We are all aware of the 401(k) contribution limits set annually by the IRS, but what if you’ve maxed out your contributions for the year and still want to save money for retirement? You could fund a brokerage account separate from your 401(k), but you would face a costly capital gains tax on those earnings. This is where leveraging an after-tax source in your 401(k) comes into play.
Overview of Limits
In most 401(k) plans, employees can save either pre-tax or Roth if the plan offers it, and if there is no option, employees save pre-tax in accordance with the annual contribution limits set by the IRS each year. For 2020, the contribution limit is $19,500, and anyone age 50 and over can put an additional $6,500 into a 401(k) for a total of $26,000. This limit is known as the 402(g) limit, named for the section code of its enacting legislation, and it specifies the amount an individual can defer on an annual basis.
There’s another limit the IRS puts on plans called the 415 contribution limit that represents the limit of employer plus employee contributions. For 2020, the 415 limit is $57,000, and for those age 50 and over who qualify for the catch-up limit, the limit is $63,500. This 415 limit is where having an after-tax contribution option in your employer-sponsored plan makes all the difference.
Leveraging an After-Tax Source in a 401(k)
Let’s take a look at an example scenario. A high-income earner with a $200,000 salary has an employer-contribution match of 5%, meaning this employee is receiving $10,000 in employer contributions into her 401(k). This employee is 40-years-old and contributes the max of $19,500 into her 401(k), and with the $10,000 in matching contributions she receives from her employer, a combined $29,500 is being contributed to her 401(k) annually. This means she has hit the limit of what she can defer pre-tax or Roth to her employer-sponsored plan; however, the 415 limit is $57,000. If she has an after-tax feature in her employer-sponsored plan, after-tax contributions are not subject to that 402(g) limit of $19,500. In other words, she can contribute after-tax dollars until she reaches the $57,000 limit, which in this case would be an additional $27,500.
This supplemental contribution of $27,500 comprises after-tax dollars, meaning taxes have already come out of the employee’s paycheck. That being said, on the surface, making this after-tax contribution is really no different than investing the $27,500 with her financial advisor or directly with Vanguard, Fidelity, or T.D. Ameritrade, for example. The benefit of leveraging this after-tax source in her 401(k) centers on the rules around an in-plan Roth conversion, referred to as a Mega Backdoor Roth. With an in-plan Roth conversion, this employee can take the $27,500 she contributed to her employer-sponsored plan after-tax and immediately convert it to a Roth inside the plan. By taking advantage of this option, she keeps all future growth on this money because any additional contributions and conversions that she makes in this after-tax account are tax-free when she starts taking contributions.
What Are the Benefits?
Because a high-income earner with a household income of $200,000, to keep with our previous example, would not be able to put money into a Roth IRA due to income restrictions, the Mega Backdoor Roth is an invaluable way for high income earners to sidestep the Roth’s income limits. In the example laid out above, let’s say the high-income earner does not plan on using the after-tax contribution of $27,500 for another 25 years until she reaches age 65. With normal market returns over those 25 years, that $27,500 would turn into $150,000, assuming a 7% projected rate of return. So now, she would have $150,000 that she can take tax-free distributions from throughout her retirement.
It’s important to note that this individual would pay around $8,000 in taxes up-front because the $27,500 is contributed after-tax, but remember, all future distributions are tax-free. Without the after-tax in-plan conversion, meaning if this individual were to take that $27,500 and save it in a brokerage account, she would pay the same $8,000 in taxes on accumulating the money, and then you would pay around another $20,000 in capital gains tax on the account in the future. That being said, for the person who wants to save more for retirement, especially if the individual has the money to do so or is behind on retirement savings and wants to get back on track but is already maxing out contributions, the Mega Backdoor Roth is a really valuable strategy to employ. Higher income earners and executives in particular find this savings vehicle to be a great addition to standard 401(k) contributions.
When you implement this option into a 401(k) plan, the primary purpose around this after-tax source is the Roth conversion for higher income earners; however, there’s a great ancillary benefit to this after-tax option for another cohort of employees who lack sufficient emergency savings. After-tax contributions can be pulled out of a 401(k) plan at any time, so you can use this after-tax source as a built-in emergency savings vehicle to your 401(k). While this is not the best recommendation for where to save money for an emergency – a high-yield savings account is typically the best option for an emergency savings fund – the after-tax feature in a 401(k) allows an individual to easily start contributing to an emergency savings account directly from his or her paycheck. The employee can contribute a small amount – 1-3%, $50 per pay period, or whatever that number is – into the after-tax source and allow that money to accumulate and grow, as it is still invested in the 401(k) plan. Because the contributions are after-tax, the employee has the ability to easily take a distribution tax-free, making this after-tax source a great turnkey option for an emergency savings fund.
The after-tax source is an invaluable vehicle for companies to add to their 401(k) plans, but there are additional compliance testing requirements that go hand-in-hand with implementing this option. Be mindful around how much you let an employee contribute after-tax because implementing this option triggers a non-discrimination test called the Actual Contribution Percentage (ACP) test that ensures the average rates of employee contributions and the company match are proportionate between the highly compensated employees and the non-highly compensated employees. All of these after-tax contributions are counted in the ACP percentage for employees leveraging the after-tax contributions, so you may need to put a limit on how much employees can contribute. It is prudent to work with your retirement plan advisor to run proper projections and analyses to ensure you remain compliant.