[Editor's Note: This is a guest post from Chad Chubb, CFP®, the founder of WEALTHKEEL LLC, a financial advisory firm with a focus on physicians. It is about after-tax 401(k) contributions followed by a Roth conversion, a concept I've written about before often called a Mega Backdoor Roth IRA. There are several minor variations on the technique, it isn't available to everybody, and it may not even be better than other options available to you, but you ought to at least find out if your 401(k) will let you do it because it sure beats investing in a taxable account. Although this is not a sponsored post, Chad is a paid advertiser on the site and on my recommended financial advisor list.]
What if I told you there is a way to save $54,000 to a Roth IRA every year, not including the usual $5,500?
You’re doing everything right by maxing out your 401k/Roth 401k each year at $18,000 and utilizing a backdoor Roth IRA contribution for $5,500. But now what? You probably have been approached by salespeople with a name tag that read, “Hi, I am a Financial Advisor,” and they told you about this incredible “low-cost” annuity or whole life strategy to continue your tax-deferred investments since “everything else” is maxed out. Bologna! Let me introduce the after-tax 401k contribution. No crappy sales pitch needed, just a quick call to HR to see if you have this option available. According to Aon Hewitt, 48% of employer retirement plans offer after-tax contributions. I would be willing to bet that most of the 48% that have it had no idea that their plan had this feature, or if they did, they had no idea what it meant or did.
$54,000 Secret Roth
Chad Chubb, CFP
The government allows you save $54,000 (2017 limit) each year to your 401k. This is a combination of your pretax, Roth, after-tax [not the same thing as Roth-ed], AND your company’s match/contribution. Let’s assume you save the full $18,000 for 2017, and your employer match totals $7,500 (3% on $250,000). Let us pause to recognize that saving $25,500 is a spectacular accomplishment! However, it CAN get better. If your employer allows you to save after-tax contributions to your 401k, you may be able to save $28,500 more! Most would be happy with this as additional tax-deferred assets. Thanks to IRS Notice 2014-54 you can ultimately use that $28,500 as a Roth IRA contribution.
If we assume no match or employer contribution, you could ultimately save $18,000 to your Roth 401k, and $36,000 ($54,000-$18,000 Roth 401k) in after-tax contributions. If converted correctly, your after-tax contributions can become Roth IRA assets, and you essentially could have saved $54,000 in Roth assets for this year (2017).
I won’t bore you with all the details of how we got to this point in Roth history, although it has been an interesting process to see this get to where it is today. I think Michael Kitces does a great job walking you through the history of the “mega” backdoor Roth conversion.
In the end, plan administrators will issue two separate checks once you retire and/or separate from service. Check 1: The traditional portion AND gains from your after-tax contributions check will get moved to your traditional IRA. Check 2: You can move your after-tax contribution check to your Roth IRA. Let that sink in for a minute. Most of you had the mindset that $5,500 to a Roth IRA was the max. Now you could potentially save nearly ten times that amount, in addition to your usual Roth IRA contribution!
The after-tax contribution check will ONLY include the actual contributions. It will not include the growth on that portion. For example, you saved $50,000 in after-tax contributions, and it has grown to $65,000. $50,000 would be issued in one rollover check to your Roth IRA, and the $15,000 in gains would be issued with your traditional IRA assets check. Uncle Sam outsmarted us on that one. Now and then I hear this called a delayed Roth IRA, and that is because you are not getting the tax-free compounding aspect until it’s moved to the Roth IRA. Remember, tax-deferred is great, but tax-deferred and tax-free is best.
Michael Kitces said it best, “Deferred Roth is better than no Roth, but Roth now is still better than Roth deferred.” If you peek down lower in this post, you will see the Investment Totem Pole. The “delayed” tax-free growth is why you still want to take full advantage of your 401k/Roth 401k and IRA/Roth IRA first, and then circle back to your after-tax contributions.
Case Study
Let’s keep it simple, Dr. Wealth finishes fellowship at 35 and wants to retire at 55. We have 20 years to save and let’s use 6% annualized growth. We will also assume the max Roth 401k, and after-tax contributions stay the same at $18,000 and $54,000 for all 20 years, and no assets go to the traditional 401k. Yes, simplified, but good for getting an idea.
- Roth 401k: 20 years of $18,000 contributions to Roth 401k with 6% annual growth over 20 years= $662,000 (rounded)
- After-Tax Contributions: 20 years of $36,000 ($54,000-$18,000 Roth 401k) contributions to after-tax over 20 years= $720,000
- That is $1,382,000 in Roth assets if all goes according to plan.
- This doesn’t factor in the growth dollars on the after-tax contributions going to your IRA. If we follow the same 6% annual rate of return, that is another $600,000 ($1,324,000 – $720,000). And if you are keeping count at home, that is a total nest egg of almost $2,000,000 by only using your 401k.
Too Good To Be True
The tax code is so complicated now that it has even confused the people who write the rules. If you read the history of this evolution, you will understand what I mean. There may come a day when this isn’t possible anymore. President Obama did propose shutting this down before, and it was the same mention that would close down the backdoor Roth IRA as well. Play the hand that you were dealt, and as of today, this strategy is still fair game. Even if they were to shut this down, I would argue the after-tax contributions become more attractive since high-income earners would be forced out of Roth contributions in total. After-tax contributions would still come with tax-deferred growth.
