Taking advantage of pre-tax retirement savings within a 401(k) or similar account is a great way to reduce your current taxable income while socking away funds for the future. With many Americans having access to pre-tax accounts, the majority of those planning for retirement are already leaning heavily on this vehicle.
Unfortunately, pre-tax money is just that – pre-tax and taxes will have to be paid when the funds are withdrawn during retirement. What if there was a way to save more than the 401k limit on an after-tax basis and then rollover the excess amount to a Roth IRA which can provide tax-free earnings at retirement?
According to the IRS, workers saving within a 401(k), 403(b) or 457 plan in 2015 can stash away up to $18,000 plus an over age 50 catch-up of $6,000 where applicable.
Interestingly, many retirement plans also allow for after-tax contributions above the elective deferral limits noted above. In fact, total 401(k) contributions (including after-tax contributions) of up to $53,000 can be made this year.
While the availability of after-tax contributions is not a new concept, the ability to convert these contributions to a Roth IRA when withdrawn is an exciting new tool that can be used to turbo charge retirement savings.
So why might it be a good idea to convert the after-tax portion to a Roth? When implemented according to IRS rules, Roth IRA earnings grow tax-free throughout retirement. Developing a retirement strategy that utilizes both pre-tax retirement accounts and after-tax Roth accounts can be an effective way to diversify your retirement distributions from a tax perspective.
Since Roth IRAs are not subjected to required minimum distributions (RMDs), this may also help to provide additional flexibility when it comes to taking distributions after age 70-and-a-half too.
How does this compare to a Roth 401(K) contribution?
First, not all plans allow for after-tax contributions – check with your administrator first. Roth 401(k) contributions are subject to the elective deferral limits noted above of $18,000 and $24,000(over age 50). If your plan allows for after-tax contributions, the total of all contributions can be as high as $53,000.
For example, if you contribute $18,000 toward a Roth 401(k), you could potentially save an additional $35,000 in after-tax contributions can later be converted to a Roth IRA.
Next, it is important to note that the tax treatment of Roth 401(k) contributions and after-tax contributions are very different. While the earnings on Roth 401(k) contributions will grow tax-free from the time they are deposited, the earnings attributed to after-tax contributions do not grow tax- free. Instead, the earnings on after-tax funds are taxable when withdrawn in the same way that pre-tax funds would be.
The principal investment and future associated earnings will not grow tax-free until they are converted to a Roth IRA when withdrawn. This highlights the importance of maxing out a Roth 401(k) before considering an after-tax strategy.
Finally, there can be additional complexity at retirement for those that are interested in only doing a partial rollover of their plan so be sure to speak to your tax adviser first.
Who should consider an after-tax conversion?
This strategy may be an effective tool for anyone who already has after-tax money in a 401(k) and is planning on rolling the funds over to their own IRA due to retirement, separation of service or as an in-service withdrawal.
Rather than have the 401(k) administrator send an after-tax check directly to you to be place in your non-retirement account when you separate from service, consider converting this portion to a Roth IRA as it is a great way to build substantially more money in a tax-free earnings bucket than would otherwise be allowable.
Additionally, for savers who have not stashed enough for retirement or would like to save more than the current elective deferral limits, this strategy can allow for more tax deferred savings while greatly improving the tax efficiency of future retirement income distributions.
While after-tax retirement plan contributions can be an effective tool, it is not appropriate for everyone. Consider speaking to your tax and financial advisers to determine the most appropriate approach for your unique circumstances.
Kurt J. Rossi, MBA, is a Certified Financial Planner Practitioner & Wealth Advisor. He can be reached for questions at 732-280-7550, kurt.rossi@Independentwm.com, www.Independentwm.com LPL Financial Member FINRA/SIPC.