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Seeking Zero

Adam M. Grossman

WHAT’S YOUR FAVORITE tax rate? This isn’t meant to be a trick question. If you’re like most people, your favorite rate is probably zero.

While a 0% tax rate is great, it isn’t easy to achieve. There’s just a handful of ways to create tax-free income. If you have young children, 529 accounts are a great option. If you earn a high income, you might buy tax-exempt municipal bonds.

And, of course, there are Roth IRAs. In my opinion, they’re the best, most flexible and most effective tool to generate tax-free income when you reach retirement. As with all good things, the IRS limits taxpayers’ ability to use Roth accounts. Each of the three primary ways to fund a Roth carries limitations.

First, you could make regular annual contributions to a Roth IRA. Problem is, there are income thresholds. Individuals earning more than $135,000 and couples earning more than $199,000 are ineligible to contribute to Roth IRAs in 2018. Even if you can get your income under these thresholds, contributions are limited this year to $5,500 per person, or $6,500 if you’re age 50 or older.

Second, you may have a Roth 401(k) option at work. Unfortunately, this feature isn’t universally available. And if you go that route, you lose the valuable tax deduction associated with traditional 401(k) contributions.

Third, you can move money into a Roth IRA by converting a traditional IRA. But that entails the difficult decision to accelerate payment of a potentially large tax bill.

The result is that many people look at Roth accounts—with their zero tax rate on withdrawals—as a sort of promised land. They like the idea, but they find it hard to make significant contributions.

That’s why I’d like to introduce you to a fourth method—one that isn’t widely discussed—that could allow you to make far larger Roth contributions. The technique involves making after-tax contributions to your 401(k). Here’s how it works:

Step 1: Contact your employer and ask whether your plan will permit after-tax contributions in excess of the usual $18,500 pre-tax limit. If so, ask for information on how to set it up.

Step 2: Decide how much you want to contribute from each paycheck. In general, the total amount that can go into your 401(k), including both employee and employer contributions, is $55,000 per year. Even if your employer offers a generous match, that may still leave quite a bit of room to make additional contributions before hitting that ceiling.

Suppose you make the maximum contribution of $18,500 and your employer’s match adds another $10,000. That would bring the total contribution to $28,500, allowing you to contribute another $26,500 on an after-tax basis, assuming you have the funds available. The amounts are potentially even larger if you’re age 50 or older.

Step 3: When you retire or leave your employer, you’ll request two separate rollover checks. One check, representing your pre-tax contributions and all of the account’s investment growth, will go to your traditional IRA—the same thing that would happen with an ordinary 401(k) rollover. The other check, representing your after-tax contributions, can go into your Roth IRA.

If your retirement plan administrator permits it, this approach may allow you to contribute far more to a Roth IRA than you could using any other method. Moreover, this strategy doesn’t preclude other options, like making regular annual Roth IRA contributions.

Since this strategy is fairly new, I recommend the following “belt and suspenders” steps to ensure that it goes smoothly:

1. Consult your accountant in advance. The IRS approved this strategy relatively recently, so you want to be sure your CPA is aware of what you’re doing and agrees that it makes sense in the context of your overall tax picture. If your accountant is not familiar with it, you can refer him or her to IRS Notice 2014-54, “Guidance on Allocation of After-Tax Amounts to Rollovers.”

2. Keep good records. When you employ this technique, your after-tax contributions will be mixed in with your standard pre-tax contributions. Your plan’s administrator will be responsible for tracking them separately, but it doesn’t hurt to maintain your own records.

3. When you retire or leave your employer, speak with your plan administrator well in advance of initiating a rollover. Remind the administrator that your balance includes both pre-tax and after-tax contributions to ensure that the firm correctly issues two checks. At the beginning of the following year, make sure you receive two separate 1099-R forms, one for each rollover.

Adam M. Grossman’s previous articles include Garbage InAll Too HumanStepping Back and When to Roth. Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.

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Chris Michener
Chris Michener
2 years ago

Is this the “mega backdoor Roth” or something different?

Jonathan Clements
Jonathan Clements
2 years ago
Reply to  Chris Michener

It is indeed the mega backdoor Roth.

Michael Clark
Michael Clark
2 years ago

I turned 50 last week. Is my annual Roth limit $6,500, $5,500, or prorated?

Jonathan Clements
Jonathan Clements
2 years ago
Reply to  Michael Clark

As long as you turn age 50 by the end of the calendar year, you should be eligible for the full $1,000 catch-up contribution.

Jason Peplinski
Jason Peplinski
2 years ago

How does this work with the annual testing of a plan? Would a higher paid employee not have this work as laid out above?

Jonathan Clements
Jonathan Clements
2 years ago

This is a little beyond my expertise, but I assume this would be the employer’s problem, not yours. The upshot: I would go ahead and try it and, if the plan isn’t meeting federal requirements, the plan administrator will let you know.

CJ
CJ
2 years ago

“When you retire or leave your employer, you’ll request two separate rollover checks. One check, representing your pre-tax contributions and all of the account’s investment growth, will go to your traditional IRA—the same thing that would happen with an ordinary 401(k) rollover. The other check, representing your after-tax contributions, can go into your Roth IRA.”

Administrators are more knowledgeable about that now. Unfortunately, in my zeal to save more when I was young, I did this many years ago at two diff employers and regretted it ever since. Neither administrator included any documented records or info about what was pre vs post tax – just transferred everything over in one lump sum rollover to Vanguard when I left those jobs.

At the time, few were writing about after-tax contributions and I lacked basic tax knowledge to know I should have kept those records separate or move out post-tax funds. Now I’ll be taxed twice on a fairly significant sum of money. Vanguard doesn’t have the records and I have no idea decades later what was pre-vs post tax. Stupid mistake on my part unfortunately.

David J. Kupstas
David J. Kupstas
2 years ago

I am a third party administrator for retirement plans. We had some referral sources ask about this a couple years ago. There are at least two reasons why this strategy will work in very few situations. First, after-tax contributions are subject to ACP nondiscrimination testing – same as matching contributions. If Highly Compensated Employees take advantage of this strategy, some Non-Highly Compensated Employees must also do so. HCEs are generally owners of the business and employees earning at least $120,000. The people that have $20,000+ lying around to contribute to a plan after-tax are usually HCEs. Second, the people asking us about this approach would have wanted to make the after-tax contributions and then immediately roll them to a Roth IRA. However, any withdrawal or rollover would have to be pro-rated between pre-tax and after-tax money. Thus, the employee won’t be able to take full advantage of this opportunity until the entire account is distributed, which is the scenario mentioned in this article.

Richard
Richard
2 years ago

On after tax 401k contributions – would an in-service withdrawal be subject to the pro-rata IRA rules just like a Backdoor roth ira contribution? What about the after-tax to roth conversion within the 401(k)?- client has a Traditional IRA account. Thanks!

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