Another issue is the pro-rata rule, the same thing that happens when you mess up your backdoor Roth IRA and start to build a basis on your IRA assets. The only time this becomes an issue with your 401k is if they allow in-service distributions. You MUST take a FULL withdrawal to avoid the pro-rata (rule 72e8) when you have both pre-tax and after-tax balances. The 401k providers can get tricky here. For example, we had a client working at a very large hospital in Central PA. He was allowed to take an in-service distribution after age 59.5. However, they required a minimum of $1 to stay in the account at all times. Since he had pre-tax and after-tax dollars, it would have been a pro-rata withdrawal. That one little dollar had a huge effect on our strategy – move to a Roth IRA now, and start the tax-free compounding growth a few years before retirement – and essentially we had to put that on hold. Moral of the story, only FULL withdrawals avoid the pro-rata rule.
Investing Totem Pole 2017
- First, contribute to get your FULL match in your 401k/Roth 401k.
- Then to your IRA/ROTH IRA and max out that account. (Capped at $5,500 or $6,500 for 50+)
- Come back and finish your 401k/Roth 401k bucket. (Capped at $18,000 or $24,000 for 50+)
- Then start to hit the after-tax contributions in your 401k. (Capped at $54,000 for ALL )
Fun Facts
- After-tax contributions are still taxed as ordinary income and will show via your W2.
- After-tax funds still have the same age 59.5 rules attached. Please make sure you have a fully funded emergency fund, and some money stashed away in an individual or joint account (liquidity).
- Roth 401k contributions and after-tax are different. The Roth 401k is capped at the $18,000 while the after-tax can go up to $54,000 for 2017.
- Make sure you have a “quality” 401k plan as well, good, low-cost investment options and minimal fees are important before you start to pump $54,000 a year into your 401k. BrightScope can help show you how your 401k stacks up against the competition.
- Many advisors will keep this a secret from you because they don’t get “paid” when you save more assets to your qualified plan. If your advisor is using an asset under management (AUM) schedule or commission structure, sadly, they are probably not talking too much about this strategy.
Investing is a good thing, and the younger, the better. However, make sure you have the rest of your financial house in good order before you start stressing about the “cool” after-tax Roth strategy. Make sure you have a solid emergency fund, no silly debt (credit cards, Ferraris, alligators, etc.), have your student loans on the proper path to pay off or to be forgiven, and the appropriate insurance to protect you and your family. Once you build a solid foundation, you would be shocked how quickly you can build net worth.
Disclosures, so my compliance team does not have a heart attack:
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- The hypothetical investment results are for illustrative purposes only and should not be deemed a representation of past or future results. Actual investment results may be more or less than those shown. Investments in securities do not offer a fixed rate of return. Principal, yield and/or share price will fluctuate with changes in market conditions, and when sold or redeemed, you may receive more or less than initially
- For ANY tax notes above, I am not an accountant or a CPA. Please be sure to consult an accountant or CPA before implementing. This blog does not constitute tax advice.
- Registered Representative offering securities through Cetera Advisor Networks LLC, member FINRA/SIPC. Cetera is under separate ownership from any other named entity. Advisory Services and Financial Planning offered through Vicus Capital, Inc., a Federally Registered Investment Advisor.
[Editor's Note: I wanted to make a few clarifying comments about this post.
First, don't assume that contributing to a tax-free (Roth) account when you have the option of using a tax-deferred account is a good idea, particularly during your peak earnings years, when it usually isn't. Learn more here about the tax-deferred versus tax-free decision.
Second, remember that you can save money for retirement even without a retirement plan. It's called a taxable account and works fine. It has some tax advantages, but is generally markedly inferior to both tax-deferred and tax-free retirement accounts. This post is about WHERE you invest your retirement money–as after-tax 401(k) contributions or as taxable account contributions–not WHETHER you invest that money for retirement. If you can't get enough (typically 20% of gross income) into retirement accounts to fund your retirement, then you need to invest it in a taxable account. After-tax contributions are markedly inferior to both tax-deferred contributions (including the employer match) and Roth contributions. If never converted, they may be so inferior that they are worse than a taxable account. They are certainly less flexible.
Third, there are many variations on the mega backdoor Roth IRA. The best one is when your 401(k) allows you to do Roth conversions within the plan each year without ever having to withdraw anything. The second best one is when your 401(k) allows you to do a full in-service withdrawal each year. The after-tax money can go to a Roth IRA and the pre-tax money can go somewhere else, such as an old 401(k) or a traditional IRA (although that would cause issues with the standard backdoor Roth IRA if you didn't roll it back into the 401(k).) The key is to get the information for YOUR plan as every plan is unique as far as what it allows. You want to ask HR if the plan allows after-tax contributions, in-plan Roth conversions, and in-service withdrawals. The answers (and thus your possible strategies) will be different for every plan.
Fourth, the longer you wait to do the conversion, the less advantageous making non-deductible contributions is. In fact, just like a non-deductible IRA (that is never converted) or a low-cost annuity, it is possible to do better in a regular old taxable account. Remember that earnings in a non-deductible IRA are taxable at your marginal tax rate whereas earnings in a taxable account are taxed at the lower dividend/long-term capital gains rates. For a tax-efficient investment, it may take decades of tax-protected growth for the non-deductible IRA/401(k) to make up for the higher withdrawal tax rate. Without some sort of plan for eventual conversion, after-tax contributions are hardly a no-brainer.]
