The “Secret” Ultimate Roth Contribution

med school scholarship sponsor

[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

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:

    1. 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
    2. 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.
    3. 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!