Another way to fund a Roth

Super back-door Roth IRA Contribution

Last week we discussed how to complete a back-door Roth IRA contribution.

For many, this strategy is a slow and boring way to do it. Fortunately, there is another option, which can lead to larger Roth contributions when you earn too much.

The ability to use this strategy is relatively new. In September 2014, the IRS released Notice 2014-54 to grant permission to utilize this tax strategy.

The exciting part is that this tax strategy allows you to make an additional $36,000 in Roth IRA contribution every year!

The first consideration is that your 401(k) plan must allow you to make additional after-tax contributions over and above the deductible thresholds. Contributions stop at a defined contribution plan limit.

When contributing to a 401(k) there are three different types of contributions available:

  1. Pre-tax Contributions
  1. Roth Contributions
  1. After-tax contributions

Pre-tax 401(k) Contribution

Pre-tax 401(k) contributions are “normal” contributions. This is your standard payroll deferral contribution. This money goes into your 401(k) without paying tax (tax-deferred contributions).

Annually the IRS adjusts the eligible amount for deferral.

Your employer typically matches up to a certain percentage of your contribution. While this is a pre-tax contribution, it does not impact your maximum contribution referenced above.

All money in this bucket grows tax-free. When you withdrawal this money it is taxable.

Roth 401(k) Contributions

You might have the option of funding a Roth 401(k).

The same contribution limits apply to the pre-tax 401(k) contributions. Your employer may also match a portion of your contribution.

The difference is that this money is subject to income tax when it enters the account. In turn, it is not subject to tax when it leaves the account. All while growing tax-free.

After-tax 401(k) Contributions

This bucket gets very little attention. It also sounds exactly like a Roth contribution.

However, it is actually like a nondeductible Traditional IRA contribution. The money goes in after paying tax. It grows tax-free. Withdrawals of the contributions (i.e. principal) are tax-free. Withdrawals of the growth are taxable.

There are limits on how much after-tax 401(k) contributions you can make. The limits differ from the pre-tax and Roth limits.

After-tax contributions can go up to the total plan contribution limit after accounting for pre-tax (or Roth) contributions plus employer contributions. Important to note is that your employer contributions count against the amount of after-tax contributions.

Like a nondeductible Traditional IRA but different

We established that money going into the after-tax bucket is similar to a nondeductible Traditional IRA contribution. The money in the account grows tax-free, and the growth is taxable upon withdrawal.

The rules of the money being located in a 401(k) are what drives the primary differences.

Money in a 401(k) is only accessible when there are certain hardships, or after employment ends.

This means you can only convert the after-tax 401(k) contributions into a Roth IRA when leaving your current employer. UNLESS… your employer also allows for in-service distributions, (i.e. 401(k) to IRA transfers while still employed).

If you have the ability to complete in-service distribution this becomes an even more powerful strategy.

If you are not fortunate enough to have in-service withdrawals, in the meantime, all of the contributions will remain in the “after-tax 401(k) contribution” bucket. If you notice, this is another significant difference from a nondeductible Traditional IRA.

With a nondeductible Traditional IRA when you convert the money to a Roth IRA, you must pay tax on the growth immediately. Under these rules are you are allowed to convert the growth into a Traditional IRA with no tax due until the money is actually withdrawn for personal use.

When the time arises (i.e. retirement or job change), you are able to convert that money into a Roth IRA.

Should you make after-tax contributions?

After maxing out your pre-tax or Roth 401(k) contributions and IRA, this is a great tax avoidance opportunity to consider.

Remember, you need to talk to your custodian on your eligibility to make these contributions. While talking to your custodian it would be good to find out if in-service withdrawals are available.

If in-service withdrawals are allowable, the benefit of making these contributions increases tremendously. That said this is only beneficial if you take the steps to transferring the money into your Roth IRA account.

Once the money is in the Roth IRA account, the growth on the account is forever tax-free.

If you can’t complete an in-service withdrawal then other factors play into how beneficial the entire strategy is for you.

For example, upon withdrawal, the money is taxed at ordinary tax rates. How does this compare to investing into a taxable brokerage account where the money is subject to long-term capital gains rates?

 

Do you want to understand how to make your money work for you and keep more of what you have earned? 

Reach out to me at nbyers@jbcwealthadvisors.com or schedule a free consultation.

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Disclaimer: This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Nate Byers a Madison, WI CPA Financial Advisor,  and all rights are reserved. Read the full Disclaimer in the footer below.