What do you think? Does your plan allow for a Mega Backdoor Roth IRA? Are you using that option? Why or why not? When do you plan to do your conversion? Comment below!
Thank you WCI! I have to admit this is pretty awesome to see this live on your page. Thank you again for the opportunity to share this idea/post with the White Coat Nation!
Timely post- I just made this move this week. Of course my situation is slightly different. I am an employed urologist. My employer just settled an ERISA lawsuit so we now have a new plan provider with Fidelity. The plan has always allowed after tax contributions but due to highly compensated employee limits, the plan limits contributions to 5% of income up to IRS limit, or 13500 per year now (270000 times 0.05). The plan also restricts after tax contributions for 6 months after a withdrawal. The plan does allow inservice withdrawals and will split proceeds into different accounts.
So, to maximize my savings, I contribute 5% until I make 270000. I then call up Fidelity, they work their magic, and the next morning my basis is sold off and deposited into a Roth IRA with them. I have them move the earnings to my solo 401k from my side business, though apparently Fidelity cannot do this electronically yet. They send a separate check made out to Fidelity that I mail back to them with a letter of instruction and voila, My after tax money is now Roth money. I cannot make any more contributions for 6 months, but I have maxed out for the year anyway so no big deal.
It is a little more complicated, and not the first move I would make, but I currently max out 403b, match, 457b, 401a, and back door Roth for myself and my spouse. I throw about 25000 a year in taxable and this strategy was the last or next to last I have added.
I have a partner I am trying to talk into this. He is a few years from retirement and has a 6 figure after tax account that would make a sweet Roth conversion. He’s just waiting for me to test the waters I suppose.
Hi DUKEISOK- Thanks for the comment! Sounds like have a solid game plan in place and utilize all the investment vehicles available to you. That is great!
Regarding the paragraph “In the end, plan administrators will issue two separate checks once you retire and/or separate from service.”
Is this assuming you wait until you retire or separate to do the Roth conversion?
I convert quarterly as allowed by my plan to minimize the taxes paid on the gains, but the both the gains and after tax contribution get converted to the Roth IRA. I’m just slightly confused on the aforementioned paragraph stating that gains get transferred separately to another account but perhaps that doesn’t apply to me?
Hi CELINE- The comment in the article was in reference to retirement/separation of service for general guidance, but every plan has their own rules. We now see quarterly and annual options more often today. However, with that said, I would check with your plan administrator because you shouldn’t be allowed to move non-taxed dollars to your Roth IRA. And by non-taxed, I am referring to the gain portion of your quarterly conversions.
The only thing I can think of is that you may be converting your Roth 401k contributions to your Roth IRA. Since you noted “after-tax,” I am going to assume that is not the case, but that is all I think of.
Let me know what you find out; you are welcome to send me a quick email as well.
Hi Chad, I do have to pay taxes on the gains, but by doing it quarterly the gains (and taxes) will be minimal.
I’m definitely not contributing to a Roth 401k so this is definitely the after tax contribution I’m making to my 401k (after my $18k traditional 401k contribution plus company match).
I did check with the plan today and coverting the cost basis plus gains is definitely allowed, again I just have to pay taxes on the gains.
Okay, great! I just wanted to make sure that was happening somewhere in the transaction. That all makes sense. Thanks for the follow-up, Celine!
Just to be clear, this is not an ADDITIONAL $54k into a 401k, right? It is for the money gap between where a match stops and $54k limit exists, correct?
For those of us who are 1099/self-employed, and “match” our 401ks all the way up to $54k each year, this doesn’t seem to be all that advantageous, is it? I suppose we could make all $54k Roth, but that would be stealing from tax-deductible contributions to our 401k to make them Roth 401k, making the tax burden big. In our peak earning years, not sure that’s what I want to do.
I still struggle with how to balance my 401k contributions between trad and Roth, because I can’t predict the future of income tax.
Thoughts/advice?
Thanks
Hi JARED- Yes, you are correct that the $54k is a TOTAL of ALL contributions to your 401k for a given year. I also agree that if you are 1099/self-employed there are other investment “buckets” to use and take advantage of.
For many high income/high tax bracket individuals, I do think the 401k (not Roth 401k) is your go-to. However, I agree that the unknown tax rates are a headache. The unknown is the reason why we typically like to see a good mix of pre-tax, Roth, and taxable buckets. It is the best way to plan for the unknown tax rates, so just keep saving and diversify your different buckets best as possible.
Very interesting. I’ve read a lot of this before. It seems “scary” though. Making just one mistake could trigger some penalties or maybe even an audit(?). Is it solely on the investor to make sure all the numbers are good and “boxes are checked”? Or is there a professional to work with? Not an accountant I’d guess (at least not mine). Probably not the average investment advisor (they want to manage investments not wiggle through tax rules). Would an average CFP actually be able to coordinate all the specifics AND help with the execution?
Just thinking out loud. Seems “dangerous” for someone without deep knowledge to handle on their own.
Hi BRAD- A solid line up of questions! I wouldn’t call it scary per se. Of course, if you are a DIY’er you should have a good idea of what’s going on, but most of the responsibility here falls on the plan providers. They are the one that has to follow the “rules” to make sure things go smoothly. Can there still be errors? Of course. That will happen with muti-step items and topics that are not as cookie-cutter.
