After-tax 401(k) limits you don’t know about & a backdoor Roth

The normal 401(k) plan contribution rules allow you save money from your paycheck before you pay taxes on it, and pay taxes as if it was income when you withdraw the funds after age 59 and 1/2 (generally speaking, and during retirement). Some plans even allow after-tax contributions in the form of a Roth 401(k), and if handled properly you’ll never pay taxes on those withdrawals.

For 2015 and 2016 the 401(k) contribution limits (pre-tax contributions or after-tax Roth contributions) is $18,000 if you’re younger than 50, and an additional “catch-up” contribution of $6,000 if you’re 50 or over. So your max 401(k) contribution is $18,000 or $24,000 per year depending on your age.

But what’s more interesting is the REAL contribution limits and the new 401(k) rules which most people don’t know about. There’s a rule called the “annual additions” limit. The annual additional limit says that your absolute maximum contribution from all sources to a defined contribution plan is $53,000 for 2015 and 2016 (up to 100% of compensation).

After-tax 401(k) maximum contribution levels are different? Let me explain.

Many plans allow for after-tax 401(k) non-deductible contributions. They’re not pre-tax, so there’s no tax deduction when the contribution is made. They’re not Roth 401(k) contributions either… yet! Who would want to make a 401(k) contribution you can’t deduct and isn’t a Roth contribution? There are a few reasons one would do this:

  • Your taxes are expected to be substantially higher in retirement
  • You really want to save more than the pre-tax 401(k) and Roth 401(k) limits
  • You have a good 401(k) plan with good low cost investment options – better than you could get on your own
  • You want to be able to borrow from your 401(k) plan in an emergency
  • You want the ERISA creditor protection that the 401(k) plan provides
  • You want the ability to withdraw funds and avoid the 10% penalty between the ages of 55 and 59 and 1/2 (or after age 50 in the case of public safety workers)

Here’s one more GIGANTIC reason to put more into your 401(k) plan than the pre-tax and Roth limit: Your after-tax contributions can now be rolled into a Roth IRA when you terminate employment. That’s right, essentially you’re funding a future Roth IRA with your after-tax 401(k) contributions!

Sounds too good to be true I know, but let’s look at how this actually works – because it really does!

Prior to IRS Notice 2014-54, if you had pre-tax and after-tax 401(k) contributions upon terminating employment you would need to roll both components into an IRA, and keep track of what’s called your “basis” (meaning your after-tax contributions). With each distribution, a portion was taxable and a portion was a return of your after-tax contributions.

Under new rules when you terminate employment you can roll over only the pre-tax amounts to a rollover IRA, and the after-tax contributions can be converted to a Roth IRA. Doing this gives you a nice IRA rollover of pre-tax amounts, and a great Roth IRA rollover.

Why does this work? The after-tax contributions are not taxable because you never received a deduction in the first place. Since you never got the deduction, you’re eligible to roll those after-tax contributions into a Roth IRA. Hence you can do a direct conversion of after-tax contributions from your 401(k) to a Roth IRA when you terminate employment, while at the same time rolling over your pre-tax contributions to a rollover IRA which ultimately will be taxable income to you.

The rules make maxing out your 401(k) not just to the annual pre-tax or Roth 401(k) limits, but to the full annual additions limits – highly advantageous.

Given our current laws, the best strategy generally runs something like this:

  • Contribute to your 401(k) plan up to the matching contributions from your employer
  • Further max out your 401(k) plan with pre-tax contributions (if your tax rates are high) or after-tax Roth contributions (if your current tax rates are low)
  • Contribute up to the maximum annual additions limit of $53,000 (2016) with after-tax contributions which eventually will be converted to a Roth IRA
  • Integrate your overall investment allocation of taxable and retirement accounts putting low yield or tax free bonds in your taxable accounts if any
  • Consider a low-cost non-qualified deferred annuity for any additional savings

For high-income earners this is a great deal! Save 53K into your 401(k) plan, get a tax deduction of between $18,000 and $24,000, and roll any additional amounts of after-tax contributions to a Roth IRA when you retire. Let’s hope the government doesn’t wipe this off the map like they did the file and suspend social security strategy a couple of months ago.