The After-Tax 401(k) to Roth IRA Strategy
You’re near retirement age, or planning to change employer in the next few years. You have the ability to access $30,000 per year of after-tax money through cash-flow or accumulated savings in a taxable account. You have a 401(k) plan with an after-tax contribution option (most DO NOT have this option, so check with HR).
If the preceding describes your situation, you’ll be well served by considering the after-tax 401(k) to Roth IRA strategy.
Illustration of the Benefit
Let’s illustrate this with a chart where we start out with $50,000 and grow it at 6% per year. For the taxable account, we’ll assume 15% tax every year. The Roth IRA is tax-free.
At the end of our 20-year period, the Roth IRA stands at $151,280 while the taxable account is only at $128,654 – a $22,626 (18%) difference. The key is that this difference requires virtually zero effort – it’s as simple as moving money from a taxable account into a Roth account. The trick is in getting the money into the Roth account – we’ll have to navigate some IRS limitations.
*This is a hypothetical example and is for illustrative purposes only. No specific investments were used in this example. Actual results will vary. Past performance does not guarantee future results.
For 2017, the maximum Roth IRA contribution is $5,500 plus for those folks over 50, an additional $1000 catch-up contribution. If you have a 401(k) plan with a Roth option, the applicable limits are $18,000 plus a $6,000 catch-up contribution. These limits are fairly low, especially if you do not have a Roth 401(k) option. In that case, it would take us nearly a decade just to put away $50,000 into a Roth IRA. We need another way.
Supercharging Your Roth IRA Account
To build truly substantial Roth assets, we have two viable options; Roth Conversions, and the After-Tax 401(k) to Roth IRA strategy. Roth conversions are by far the more common scenario (transfer money from IRA to Roth IRA, pay applicable taxes), so we’ll focus on the more obscure After-Tax 401(k) to Roth IRA strategy.
The key is that 401(k) accounts have two sets of contribution limits – one is for elective deferrals ($18,000 + $6,000 catch-up) and the other is for the total contributions ($54,000 plus $6,000 catch-up). The total includes elective deferrals PLUS employer matching, forfeitures, profit-sharing, and after-tax contributions. In practice, you should be able to contribute around $30,000 per year toward the after-tax account, after elective deferrals, depending on how generous your employer is with matching and profit-sharing contributions.
You’ll need to have a 401(k) account that accepts after-tax contributions. Most 401(k) plans do not have this option, so you should check with your HR department. If your plan does not offer it, you can work with HR to have the option added. Be prepared for a fight – you’ll need to come armed with knowledge of how this would help the employer retain talent, along with costs and benefits. If the after-tax option is available, using it is as simple as setting up contributions to go toward the after-tax account through payroll deduction.
Once you terminate your employment, any after-tax contributions (just the contributions, not the earnings) will be eligible for rollover into a Roth IRA account. The earnings component, along with any pre-tax contributions are eligible for rollover into a Traditional IRA account.
As you can see, it’s entirely possible to create a 6-figure Roth IRA account in only two years, through a combination of Roth 401(k) contributions and after-tax 401(k) contributions. We’ve just increased the maximum Roth contribution amount by over 100%!
A Note on the Ordering of Contributions
While the after-tax 401(k) to Roth IRA strategy is powerful in gearing up the amount you can contribute toward a Roth IRA, it should seldom be the primary savings vehicle. In most cases, we recommend the following order:
HSA (if available)
Pre-tax or Roth 401(k) or other retirement plan
Traditional IRA or Roth IRA
After-tax investment or savings account
The ordering above is essentially the tax-efficiency of each account type. The after-tax 401(k) contributions are neither tax-deductible, nor tax-free unlike HSA (deductible & tax free withdrawals), pre-tax (tax-deductible) or Roth (tax-free withdrawals) contributions. This means that we should only use it once we have hit the limits of the options above it. There may be some edge cases, where for tax reasons and lack of a Roth 401(k) option, we might use the after-tax 401(k) account prior to funding a pre-tax retirement account.
How your personal savings accounts should be structured depends on multiple factors including planned retirement date, income, tax considerations, cash-flow, and goals. If you feel like you could use a second opinion around your retirement saving plan, to make sure it’s as efficient as possible, let us know!