Tax Hacks: The Backdoor Roth 401(k)

Can I interest you in saving over $50,000 a year in your 401(k), all of which is tax-free income? Sure, you may be familiar with a backdoor Roth IRA, but have you heard about it’s bigger and much better brother, the backdoor Roth 401(k)? No, this strategy is not for everyone, but those who want to really max out their savings, the backdoor Roth 401(k) may be your best option.

What is a backdoor Roth 401(k)?

Many people have heard of and implemented a backdoor Roth IRA. This strategy involves making a nondeductible (after-tax) IRA contribution and immediately converting to a Roth IRA. This allows a person who earns over the Roth IRA earnings limit, to still make a Roth contribution. The Roth 401(k) involves a similar strategy.

First, you probably know that you can make pre-tax contributions of $19,000 (or $25,000 if over the age of 50) to a 401(k) in 2019. If your company allows, you may be able to make Roth 401(k) contributions as well. What you may not know, is what happens if you go over these contribution limits. In 2019, the IRS limits for total 401(k) contributions is $56,000 if under age 50, and $62,000 if over age 50. This contribution limit includes both your contributions and your employers contributions. So, if you are over the age of 50, and your employer makes an annual contribution of $10,000, you would be able to contribute $51,000 to your 401(k). Now, of that $51,000 the first $25,000 would go in either pre-tax or Roth. The remaining contributions would go in an after-tax account in the 401(k). These after-tax contributions are the key to unlocking your 401(k).

Converting the after-tax to Roth

After-tax money is not nearly as tax friendly as Roth money. Roth money grows tax-free and distributions are tax-free. After-tax money growth is all taxed, therefore, the goal is to get as much money as possible into the Roth account. I see many clients with huge after-tax account balances in their 401(k). Having a large after-tax account balance in the 401(k) is a good thing, but having this money in a Roth account, is much better. Thankfully, there is a way to convert this money, and it may involve you paying no taxes.

When you convert any of your after-tax contributions to a Roth account, this money is converted 100% tax free. Now, any growth of the after-tax account is taxed when you do the conversion. Still, there is a way in which you may be able to do all of the conversion without any tax liability.

Types of conversions

There are two types of conversions that you can do: an in-plan conversion and a Roth IRA conversion. An in-plan 401(k) conversion involves converting the after-tax contributions and growth in the 401(k) to a Roth 401(k), still in the same plan. You will need to verify with your 401(k) provider that this is allowed. In this scenario, typically you need to convert both the contributions and growth into the Roth 401(k), and pay taxes on the conversion of the growth.

The other type of conversion is taking the after-tax money and rolling it out into an outside Roth IRA. In this scenario, you roll the after-tax contributions right into a Roth IRA, and the growth gets rolled into a rollover IRA. This strategy allows you to convert your after-tax contributions, completely tax-free, no matter how much growth you may have on the account. For people that have a significant amount of after-tax money in their 401(k) this is typically the preferred method.

The backdoor Roth 401(k) strategy

Here are the steps to take your 401(k) savings to the next level.

  1. Start by maxing out your pre-tax 401(k) contribution limit
  2. Make additional after-tax account contributions
  3. Convert these after-tax contributions to either an outside Roth IRA or do an in-plan conversion each year
  4. Remember, don’t go over the 2019 401(k) contribution limits of $56,000 or $62,000 if over the age of 50.

Before starting a backdoor Roth 401(k) conversion strategy, you will want to  check with your 401(k) administrator. Make sure the administrator allows both after-tax contributions and also either in-plan conversion or rollovers into a Roth IRA. If they don’t allow the conversion now, you can still make after-tax contributions and do the conversion once you hit age 59 ½. The earlier you begin the Roth conversions however, the better.  

In Conclusion

The backdoor Roth 401(k) contribution is a great way to take your retirement savings to the max. This is a great strategy for people who are looking to max out their savings, and especially if you make too much to contribute to a Roth IRA. Between making regular Roth 401(k) contributions, and the doing the backdoor Roth 401(k) conversion, you may be able to contribute over $50,000 per year to a Roth 401(k).

Before starting a backdoor Roth 401(k) conversion strategy, I strongly recommend speaking with your financial planner. Implementing the strategy can result in large taxes, and potentially penalties, if not done correctly.

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