The benefits of saving in a “traditional” 401(K) can be powerful. By contributing pre-tax dollars you reduce your taxable income and will lower your tax bill (e.g., if you make $100,000 and contribute $15,000 to a 401(k), you are only taxed on $85,000 of earnings). These 401(k) contributions can be invested, with the taxes deferred until you withdraw. You may also receive a company match (i.e., free money).
Some 401(k) plan providers also offer a “Roth” option, which has been available since 2006. Roth’s allow you to contribute money that you have already paid tax on. The benefit is that, under current tax law, this money will never be taxed again. The downside is that you pay the income tax upfront, at what may be high state and federal income tax rates. For high income earners, the Roth is typically not chosen, as high-income earners tend to focus on lowering their current tax bill.
To show how a Roth account works, let’s say you have contributed $20,000 to a Roth 401(k) which grew to $30,000 over time. Now you have left your company and want to roll the money over to a Roth Individual Retirement Account (IRA). By utilizing a Roth 401(k), 100% of the money can be transferred to a Roth IRA. This means that the total account value (contributions + investment gains) will never be taxed:
For 2019 the maximum allowed contribution for a traditional or Roth 401(k) is $19,000 ($25,000 if you are 50 or older).
Some employers, such as Google (aka Alphabet), Microsoft, Nvidia, and Apple, offer an “after-tax” 401(k). This option allows employees to contribute additional post-tax money on top of the limits mentioned above. The benefit is that this allows you to save more. The caveat is that your contributions are never taxed again, whereas the investment gains from those contributions are tax-deferred, and taxable at your ordinary income rate upon withdrawal in retirement. Using the same contribution example from above, we can see how an after-tax 401(k) differs from a Roth 401(k).
When you rollover an after-tax 401(k), the contributions are deposited into a Roth IRA, while the investment gains are deposited into a traditional IRA. You do not have to worry about tracking your contributions versus gains, as that is typically handled by the plan sponsor.
The maximum contribution to a 401(k) in 2019 is $56,000 (or $62,000 if you are age 50 or older), which includes the employer’s contribution. Considering an employee who is younger than 50, that means if you maximize your “traditional” tax-deferred contribution of $19,000, there is still the opportunity to contribute an additional $37,000 using the after-tax option.
It Gets Better! The Mega Backdoor Roth
Certain 401(k) providers offer “In-Plan Rollovers.” This feature allows you to convert money that you have contributed to the after-tax 401(k) and convert it to the Roth 401(k). This is an amazing opportunity. It allows you to contribute up to $37,000 extra per year to a Roth 401(k) on top of the original $19,000!
It’s important to note that if there are gains on the after-tax contributions, those will be taxable at ordinary income rates when you convert. That is why we recommend you initiate the conversion shortly after making the after-tax 401(k) contribution.
Is It Right For Me?
If you already maximize your traditional or Roth 401(k) contributions and do not need the additional cash flow, consider the after-tax 401(k). It can be a powerful tool to contribute additional retirement funds in a tax-aware way.
If you have questions about your after-tax 401(k), please let us know. We are happy to help.
Written by: Will Steinberger