For which professionals to use, I hope they could all help with this subject, but unfortunately, not all will. And that’s okay. However, these are the topics you should be asking before you pick a professional to work with. Look for professionals (CPA, CFP, Financial Coach, etc…) that truly focus on your profession, it won’t be their first rodeo with 95% of these topics.
Don’t be overwhelmed, one or two calls to the plan provider should give you a great starting point if you were to pursue this topic/idea.
@WCI What value if any should we assign to the asset protection feature of “after tax contributions” vs “taxable account” when you get to that part of your contributions? It seems like your eventual withdrawal difference between taxable income versus capital gains is kind of like an additional insurance premium against the assets being lost in a lawsuit. Am I thinking about this correctly?
Sure, but I have no idea how to assign a value to that. It’s dichotomous. If you are never sued above your limits, its value is zero. If you are, it has huge value.
Can you do this if you are doing a defined benefit/profit sharing plan?
Hi VERNON – This entire post/strategy is specific to a defined contribution (DC) plan. However, most defined benefit (DB) plans are created to allow larger contributions. Just to give you a basic idea, the maximum contribution to a DC plan for 2017 is $54k (hence this article), but for a DB it is $215,000. The main kicker is that most DB plans follow a formula, meaning you can’t just say “Here is my money, please invest it.”
It would be impossible to address your specific plan here since DB plans have even more moving parts than a DC plan. It would be worth a conversation with HR or the plan provider for the DB to ask for more specifics on your plan.
Is it possible to employ the same method but instead of going Roth, just add more for traditional 401k contribution?
Hi XRAYVSN- In theory, I am sure you could get a plan provider to do that for you, but you wouldn’t want to do that. You already paid Uncle Sam on the after-tax contribution. This would just lead double taxation if any plan provider would even allow it. Safe to say, try to avoid any forms of double taxation 😉
I hope I read your question correctly. If not, please don’t hesitate to send me an email.
Nice guest post- Our HR team/employer allows for this option and actually discusses it regularly. They also advocate investing the funds and at some point converting them into a Roth 401K. The timing of the conversion depends on your income, retirement date, etc. Most of my colleagues go to part time before they retire and with the reduction in income, it is a good time to make the conversions.
I think at the end of the day saving is what is important. If you are not saving, then it doesn’t matter what is available to you. If you are saving, then you are likely going to be okay. These tweaks- roth conversions, taxable vs tax deferred accounts, etc. are important but not the mammoth that produces wealth.
Hi, Dads Dollars Debts- Thanks for the comment! A personal shout out to you and the material from your posts as well! Great stuff!
I think it is awesome that you have an HR team/employer that are making you aware of these topics. You would be shocked by how many advisors (you read that correctly) don’t even know of this subject or discuss it with their clients.
I could not agree more with your savings comment. In the end, that is the key factor. Yes, you can be strategic with which buckets you choose, but as long as your saving $X, that is the primary wealth multiplier.
Does anyone know if the post age-50 $6k catch up bonus applies here? In other words, could someone 50 or older contribute up to $60k per year total as opposed to $54k?
Thanks.
Hi Jay Jay- You are correct, the $6,000 catch-up does apply to bring your total maximum contribution to $60,000. I should have noted that in the post somewhere, I apologize.
The commentary below is from our compliance team adding to some of the cautionary viewpoints.
“Since the income limits on Roth conversions were removed in 2010, higher-income individuals who are not eligible to make a Roth IRA contribution have been able to make an indirect “backdoor Roth contribution” instead, by simply contributing to a non-deductible IRA (which can always be done regardless of income) and converting it shortly thereafter.
However, in practice the IRA aggregation rule often limits the effectiveness of the strategy, because the presence of other pre-tax IRAs and the application of the “pro-rata” rule limits the ability to convert just a new non-deductible IRA. On the other hand, those with a 401(k) plan, that allows funds to be rolled in to the plan, can avoid the aggregation rule by siphoning off their pre-tax funds into a 401(k) plan, reducing your taxable IRA accounts to zero, and then converting the now-just-after-tax IRA remainder to a Roth IRA.
CAUTION :The greatest caveat and the potential blocking point for doing a backdoor Roth contribution is called the “step transaction doctrine”, which originated decades ago in the 1935 case of Gregory v. Helvering. Which allows the Tax Court to recognize that even if the individual contribution-and-conversion steps are legal, doing them all together in an integrated transaction is still an impermissible Roth contribution for high-income individuals. to which the 6% excess contribution penalty tax may apply. The Tax Court can look at what are formally separate steps of a transaction, that have no substantial business purpose to be separate, and conclude that they are a really just a single integrated tax event, and treat it as such.
In the context of the backdoor Roth contribution, this means if the separate steps of non-deductible IRA contribution and subsequent conversion are done in rapid succession, there is a risk that if caught the IRS and Tax Court may suggest that the intent was to make an impermissible Roth contribution… and then disallow it (and potentially apply an excess contribution penalty tax of 6%), if the individual’s income was too high to qualify in the first place.
It’s crucial to recognize that with the step transaction doctrine, each step of the transaction continues to be entirely legitimate. The point is not that each step cannot be legally done, nor even necessarily to say that they can’t be done one after the other. The ultimate point of the step transaction is that when the multiple steps are done with the clear intent of accomplishing a single transaction, though, the Tax Court can recognize (and tax or penalize) it accordingly.
