Supersize a Roth 401(k) With Backdoor Contributions

What to Watch for

In order for the advantageous backdoor Roth 401(k) strategy to work, however, the terms of the specific plan must be closely examined to determine whether the plan allows for either in-service withdrawals (importantly, in-service withdrawals are different from hardship distributions and plan loans) or in-plan conversions.

An in-service withdrawal would allow the client to withdraw the funds from the 401(k) immediately and transfer those funds in a tax-free rollover into a Roth IRA.  An in-plan conversion, on the other hand, would allow the client to immediately transfer the funds into a segregated Roth 401(k) that is offered in conjunction with the traditional 401(k).  Under either strategy, the transferred funds would begin to grow tax-free as soon as they hit the Roth account.

If the plan doesn’t offer in-service withdrawals or in-plan conversions, the value of the earnings on the original 401(k) contributions will also be subject to tax when the client retires or is otherwise permissibly able to withdraw the 401(k) funds without penalty.

Further, clients should be advised that supersizing the Roth portion of their 401(k) with after-tax contributions is generally only advisable after the client has contributed the maximum possible in pre-tax contributions to accounts such as traditional 401(k)s, IRAs and health savings accounts (HSAs) because those funds both reduce the client’s current overall tax liability and grow on a tax-deferred basis.

Clients should also consider whether they will need access to the after-tax funds prior to retirement (in which case, a traditional taxable investment account may be a better option) and the actual features of the account to which they plan to contribute.  Higher fees and poor investment options within the Roth 401(k) might mean losing out on investment gains that could be possible outside of the retirement savings vehicle, and should always be considered in relation to the tax benefits of the Roth.

Conclusion

For clients with significant savings potential who are already maximizing contributions to their retirement accounts, accessing the backdoor Roth 401(k) through the use of after-tax contributions can provide an attractive solution for both maximizing their overall retirement savings and the tax benefits that those savings can generate.  While the backdoor strategy was indirectly blessed in connection with the 2017 tax reform, it remains important, however, to analyze the client’s entire financial picture and goals to ensure the strategy is right for them.

• Check out previous coverage of the backdoor Roth IRA rules in Advisor’s Journal.
• For in-depth analysis of the Roth 401(k) feature, see Advisor’s Main Library.
• Your questions and comments are always welcome. Please post them at our blog, AdvisorFYI, or call the Panel of Experts.