Would it not be wonderful if we were allowed to put as much as we wanted into retirement savings vehicles each year to maximize our tax-sheltered savings? Alas, the IRS does not allow unlimited contributions into IRAs, 401(k)s, and other qualified plans. However, little-known strategies exist for socking more money away for retirement.
In a previous blog, we talked about backdoor Roth contributions for high wage earners. To recap, a backdoor Roth contribution involves making a non-deductible contribution to a traditional IRA and then converting that IRA to a Roth. However, this becomes a complex strategy if you already have other traditional IRAs due to the pro rata rule. See our recent blog on backdoor Roth conversions here.
There is also another strategy that can be used to make a Roth conversion. At the end of 2014, the IRS issued guidance on the treatment of after-tax contributions made to a traditional 401(k). Traditional 401(k)s are pre-tax savings and as mentioned above, the IRS limits the amount you can contribute to your 401(k) pre-tax. The amount for 2015 is $18,000 with a $6,000 catchup for those ages 50 and over. However, this is just the pre-tax amount that the employee is allowed to contribute. Your employer can also contribute to your account beyond this limit up to a max of $53,000.
What if your contributions plus your employer’s contributions adds up to less than $53,000? Well, this actually means that you have the opportunity to save more tax-sheltered money. Some 401(k) plans allow employees to make after-tax contributions to the plan above and beyond the pre-tax contributions. For example, let us say that you are over age 50 and contributed the full $24,000 pre-tax contributions this year to your 401(k) and your employer contributed another $6,000, bringing you to a total of $30,000 in contributions. This means that you could potentially contribute another $23,000 in after-tax money to your 401(k) – up to the $53,000 maximum annual limit.
The tricky part about this strategy in the past was that it was not exactly clear whether or not the pro rata rules still apply when rolling this after-tax money out into a Roth IRA. The good news is that last year, the IRS made it transparent that individuals can roll after-tax contributions directly to a Roth IRA and the pro rata rules do not apply to these conversions. You can see the benefits of this strategy. After-tax contributions to your 401(k) could be substantially larger than the amount you are allowed to contribute to an IRA (which is $5,500 this year with a $1000 catchup for those 50 and over) and this allows you to do a tax-free Roth conversion!
Please be aware that not all 401(k) plans allow you to make after-tax contributions. In addition, there are some logistics to actually rolling the after-tax contributions to a Roth IRA at retirement. Therefore, as always, it is important to consult with your tax advisor and financial planner for assistance with correcting implementing the conversion and to make sure that this strategy is optimal for meeting your financial goals. Happy saving!
Kim Butler, CFP®
Associate Financial Planner