Possibly, the step transaction doctrine can be navigated, by allowing time to pass between the contribution and subsequent conversion (although there is some debate about just how much time must pass!). But perhaps, if the goal is to demonstrate to the IRS and the Tax Court that there was not a deliberate intent to avoid the Roth IRA contribution limits, stop calling it a backdoor Roth contribution in the first place!
It’s important to recognize that the step transaction doctrine is ultimately not a black-and-white test; instead, it is a nuanced interpretation of the facts and circumstances of the situation. In point of fact, this is why it has evolved as a judicial doctrine in the courts, not merely as an arbitrary rule that the IRS can apply at will.
It is fair to acknowledge that the actual risk of getting “caught” with a questionable backdoor Roth contribution is low. Nonetheless, though, for someone who is caught, it may be difficult to defend that a backdoor Roth contribution was not a step transaction, if they were in fact done in very rapid succession. This is roughly analogous to speeding by driving 57mph in a 55mph zone; the odds that a police officer pulls you over are low, but if you are pulled over and end out in traffic court, you can’t really dispute that you were guilty of speeding (and at best, you can just ask for leniency on the punishment!).
On the other hand, given the dollar amounts involved, if the client is challenged, it’s almost certain in practice the client will just choose to acquiesce and pay any penalties the IRS assesses, as the cost to fight the matter with the IRS will likely be worse than just accepting the consequences and moving on. Though given that repeated years’ worth of backdoor Roth contributions could create a compounding excess contribution penalty tax (potentially even compounding enough to trigger a 20% accuracy-related penalty in the final year as well), eventually it may be the case that a client will wish to fight to defend the strategy.
However, from the IRS’ perspective, as the magnitude of dollars engaged in the strategy increases, that may also increase the likelihood that the IRS will pursue the matter in the first place. And in fact the reality that the dollar amounts involved are typically still small may indicate why the IRS has not aggressively pursued the strategy… at least, not yet?”
Any business owner will need to consult with their Tax Advisor to make sure that this is a transaction that they really want to execute.
Hi Tom- Thank you for the comment, and you have a lot of great details in here. I agree with many of your points, and typically discuss the step doctrine and not calling it a “Backdoor Roth IRA” with our clients. The only kicker is that this is not a Backdoor Roth IRA.
With that said, you could take your comment and post it to any articles for Backdoor Roth IRAs because you do have great points and details in your post!
In your defense, Congress will typically lump this strategy and the backdoor Roth IRA together when they discuss fixing some of the “loopholes.” With any tax strategy, you should always talk to your CPA to make sure it fits your specific details.
I don’t know of a single case where the Step Doctrine was applied to the Backdoor Roth IRA. Do you? I’d love to hear about it.
The counterargument to the step doctrine being applied to Backdoor Roth IRAs is that a converted Roth IRA has substantial differences when compared to a direct Roth IRA.
The IRS has already said that the waiting time doesn’t matter. You don’t have to wait to convert.
I am with you WCI, I still have not seen this come up personally with any clients, friends, or family. I don’t think I have spoken with a CPA who could give me a real world example either. We know there was at least one court case in 1935 (aka Gregory vs. Helvering)!
We used to use the next day method, and then I read Kitces blog on the step doctrine, and now we add a time lapse to the transaction. You have to love the IRS and their specific details on this stuff!
The IRS has essentially debunked Kitce’s/Your method. They said that time period doesn’t matter, i.e. no reason to wait. It’s not like they don’t know about this.
Are these after tax contributions treated the same as employer contributions with regard to non-discrimination testing for the plan?
We max out at well short of $54k due to non discrimination testing and the limited contributions we (partners) make on behalf of the the non highly compensated employees. We can typically only contribute $18k + ~$20k instead of a full $54k.
Better run those numbers again and ask other TPAs. Our group has both HC and non HC individuals as well. And we can do it. Infact it allows us to do contributions upto 14k (we don’t even have to do 18k) the rest is all made up by the company to max of 54k..
Hi Phil- First disclosure is that each plan is unique and there are even different rules for how each plan tests for their non-discrimination. Without a summary plan description (SPD), it’s hard to even generalize the internal piping of a qualified plan, Heck, even with the SPD, it may require a few phone calls.
Dr. P.K. brings up a great point on getting confirmations from your current plan provider and maybe getting a 2nd option on the plan itself. However, it is not uncommon to start to have some administrative issues with non-discrimination rules once you start to max out your after-tax savings. This is more common in smaller plans with the more HC employees than Non-HC. The details of how to address/fix the issue really depends on your testing type and your plan specifics.
What are your thoughts on doing the mega backdoor roth IRA through a solo (i.e. individual) 401k plan? I know most of the off-the-shelf plans from Vanguard, Fidelity, etc do not offer such an option. However, from my googling, there are some providers such as mysolo401k that have all the requisite features that would allow you to do this.
(check out https://www.mysolo401k.net/mega-back-door-roth-using-solo-401k-plan/)
Are there any legal or tax barriers to doing this via a solo 401k (as opposed to an employer-based 401k)?
You could if you really wanted a lot of Roth. Most docs maxing out individual 401(k)s are in peak earnings years when tax-deferred contributions usually maks a lot of sense.
