September 08, 2020
Big savers who think they are maxing out their 401(k) contributions each year may have a powerful way to contribute even more if their plans offer mega-backdoor Roth options. In 2020, as an account owner, you may be limited to contributing $19,500 to your 401(k) ($26,000 for those age 50 and older) through elective deferrals. However, current regulations generally permit a total of $57,000 overall to be contributed to a 401(k) each year ($62,000 for those age 50 and older).
If your employer makes matching or profit-sharing contributions to your 401(k), those contributions, along with your elective deferral, will apply toward the $57,000 annual limit. Let’s say that you maxed out your $19,500 elective deferral and that your employer made matching and profit-sharing contributions totaling $5,500 for the year, so $25,000 was added to your plan through your elective deferral and the employer contributions combined. That’s great, but what about that $57,000 contribution limit mentioned above? Is there a way to contribute another $32,000 into the plan to meet the limit? The answer is “yes,” if your plan has a few specific provisions that allow for a mega-backdoor Roth conversion.
So, what are the provisions that a 401(k) must have? First, the plan must allow for after-tax contributions in addition to your elective deferral. If your plan allows you to make elective deferrals on a Roth (or after-tax) basis, that is not the same thing as an after-tax contribution. For purposes of the mega-backdoor Roth, after-tax contributions are a third form of contribution that can be made from your post-tax income, in addition to your elective deferral and any employer contributions. Going back to the example above, if permitted by your plan, you could make $32,000 in after-tax contributions, in addition to your $19,500 elective deferral and the $5,500 in employer contributions, to reach the $57,000 limit.
Once you’ve made after-tax contributions to your 401(k), those assets will grow tax-deferred; however, they will be subject to ordinary income tax once they are withdrawn from the plan. So why would you contribute after-tax income to the 401(k) only to have it taxed as income a second time when you withdraw it? You wouldn’t, unless your plan allows you to make in-service distributions to a Roth individual retirement account (IRA), or if it allows you to convert the after-tax contributions over to the Roth portion of your 401(k). Either option can allow you to convert your after-tax contributions to Roth assets.
To understand the potential tax benefit this represents, let’s review a few quick facts about retirement accounts. If you are single and don’t have access to a company-sponsored retirement plan like a 401(k), you could make a maximum tax-deductible contribution of $6,000 to a traditional IRA each year ($7,000 for those age 50 and older). That’s quite low compared to the $19,500 elective deferral limit for a 401(k) plan. While your traditional IRA contributions are tax-deductible, your withdrawals from the IRA will be taxed as ordinary income. Furthermore, under current rules, you are required to take required minimum distributions from your traditional IRA at age 72 (70 1/2 if you reach that age before January 1, 2020) and pay income taxes on those distributions.
In contrast, Roth IRA contributions are not tax-deductible; however, since after-tax contributions are made, withdrawals from Roth IRAs are not taxed as income. Furthermore, Roth IRAs are not subject to required minimum distributions, giving you the ability to withdraw your money without paying additional taxes at retirement, or earlier if certain requirements are met.
The tax benefits of Roth IRA accounts can be so significant that current law prohibits an unmarried taxpayer earning more than $206,000 per year from contributing to a Roth IRA. Oddly, there are no income restrictions on making Roth contributions to a 401(k), if the plan allows it. So, while a person making more than $206,000 per year without access to a 401(k) can’t contribute a single penny to a Roth IRA, a person making far more can make up to $19,500 per year in Roth contributions ($26,000 for those age 50 and older) to a 401(k) if the plan allows.
The mega-backdoor Roth option amplifies the tax benefits of the 401(k) even more as the following example illustrates. Let’s consider that same single taxpayer (under age 50) who’s earning more than $206,000 per year and therefore is unable to contribute to a Roth IRA. Fortunately, her employer provides a 401(k) that allows Roth contributions, so she maxes out her elective deferral by making $19,500 in Roth contributions. Let’s also say that her employer doesn’t provide matching or profit-sharing contributions, so there are no employer contributions to apply to the $57,000 annual limit. That means that our taxpayer’s total contribution (so far $19,500) is $37,500 under the federal limit of $57,000 for the year.
If our taxpayer’s 401(k) allows her to make after-tax contributions, she could elect to contribute another $37,500 to her 401(k) to hit her $57,000 annual limit. Let’s also assume that her 401(k) allows for in-service withdrawals, which permits her to roll her after-tax contributions to a Roth IRA. This same taxpayer who is prohibited from contributing directly to a Roth IRA (because she’s above the $206,000 income limit) now has the ability to roll $37,500 from her 401(k) into a Roth IRA through the “back door.” This is in addition to the $19,500 Roth contribution (her elective deferral) that will remain in the plan.
The mega-backdoor Roth IRA may sound too good to be true, but the strategy can be an effective tool if your 401(k) has the appropriate features. That said, a big word of caution: 401(k) plans vary, so we encourage you to consult with your plan administrator and financial advisor to confirm whether this strategy is viable under your plan.
Also, the strategy is not without potential pitfalls, such as possibly overfunding your 401(k). For example, remember the $57,000 annual 401(k) contribution limit? Your elective deferrals, employer contributions and after-tax contributions all count toward the $57,000. What if you max out your elective deferral at $19,500 and your after-tax contribution at $37,500 to fund the $57,000 limit by midyear, only to learn that your employer decides to make a generous profit-sharing contribution for you in December? Depending on the terms of your plan, you might forfeit this “free” money from your employer because you already hit your contribution limit.
If you’re maxing out your elective deferral every year and are looking for a tax-advantaged way to save additional money for retirement, it’s worth exploring whether the mega-backdoor Roth IRA conversion strategy is viable under your 401(k) plan. As with any financial planning strategy, it is important to consult qualified experts to determine an appropriate planning option. Learn more about The Financial Side of Retirement Planning.
Shawn Leist is a managing director and senior relationship manager for CIBC Private Wealth Management with 13 years of experience helping high net worth families achieve their wealth management goals.
Jerimiah Booream, CFA
August 14, 2020
Dave Donabedian, CFA
August 27, 2020
September 01, 2020
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