Many individuals are aware that in 2019 they can contribute up to $19,000 in their 401(k) as well as an additional $6,000 if they are 50 or older. However, what most individuals are not aware of is that there is a provision that some employer’s 401(k) plans allow for a potential additional employee after-tax contributions over and above the allowed $19,000 (or $25,000) as an after-tax contribution. Some plans may even then allow these extra after tax-dollars to be rolled out of the plan into a Roth IRA or moved internally inside the 401(k) plan to follow the Roth contribution rules. This provision is known as a Mega Backdoor Roth Conversion and if done correctly it can give employees the ability to put away large amounts towards retirement in a tax-efficient manner. For those less familiar with 401(k) provisions BankRate.com has a great breakdown of the basic features of these plans.
Take Action: Read Your 401(k) Plan Options!
Let me start by trying to save you some time. Each employer’s 401(k) plan is different and many of these do not give you the option to do a Mega Backdoor Roth Conversion. Pull up your employer’s benefits packet or contact your plan administrator to see if this is an option. You will need to answer two important questions. First, can you do an after-tax (not Roth) contribution to your 401(k)? Second, can you do an in-service or in-path rollover?
Context
To provide you some context, there are three types of contributions you could potentially utilize in a 401(k) plan. The traditional contribution (pre-tax) is where you do not pay taxes on contributions and gains today but pay taxes on the distributions in retirement. The second option is to do a Roth contribution to the 401(k) plan. Roth contributions result in paying taxes today on the contribution but you do not pay taxes on any of the gains or contributions when you take distributions in retirement. These are the two most common choices that are offered in 401(k) plans. If your employer’s 401(k) plan offers both options you can contribute either all or a mix of pre-tax or Roth contributions to the $19,000 (or $25,000) limit in 2019. Often professionals, suggest basing contribution decisions on one’s effective tax rate today and their expected effective tax rate at retirement.
The third type of contribution is called an after-tax contribution. If allowed by your employer’s plan, it provides bandwidth to top of your total 401(k) contributions of the $19,000 ($25,000 if over age 50) up to $56,000 in 2019. From a tax perspective, after-tax funds are taxed upon contributions and then the growth is tax-deferred. As you take distributions from the growth, it will be taxed again.
Implementing the Mega-Back Door Roth Conversion
Now that we understand the three contributions types allowed in a 401(k) plan, we can dive into how to implement this strategy. First, one would contribute the first $19,000 (or $25,000) as a normal pre-tax or Roth contribution. Then designate that additional funds would go in as an after-tax contribution to your 401(k) plan up to $56,000 ($62,000 if eligible for catch-up provision) in 2019. Before topping off to the $56,000, you will need to subtract any employer’s matching or profit-sharing. For example, an employee who is under the age of 50 and contributing $19,000 to their 401(k) with an employer match of $5,000, this equals a total of $24,000 contributed to the 401(k) plan. This leaves a total of $32,000 ($56,000-$24,000) in remaining potential after-tax contributions.
Wait are After-Tax Contributions Tax-Efficient?
Simply making after-tax contributions to your 401(k) is not that tax-efficient. With after-tax contributions, you will pay taxes on the initial principal contributions and then the growth on the after-tax funds is tax-deferred but will be taxed as income once you withdraw the gains at retirement. This does provide some benefit but does not provide the same advantage of a Roth contribution.
The Solution
Here is the solution. The IRS has recently confirmed that you can effectively move the after-tax contribution basis in your 401(k) to a Roth IRA or to the Roth contribution category inside of your 401(k). An in-service rollover option gives the ability to move the after-tax contributions to a Roth IRA outside of the 401(k) plan even while employees remain employed. While an in-path rollover allows for one to move the after-tax contribution to a Roth contribution inside of the 401(k) plan. If done correctly, the after-tax contributions will not have any taxable impact and contributions will follow the Roth contributions rules of growing and being withdrawn tax-free going forward! When allowed, the after-tax contribution combined with doing an in-service or in-path rollover is a tax-effective strategy to gets above the standard contribution limit of $19,000 per year.
What Happens if You Cannot Do an In-Service or In-Path Rollover?
In the above example, the employee is able to contribute an additional $32,000 in after-tax funds to their 401(k) plan. The solution was to make an in-service rollover with the after-tax funds to a Roth IRA or an in-path rollover inside the 401(k) plan from an after-tax contribution to a Roth contribution. However, what happens if you cannot do an in-service or in-path rollover and it is stuck as an after-tax contribution?
If neither of these options is available this makes using after-tax contributions less attractive. If you make an after-tax contribution, it will have to stay as an after-tax contribution until you leave your employer. Using the sample example above, the $32,000 after-tax contribution will often grow if the funds are invested. Let us assume that the after-tax contributions grew by $8,000 when you leave your employer two years after the initial contribution. This leaves you with $40,000 of after-tax funds. If you rollover the full $40,000 into a Roth IRA you will have to pay income tax on the $8,000 growth. To avoid this taxable event, you would want to move the original after-tax contribution of $32,000 to your Roth IRA and any after-tax growth to a traditional IRA. Any pre-tax contribution and employer’s match usually goes to a traditional IRA to continue tax deferral. Additionally, Roth 401(k) contributions go to a Roth IRA to continue tax-free growth.
How to Research This Strategy!
Now keep in mind, if you wish to employ this strategy you will want to confirm the two points as discussed. First, does your employer allow for an after-tax contribution? Second, do they allow for an in-service or in-path rollover? Working with a financial planner can help navigate the do’s and don’ts of this strategy. Also, if your employer does not offer these options this is a great opportunity to inform your Human Resources (HR) department of the benefits of implementing this strategy to retain key highly compensated employees. I hope that this guide has helped educate and will allow you to feel confident when explaining this strategy so that you can begin to grow and keep your wealth today!
James Hargrave
Director of Financial Planning
