Almost every advisor and serious retirement saver out there understands the basic limits that apply to pre-tax contributions to a 401(k) account, whether a Roth or a traditional account.
These clients are likely also well versed in the traditional backdoor Roth IRA, which allows clients to convert IRA funds to a Roth IRA. What many clients fail to grasp, however, is the fact that some clients with high saving potential may be able to stretch the limits of the added value of a Roth’s tax-free withdrawals by contributing to a backdoor Roth 401(k) by using special contribution rules to access the “backdoor” to the Roth 401(k). By paying close attention to both the IRS rules and the plan-specific rules that may apply, the client may be able to nearly triple the level of funds that are funneled into their overall 401(k) strategy while significantly increasing the level of funds that are available to grow and be withdrawn tax-free in the process.
Benefits of the Mega-Backdoor Roth 401(k)
The basic IRS 401(k) contribution rules allow a client under age 50 to contribute up to $19,000 in pre-tax funds to his or her 401(k) in 2019 ($25,000 for clients who have reached age 50). However, the overall contribution limit that applies to employer, employee pre-tax and employee after-tax contributions combined is $56,000 (or $62,000 for clients 50 and over).
Because of this, some clients may be able to significantly increase the level of after-tax contributions added into the 401(k). However, if those after-tax contributions are left in the traditional 401(k), the earnings on those contributions will eventually be subject to tax at the client’s ordinary income tax rate—even though the after-tax contribution itself could be withdrawn tax-free.
Roth 401(k)s are subject to the same contribution limits as traditional 401(k)s, but are treated differently from a tax perspective. The second that the after-tax contribution is funneled into the Roth portion of the 401(k) (or into a Roth IRA), those same earnings begin to grow on a tax-free basis—meaning that those earnings are not subject to tax as they accrue within the Roth and they are not subject to tax when withdrawn, so long as the applicable withdrawal rules are followed.
Using this backdoor strategy, the client is essentially able to “supersize” the value of the after-tax contributions by generating tax-free growth on even the earnings portion of those larger contribution amounts (note that direct Roth IRA contributions are currently limited to only $6,000 in 2019)—especially if the client plans to leave the funds invested in the Roth for a significant period of time.
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.
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.