Great stuff to think about – definitely on my list to find out the rules for the 401(k) for my new employer when I start. Appreciate all of the clarifying comments, WCI. I had multiple questions building up as I read that I was going to post here, but when I got to the bottom of the article, you already answered them all! Thanks!
Hi ID Doc- Thanks for the comment and best of luck with the new job!
I’m getting pretty good at knowing the questions readers will have after a guest post. So I either have the submitter include them in the post or add an editor’s note.
Chad and Ed.,
Thanks for the great post. Also excellent comments, along with thoughtful replies from Chad. Major airline pilots have many of the same issues and opportunities as White Coat Nation. In my spreadsheet the fees become a critical differentiator comparing 401k/Roth to simple after-tax investment account on the open market. Taxing 100% at income tax rates vs only gains at capital gains rates is a significant consideration. Also having full control of “free” investments is an intangible benefit, not to mention the likely future of means testing. Agree with overall prime directive to save…anywhere, early.
Hi Andy- Thanks for the comment and the kind words! I agree wholeheartedly with your comment. It is hard to exercise my true “nerdy” side in these posts because it will become a novel. However, we will analyze a client’s 401k/403b in detail before we tell them to start cranking $54k into a sub-par plan. For example, if their plan has high administrative fees and the internal expenses of their fund options are coming in at 1%+, we are going to do some homework on what other buckets a client could use.
In today’s investment world you can build a pretty tax-efficient taxable account with the addition of ETFs and a passive investment strategy. For this post, I didn’t get into those details, but WCI did an excellent job adding this idea with his 2nd editor’s note.
It takes really high fees before skipping out on 401(k) contributions in favor of investing in a taxable account becomes a good idea. Think 2%+. Especially if you are likely to change employer/plan relatively soon.
Agreed, and the 401k world is getting better with their plans. Plan fees and the internal investment options have been on a nice path to improvement for employees.
Several comments on how you can get this done in your plan:
1) As a W2 employee, there isn’t much choice. You are subject to plan rules. If you are allowed after-tax contributions, great, and if you are allowed to roll these over into a Roth, even better, but in general that’s not going to be the rule.
2) If you have 1099 income and can open your own plan, there is a solid strategy that is much safer to implement given that we don’t know whether IRS will like the idea of doing annual rollovers of after-tax contributions into a Roth IRA. This strategy is ‘in plan Roth conversion’ which has become available relatively recently. With a custom plan document you can, instead of doing the constant conversion of after-tax contributions, simply convert your profit sharing contribution to Roth right inside the plan without having to move any money out of the plan (and do $18k Roth salary deferral on top of that) at the touch of a button. This is a much safer strategy in my opinion. Again, you need a custom plan document and a TPA to pull this off, so this would work for someone who is maximizing their 401k contribution anyway.
For those who can not max out their 401k and still want to do after-tax, I would recommend making after-tax contributions, and waiting until such time that either you can convert after-tax to Roth INSIDE THE PLAN (which is currently not allowed, but eventually will be – if rollovers are allowed, this just makes sense), OR until IRS can explain HOW OFTEN you can move the money out your plan into a Roth IRA (and if annual rollovers are OK, then so be it), as at this point IRS examples clearly show sporadic/one-time rollovers (when changing employers for example), not constant ones. The downside is that any after-tax growth is actually taxable, but this is the best one can do if you can’t fill up your 401k with tax-deferred contribution up to $54k.
3) With a small practice plan, after-tax will never work for a smaller practice, so doing in-plan Roth conversions will ALWAYS work to get you massive Roth contributions. Again, all this requires is an ‘in plan Roth conversion’ option, and that’s all. This is something we always add to our plans, and as long as you can max out your plan contribution, you can convert the whole thing to Roth if you so desire.
Please note, that if you are in the highest tax brackets, I would advise not to do the Roth conversion strategy, and to just be content with backdoor Roth for the following reason: you can convert your tax-deferred assets to Roth during retirement prior to age 70 1/2 in a massive tax-deferred to Roth conversion spree, and even if that takes you into the higher brackets temporarily, the long term effect of this conversion will be extremely beneficial, so you can have a cake (tax deferral) and eat it too (lower your eventual RMD taxes and have a massive Roth account in the process, while you do so when you are potentially in the lower brackets in retirement).
Hi Kon- Thanks for the comment and additional insight!
WCI-a follow up on WBW’s question from before and Kon’s post.
My employer’s 403b doesn’t allow after tax contributions, but I would love to be able to do additional after tax contributions and roll into a Roth IRA. This wasn’t possible in the past with solo 401ks either (especially with mine through fidelity).
Is the solo 401k after tax contribution to Roth IRA conversion route now more accepted from an IRS standpoint? Are the plans WBW mentioned (and Kon’s option) viable?
It’s always been accepted by the IRS, but the plan document must allow it.
What issues are you talking about here?
“Your pre-tax money can go somewhere else, such as an old 401(k) or a traditional IRA (although that would cause issues with the standard backdoor Roth IRA if you didn’t roll it back into the 401(k).)”
We just rolled an old 401k into an IRA, we are currently contributing to another 401k, and a Roth IRA. Are we going to run into trouble with that if we eventually do the backdoor Roth?Should we have not opened the traditional IRA for the old 401k? What am I missing?
