401k Tricks: Backdoor Roth IRA Contributions
In my previous post on our plan for retirement contributions for the year, a couple folk sent me questions about the big $27k after tax contribution I was making to my 401k plan. How was this possible and what did I mean by a Roth conversion?
Many people assume that their contributions to a 401k plan max out at $18k plus whatever their employer decides to kick in to match. This is incorrect. The actual contribution limits to a defined contribution plan like a 401k are $54k ($60k if in the catchup period). Read this handy page from the IRS if you doubt me. The $18k figure that most people throw around is simply the limit on tax-deferred contributions or contributions directly to a Roth 401k. This is also the practical limit imposed by many employer 401k plans, you simply cannot contribute more even if you wanted to.
The additional contributions up to that $54k cap, $27k in our case, are ‘after-tax’ contributions to my traditional 401k plan. I.e. we will still pay taxes on all that income, but those contributions will just end up lumped in with my other pre-tax contributions in the same account. If we did nothing else, those after-tax contributions would grow, tax deferred, with all of my other 401k contributions until I decided to withdraw them many years from now. When we withdraw anything far in the future we pay income tax on the pre-tax contributions and the growth of everything. We would not have to pay taxes on the original after-tax contributions since that income has already been taxed.
Just this alone would be a great deal! An additional $27k in a tax-deferred account is an excellent way to shield a lot of growth over long time horizons. Even though you eventually have to pay income tax on the gains it is still worth doing.
What do you need: Your 401k plan needs to be able to accept after-tax contributions. If you’re asking your plan’s administrator about this be sure to highlight that you DON’T mean typical Roth contributions, you mean contributions above and beyond the normal $18k limit.
But it get’s much much better. They IRS, in all their wisdom, has enabled a special loophole for rollovers from 401k plans. Essentially, you can take those after-tax contributions and roll them directly into a Roth IRA. You convert those dollars from an account in which you would have to pay income taxes on the gains into an account that grows tax-free forever. Roth IRA’s are fantastic and this is one of the best ways to get large sums of money into one. Even better, this completely bypasses the traditional income limitations normally associated with Roth IRAs.
The only real downside is that, depending on how your plan is set up, you may have to roll the pre-tax portions of your 401k into a traditional IRA at the same time. But since the tax treatment of those accounts is the same it’s not a significant problem. As crazy as this sounds, it’s all perfectly legal. It’s a fantastic way for folks well above the income limitations on Roth IRA’s to get even more of the same good thing. Is it fair? Hell no! But taxes rarely are, so if you can take advantage of it I suggest you do. You can read about the gory legal details over on the IRS’s page here.
What do you need: Ideally your plan is set up to accept something called ‘in-service withdrawals or transfers’. This means you can take money out while you are still employed at your company, including making rollovers into IRAs and Roth IRA. If these are available you can contribute your after-tax dollars, wait a couple months (the IRS has some restrictions on how long you have to hold the money in the account), and roll everything over into IRAs and Roth IRAs with no taxes on any of it.
Even without in-service withdrawals, this plan still works. You perform the same rollover into Roth and Pre-tax IRAs when you leave your company. There are only two problems with this. One, any gains made on the after-tax contribution have to go into a pre-tax IRA, not a Roth. Two, no one knows how long this loophole will be in place as politicians on both sides talk about closing it. So if you delay you may not be out of luck.
How my plan is set up
Grizzly Dad is very lucky in that my plan is set up to perfectly accommodate this process. We just had everything enabled this year after a big push from a number of employees, including myself. We now have a plan that accepts after-tax contributions. Has in-service withdrawals on after-tax contributions. And even automatically sets up our in-service rollovers every quarter so we don’t have to mess with paperwork. I’ll be making a ton of contributions this quarter. At the end of March, all of my after-tax contributions will roll immediately into a Roth IRA account at my plans administrator, Fidelity. Pretty good deal!
Essentially none if you are able to take advantage of it. This is an amazing way for the grizzlies to get almost 5x the amount of Roth IRA contributions allowed for people well below our income level. It’s as close to a no-brainer as you can get.
The biggest downside of the entire process is that it is 100% dependent on your employer. If you work for an awesome company that get’s everything enabled you are golden. If not, there’s nothing you can do on your own to take advantage of it – other than pressure your employer to adopt the changes. Those changes might be very easy or very difficult depending on how your 401k plan is currently set up, who runs it, the income distribution of your company, and a number of other factors. It’s one of the least fair elements of our retirement system. But as I said above, there are many unfair portions of the tax code. You should take advantage of whatever you can, everyone else is.