Most retirement savers haven’t heard of an after tax 401k Roth conversion. It’s a pretty unique thing after all, and unfortunately it doesn’t apply to most 401k savers. If it does however, it’s an amazing deal!
For 2017, most 401k participants can contribute $18,000 to their plan. They can get a nice tax deduction for it too!
For the current tax year it’s like you never even earned that pre-tax contribution. This could save you thousands of dollars in current tax liability.
If the plan allows however, a 401k saver could forego the current tax break and contribute to a Roth component of the 401k plan. They wouldn’t get an immediate tax break, but they’d enjoy a tax free retirement later.
Some plans even allow after-tax contributions over and above the deductible or Roth limits. When handled properly, these contributions can become after-tax 401k Roth conversions.
Retirement Savings Recap
Remember, there are two MAIN types of retirement savings, pre-tax and Roth. Most investors forget about the ability to do after-tax contributions as well.
Here’s the quick recap:
- Pre-tax 401k contribution. You get an immediate tax deduction as if you never earned the money for income tax purposes, AND your investment grows tax deferred. You pay taxes on the money when you withdraw it, typically in retirement. Withdrawals prior to age 59 and 1/2 will generally be subject to taxes and a 10% penalty.
- Roth 401k contribution. You get NO immediate tax break. Your investment grows tax-deferred however, and can be withdrawn in retirement with no income tax due. There’s also NO requirement for age 70+ distributions.
- After-tax 401k contribution. You get NO immediate tax advantage, however you establish “basis” of the contributed amount in your 401k plan. That basis can be withdrawn later as a pro-rate return of principle. Your earnings will grow tax-deferred, however you’ll pay ordinary income tax on them when you withdraw in retirement.
The Annual Defined Contribution Limit
One key to an after-tax 401k Roth conversion is the annual defined contributions plan limit. That limit is the ultimate maximum any defined contribution plan can accept for a particular year from employer contributions, employee contributions, and forfeitures.
If you’re age 50 or older, it’s important to know this limit is net of the “catch-up” provision. In other words, any catch up contribution the worker is eligible for is added on top of the annual defined contribution plan limit. For 2017 the maximum contribution is $54,000 (add another $6,000 if the employee is age 50 or older).
What Is An After-Tax 401k Roth conversion?
Not every 401k plan allows participants to make after-tax voluntary contributions above the normal contribution limits. Remember, these are NOT Roth contributions, and not tax-deductible contributions. Over the $18,000 limit, those contributions may then later be converted to a Roth IRA. Here’s an example of how it works:
- Jane has a 401k at work. She contributes the maximum $18,000 pre-tax because she’s in a high income tax bracket.
- Jane is also 51 years old. She takes advantage of the “catch-up” rules and contributes additional $6,000 per year as her “catch-up” contribution.
- Jane contributes a total of $24,000 to her 401k plan.
- The annual defined contribution limit for Jane is $59,000. That’s the normal $53,000 plus the catch up contribution of $6,000.
- Assuming the company has no match and Jane is eligible, she can contribute an additional $35,000. That’s the $59,000 annual additions limit minus the $24,000 already contributed.
- The $35,000 contribution DOES NOT get a tax deduction. The earnings however will grow tax-deferred.
- When Jane retires, the $35,000 can be separated and rolled into a Roth IRA under IRS 2014-54.
If Jane’s company is awesome and she has a 401k match or other contribution made for her, she’ll need to reduce the amount she can contribute after-tax. If the company matches her contributions in the amount of $5,000, the maximum after-tax voluntary contribution is reduced to $30,000 ($59,000 minus $24,000 minus $5,000). She must also be aware that if she’s an HCE (highly compensated employee) she may run into issues with ACP (average contribution percentage) testing.
Prior to IRS 2014-54 the pro-rata rules applied
The 2014 IRS ruling changed the game completely. Prior to that, pro-rata rules would apply to rolling any after-tax 401k funds into a Roth IRA.
Let’s say you saved $500,000 in your 401k. For various reasons $100,000 of that amount was contributed after-tax. That $100,000 is basis and will not be taxed, however pro-rata rules affect your distributions.
You can’t simply withdraw $100,000 when you retire and say it’s all of your pre-tax contributions. That would be far too simple! Rather it’s like a cup of coffee with cream.
When you fund your 401k with pre-tax contributions that’s the coffee. If all you have is pre-tax contributions when you pour out the coffee it’s 100% taxed as ordinary income.
Your after-tax contributions are the cream. When you add cream to the coffee you can’t separate the two – they’re mixed together forever! Hence when you take IRA distributions and pour out the coffee, a pro-rata portion of that is cream.
In the example above 80% of the 401k is taxable ($400,000 divided by $500,000), and 20% is not taxable ($100,000 divided by $500,000). If you retired and rolled $100,000 to a Roth and $400,000 to an IRA 80% of the Roth would be taxable. You can’t separate the coffee from the cream.
Now with the 2014 ruling you can distinguish between the two types of contributions. The after-tax contributions can be rolled directly into a Roth IRA and the pre-tax contributions can be rolled into an IRA. This IS a game changer!
Income limits don’t apply
The beauty of supercharging your 401k with after-tax voluntary contributions is regular income limits don’t apply. Normally, high income earners may be prohibited from funding a Roth IRA due to income limits. For example, married filing jointly couples cannot contribute to a Roth IRA if their income is higher than $194,000. Single filers can’t fund a Roth IRA if their income is greater than $132,000.
But these income limits do not apply to 401k contributions. No matter what your income level, you can maximize your 401k contributions up to the normal and annual additions limit. This of course may be inhibited if you’re a highly compensated employee and your plan fails annual non-discrimination testing.
After-tax contribution earnings are separate
Remember the after-tax 401k Roth conversion applies to contributions only. We’re not including the earnings on those contributions. In Jane’s example, if you contribute $35,000 and it grows to $45,000 over time only the $35,000 is eligible for the after-tax 401k Roth conversion.
Earnings on your after-tax contributions are considered pre-tax. Those earnings must be rolled into an IRA when you retire. When you ultimately distribute those funds they’re taxable as ordinary income.
This isn’t a bad deal however. It would be great if you could roll the earnings on your after-tax contributions to a Roth, but just being able to roll the contributions to a Roth is pretty powerful!
What to do now?
The key is does your plan allow for after-tax contributions. Many plans do not, and if your plan doesn’t allow for them unfortunately you’re out of luck with this strategy. So the very first step is to contact your 401k plan administrator and see if the plan allows you to make after-tax contributions.
If your plan allows for it, max out your 401k first ($18,000 or $24,000 if you’re 50 or older for 2016). After that, sock more money after-tax into your plan up to the annual additions limit. Pay special attention not to fund your 401k plan over the limit, and remember the limit is from all contribution sources!
Thanks to IRS 2014-54 you may have an awesome opportunity to save a LOT of money after-tax. This can later be converted to a Roth IRA when you retire. Outside of the potentially triple tax-free Health Savings Account contributions, this is probably one of the best retirement savings tools I’ve ever seen!