Hi Sarah- I will keep this general since we don’t have that many details. The quick answer is that if your plan is to take advantage of Backdoor Roth IRA contributions going forward, you will want to get rid of the Traditional IRA balance. If you start the Backdoor Roth IRA process while having a Traditional IRA, you are going to start the IRA basis problem.
There are plenty of options to fix the issue, and they are all rather simple fixes, but it is easier to fix sooner than later. WCI has plenty of great information on this topic as well.
Yes. See Line 6 on Form 8606, or this post:
https://www.whitecoatinvestor.com/backdoor-roth-ira-tutorial/
Thanks for another great article!
I remember other articles on this topic and the topic of what the plan administrator allows in terms of in service distribution rules and where exactly the plan administrator can send your $. Can you touch on strategies on how to avoid the pro-rata rule when doing the “mega roth” based on a few different theoretical types of 401k plans with the ability to contribute post tax dollars? Thanks!
Agreed, this would be helpful. In particular I’m not sure I fully understand how the pro-rata rule applies to an in-service withdrawal. For instance, if the plan only allows in-service withdrawals of ‘voluntary after-tax’ contributions, I was under the impression that the IRS guidelines means you can deposit directly to a roth IRA. This bypasses the pro-rata rule. Or does the rule still apply based on the entire 401k balance?
If the plan allows that, it shouldn’t be pro-rated. But the key is to read the plan document to see what it allows.
Actually, pro rata rules do apply:
https://www.irs.gov/retirement-plans/rollovers-of-after-tax-contributions-in-retirement-plans
This is where things get tricky. If you have a mix of after-tax and tax-deferred assets, pro rata rules apply, and you can’t just take the after-tax out into a Roth. Also, any growth of after-tax assets is tax-deferred.
This is probably why such rollovers are intended to happen only when you liquidate/roll over the entire plan (such as when changing jobs). So one has to really understand exactly what the plan allows and what type of money is allowed to be rolled out of the plan (if at all), and whether any pro-rata tax calculations would be required.
I agree with your last paragraph. There are situations where pro-rata calculations are made and situations where they aren’t.
If the strategy involves money in a traditional or SEP-IRA on Dec 31st, then the pro-rata issue on 8606 will be an issue. That would be the main thing. But if you can do in-plan conversions, that’ll never be an issue, or if the plan allows you to just pull after-tax money out and immediately convert it, not an issue.
Hi Brian- Thanks for the comment and kind words! WCI nailed that, and pro-rata should not be an issue for this strategy, assuming your plan allows it.
However, I can understand your confusion. I have received a few emails and comments already on the same topic/question. I think the issue is how the plan words Roth vs. After-Tax contributions which is leading to this strategy and the traditional Backdoor Roth IRA to get intertwined.
Not correct, please see my post above regarding pro-rata rule, it does apply if you have a mix of assets in the plan.
Hi Kon- I understand your point, and hence my comment of “should not be an issue.” However, you sending tax code links and that is the same information plan providers will follow (should follow). So yes, you can make an error by not taking it proportionally which leads to a pro-rata issue, but my assumption/experience has been your plan provider should do a good job warning you of this downside. Or if you have a good advisor/CPA they will explain this point before proceeding.
The easiest way to avoid this whole issue is to wait until separation of service which is why I used that as my example in the post. However, some try to take advantage of this more frequently (ex: annually) and that is where you have to be aware of the proportional and the after-tax issues.
While you have brought up stellar points in all your posts, you are adding details that are tough to address in a post without overwhelming/confusing the readers. I try to write in the simplest terms possible for mass audiences.
Just how exactly do you determine if your plan allows this? I looked up the plan information for my 401k and they allow before and after tax contributions, but they say that the combined total is capped at $18k a year. Do just contribute more than the $18k and then roll it the after tax portion as part of this plan?
Remember Roth is not the same as after-tax. Your plan allows $18K in contributions including Roth and tax-deferred. We’re talking about a third type of contribution, “after-tax.” Confusing, I know. With after-tax, earnings are tax-deferred. With Roth, earnings are tax-free.
Hi Bryan- To build on WCI, it is confusing. Even after we get a summary plan description for our clients, we will sometimes call the plan provider 2-3 times to make sure we are getting consistent answers.
The problem is you will get customer services reps who label Roth and after-tax contributions as the same thing. Even HR teams will do this every now and then. Financial literacy can affect the individuals who are there to help. Just wait until you have to call Social Security someday, you will get a different response each time you call, even after ten calls.
One thing that is often left out in articles on this subject is the 401k compliance testing. For businesses, it’s impossible to contribute post-tax without compliance implications (of the company needing to pay NHCEs) if NHCE’s did not also contribute post-tax. i.e., if HCE’s start making post-tax contributions, there is a formula that must be resolved and you can’t have 0% contributions on the NHCE side without any implications to those original HCE contributions or making additional contributions from the business into NHCE accounts.
Hi Oscar- I agree 100%. The first problem is that if we start adding that type of detail to a post, many readers will fall asleep. They other issue is that every plan is so unique that is it impossible to even give cookie-cutter responses for 401k compliance testing. If you are in a private practice with 4 Docs and 5 staff, yes this is going to be harder. If you are a Doc at Penn Medicine, where there are thousands of physicians and staff, it should be easier.
With such a diverse group following WCI, it is difficult to be specific to plan details. Even the terms HCE and NCHE are too much technical jargon for most, but I do agree with your points.
