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Supercharge Your Retirement Savings with Mega Backdoor Roth IRA 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, that 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 even sooner if your employer allows "in service" distributions), 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 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.

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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