Super-Size Your Roth IRA

Comprehensive and insightful retirement planning advice will typically encourage you to fund an emergency savings account, maximize your annual contribution to your workplace 401(k), collect your employer’s match, contribute to a health savings account and fund a Roth IRA if you’re eligible. Once you’ve maximized your allowable contributions to these accounts, saving in an after-tax investment account is the logical next step. We often hear from families that have dutifully saved in each of these structures that they desire to contribute even more to their Roth IRA. For the committed saver, there’s an often-missed approach to boost Roth IRA balances that has been hiding in your workplace 401(k) plan all along.

Few investors are aware that the total 401(k) contribution limit for 2019 is $56,000 ($62,000 if you’ve reached age 50). There are three methods to contribute funds into a 401(k):

The employee’s own pre-tax or Roth deferrals (the popular $19,000/$25,000 “maximum”),
Employer contributions (commonly referred to as the “match”), and
After-tax contributions.

Before we explore how anyone (regardless of income level) can accelerate their Roth IRA savings, it is essential to distinguish the three types of retirement plan contributions:

Pre-tax or Roth Deferrals

Many workplace 401(k) plans allow employees to decide how they would like to contribute their annual $19,000 deferral ($25,000 if age 50+). If an employee elects to make pre-tax deferrals, dollars will go into their 401(k) without the employee paying taxes on them. While the funds remain inside the 401(k), the employee won’t owe any taxes on investment earnings, but will owe taxes once funds are withdrawn in retirement. Roth 401(k) contributions experience the opposite tax treatment. An employee would elect to defer dollars that they’ve already paid income taxes on in order to avoid taxes when the funds and earnings are withdrawn in retirement.

Employer Contributions

Employers will typically add a certain amount to your retirement savings based on your own annual deferral. No matter what election an employee makes with their deferral, employer contributions are always provided on a pre-tax basis. Contributing enough to receive your full employer match ensures you won’t leave free money on the table.

After-Tax Contributions

After-tax contributions can be added to their 401(k) after the deferral amount has been maximized. For example, a 60 year-old employee defers $25,000 into their 401(k) and their employer kicks in another $9,000 for a total contribution of $34,000. This leaves $28,000 that the employee can contribute for the year with after-tax dollars. Unfortunately, not all workplace retirement plans allow after-tax contributions. Your plan administrator will be able to determine if your plan allows for this type of contribution.

After-tax contributions may sound like Roth 401(k) contributions but there is a significant distinction: Roth 401(k) contributions begin compounding earnings tax-free as soon as the money is added to the account. After-tax contributions compound earnings on a tax-deferred basis when they’re added to a 401(k) plan. While after-tax contributions have been funded with the same type of dollars as Roth 401(k) contributions, they’re not under the protective tax-exempt shield offered by a Roth structure.

When you leave a company, after-tax 401(k) earnings can be rolled into a traditional IRA. This would effectively enhance retirement savings but would still require employees to pay taxes upon withdrawal. Increased retirement savings is generally a productive goal. How can we improve upon this strategy, reduce income taxes, and enhance Roth IRA balances?

Under current tax policy, there are income boundaries that restrict Roth IRA contributions, but not conversions. If your retirement plan allows frequent in-service withdrawals of after-tax contributions, you can directly convert your after-tax contributions to your Roth IRA on a regular basis. If your plan doesn’t allow in-service withdrawals, you may still be able to facilitate an in-plan conversion which enables a saver to convert their after-tax contributions into a Roth 401(k). Under either approach, it’s advantageous to convert after-tax contributions to a Roth structure as quickly and frequently as possible. Facilitating this conversion on a timely basis will allow savers to accumulate tax-free earnings sooner.

This generates an attractive savings strategy that’s often overlooked: your after-tax 401(k) contributions can be rolled into a Roth IRA where future growth will be exempt from taxes. Many investors can dramatically increase their Roth savings by utilizing the after-tax contribution feature of their workplace 401(k).

Resuming our example from earlier, our 60 year-old saver (assuming their workplace 401(k) plan allows frequent in-service rollovers) could decide to rollover their $28,000 after-tax contribution every year into a Roth IRA. This would allow our saver to contribute four times the annual maximum for a Roth IRA ($7,000).

Unfortunately, not all retirement plans offer conversion options for after-tax contributions. To determine if you’re eligible to save after-tax contributions in your 401(k) plan, facilitate in-service withdrawals, or conduct in-plan conversions we recommend contacting your plan administrator. We encourage Greenleaf Trust clients to reach out to a member of their Client Centric Team to decide if after-tax retirement contributions are appropriate for them.