It is nearly a given that you can’t do after-tax contributions in a small group practice plan. Please see my post above about what can be done if you have access to your own retirement plan (with or without partners). In-plan Roth conversion is a much better strategy for small practice owners than after-tax contributions.
This is where it is hard to write a post to address specifics. The problem is that many physicians (really, any high-income earners) need to be careful/precise with “Roth conversions.” While I am a firm believer in having pre-tax and after-tax buckets, it is tough to tell high-income earners to convert at a 39.6% federal tax bracket.
I am not sure I would say “much better” but it is certainly something to look at if the after-tax contribution is not available to you.
“Much better” just means that that’s the only cost-effective way of building a Roth bucket for most practice owners/partners who work for practices with staff. There is no option to do after-tax because of the significant cost associated with it in terms of employer contribution.
My current employer’s 401k plan permits me to do an in-plan Roth conversion. I’ve been contributing $18K pre-tax, then continued to contribute after-tax up to the $54K limit, which includes the employer contribution. My employer only permits me to do one in-plan Roth conversion per year. So I’ve been waiting until the end of the year to convert the after-tax portion of my contributions and earnings to a Roth 401K. I pay tax on the earnings, however does this in-plan conversion to a Roth 401K subject me to the pro-rata rule?
Not sure if this makes a difference, but I have a Roth IRA outside of my current employer’s 401K plan that was a rollover from a previous employer’s 401k.
My accountant must not deal with a lot of these because he wasn’t sure the answer to this question. My employer’s retirement plan hotline rep told me I should be ok, but I’m not confident in his response either.
I realized I stated that middle sentence incorrectly. What I meant to say was:
“Not sure if this makes a difference, but I have a Rollover IRA outside of my current employer’s 401K plan that was a rollover from a previous employer’s 401K”.
There is after-tax contributions that can be converted to Roth (but I have not yet seen a single case where this can be done INSIDE the plan – usually the assets are rolled into a Roth IRA, so if this is allowed inside the plan you need to verify that this is indeed the case) and there is in-plan Roth conversion of tax-deferred asserts. First thing to do is to look at the plan document and determine exactly what is allowed and what can be done. Then you should figure out how this affects your personal situation in terms of pro-rata rule. If you have a mix of assets (after-tax, tax-deferred) and you convert after-tax to Roth, yes, pro rata rule will apply. Giving advice on a forum like this is not very useful because details matter. You might need to find a good CPA and/or an ERISA attorney and pay them to get an accurate answer because they have to dig into the details to see what exactly you can do with your plan. Alternatively, you can try to talk to your plan’s TPA and see what they say about it.
Wife and I will be full time traveling in 2019. Since we will have very little (or no) income can we contribute directly to a Roth account (no conversions of IRA funds) and not pay any taxes since the new standard deductions for MFJ is $24k? We’re expecting a little SE income while overseas, so we’ll have to pay the 15% tax on that and there’s no way to reduce that burden, unfortunately. Thanks.
You must have earned income to contribute to any retirement account.You could do Roth conversions though.
Ok. Is the earned income requirement in kind? For example, do I need $5k in income to contribute $5k into a Roth IRA? In that example could I contribute 100% of the $5k and pay no tax? Or if I made $10k and contributed $5k into a Roth IRA, would that work? Thanks.
Yes.
Yes.
Yes, that would also work.
That’s great to know, thanks! So after 5 years have passed since I contributed to the Roth I can withdraw tax free going in and going out? Is there a special form to fill out for this loophole to work when filing taxes for the year funds are converted to Roth or the year I pull them out tax free?
I’m not sure what you’re saying. What does “withdraw tax free going in” mean?
You do report IRA contributions on your taxes each year as well as Roth conversions.
As in it’s tax free when I contribute and then tax free when I withdraw. Sorry for the confusion. I don’t know if it’s possible to contribute to a Roth during low income years thanks to the new 24k MFJ deduction.
Total financial newbie so I apologize for the basic questions:
1. is the $5500 limit for IRAs (backdoor roth IRA) part of the 55k year 401k limit or is it separate? I can contribute 55k to my 401k and an additional 5.5k to my IRA per year?
2. Can you have multiple roth IRA accounts? For example I have a traditional IRA and roth IRA with Vanguard in order to do a backdoor roth conversion. However, my 401k is with Fidelity. If I am available to make post-tax contributions to my 401k can I convert it into my Vanguard roth IRA or would it be easier to open an roth IRA with Fidelity?
Hey Financially Confused,
No need to apologize, great questions!
1. No, the $5,500 is on its own separate island. You can fill up your 401k bucket at $55k (assuming after-tax is allowed), and then fill up your IRA/Roth IRA bucket for another $5.5k each year.
2. Yes, you can have as many Roth IRAs as you want, but the total contribution between all IRAs/Roth IRAs is $5,500 ($6,500 if age 50+). For example, you open 10 Roth IRAs this year, you could save $550 to each account for a total of $5,500. Your current set-up is fine, when the time comes to rollover your post-tax 401k contributions, you would complete a direct rollover from your Fidelity 401k to your Roth IRA at Vanguard.
1. Separate. Yes.
2. Yes. You could do either, but I’d keep it simple and do any rollovers into your existing Roth IRA. Bear in mind your 401(k) probably won’t let you do that until you leave the employer. Read the plan document to know for sure.