesses.  

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